Good pension policy requires transparency

In assessing a state’s pension system, there are some basic questions that should be asked, like “how much do we owe to retirees?” or “how much does it cost to provide pension benefits?” or “how much should we expect to have to put into the pension fund next year?” But if you open up a pension system’s Comprehensive Financial Annual Report, the answers to these key questions will be either missing or wrong.

As I discuss in a new report from the Manhattan Institute, “Unmasking Hidden Costs: Best Practices for Public Pension Transparency,” a few simple changes to pension financial statements would make these documents much more useful to lawmakers. These changes include calculating pension liabilities on an honest, market-value basis; using that same market-value basis to determine how much a typical public employee earns each year in future retirement benefits; and projecting pension funds’ financial needs several years into the future based on a variety of stock market scenarios.

A bill currently before Congress, the Public Employee Pension Transparency Act, would strongly incentivize state government pension plans to make some of these disclosures. As sponsor Devin Nunes said at a press conference Wednesday, "Government at all levels needs to take its collective head out of the sand," and this bill would help them do that. But whether or not Congress acts, states can and should adopt better transparency practices on their own.

The most widely discussed problem with pensions’ financial disclosures relates to how they calculate their liabilities. The liability side of a pension fund’s balance sheet consists of a stream of payments owed, from benefits due this month to current retirees to checks that will be sent decades from now to young workers recently hired. Payments not due until far in the future are “discounted” to a present cost by using an interest rate. In other words, since governments don’t have to pay these benefits for years, we can anticipate some investment return every year until we have to pay them, allowing us to put in less money upfront.

Discounting is itself an appropriate practice, also used by pension funds in the private sector. The trouble is that government pension funds are permitted to use an excessively high interest rate when discounting, typically around 8 percent. This represents the investment returns they expect to achieve on average. The problem is, most pension funds invest heavily in equities, meaning that returns are highly variable: in some years returns will far exceed 8 percent, while in other years they will be negative. However, none of that risk can be passed on to the pension beneficiaries, who are guaranteed a fixed payment.

Private-sector plans must use a much lower discount rate, currently close to 5 percent, even if they too put most of their money in equities with higher expected returns. This discount rate is keyed to a theoretical, bond-like investment that would produce enough returns to pay retirees with a high degree of certainty, instead of being subject to the vagaries of the stock market. This is called a “market value” discount rate, and public pensions should also adopt it, as it reflects the fact that the plan sponsor—the taxpaying public, in the case of government pensions—provides valuable insurance to retirees, agreeing to top up pension funds when returns fall short in recessions.

Using a market-value discount rate isn’t a small adjustment—accepting plans’ discount rates at face value leads to the estimate that unfunded pension liabilities nationally total about $500 billion. Applying a market value discount rate leads to the much higher (and more accurate) estimates around $3 trillion that have recently attracted much press attention. Because state and local bond debt totaled $2.4 trillion as of 2008, correcting the discount rate leads to nearly a 100 percent increase in the estimated debt load of state and local governments. Plans should end this confusion by uniformly reporting their unfunded liabilities on a market-value basis.

Of course knowing the true size of unfunded pension liabilities does not necessarily make clear what policy course a government should take—you also need to know how long you will have to pay off the liability. This is why pension funds should make another disclosure that makes clear the medium-term cost of pension policy: projections of future required contributions. As that unfunded liability swells, so does the amount that taxpayers must pay into pension funds each year to keep them from going broke.

Today, lawmakers typically know only what they have paid in the past. They don’t know what they are likely to have to pay into pension funds in future years—even though pension plan administrators could predict the future with reasonable accuracy. Particularly, because pension systems usually recognize unusual stock market gains and losses over a period of five years, most state and local governments will continue see their required pension contributions rise until each year through 2014 or 2015, even if the stock market performs very strongly between now and then. You don’t need a crystal ball to see that coming, you just need to open up the inner workings of pension funds’ financials.

As an example, school districts in New York State can expect to pay five times as much in 2015 as they did in 2010 to shore up that state’s teacher pension fund. But the pension fund has not announced that expected growth—the estimate comes only from a Manhattan Institute study. In Utah, it took a state senator’s request for future year projections of required pension payments to expose a coming cost explosion and galvanize support for one of the best pension reforms enacted last year.

Neither of these disclosures—market value liabilities and expected future year payments—would be difficult for pension funds to make. But today, in most states, they aren’t made, and that forces lawmakers to decide pension policy in the dark. Pension disclosures along the lines I recommend, or as required by the Public Employee Pension Transparency Act, would pave the way for state lawmakers to make better decisions about retirement benefits.

Josh Barro is the Walter B. Wriston Fellow at the Manhattan Institute and author of the new report, "Unmasking the Hidden Liabilities: Best Practices for Public Pension Transparency."