Games States Play with Underfunded Pensions

Public pension funds across the country are severely underfunded, threatening the retirement security of government workers and the wallets of taxpayers.

State Budget Solutions, a non-partisan fiscal watchdog, says the underfunding is more than $4 trillion.

Moreover, states and local governments are playing lots of monkey shines with their bookkeeping for pension debt, which doesn't appear on state balance sheets, says Bob Williams, who heads State Budget Solutions.

Williams, a former Washington state legislator, gubernatorial candidate and auditor with the Government Accountability Office, also notes that states use special accounting rules for themselves that are nothing like what the private sector uses, which mask and understate the problem.

He says the states can then use these rules to boast that they have balanced budgets, even though tens of billions of dollars in unfunded pension liabilities are flooding their state houses.

“State governments have repeatedly not fully funded the actuarial-required contributions to pensions,” says Williams. “State requirements for a balanced budget do not apply to pensions.”

He adds: “Rather than raising taxes, cutting programs, or not giving salary increases to state employees, the governors and legislators do not fully fund the actuarially determined annual required contribution (ARC) to pensions. Thus legislators can underfund pensions, spend that borrowed money and not be held accountable for their actions.”

All of these moves are putting pressure on local budgets. In Miami, an estimated one quarter of the city’s operating budget goes towards pensions. The state of Illinois puts aside 12% of its budget for its underfunded pension. But for years, state and local pension have kicked the can way down the road via all sorts of accounting shenanigans, says Williams.

For one, states can assume a high rate of return, based on “expected” asset returns, rather than what happens in reality. The name of the game is that the stock market will take care of the returns for us, a “keep irrational hope alive” thinking that ensures pension underfunding and pushes the burden onto taxpayers. Taxpayers have to make up that difference in returns.

Disastrous results have followed when municipal bankruptcy occurs.

Take Stockton, California -- now insolvent.  The problem is pension benefits can’t be cut during bankruptcy because if Stockton did so it would trigger a takeover of pension obligations by the California Public Employees' Retirement System (Calpers). In turn, the sums owed could get repriced at a 3.8% discount rate, instead of the 7.5% discount rate Calpers typically uses. Under state law, Stockton could be required to pay Calpers a big fat lump sum to cover unfunded liabilities.

The credit rating agencies are taking a tougher line in valuing pension liabilities in their credit analyses of states and local governments. For example, Fitch Ratings will now assume a return on assets of 7%, lower than the average return of 8% used by most pension plans.  That translates to an increase in the average plan liability of 11%. In turn, plans in Montana, Hawaii, Vermont and New Jersey are among those whose funding ratios may fall under 60%, based on Fitch’s assumptions. But new government accounting guidelines to take effect over the next two years still won’t stop this problem.

“A pension system can reduce its measured liabilities by nearly one-third by shifting from a portfolio with an expected return of 6% to one with an expected return of 8.5%,” says Williams. “So a plan that was 70% funded under a low-risk portfolio suddenly becomes 100% funded under a higher-risk portfolio. These inflated returns hide billions of dollars in unfunded pension liabilities and expose taxpayer dollars to greater risk.”

Williams notes that state legislators are misusing pension obligations on purpose to fund other projects. He found a number of states that “’game” the system and divert funds that should be going to pensions to fund other projects,” including Illinois, California and New York.

“The size of the diversions of funds that should have gone into pensions amazed me,” Williams says, adding, “I don’t think the average California legislator realizes they appropriated $17.9 billion less than the required contributions to pensions over the past ten years,” due to these moves.

Williams says the way it works is, “legislators fund other projects; then when they don’t have enough revenue to balance their budgets, they start using gimmicks like not fully funding the annual actuarial-required contribution to pensions.”

The trouble for watchdogs and taxpayers is, not all of these moves are transparent.  State officials are “very sophisticated in how they hide their budget gimmicks in their attempt to make it appear that the budgets are balanced,” Williams says. “You simply cannot track specific dollars raided from pensions to specific funding of programs.”

Here are some examples of what is happening at the state level that Williams and his team found, based on state disclosures and research from state-based think tanks including State Policy Networks. In all of these cases, taxpayers need to make up any increase in pension benefits or pension spiking that was never factored into the original pension calculations, Williams says:

California In the past ten years, California officials have appropriated $17.9 billion less than the required contribution to pensions. That means California taxpayers have to make up the $17.9 billion that wasn't invested into pensions, plus the lost assumed rate of return as well as losses on whatever contributions were made. The assumed rate of return over the last ten years was 7.75% for Calpers, but the actual rate of return was only 5.4%.

