How States Underfund Public Pensions
Politicians evade balanced budget requirements and debt limits by underfunding public pensions, covertly passing the financial burden onto future taxpayers.
Balanced budget requirements, which exist in 49 of 50 states, give many citizens the false impression that their elected officials are protecting the integrity of state finances. The truth is that, despite these requirements, the states' have combined debt totals over $4 trillion. One reason that states face such enormous debt is that requirements for a balanced budget do not apply to public pensions. Legislators repeatedly underfund pensions, spend that borrowed money that would otherwise go towards pension funds, and avoid accountability for their fiscal manipulation.
Lawmakers play several different games with pension funds, but they are very consistent in how they underfund pensions. During economic downturns, when the demand for services increases and the money to provide them falls short, legislators put less money into the pension system than the actuarially determined Annual Required Contribution (ARC) calls for. In some cases, states legislate around meeting their ARC. Virginia, for example, created a "statutory required contribution" that is less than the ARC but allows financial documents to show 100 percent yearly funding. Some legislators, as a result of the often secretive and hierarchical nature of the budget process, are unaware that their state is not meeting this basic requirement.
By underfunding pensions, politicians can promise higher spending and government benefits without tax increases. In addition to eliminating the need for additional revenue, underfunding helps garner increased public employee and voter support. If elected officials reduced pension benefits or raised taxes to truly balance the budget, they would likely face stronger opposition at the polls. The practice transfers the current cost of government to future taxpayers who receive no benefits but all of the burden.
Lawmakers funding 100% of the ARC does not always guarantee adequate pension funding, however. Under current government pension accounting rules, unfunded liabilities can grow even when lawmakers do satisfy the ARC because Governmental Accounting Standards Board (GASB) rules allow state and local governments to rely on unrealistic return rate assumptions. These inaccurate assumptions, typically as high as 7-8 percent, are used to calculate each year's ARC. Over the past 10 years, few funds have come even close to meeting this target. Illinois' Teachers Retirement System, for example, bases calculations on an expected 8.5 percent return. In fiscal year 2012, real returns were 0.76 percent. Pension managers rely on these expected returns rather than calculating the likelihood that a pension system can pay a future liability based on actual returns.
Even under new GASB guidelines set to take effect over the next two years, a pension system can still manipulate its measured liability by shifting from a portfolio with an expected return of 6 percent to one with an expected return of 8.5 percent. A plan that was 70 percent funded under a low-risk portfolio suddenly becomes 100 percent funded under a higher-risk portfolio. These inflated returns hide billions of dollars in unfunded pension liabilities.
Responsible accounting rules in line with Generally Accepted Accounting Principles (GAAP, or market valuation rules) reveal the cost of financial manipulation under GASB standards. A report by State Budget Solutions found total state and local unfunded liabilities to be nearly $4.6 trillion, more than five times the official estimate.
States underfund public pensions largely by failing to pay their ARC and by assuming investment returns far out of touch with reality. Ultimately, taxpayers must make up these differences, along with any bonds issued to fund pension payments, and increased benefits or pension spiking not factored into original calculations. The following charts show real versus required contributions based on state financial reports from fiscal year 2011, along with funds' ten-year investment returns compared to actuarial assumptions.
These unfunded pension costs are enormous and no governments can afford them. If the costs of public sector defined benefit pensions were transparent, and the accounting maneuvers relied upon by legislators were revealed and eliminated, people would demand change.
The charts below were updated on December 19, 2012 to include additional states.
Note: Kentucky information includes fiscal years 2003-2012.
Note: Minnesota information includes fiscal years 2003-2012.
Note: New Jersey information includes fiscal years 2003-2012.
Note: South Carolina information includes fiscal years 2003-2012.
ARC refers to annual required contribution.
ROI refers to return on investment.