The recent enactment of sweeping changes in federal laws governing private pension plans, the issuance of a scathing auditors' report on the collapse of San Diego's pension fund, and the disclosure of potential shortfalls in New York City's pension funds all point to what should be the nation's next big target for financial reform. Because their size and complexity offer such a wide field for abuse, state and local retirement systems pose a significant moral hazardÃ¯Â¿Â½threatening the long-term fiscal stability of many of their sponsors.
San Diego's storylineÃ¯Â¿Â½marked by deliberate underfunding, increases in already generous retirement benefits and the use of debt to refinance paymentsÃ¯Â¿Â½has had eerie parallels across the country. Only 43 of the 125 retirement systems in the most recent Public Funds Survey were within 10% of full funding status; one-quarter had actuarial funding ratios below 80%. But if private-sector accounting standards were applied to these systems, they would all look much worse.
In determining a system's necessary funding levels, a crucial consideration is the discount rate applied to future obligations: The lower the rate, the larger the contributions required to maintain "fully funded" status. Private plans are required to discount their liabilities based on corporate bond ratesÃ¯Â¿Â½which are usually lower than these plans' projected returns on investments.
Public funds, however, are allowed to discount their long-term liabilities based on the assumed annual rate of return on their assetsÃ¯Â¿Â½which, for most public funds, is pegged at an optimistic 8% or more. In other words, the risk premium in the investment target is compounded in the liability estimate. (This accounting twist also explains how politicians can claim, with straight faces, that pension obligation bonds are a nifty arbitrage play.)
If the liabilities of public pension funds were valued on the same basis as private fundsÃ¯Â¿Â½using, for example, the 30-year municipal bond rate as the discount rateÃ¯Â¿Â½funding requirements would be dramatically higher. Estimates of the nation's real public pension funding shortfall range from an added $500 billion for state retirement systems to at least $1 trillion for all public systems.
The 8% rate of return assumption, while shared by some major corporate plans, is certainly open to question. But public pension fund managers are in a pickle: If assumed returns were reduced, even "fully funded" systems like New York's would find themselves tens of billions in the holeÃ¯Â¿Â½as shown by alternative calculations buried in financial reports for Gotham's retirement systems. And so, in the name of protecting taxpayers from having to pay higher contributions in the short term, funds expose them to more volatility and risk over the long term.
Public pension funds used to be run on more of an insurance model, heavily reliant on fixed-income securities. But over the past 40 years, the vast expansion of government at every level has vastly expanded the pool of public pension liabilities. This leads to a vicious cycle: As the employee head count rises and unions lobby for bigger pension entitlements, funds feel pressure to pursue riskier investments with higher returnsÃ¯Â¿Â½which explains their increasing reliance on stocks, as shown in the nearby chart. But when returns exceed expectations, as in the boom market of the 1990s, politicians and fund trustees feel irresistible pressure to raise benefits again.
Meanwhile, their increased presence in the equity markets has turned public pension funds and their managers, like California treasurer and gubernatorial candidate Phil Angelides, into major players on Wall Street. And as my colleague Nicole Gelinas has documented, in the wake of corporate accounting scandals, public fund managers have pushed further into corporate boardrooms.
In reforming private sector pensions, Congress and President Bush were motivated largely by a desire to provide greater financial security for current and future retirees threatened by corporate bankruptcies. The public sector is different: Governments can't go out of business, and their retired employees are in no danger of being left high and dry. Guaranteed under state laws and constitutional provisionsÃ¯Â¿Â½that is, by the taxpayersÃ¯Â¿Â½public pensions are far more secure and more generous than those offered by private-sector plans.
The overriding concern of public pension reform should be to reduce the taxpayers' exposure to accounting and financial riskÃ¯Â¿Â½now and in the future. Here are four essential steps towards that goal:
* Shift to defined contribution plans for all future workers. In short, stop the bleeding. Because traditional defined-benefit plans rely on contributions from younger employees to finance the benefits of long-term workers, this shift is in no way a quick fix for under-funded systems. But the alternativeÃ¯Â¿Â½maintaining defined benefit plans, but with lower benefits for the newly hiredÃ¯Â¿Â½is worse. As long as an open DB plan exists, it will be a target for political and financial manipulation.
* Immediately recognize and fund the full cost of any benefit increase. The ability to amortize benefit increases over decades is one reason why politicians and unions have been able to sell pension sweeteners as a free lunch. Closing this window would be a disincentive for future giveaways.
* Expand financial reports to include alternative funding assumptions. Simply requiring public funds to adhere to the same financial standards as private funds sounds tempting but it would be extremely disruptive, sharply increasing volatility and boosting contribution requirements. Following the lead of New York City's actuary, government financial reports should clearly show how funds would balance if assets were marked to market and if liabilities were discounted at market rates.
* Gradually lower the required rate of returnÃ¯Â¿Â½and invest accordingly. Over the long term, this is an essential step for reducing the taxpayers' collective risk. It also would reveal the true economic costs of current benefits.
Fraught with financial complexity, the growing public sector pension burden fundamentally poses a test of political wills. Although benefits for their current members are legally untouchable, union leaders derive substantial power from the existing system and will battle any attempt to change itÃ¯Â¿Â½as they did in beating back Arnold Schwarzenegger's attempt last year to establish a 401(k) plan in California. Today, improved accounting practices can at least force elected officials to face up to the price tag of their rash promises. In the future, they must turn from union lapdogs to taxpayer watchdogs.