Bad Pension Math Is Bad News for Taxpayers

Much of the blame for the government pension crisis in America has been aimed at overly optimistic projections of investment returns, which have allowed politicians to promise government workers attractive benefits at what seems like a low cost to taxpayers. When pension funds have missed these investment marks, as they did spectacularly in 2008, pension debt has soared and taxpayers have been stuck making up the difference.

Now a new study by Moody's finds that state and local retirement debt has grown sharply even during periods when pension funds have largely hit their investment goals, thanks to the questionable accounting techniques employed by many public funds. Given that few of the reforms passed by states recently have addressed the dubious booking-keeping that Moody's criticizes in its report, taxpayers should worry that the pension crisis will only grow worse in coming years.

From 2004 through the end of 2012, unfunded liabilities in the biggest government pension funds nearly tripled to just under $2 trillion, the disheartening new report notes. During this period, the funds' investment returns averaged 7.45 percent annually, just slightly below their projections. But by employing a host of questionable accounting techniques, the pension funds understated their debts and minimized the amount of money that governments and workers needed to contribute to these systems, shorting them of valuable assets.

One example of the problematic accounting is known as smoothing, in which funds calculate their assets by averaging them over an extended period of time to hide the impact of sudden drops in the marketplace. In times of distress, pension systems have sometimes extended their window for smoothing assets further and further into the past.

In 2005, for instance, the California Public Employees' Retirement System, or Calpers, under intense criticism from California state and local officials because of rising pension costs, initiated a 15-year smoothing program by which the fund blended its market losses in the early 2000s with its big investment gains in the 1990s. The move inflated the amount of assets in the fund and allowed Calpers to restrain the growth in contributions it demanded from irate local government officials, but at the cost of rising unfunded liabilities.

Some government pension funds also lay out unusually long periods-typically 30 years and more-- to amortize, or pay off, the debt their funds have accumulated. Extending debt repayment over such a long period is another technique to reduce yearly contributions that governments must make, but at the risk of new liabilities piling on top of older debt. Some of the worst cases of pension underfunding have resulted from this practice.

In 1994, for instance, the state of Illinois announced a plan to pay off pension debt that had been growing for more than a decade. But politicians gave themselves 50 years to amortize the debt. The result, as the Securities and Exchange Commission noted in 2013 when it charged Illinois with misleading investors about the condition of its pension system, produced a funding schedule that didn't actually pay off debt but instead merely shifted the burden of pension costs to the future.

Politicians like such gimmicks because they diminish the impact of pension charges on budgets. But the questionable accounting exemplifies a long-term, hazardous shift in which plans rely less and less on contributions into the system, and more and more on investment returns. Typically, today, payments from employees and government employers make up about one-third of the money a pension system will eventually need to pay retirees. The other two-thirds must come from market gains. Decades ago, by contrast, contributions accounted for about half of what a fund would eventually need to pay retirees. The shift has allowed politicians to offer workers higher benefits without increasing employee or employer contributions. But the change has also increased the likelihood that pension systems will come up short.

"Employer and employee contributions are the bedrock of any defined benefit pension plan because they establish the base of assets that investments should then help expand," Moody's argues in its report.

Although the Governmental Accounting Standards Board has been tightening up its guidelines for public pension funds in recent years, GASB's standards are recommendations that political leaders are free to ignore. Many have. In fact, in some cases states have used questionable accounting in reform legislation pitched to taxpayers as a way to solve pension underfunding. When New Jersey passed pension modifications in 2011, the legislation included something called an "open amortization" period which allows the state to recalculate the payoff period for the pension fund every year. That open amortization, equivalent to a homeowner resetting a 30-year mortgage every year to a new 30-year period, pays off debt much more slowly than a typical repayment plan.

Despite these gimmicks, states can only run from their obligations for so long, and the list of places forced to raise taxes to deal with big pension woes is growing. Illinois increased taxes by $7 billion annually in 2011 but the state, which used no taxpayer money the previous year to contribute to pensions, has had to put more than half of the money from the tax increase toward paying the state's increasing pension costs. Now Illinois is proposing to extend those tax increases, which expire this year, because without the additional money the state would have to make huge spending cuts in other areas or go back to shorting its pensions.

In Pennsylvania, rising pension costs are producing a pinch on school budgets. One result is that 163 school districts last year asked for permission to raise property levies above the state's annual 2.1 percent tax cap. Every one of them, according to the governor's office, listed growing pension costs as a primary contributor their requested increases.

In California, meanwhile, voters passed a $6 billion tax package in November of 2012, with much of the money earmarked for education. But most of that money will go toward educator pensions after Gov. Jerry Brown passed a new funding plan for Calstrs--the severely underfunded California state teachers' pension system--which collectively increases retirement contributions by school districts from $2 billion to $6 billion over the next five years.

Bad pension math, it seems, is turning out to be bad news for taxpayers.