What pensions ‘cost’ and what they really cost

PERS is dramatically understating its liabilities

By Geoffrey Lawrence
  • Tuesday, April 6, 2010

It's a shame that actuaries aren't required to study financial economics. If they were, the public might have a much better understanding of the urgency behind public pension reform.

In its latest financial report, the Nevada Public Employees' Retirement System calculated its unfunded liability to be $9.1 billion using the actuarial approach. This simplistic approach examines the system's accrued liabilities and discounts those liabilities to the present using an assumed 8 percent annual rate of return. The difference between liabilities, calculated as such, and assets is considered to be the system's "unfunded liability" — the amount which it would be unable to pay without higher returns or a larger infusion of tax dollars.

However, this approach assumes that the plan will be perpetually immune from short-run investment risk and market volatility. For such an assumption to be valid, the analysis would have to be based solely on a risk-free investment portfolio that accounts for the additional costs of pricing and selling risk. 

Examples of investment options that are generally considered risk-free include federal Treasury bills or stock options whose risk is inoculated through the purchase of a "put option." The problem with conducting an actuarial based on a risk-free investment portfolio is that the expected rate of return would fall nearly in half — greatly exaggerating the size of the unfunded liability. Yet, because PERS' current accounting method assumes high rates of return while failing to consider risk, it has no grounding in reality.

In order to purchase genuine security from risk (through put options, for example), PERS would have to have on hand more assets than simply a sum equal to the discounted accrued liabilities. The lesson here is that, even if the system were considered "fully funded" by actuarial standards, it would still face significant danger of being unable to meet its liabilities because of those standards' failure to account for risk or volatility in the marketplace.

In fact, Andrew Biggs of the American Enterprise Institute recently concluded that a public pension plan considered "fully funded" by actuarial standards would only have a 35 percent likelihood of being able to fully pay accrued benefits. Biggs reached this conclusion after performing a standard financial analysis test intended to determine the impact of market risk and volatility known as a "Monte Carlo" simulation.

This is a particularly ominous finding for Nevada PERS, which falls well short of even the "fully funded" level posited by actuarial standards. Currently, actuaries say the system's assets will cover only 72.5 percent of accrued liabilities.

In fact, Biggs determined that a market valuation of Nevada PERS assets using an economically sound "options pricing" method of accounting for risk reveals a total unfunded liability of $33.5 billion. At current levels, that would amount to roughly 10 years' worth of state General Fund spending! To put it another way, market-priced unfunded pension liabilities amount to 32 percent of state Gross Domestic Product.

According to Biggs' analysis, the probability that PERS' assets will be sufficient to cover accrued liabilities is only 6 percent for police and firefighters and 10 percent for regular employees.

One would expect that a pension system with such a high risk of default would elicit tremendous concern from employees who expect to receive retirement benefits from that system. Yet, such an outcry from PERS participants has yet to emerge, even though a market-based accounting of PERS reveals that the system has virtually no chance of meeting its future liabilities.

This is likely due to the fact that PERS does have a plan for mitigating risk — namely, offloading any unforeseen costs onto taxpayers. Biggs details how state and local governments across the country have routinely treated pension liabilities as senior debt in practice, continuing to make benefits payments even as they defaulted on bondholders, laid off employees and made cuts to public services. 

Indeed, to the degree PERS administrators are counting on taxpayers to bail them out of a $33.5 billion hole, they are, by extension, planning on massive reductions in public services in Nevada, as funding for schools, roads and police is diverted into pension payments. Given the size of the system's true unfunded liability, it is doubtful this "plan" will ever be politically feasible.

Absent the massive taxpayer bailout that PERS implicitly presumes, the system would probably be forced into Chapter 9 bankruptcy proceedings to reconcile the gap between assets and liabilities. Under such a scenario, probabilities are high that the courts would mandate massive reduction in retiree benefit payments.

Given the reality that PERS faces when its pecuniary position is subjected to market-based accounting, odds are high that the system will eventually become insolvent.

Nevada lawmakers must end their decades of irresponsibility now — or the carnage they have stored up for the Silver State will be even worse.

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

Read more:

blog comments powered by Disqus