States Must Face the Truth about Pensions to Fix Debts

Andrew G. Biggs, Resident Scholar at the American Enterprise Institute, contended that economist are almost universal in believing that the accounting rules governing state and municipal governments’ pension contribution rates understate plans’ true liabilities. “As bad as the current pension funding situation may look, the reality is likely far worse,” he said.  

Biggs noted that current pension accounting practices allow plan to discount benefit liabilities that are guaranteed by law using the expected interest rate on a portfolio of risky assets.  “Economists are nearly unanimous in believing that this approach is both technically wrong and, from a policy perspective, dangerous,” he contended.  

“According to economic theory as well as the practice of financial markets, the discount rate used to value a liability should reflect the relative risk of the liability, not of any assets set aside to fund the liability,” Biggs added.  

In addition, Dr. Robert Novy-Marx, Professor of Finance at the University of Rochester Simon Graduate School of Business, noted that under Government Accounting Standard Board (GASB) rules, a plan’s reported financial status improves when it takes on more investment risk. “This logic is clearly flawed… How you invest your assets has no impact on the current value of your liabilities,” he said.  

Biggs contended that if public sector pensions were required to use economically sound accounting rules, the cost of pension funding would rise from around 12% of employee wages to 46%. Novy-Marx contended that properly accounted for, the unfunded portion of pension promises already made to state and local workers is roughly $3 trillion, or three times as large as that recognized under GASB. “This exceeds all recognized state and local debt combined, and represents a debt owed to state and local government workers of roughly $25,000 for each U.S. household,” he noted.  

Both agreed that the Public Employee Pension Transparency Act reintroduced in the House this year (see Public Pension Transparency Bill Reintroduced in the House) would deflect states from taking a “see no evil” approach to pension financing issues.