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Growing Deficits Threaten Pensions
Accounting Tactics Conceal a Crisis For Public Workers

By David Cho
Washington Post Staff Writer
Sunday, May 11, 2008

The funds that pay pension and health benefits to police officers, teachers and millions of other public employees across the country are facing a shortfall that could soon run into trillions of dollars.

But the accounting techniques used by state and local governments to balance their pension books disguise the extent of the crisis facing these retirees and the taxpayers who may ultimately be called on to pay the freight, according to a growing number of leading financial analysts.

State governments alone have reported they are already confronting a deficit of at least $750 billion to cover the cost of the retirement benefits they have promised. But that figure likely underestimates the actual shortfall because of the range of methods they use to make their calculations, including practices that have been barred in the private sector for decades.

Local governments use these same techniques for their pension funds and face deficits that further contribute to what some investors and analysts say may be shaping up to be a massive breach of faith with a generation of public employees.

This gap is growing more yawning with the years. It has already presented taxpayers with a whopping bill that is eating up a vast portion of government budgets at the cost of other services. In Montgomery County, for instance, pension and retiree health care costs are already higher than the combined budgets for the departments of transportation and health and human services. Eventually, officials responsible for the funds will have to choose whether to continue paying out or renege on benefits promised to retirees.

By their own assessment, state and local governments acknowledge that their funds for retiree benefits are increasingly falling behind, with the number that are severely underfunded soaring to 40 percent in 2006, a five-fold increase from 2000, according to the U.S. Government Accountability Office.

But even these grim calculations are based on assumptions that some analysts consider too aggressive, including projections about how the investments of pension funds will fare and how long retirees will live.

"Very small shifts in actuarial assumptions can generate huge changes over time," said Susan Urahn of the Pew Center on the States, which has studied the issue. "It is not very transparent, and even where it is transparent not many people understand it."

Pension funds generate money from worker contributions, government payments and the returns from investing that money. These funds pay an annual pension salary and health benefits to retirees for as long as they live.

But with workers retiring earlier and living longer, governments have been struggling to keep up with the promises they made. Many are taking out loans to restock their pension funds, which is akin to using a credit card to cover monthly mortgage payments. Others are passing the bill to future generations by using sunny projections of what their investments will return, claiming they do not need to dedicate more money now to their pensions.

Such "accounting nonsense" has been "pushing the envelope -- or worse -- in its attempt to report the highest number possible" for their investment returns, wrote billionaire investor Warren E. Buffett in a recent letter analyzing pensions for shareholders of his company. Taxpayers ultimately will pay the price when these forecasts prove wrong.

"Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that problems will only become apparent long after these officials have departed," he wrote. "In a world where people are living longer and inflation is certain, those promises will be anything but easy to keep."

Public pensions have broad leeway in their accounting methods because, unlike their counterparts in the private sector, they have no federal oversight. Private pension funds were forced by regulators starting a generation ago to use far more conservative forecasts in their pension calculations and follow uniform guidelines set by the federal government. The move toward stricter regulation provided a clearer picture of pension costs, and many corporations are now switching their employees to 401(k) retirement plans, which offer far less generous benefits.

For public pension funds, a nonprofit body called the Governmental Accounting Standards Board sets guidelines but has no power to enforce them and little incentive to confront the states and localities that finance its budget. So some states, pension analysts said, have adopted accounting techniques motivated more by politics than prudent financial considerations.

Virginia, for instance, has been using an accounting method since 2005 that allowed the state to contribute about $300 million less into its pension funds each year than what its own pension board has recommended. Some pension actuaries called this "highly unusual" and "troubling."

Maryland adopted a funding formula in 2002 that prompted a sharp drop in pension funding levels, ignoring repeated requests by the state's pension board to amend this approach. In 2006, even as funding levels dropped, the state significantly raised the retirement benefits promised to teachers and other public employees.

The District's pension funds are among the healthiest in the region, according to figures provided by the governments. The District has determined that its pension liability is $4 billion this year, which means the funds are slightly overfunded. But if the District used more conservative methods common in the private sector for projecting assets and costs, it could instead face a shortfall of several billion dollars, analysts said.

In Montgomery County, which has promised to pay $3 billion in health-care benefits to retirees, government officials accepted the advice of consultants who urged the county to nearly quadruple the amount it sets aside to cover this commitment. But the county council voted to delay this full funding for five years. Now the council, which claims wide legal latitude, is considering whether to postpone it for another three years.

"The biggest issue is the lack of standards in regards to government pensions," said Timothy L. Firestine, Chief Administrative Officer in Montgomery County. "You can make up your assumptions as you go."

Of all the assumptions, among the most fateful is the figure chosen for how much money the fund will make on its investments. The better these investments fare, the more flush is the fund. And if a government projects a high rate of return, there is less need to tap taxpayer money to finance a shortfall.

Most public pension funds limit their contributions by assuming their investments will grow between 7.5 percent and 8.5 percent a year.

"While anything is possible, does anyone really believe this is the most likely outcome?" Buffett wrote in the most recent annual report his firm, Berkshire Hathaway. Buffett is also a Washington Post Co. director.

A growing number of leading investors are warning that the return rates used by state and local governments are unreasonably optimistic. Buffett, for one, has pointed out that over the 20th century -- when the Dow Jones Industrial Average soared from 60 points to 13,000 -- the stock market produced a 5.3 percent annual return for investors. Over the next century, the Dow would have to explode to 2.4 million to produce a similar rate of return.

Yet even that would be less than the rate of return commonly projected by public pension funds.

Many public pension managers say their projections are based on past experience. Moreover, they say they can take more risks than private companies because there's no chance of going out of business.

"There's been a government in our city since 1779," said Mark Jinks, chief financial officer for Alexandria. "You can't be sure that the promises made to private sector employees will outlive their company."

Another concern for public funds is demographic: We are living longer and more of us are getting old. By 2015, life expectancy is expected to reach 79.2 in the United States. By 2030, one out of five people will be over 65.

In addition, retiree costs are soaring. A study by California predicted its retiree health care costs would jump from $4 billion today to $27 billion by 2019.

Nor has the crisis in the housing and debt markets helped matters. Investment returns for most pension funds across the nation turned negative for the first part of this year. State and local governments are also facing budget deficits that are expected to top $30 billion next year, according to Standard & Poor's, making it tough for officials to find more funding for pensions.

Urahn, of the Pew Center, called the current environment "a perfect storm" and expressed a concern over whether governments may be tempted to cut their pension contributions. Yet most are loath to revise the benefits employees have traditionally been promised.

"The age of retirement was set when people did not live that long. It's very hard to change that now," she said. "People feel these pension obligations were a promise. And changing them feels like you are breaking a contractual promise, that you are changing the rules of the game. But the game has changed."

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