Optimism not productive in accounting

PERS’ generous accounting assumptions could spell trouble

By Geoffrey Lawrence
  • Thursday, March 18, 2010

Everyone likes an optimist — unless, of course, that starry-eyed optimist is managing your finances. When it comes to accounting, optimistic assumptions can easily wreak havoc.

Just ask the taxpayers who are obligated to finance the pension system for Nevada's public employees. The generous accounting assumptions used by administrators of the Public Employees' Retirement System may be masking the true burden that PERS will place on taxpayers.

PERS administrators assume an average annual rate of return on investments of 8 percent. Yet, they haven't met that lofty goal in years. Over the past 10 years, PERS averaged a 3.83 percent annual return on investment. For the past two years, PERS has experienced a negative rate of return as the economic recession has led to deterioration in stock values. In FY 2009 alone, PERS lost $3.5 billion from the value of its assets, amounting to a 15.8 percent decline in total value.

By the end of FY 2009, PERS' unfunded liability stood at a record $9.1 billion. This is nearly four times the $2.3 billion unfunded liability that existed just 10 years ago. State and local taxpayers should take note of this number, because they are contractually obligated to make up this amount in order to finance current public employees' retirement costs. As PERS' unfunded liability grows, taxpayers are likely to face either a higher tax burden or a reduction in public services as pension costs consume ever-larger shares of government expenditure.

In actuality, PERS' official estimate of $9.1 billion may understate the size of the system's unfunded liability. That estimate relies on the highly optimistic assumption that PERS will be able to do in the indefinite future what it has been unable to do in the recent past — average an 8 percent rate of return annually on investments. Realistically, it is questionable whether this will happen — meaning that the true size of the unfunded liability could be far beyond $9.1 billion.

While public pension plans such as Nevada PERS have been able realize such high rates of returns in decades past, the prolonged injection of artificial credit by the Federal Reserve has kept interest rates depressed over the past decade. As a result, bond yields have remained at historic lows and, because PERS maintains 60 percent of its assets in the lower-risk bond market, its cumulative rate of return has been low.

From all indications, this is a trend that is likely to continue. In response to the recent financial crisis, Federal Reserve policy has only been to accelerate the creation of artificial credit to unprecedented levels — holding the daily effective federal funds rate down near zero percent. Given this trend in Fed policy, it is unreasonable to assume that bond yields would recover in the foreseeable future.

This reality means the prudent action by PERS administrators would be to downwardly adjust the actuarial assumptions underlying the system's expected yield — regardless of what happens in the stock market.

So why haven't they made such an adjustment? The chief investment officer for Wyoming's public pension system provides an answer: "Nobody wants to adjust the rate," he recently said, "because liabilities would explode."

Indeed, a very small adjustment in the anticipated rate of return could have a tremendous impact on the size of the unfunded liability. Administrators at the Colorado Public Employees' Retirement Association, for example, have estimated that a one-half-percent reduction in their system's expected rate of return would increase the unfunded liability by 19.6 percent.

Nevada PERS administrators have not produced a similar estimate, but it should be clear that any such reduction — while reflecting a more accurate scenario — would only further erode the system's already tenuous financial standing . That might be a bullet that system administrators and policymakers alike are unwilling to take.

So long as policymakers can pretend that the numbers are smaller than is the case, they will continue to evade confronting the need for the type of fundamental reforms required to move to the needed defined-contribution system.

At the very least, policymakers need to understand that the official PERS liability estimate of $9.1 billion is most likely too low. With more realistic assumptions, the true number is likely to be significantly higher.

Nevada's problem is large and growing. If left unchecked, the PERS obligations will soon swamp state and local government finances.

Geoffrey Lawrence is a fiscal policy analyst at the Nevada Policy Research Institute. For more visit http://www.npri.org/.

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