Detroit’s bankruptcy is proof that states are calculating public pensions all wrong

July 24, 2013
July 24, 2013

The Detroit bankruptcy has raised concerns about the future of state and municipal pensions. When pensions are severely underfunded and states or municipalities fall on hard times, either the taxpayer or retirees pay the price. Paying benefits might mean reducing other services, such as education, or cutting the benefits of existing or soon-to-be retirees who made large contributions to these plans for decades and budgeted their retirement around what they’ve been promised. It’s unknown who will wind up paying in Detroit’s case. In many states, the pension benefits are guaranteed by the state constitutions (it is in Michigan), but bankruptcies in other states have tested that. The lawsuits in Detroit have already begun; two pension funds claim the city has no right to cut their benefits.

You know it’s a problem when technical squabbles between actuaries and financial economists make the news. Journalist Heidi Moore blames pension managers for taking out-sized risks when they invested the pension plan’s assets and underfunding the plans. But the current accounting standards give managers every incentive to do that. The lesson we should learn from this is that public pensions must start to account for risk.

State pension accounting is currently based on fiction. When you calculate how well-funded a pension fund is, you estimate future assets and liabilities, which results in your funding status—when assets are smaller than liabilities, the pension is underfunded. How you estimate assets and liabilities is the source of controversy. Estimating assets requires making an assumption about how much the fund’s investments will earn. This assumption is often 8%, which is optimistic and state plans have been criticized for using such a large number. But the disagreement over the right expected return points us to the real issue: risk.We don’t know what the assets will earn in the future; pensions are invested in risky assets so maybe they’ll earn more in some years less in others. Generally, the higher your expected return, the more risk you are exposed to. State pension funds don’t account for risk when they estimate their funding. Pension funds also assign a value to their liabilities; future benefits they’ll pay to retirees. That is not simply the benefits paid over time, the value must also be calculated using a discount rate. The larger the discount rate, the smaller your liabilities, since you divide future payments by the discount rate. State pension funds currently use their expected returns, often 8%, as their discount rate. This is horrific to financial economists. According to Josh Rauh, “Discounting liabilities at an expected rate of return on the assets in the plan runs counter to the entire logic of financial economics.”

Financial economists believe that liabilities should be discounted at a rate that reflects the likelihood they won’t be paid. When markets are down, it is typically harder to raise capital to cover the payments you owe. Using the expected return on assets essentially assumes when investments don’t pay off, states won’t need to pay out full pensions. A more appropriate discount rate would be a municipal bond rate, which reflects the market’s expectation that municipalities will default on their debt, or even the Treasury rate, if you believe states will default on their bonds before their pension obligations. These rates are much lower than 8%, so using them results in a larger unfunded liability. Estimates by Rauh and Robert Novy-Marx found that using the wrong discount rate means states are understating their unfunded liabilities by more than $3 trillion dollars. According to a recent report by the Center for Retirement Research, using the current rules pensions can fund 73% of their liabilities. Using a risk-free rate that percentage falls to 50%.

The current accounting rules give pension managers an incentive to take on more risk because a higher return means more assets and smaller liabilities. If they take enough risk, they can eliminate their underfunding all together. Soon new provisions, expected to take effect in 2014, only allow public pensions to only use their expected return as a discount rate on liabilities that can be financed by their assets, hardly an improvement.

The Detroit bankruptcy highlights the sort of risks pension funds are exposed to. The current accounting methods are often defended because state plans theoretically last forever and the state can turn to the taxpayer. But Detroit shows that’s not always true. Assets often underperform during recessions, this is also when the tax-base is smaller and aggregate demand is lower, so raising taxes may not be feasible. Cities also lose tax revenue as people move away, which is more likely during a recession in an economically depressed area. Potentially, it could become a vicious cycle: large obligations increase taxes and degrade services, so taxpayers move, further eroding the tax base. All this suggests that states and municipalities do face risk and will have a harder time raising capital when their assets underperform. The most effective way to make pension managers cognizant of risk is to adopt accounting standards that force them to recognize it, just as public plans in Canada and the Netherlands and corporate pensions plans in America do.

Properly accounting for risk means the true cost of guaranteed pensions are apparent. There is nothing wrong with defined benefit plans. They have many desirable features in terms of risk pooling, assuming they are properly funded. The pension benefits of corporate plans are insured (though pensioners take a large haircut in the case of bankruptcy), but sadly that’s not the case for public plans, which leave state workers and the taxpayers vulnerable. Given what’s at stake, it’s troubling that influential economists are derailing the conversation by saying that the problem is motivated by a political agenda to undermine defined benefit plans. That suggests venerable economists Modigliani and Miller (who pioneered risk accounting measures) were in on this conspiracy back in the 1950s, which is absurd. The surest way to ensure retirement security is a frank and honest dialogue about the numbers. Most state and municipalities are not on the verge of bankruptcy, so state pensions don’t pose an immediate crisis. But that gives them an opportunity to get it right now and avoid problems in the future.

You can follow Allison on Twitter at @AllisonSchrager. We welcome your comments at ideas@qz.com.

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