[Infowarrior] - Public Pensions Cook the Books

[Richard Forno]

Public Pensions Cook the Books

Some plans want to hide the truth from taxpayers.

By ANDREW G. BIGGS
http://online.wsj.com/article/SB124683573382697889.html

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.

Public employee pension plans are plagued by overgenerous benefits,  
chronic underfunding, and now trillion dollar stock-market losses.  
Based on their preferred accounting methods -- which discount future  
liabilities based on high but uncertain returns projected for  
investments -- these plans are underfunded nationally by around $310  
billion.

The numbers are worse using market valuation methods (the methods  
private-sector plans must use), which discount benefit liabilities at  
lower interest rates to reflect the chance that the expected returns  
won't be realized. Using that method, University of Chicago economists  
Robert Novy-Marx and Joshua Rauh calculate that, even prior to the  
market collapse, public pensions were actually short by nearly $2  
trillion. That's nearly $87,000 per plan participant. With employee  
benefits guaranteed by law and sometimes even by state constitutions,  
it's likely these gargantuan shortfalls will have to be borne by  
unsuspecting taxpayers.

Some public pension administrators have a strategy, though: Keep  
taxpayers unsuspecting. 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."

While corporate pension funds are required by law to use low, risk- 
adjusted discount rates to calculate the market value of their  
liabilities, public employee pensions are not. However, financial  
economists are united in believing that market-based techniques for  
valuing private sector investments should also be applied to public  
pensions.

Because the power of compound interest is so strong, discounting  
future benefit costs using a pension plan's high expected return  
rather than a low riskless return can significantly reduce the plan's  
measured funding shortfall. But it does so only by ignoring risk. The  
expected return implies only the "expectation" -- meaning, at least a  
50% chance, not a guarantee -- that the plan's assets will be  
sufficient to meet its liabilities. But when future benefits are  
considered to be riskless by plan participants and have been ruled to  
be so by state courts, a 51% chance that the returns will actually be  
there when they are needed hardly constitutes full funding.

Public pension administrators argue that government plans  
fundamentally differ from private sector pensions, since the  
government cannot go out of business. Even so, the only true advantage  
public pensions have over private plans is the ability to raise taxes.  
But as the Congressional Budget Office has pointed out in 2004, "The  
government does not have a capacity to bear risk on its own" --  
rather, government merely redistributes risk between taxpayers and  
beneficiaries, present and future.

Market valuation makes the costs of these potential tax increases  
explicit, while the public pension administrators' approach, which  
obscures the possibility that the investment returns won't achieve  
their goals, leaves taxpayers in the dark.

For these reasons, the Public Interest Committee of the American  
Academy of Actuaries recently stated, "it is in the public interest  
for retirement plans to disclose consistent measures of the economic  
value of plan assets and liabilities in order to provide the benefits  
promised by plan sponsors."

Nevertheless, the National Association of State Retirement  
Administrators, an umbrella group representing government employee  
pension funds, effectively wants other public plans to take the same  
low road that the two Montana plans want to take. It argues against  
reporting the market valuation of pension shortfalls. But the  
association's objections seem less against market valuation itself  
than against the fact that higher reported underfunding "could  
encourage public sector plan sponsors to abandon their traditional  
pension plans in lieu of defined contribution plans."

The Government Accounting Standards Board, which sets guidelines for  
public pension reporting, does not currently call for reporting the  
market value of public pension liabilities. The board announced last  
year a review of its position regarding market valuation but says the  
review may not be completed until 2013.

This is too long for state taxpayers to wait to find out how many  
trillions they owe.

Mr. Biggs is a resident scholar at the American Enterprise Institute.