We know that state pension plans are in crisis. But it is much worse than the states acknowledge. My colleague at the Mercatus Center at George Mason University Eileen Norcross argues in her December 2010 paper “Getting an Accurate Picture of State Pensions” that the differences between government accounting rules and private-sector ones lies at the core of the unfunded-liability problems of most of the states.
The accounting standard used by private pension plans is the market value of the liabilities (MVL). The MVL requires that future liabilities be discounted at an interest rate that matches their risks and represents the amount a private insurance company would demand to issue annuities to cover all the benefits owed by a plan. This means that if you know you will have a binding commitment to pay workers in the future, you should invest as much as possible up front and rely on more conservative investments to minimize the risk.
By contrast, that states’ current pension reporting calculates the value of pension liabilities based on what the assets are expected to return when invested. This is the equivalent of going to Vegas, putting $5 on red at 5-to-1 odds, and committing your winnings to paying for your future $25 lobster dinner. If you hit on red, you have nothing to worry about. But if the ball stops on black, you’re left without your $5 and a $25 bill on its way.
Couple this standard with the fact that, on average, states have used an unrealistically high 8 percent expected annual return on pension investments, and you don’t get lobster for dinner; you get a dramatic shortfall in state plans, because, as Norcross explains, not only did state officials not set aside sufficient money to fund future benefits, they also assumed that the riskier the investment, the better funded the plan would be.
This week’s chart illustrates that point. While official reports claim that in 2008 state pensions were underfunded by $452 billion, with total liabilities of $2.8 trillion, these numbers change dramatically when private-sector accounting methods are applied. Needless to say, state pensions are likely the next ticking time bomb.