On Pension Reform in the States

by Veronique de Rugy

I haven’t written about pension reform in a while. As you may know, Rhode Island recently approved legislation that attempts to address the state’s large unfunded pension liability. Officially, some 41 percent of the pension promises made to state employees are unfunded, and in August the city of Central Falls filed for Chapter 9 bankruptcy protection, citing an $80 million unfunded pension liability. Here is a short description of the reform:

The bill creates a hybrid plan that merges conventional public defined-benefit pension plans with 401(k)-style plans. While some other states have implemented hybrid plans, Rhode Island’s would be the first to affect current employees, according to the Pew Center on the States.

It also includes a suspension of cost-of-living adjustment increases for retirees and raises the retirement age for employees not yet eligible for retirement.

We can hope that Rhode Island’s reforms will trigger a trend and that more states will go forward with pension reform. However, a warning is necessary. It is likely that the steps taken by the state — while a step in the right directions — aren’t enough. That’s because the public pension problem may be twice as bad as the officials trying to address say it is.

While measuring its unfunded liability, Rhode Island used a discount rate that makes it look much smaller than it really is. As a result, the measures adopted may be too tame. According to a recent paper on the Rhode Island pension system, my Mercatus Center colleagues Eileen Norcross and Benjamin J. VanMetre find that the unfunded pension liability is almost twice the state’s estimated number ($18.8 billion vs. $9.3 billion). To measure the real liability, they use a smaller discount rate than state officials usually use, one that many financial analysts believe properly reflects the costs of delivering promised benefits to public employees. They explain:

According to government estimates, the unfunded liability for municipal plans and state plans totals $9.3 billion. These figures are calculated under assumed discount rates based on the expected return on pension asset investments. However, according to economic theory, pension liabilities should be valued based on their relative risk and thus the return on Treasury Bonds is currently the appropriate discount rate to use when valuing liabilities. Under this valuation, the unfunded liability for municipal governments including MERS and locally administered plans (and excluding the local portion of the teachers’ plan) swells from $2.4 billion to $6 billion. The unfunded liability for the state plans increases from $6.8 billion to $12 billion.

The result of this miscalculation is that many municipal governments are in far worse shape than is currently reported, which presents serious revenue challenges for a number of Rhode Island municipalities.

The whole paper is here.