Cost of State and Local Pensions Underestimated, Finance Expert Says

April 13, 2011

State and local governments in the United States have badly underestimated the cost of pensions promised to their employees, warned speakers at the Harvard Kennedy School (HKS) on Tuesday night (April 12).

Even with the recent upturn in the economy, fiscally strapped state and local governments still have approximately $3 trillion in unfunded pension liabilities, asserted Joshua Rauh, associate professor of finance at Northwestern’s Kellogg School of Management at “The Fiscal Crisis of State and Local Government Pension Systems,” a lecture co-sponsored by HKS’ Taubman Center for State and Local Government, Rappaport Institute for Greater Boston, and Mossavar-Rahmani Center for Business and Government.

The $3 trillion figure is almost three times higher than what state and local governments officially estimate as their unfunded pension liability. The difference is due to the fact that current accounting rules allow state and local governments to estimate that their pension funds, which invest in a diversified portfolio of assets, will grow by about 8 percent a year. However, because they are legally required to fund the promised pensions even though there is no assurance that they will earn the projected returns, “this approach is contrary to all principles of financial economics,” Rauh asserted.

The correct approach, he said, is to use the expected return on risk-free investments, such as a blended U.S. Treasury bill interest rate (currently about 3.5 percent). For Massachusetts, which covers state employees and local teachers, this would increase the unfunded pension liability from $23 billion to $55 billion, about $21,000 for every household in the state. In Boston, the estimated liability would increase from $1.6 billion to $3.2 billion, about $12,500 for every household.

On a per-household basis, “Massachusetts and Boston are in the middle of the pack,” said Rauh. But unlike other states and cities, the pension problems in Massachusetts and Boston are not getting significantly worse because both employees and the government have been making large, ongoing contributions to the pension system. Consequently, Rauh said, unlike many other states, “Massachusetts is not in imminent danger of having its pension plan go broke.”

Some states are trying to address their pension problems by reducing cost-of-living increases, requiring increased contributions from employees, increasing retirement ages, and — at least for new employees — replacing traditional pension plans with “defined contribution” plans similar to the private sectors’ 401K plans.

Massachusetts already has taken several of these steps and is considering others. However, Rauh noted, because of relatively high contribution rates and the fact that state and local employees in Massachusetts are not part of the Social Security system, the state would not save much money by shifting new employees to a defined contribution plan.

Nevertheless, Massachusetts, like other jurisdictions, must make difficult decisions about how to close its funding gap, noted Gregory Mennis MPA 2007, the state’s assistant secretary of administration and finance, who commented on Rauh’s talk. While many people think discussions about unfunded pension liabilities are boring, he added, “they would be surprised at how heated these conversations can be.”

Joshua Rauh

Joshua Rauh, associate professor of finance at Northwestern’s Kellogg School of Management at “The Fiscal Crisis of State and Local Government Pension Systems." Photo credit, Sandra Garron.

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