It would be tempting to write that the Governmental Accounting Standards Board (GASB) is poised to blow a $3 trillion hole in the budgets of state and local governments. But in fact, if you want to be precise, GASB is getting ready to blow the lid off of the $3 trillion hole that is already there.
The problem is this: State and local governments have, for the most part, woefully underfunded their employee-pension systems. As a result, they have massive unfunded liabilities for future pension payments — liabilities that total as high as $3 trillion, by some estimates. They can’t forgo writing those pension checks, they don’t have money set aside to cover those pension checks, and they are promising ever more generous pension checks in the future.
Once earned, a government has a present obligation to pay the benefits in the future — a total pension liability. Most governments try to meet this obligation by making annual contributions to a pension plan to accumulate resources in an irrevocable trust for the purpose of making future payments when they are due. To the extent that the total pension liability is greater than the value of the net assets available in the plan for paying benefits, a government has a net pension liability, and would report that amount as a liability in its accrual-based financial statements (for example, the government-wide Statement of Net Position).
At present, the difference between a government’s total pension obligation and assets available for benefits — often called the unfunded liability — is disclosed in notes, but does not appear on the face of the financial statements. Consequently, some analysts are uncertain whether to incorporate the unfunded liability into financial ratios that include debt and other long-term liabilities. Some analysts include it, some do not. Recognition in the financial statements, alongside other liabilities such as outstanding bonds, claims and judgments, and long-term leases, will clearly put the pension liability on an equal footing with other long-term obligations.
Those unfunded liabilities are now going on the books officially, and entities that have an incentive to pretend that these liabilities aren’t real liabilities — a group that includes everybody from governments themselves to bond underwriters to big institutional investors — are going to have to move a little bit closer to reality. (Not all the way there — more on that in a bit — but a little bit closer.)
If unfunded pension liabilities must be considered “on an equal footing” with other obligations, then the credit position of a great many state and local governments will be degraded. If (a) your income is $50,000, (b) your savings are $100,000 (call it $50,000 in the bank and $50,000 in home equity), and (c) your debt is $100,000 (say $75,000 on the mortgage, $20,000 on the car, and $5,000 on the credit cards), then you’re not in irreparable financial shape. But if (a) your income is $50,000, (b) your savings are $100,000, and (c) your debt is $1 million, you’re bankrupt. A lot of local governments will have to seriously revise Column C if GASB changes the rules. And it is likely that doing so will reveal some of them as either insolvent or on the way toward insolvency.
The effect of that revision will vary greatly from state to state. That’s because some states are more honest about their obligations and more prudent about providing for them, and some are less so. As the Wall Street Journal reports, “market valuation” is the most accurate way to account for liabilities — which means it’s the last thing governments want to use. The state of Montana was shopping for a new actuary a few years ago and explicitly stated that anybody pushing market valuation would be disqualified:
Here’s a dilemma: You manage a public employee pension plan and your actuary tells you it is significantly underfunded. You don’t want to raise contributions. Cutting benefits is out of the question. To be honest, you’d really rather not even admit there’s a problem, lest taxpayers get upset.
What to do? For the administrators of two Montana pension plans, the answer is obvious: Get a new actuary. Or at least that’s the essence of the managers’ recent solicitations for actuarial services, which warn that actuaries who favor reporting the full market value of pension liabilities probably shouldn’t bother applying.
. . . The Montana Public Employees’ Retirement Board and the Montana Teachers’ Retirement System declare in a recent solicitation for actuarial services that “If the Primary Actuary or the Actuarial Firm supports [market valuation] for public pension plans, their proposal may be disqualified from further consideration.”
Scott Miller, legal counsel of the Montana Public Employees Board, was more straightforward: “The point is we aren’t interested in bringing in an actuary to pressure the board to adopt market value of liabilities theory.”
CalPERS, the gargantuan California public-sector pension system, managed to avoid making adequate pension contributions for years by convincing the state legislature (which was only too willing to be convinced) that the Dow would hit 25,000 in 2009. (It didn’t. And it also may not hit 28,000,000 by 2099, as CalPERS predicted.) The legislature used those numbers to justify an enormous increase in pension benefits for California’s public-sector parasites, at a theoretical cost of $0.00: “No increase over current employer contributions is needed for these benefit improvements,” the fairy tale went. Those who want a stronger government whip hand over the investment industry should consider how governments act when they are investors.
Treating future obligations like future obligations is one step toward rationalizing public-sector pensions, but it will have painful consequences: If state and local governments don’t want to see their balance sheets go into the toilet permanently, they are going to have to start making bigger contributions very quickly. Pension-funding costs already are a significant and growing share of state and local spending. That means that taxpayers right now are going to have to bear higher taxes or reduced services (or both) in exchange for precisely nothing.
There are other problems with the way these liabilities are calculated. As our friends at George Mason University’s Mercatus Center point out, pension benefits are guaranteed, usually by statute and sometimes by constitutional provisions. States and cities can’t just decide not to write those pension checks. A guaranteed (risk-free) future benefit normally would require that the assets be invested in risk-free investments, such as Treasury bonds. But those investments, being theoretically risk-free, are relatively low-paying propositions. So, instead, state and local governments invest in stocks and bonds, often with ridiculous assumptions about future returns, as in the case of CalPERS, and use those rates of return to account for their projected liability. This means that risk is not properly accounted for.
Businesses with incentives to understand these trends already are acting on them. Many firms have identified California’s unstable and deteriorating fiscal position as a reason for relocating to other states. Caterpillar cited Illinois’s fiscal condition as a reason for choosing to relocate a new facility elsewhere. Just at the moment when these states need to defend and expand their tax bases, they are driving them away.
But a fair number of financial actors have reason to pretend that they do not understand these trends. Cities and states want to be able to keep borrowing money at cheap rates and to proclaim that everything is hunky-dory in the long term. Investment banks that help governments issue bonds, and institutional investors that buy them, have incentives to overstate the fiscal strength of states and cities, because it is a lot easier to move high-grade municipal bonds than low-grade ones. Some cities already have been downgraded to junk status. (The case of Montebello, Calif., is a particularly instructive illustration of the kind of fiscal shenanigans that go on at the local level. Among other things, HUD accused the city of giving low-income-housing funds to a fellow who owned four properties in Hawaii. Keep in mind, the next time somebody whines about balancing the budget on the backs of the poor, that some of those backs are remarkably tan and relaxing in the tropics.)
We used to joke that if a private business ran its operations as irresponsibly as the government does, the boss would go to jail. Alas, we now know that that is not true. But that does not change the fact that what is going on here is a combination of gross negligence, semi-criminal misuse of funds, and legalized looting. The change in the accounting rules may help us understand the scale of the crime, but it will take more than that to bring the miscreants to justice.
— Kevin D. Williamson is a roving correspondent at National Review.