State pension hole is much deeper than official estimates

Taxpayers have been duped. They've been told the state's pension plans are well funded, and compared with states like Illinois or New Jersey, they are. But that is tantamount to being the prettiest hog in a slaughterhouse.

If Washington pension plans were judged by the standards that private-sector pensions are required to follow--standards that academic economists, the Federal Reserve and the Congressional Budget Office endorse--Washington pensions would face unfunded liabilities exceeding $50 billion. The costs of truly fully funding public-employee pensions could swamp the state budget, and at more than $20,000 per household, taxpayers too.

Whether Washington pensions have merely hit a speed bump or are sorely underfunded comes down to an arcane debate over how to translate benefits owed years or decades in the future into terms that make sense today.

"But more important, they need to consider whether a fundamental shift toward defined contribution, 401(k)-style pensions makes sense."--Andrew Biggs

Currently, plans "discount" their future liabilities to the present--a process that is like compound interest in reverse--using the 8 percent interest rate they assume they'll receive on their investments. A high discount rate implies a lower present value.

This accounting approach makes sense until you consider one side effect: The more investment risk a pension takes, the better funded it appears. On paper, Washington could make its pensions fully solvent overnight simply by putting all its money in stocks and assuming a 10 percent rate of return.

But that's like a guy handing his apartment key to 25 women at a bar. He might believe himself to be a Casanova, but taking high risks is no guarantee of high returns.

Additionally, no matter how much investment risk the pension takes or whether those risks pay off, the benefits remain guaranteed and must be paid. That's why economists agree that you should value a liability based upon its own risk characteristics, not those of any assets that might fund it.

If pension payments are guaranteed by the government, they should be valued on par with guaranteed payments like government bonds, by discounting them using the return on government bonds. This approach, which would lower the discount rate to around 4 percent, converts Washington's unfunded liabilities from under $5 billion to more than $50 billion.

This is how private-pension accounting works. Private pensions can and do invest in stocks and other risky assets, but they can't credit themselves with the higher returns until after the risks have paid off. Public pensions, by contrast, can take as much risk as their managers like and book the hoped-for gains today. As a result, public pensions around the country have shifted toward increasingly risky investments.

Judged by private-pension standards, Washington state's public pensions aren't fully funded--rather they're about 52 percent funded. For context, the U.S. Department of Labor rules that any private pension under 65 percent funding is considered "critical" and must immediately move to fix its problems. And the burden of truly fully funding pensions on Washington's budget won't be the 3 to 4 percent the state is currently putting aside, but several multiples of that.

By any rational standard of pension accounting, Washington and other states aren't close to meeting their obligations. If pension investments fall short of their assumed returns, an ever more likely scenario, then future taxpayers are on the hook. Washington lawmakers need to fix their accounting so they know what they're getting into when they promise benefits and alter their investment risk to hedge the guaranteed obligation to pay benefits.

But more important, they need to consider whether a fundamental shift toward defined contribution, 401(k)-style pensions makes sense. The problem isn't just accounting, it's lawmakers' continued habit of avoiding doing what they should, of increasing benefits in good times, failing to make the necessary payments in bad times, and using accounting tricks to cover up the mess.

The problem with our current defined-benefit public-employee pensions is human nature, in particular politicians' desire to promise benefits without paying for them. That's a lot bigger, and a lot harder, problem to solve.

Andrew G. Biggs is a resident scholar at AEI

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