Growing Old: Paying for Retirement and Institutional Money Management after the Financial Crisis

The Crisis in Local Government Pensions in the United States

47 The Crisis in Local Government Pensions in the United States 3 State and local governments follow the same accounting framework for measuring the value of their pension promises. The value of those promises is disclosed in accordance with Government Accounting Standards Board (GASB) statement 25, which stipulates that benefit promises are to be discounted at an assumed return on pension plan assets. That assumed return determines how the future stream of cash benefits that the state or local government has promised is converted into a present value liability measure. It also governs the actuarial recommendation for the annual amount that state and local governments set aside to fund newly promised benefits. The higher the assumed return, the lower the present value of recognized benefit cash flows and the less money the government entity sets aside on a flow basis to cover a given benefit stream. As we have pointed out previously (Novy-Marx and Rauh 2009, 2010a, and 2010b), this system misrepresents the value of pension promises. The field of financial economics is unified in agreeing that the present value of a stream of cash flows is a function of the risk of the cash flows themselves. The pension payments promised to government workers do not depend on the performance of pension fund assets. The value of the liability therefore depends on the risk robert novy-marx joshua rauh We are grateful to Olivia Mitchell and conference participants for comments and discussions. We thank Suzanne Chang and Kevin Soter for research assistance. of the stream of cash flows associated with that liability, not on the assets that back the liability. If households could use the GASB accounting system, then they could write down the value of their mortgages by simply reallocating their savings from a money market account to the stock market. By doing so, they would increase the expected rate of return on their assets and get to use that higher rate to discount their debts. If state and local governments took further advantage of this system, they could make their liabilities essentially disappear by taking on risky investments with high average returns and high risk. In previous work we have shown that the total liability for the major pension plans sponsored by the fifty U.S. state governments is approximately $5 trillion using Treasury discount rates, contrary to government accounting, which would point to total liabilities of only $3 trillion. The unfunded liability for the major pension plans sponsored by the fifty U.S. state governments is approximately $3 trillion using Treasury discount rates, contrary to government accounting, which would point to unfunded liabilities of only $1 trillion. In this chapter, we examine municipal pension promises. In particular, we apply financial valuation to seventy-seven pension plans sponsored by fifty major cities, counties, and other local government entities. This sample represents all nonstate municipal entities with more than $1 billion in pension assets, covering 2.04 million local public employees and retirees. According to the U.S. Census of Governments, a total of 3.03 million individuals is covered by 2,332 local pension plans in the United States.1 Thus, while we capture only 3 percent of municipal pension plans, we capture about two-thirds of the universe of municipal workers. According to the latest reports issued by the local governments themselves, they have $488 billion in liabilities. When we reverse-engineer the cash flows and limit recognition to only those benefits that have been promised based on today’s service and salary and use the plan-chosen discount rates, that figure drops to $430 billion. When we use taxable AA+ municipal yield curves to discount those benefits, we obtain liability measures that are around 18 percent larger. When we use the Treasury yield curve, we find a total liability of $681 billion, which is 39 percent above the stated level and 58 percent above the already promised benefit at municipally chosen rates. Net of the assets in the plans, the unfunded liability is $383 billion using Treasury discounting, or over $5,300 per capita and over $185,000 per member. If on a per-member basis the unfunded liability is the same for the approximately 1 million local workers covered by municipal plans 48 robert novy-marx and joshua rauh 1. See the 2008 survey of State and Local Government Employee Retirement Systems (U.S. Census Bureau 2008). not in our...