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Gov. Chris Christie recently said what every governor across the country is secretly thinking: Without reform, public sector pension costs will crush state budgets. In fact, the true value of public pension shortfalls is far higher than even the $32 billion reported by New Jersey’s plans.
If valued by the standards applied to private pensions, New Jersey’s unfunded liability reaches $145 billion, equal to almost $17,000 for each resident. Unless pension accounting rules are updated, taxpayers in New Jersey and around the country are in for a shock when the pension bill comes due.
These hidden pension costs result from arcane but hugely important decisions regarding “discounting.” Pension accounting compares the future benefits a plan has promised to the assets it holds today. The difference between the two equals the plan’s unfunded liability. Analysts make future dollar amounts comparable to dollars today by “discounting” them at a given interest rate. For instance, assuming 5 percent interest, one dollar today could fund $1.05 in benefits a year from now. A higher discount rate implies that each dollar of today’s assets can fund more benefits tomorrow.
But how do you choose the correct discount rate? Public pensions use the rate of return they project for their portfolios of stocks and bonds–in New Jersey’s case, 8.25 percent per year. Using this method, as of June 30, 2008, New Jersey’s three main pension plans had unfunded liabilities of around $32 billion. That’s about $3,775 for each New Jersey resident and slightly more than all state revenues this year. Since mid-2008, markets have declined, so we can expect that today’s shortfalls are even larger.
But here’s the problem: While the stocks and bonds held by pensions can be highly risky, the benefits promised to public employees are practically risk-free. In New Jersey and around the country, public sector pension benefits have legal and constitutional protections that make them almost impossible not to pay. As Donald Kohn, the vice chairman of the Federal Reserve Board, put it: “The only appropriate way to calculate the present value of a very low-risk liability is to use a very low-risk discount rate.” Pension plans’ violation of this rule, Kohn said, means that “current measures of pension liabilities might be less than fully revealing.”
Academic studies discount public pension liabilities using the interest rate on U.S. Treasury securities. By that measure, New Jersey’s unfunded pension liabilities are truly staggering: around $145 billion. While New Jersey pensions report they have assets sufficient to cover 73 percent of liabilities, using proper market valuation shows these plans are only 38 percent funded.
Ironically, corporate pensions, whose benefits are less ironclad, are required to discount their liabilities using lower interest rates than public plans.
Defenders of the pensions’ accounting techniques say that government is special. Unlike corporations, governments have the power to tax. So if New Jersey pensions run out of money they can always go to the citizens for more. That’s not just a nonsensical argument–the fact you can raise taxes to cover a pension deficit doesn’t mean the deficit doesn’t exist–it also shouldn’t be surprising if New Jerseyans aren’t exactly comforted by it.
New Jersey’s pensions, like plans across the country, require significant reforms. But to understand the need for reforms such as higher employee contribution rates, on-time-and-in-full contributions from the government, higher retirement ages and more modest benefits, we first must know the scale of the problem. Current accounting methods could let pensions paper together a reform that would not stand muster under private sector standards. Both state workers and residents deserve better than that.
Andrew G. Biggs is a resident scholar at AEI.
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