America’s pension crisis may be much worse than we thought. A new report from State Budget Solutions looks at each state’s pension liabilities using a lower estimate of the rate of return than the states use themselves, and found that the country’s plans are underfunded by $4.1 trillion, and only 39 percent funded overall. The state-by-state breakdown looks even worse, with Illinois, Connecticut, Kentucky and Kansas holding plans that are less than 30 percent funded, and another 27 states below 40 percent. Other states have it bad as well: Reuters notes that in five states, pension liabilities more than 40 percent as large as the state’s economy as a whole, and in Ohio and New Mexico, they’re more than half as large. Considering that many people consider plans to be “safe” only when their funded level is over 80 percent, this is troubling news indeed.
These numbers are significantly higher than those we’ve seen before, which is due to the extremely conservative estimates of the rate of return. Rather than assuming a rate of return in the 7-9 percent range, as most plans do, State Budget Solutions is using the “risk free” rate of 3.225 percent, which is tied to the yield on treasury bonds. The SBS explains its reasoning:
Current public sector practices involve discounting a liability according to the assumed investment returns of plan assets, typically around 8 percent. Yet with discount rates tied to expected investment performance, plan sponsors can easily take on greater risk in order to make liabilities appear smaller. This reduces the resources required today to pay for the promises of tomorrow.
Accurately accounting for a pension system’s liability requires incorporating the nearly certain nature of benefits. That is, once promised, the chances that benefits will not have to be paid are extremely low.
A fair-market valuation does away with optimistic investment return assumptions and instead uses a rate that reflects the risk of the liability itself. One common approach, taken here, is to discount liabilities according to the yield of a 15-year Treasury bond.
We’re not actuaries, and we’re not sure whether the the rate of return will be as low as the risk-free rate suggests. Nonetheless, it’s obvious that the rates of return used by cities and states are far too high, and given the problems we’ve seen with underfunded pensions, it’s probably prudent for states to err on the side of caution when it comes to calculating the rates of return on pension investments.
[Stock graph image courtesy of Shutterstock]