Public Pension Funding: A Matter of Perspective?

By John Iekel • March 17, 2017 • 0 Comments
It’s no secret that public-sector pension plans in the United States face many challenges. But is there more than raw figures at play? A recent paper suggests that the way accounting rules are applied has something to do with how their condition is perceived and addressed.

In “Funding Public Pensions: Is Full Pension Funding a Misguided Goal?” a paper by the Haas Institute, Tom Sgouros argues that part of the problem is how those rules are used to evaluate and govern pension plans. Says Sgouros, “the crisis is the result of the accounting rules governing both these plans and the governments that sponsor them. These rules are designed to insure against risks that public pensions systems do not face, while simultaneously failing to insure against the risks they do face.”

But Sgouros is far from finished, commenting, “The rules also encourage ‘reforms’ that frequently do not improve the financial situation of a given pension system. This is not just deplorable, but a recipe for making a bad situation worse — precisely what we’ve seen over the past few decades.”

The State of Things

“Across the nation,” says Sgouros, “public pensions are in crisis, and have been so for a long time.” He notes that funding them has become a “political issue” in jurisdictions at every level below the federal government and argues that funding problems are a justification for reduced government spending on education and other government investments. “In thousands of other governments across the country, pension contribution increases are a constant source of fiscal stress, resulting in cuts to schools, infrastructure, and increases in taxation,” he writes.

But Sgouros is not convinced that public pension problems necessarily equate to a jurisdiction’s fiscal armageddon. “The narrative of runaway pension obligations sinking an ailing city’s finances is simply not supported by the facts, which had much more to do with a sudden loss of state support and ill-advised interest-rate swaps,” he posits, continuing, “Long-term debt due decades in the future cannot cause insolvency today even if it is a sign of trouble to come.” Insolvency, he says, “is the result of being unable to pay current obligations; long-term debt is just a threat.”

A Matter of Perspective?

The accounting standards used to evaluate the pension plans of cities that are experiencing fiscal stress are part of the reason those plans often are blamed for those municipal woes, Sgouros says. He writes: “Debt due in the distant future is not a crisis today, even if it is a cause for concern. To a large extent, the source of the crisis is the accounting rules themselves and their misapplication by policy makers and ratings agencies.”

“Pension accounting relies on a presentation of assets and liabilities in their ‘present value,’ the value today of a sum of money tomorrow,” explains Sgouros. He doesn’t think much of this approach, remarking “there is a time dependency of the value of money, so it makes no sense to compare 2016 assets with 2046 liabilities, except by computing the present value of the liabilities to compare to the current value of the assets.”

Full Funding? Bah!

Sgouros is similarly unimpressed with seeking full pension plan funding. “The drive to full funding cannot be justified actuarially, either. Though the details depend on actuarial characteristics of the employee and retiree population, many, if not most, defined-benefit pension systems can operate forever at far less than full funding,” he says.

Sgouros explains his contention: “A pension fund must pay 100 percent of its debts. But it need not pay them a moment before they are actually due, and since a pension plan is constantly receiving new contributions, the fund itself need not be the only source of payments. As a result, even if all the debts are paid, at any one time, the fund itself may be at some level well below 100 percent funding.”

Not only that, argues Sgouros, overfunding is a risk as well. “Full funding is arguably a synonym for overfunding,” he says. And that would have a ripple effect, Sgouros says, arguing that overfunding wastes resources and diverts financing from other priorities, as well as creating a temptation to divert funds for other purposes.

Further, Sgouros contends, overfunding ironically could sow the seeds for future problems for a pension plan. “It is virtually a law of nature that an overfunded pension plan — or any plan over, say, 90 percent funded — will see retiree benefits increase or budgeted contributions decrease,” he writes, adding, “And as predictably as the sun rises, after the next investment downturn, it will be an underfunded pension plan again, but now with a government budgeting for lower payments and retirees accustomed to higher benefits.”

Sgouros argues that the current rules are not necessary, and further asserts “’Full’ funding of any pension system requires spending more money than necessary to meet the government’s obligations.” He contends that that is “the very definition of waste” and suggests considering whether it is worth it to consequently “drive thousands of municipalities into bankruptcy” and “deprive millions of public employees of pension benefits they have earned.”