The Ticking Time Bomb in State Pensions

President Bush recently signed into law the Pension Protective Act of 2006 in an effort to strengthen the financial health of corporate defined benefit pension plans.
However, little attention is paid to a retirement sector in even greater financial straits: state government pension plans. These plans are facing a $1.3 trillion shortfall that presents a serious threat to their very survival — as well as to every taxpayer in the country.

State pension programs — which cover 12.8 million Americans and manage assets worth $2.3 trillion — are a pillar of the nation’s retirement system. By comparison, corporate defined benefit pension plans cover 44.1 million participants but possess fewer assets — about $1.7 trillion.

At first glance, state plans seem to be nearly as healthy as their corporate counterparts: they face a shortfall of $348 billion under current accounting rules, according to the National Assoc. of State Retirement Administrators. This implies they are 86% funded, versus 90% for corporate plans.

However, these projections are misleading. The real shortfall of state-defined benefit pension programs is closer to $1.3 trillion, which translates into the plans being 64% funded. This alarming gap could set off a crisis whose magnitude would dwarf the $200 billion government bailout of the savings and loan industry in the 1980s. Just as disturbing, this threat is largely ignored because of opaque accounting.

Opaque accounting dramatically distorts the liability side of the pension ledger. The key question is whether pension plan liabilities are being properly measured. The liabilities of defined benefit pension plans are measured by using a discount — or interest — rate.

Unlike corporate plans, which must use high-quality corporate bond rates as their discount rate, state pension plans are allowed to use the much higher expected return on the assets they manage, artificially shrinking their liabilities.

This practice perniciously disguises the actual health of state-funded pension programs. As with corporate plans, state plans should be discounted using long-term corporate bond rates instead of the expected rate of return on assets, which is the current practice of most state governments.

Consider how distorting this practice is. Specifically, the average expected return on assets across state pension plans today is about 7.89%, according to the NASRA. Based on this return, their liabilities are estimated at $2.5 trillion. If, however, the plans use as their discount rate the more credible 10-year Treasury rate, at about 4.9%, their liabilities would weigh in at $3.5 trillion — a whopping 42% increase.

Startling as this finding is, it simply stems from applying to state-defined benefit pension plans the same accounting principles that corporate plans must live by.

States must be honest about their pension liabilities and the true value of plan underfunding. They must then take assertive steps to close the gap through a combination of benefit reductions, tax increases, and tapping other sources of non-recurring revenues. Issuing bonds to fund pension liabilities, for example, doesn’t solve the problem, but it makes it more visible by moving the obligation onto the state’s balance sheet, thus encouraging more responsible management.

Longer term, states will probably follow in the footsteps of the corporate sector and both freeze their defined benefit plans and shift employees to defined contribution plans.

While not as economically advantageous in the long term, the latter are often more popular among workers and are more transparent. Under defined contribution programs, politicians would not have the luxury of granting employees generous pension allowances that state plans are ill-equipped to afford, or to consistently defer contributions.

And that would be a relief to taxpayers, once they become aware of the $1 trillion pension bombshell headed their way.-

Thomas J. Healey is a retired partner of Goldman Sachs & Co., and currently a senior fellow at Harvard University’s Kennedy School of Government. He served as assistant secretary of the Treasury under President Reagan.