Illinois This state has been the most egregious, according to Williams. He says that in the past ten years, Illinois appropriated $5.4 billion less than the official annual required contribution to pensions. This was after it issued $10 billion in pension obligation bonds in June 2003 to cut its pension unfunded liabilities. The state issued the bonds in order to pay off unfunded liabilities in the pension system, but then it appears to have instead spent the money on current budget expenditures.  All this means Illinois taxpayers potentially may have to make up the $5.4 billion that wasn't invested into pensions, the lost assumed rate of return on the $5.4 billion, plus principal and interest on the $10 billion in pension obligation bonds. The Illinois legislature also passed a pension holiday in 2006 and 2007, purposely underfunding the pensions by $2.3 billion. “Yes it was legal, but in today's world, amazing that they got away with it and that they could call it a ‘holiday,’’ Williams notes.

Maryland In the past ten years, Maryland officials appropriated $1.7 billion less than the annual required contribution to pensions. That means Maryland taxpayers have to make up the $1.7 billion that wasn't invested into pensions, plus the lost assumed rate of return on the $1.7 billion. In addition, over the last ten years the assumed rate of return was 7.75%, but the actual rate of return was only 4.74%. Taxpayers not only need to make up the difference between the assumed rate of return and the actual rate of return, but also insufficient contributions based on the false rate of return assumption.

Massachusetts In the past ten years, Massachusetts appropriated $1.8 billion less than the annual required contribution to pensions. That means taxpayers in Massachusetts have to make up the $1.8 billion that wasn't invested into pensions plus the lost assumed rate of return. In addition, over the last ten years the assumed rate of return was 8.25% but the actual rate of return was only 6.53%. Taxpayers not only need to make up the difference between the assumed rate of return and the actual rate of return, but also insufficient contributions based on the false rate of return assumption.

Michigan In the past ten years Michigan appropriated $1.9 billion less than the annual required contribution to pensions. That means Michigan taxpayers have to make up the $1.9 billion that was not invested into pensions plus the lost assumed rate of return. In addition, over the last ten years the assumed rate of return was between 4-8% for the various Michigan pension funds, but the actual rate of return was only 5.6%. Taxpayers not only need to make up the difference between the assumed rate of return and the actual rate of return, but also insufficient contributions based on the false rate of return assumption.

New Jersey In the past ten years, New Jersey officials appropriated $9.8 billion less than the annual required contribution to pensions. That means New Jersey taxpayers have to make up the $9.8 billion that wasn't invested into pensions plus the lost assumed rate of return. In addition, over the last ten years the assumed rate of return was 8.25% but the actual rate of return was only 5.2%.

New York Uses a pension funding gimmick, a law that lets the state and localities "amortize" its pension obligations over an additional 10 years, with a payback at interest much lower than the pension fund's 7.5% targeted rate of return. But it is not possible to link the savings from this to any particular project.

Pennsylvania In the past ten years, Pennsylvania officials appropriated $10.7 billion less than the annual required contribution to pensions. That means Pennsylvania taxpayers have to make up the $10.7 billion that wasn't invested into pensions plus the lost assumed rate of return.

Texas In the past ten years, Texas officials appropriated $3.1 billion less than the annual required contribution to pensions. That means Texas taxpayers have to make up the $3.1 billion that wasn't invested into pensions plus the lost assumed rate of return. In addition, over the last ten years the assumed rate of return was 8% for the Investment Pool but the actual rate of return was only 6.34%.

Virginia In the past ten years, Virginia appropriated $2.8 billion less than the annual required contribution to pensions. That means Virginia taxpayers have to make up the $2.8 billion that wasn't invested into pensions plus the lost assumed rate of return on the $2.8 billion. However, legislative leaders “gamed” the system by using “statutory required contribution” and showing that the legislature funded 100% of the statutory required contribution. Few legislators are informed of the difference between the annual required contribution and the statutory required contribution. In addition, last year the state “contribution” was in the form of an IOU paying 7% interest. And, over the past five years the assumed rate of return has varied from 7% as of fiscal year 2010; down from the 7.5% rate from fiscal year 2005-2010 and 8% from fiscal years 1988-2005. Meanwhile the actual rate of return was 4.3%. Again, taxpayers have to make up that difference in return.