HERE'S MORE evidence that state governments are not leveling with their citizens about the costs of pensions for public employees: A new Stanford University study commissioned by California Gov. Arnold Schwarzenegger (R) has found that that the state's pension funds are understating their likely unfunded liabilities by almost half a trillion dollars.
California's three largest funds, with a combined $442.1 billion in assets as of mid-2008, calculate their projected liabilities based on rates of return of between 7.5 percent and 8 percent. These assumptions yield a relatively modest $55.4 billion gap, easily covered by adjusting annual contributions. But this rosy scenario begins to look implausible when you consider that it requires fund managers to beat the 5.3 percent annual rate of return that U.S. stocks rang up in the 20th century. The Stanford researchers used a far more conservative and -- given both distant and recent history -- realistic rate of 4.14 percent, roughly what the funds would earn if invested in risk-free U.S. Treasury securities. The result was an estimated unfunded liability 10 times bigger than the official figure.
To be sure, there is absolutely nothing illegal or improper about the way California's pension funds do the math now. The vast majority of states and local governments calculate their liabilities similarly. It is, in fact, perfectly permissible to do so under guidelines set by the Governmental Accounting Standards Board (GASB), the official body that sets norms in this area. But that's just the problem: Everybody does it. According to research by Robert Novy-Marx of the University of Chicago and Joshua D. Rauh of Northwestern University, doing the same calculation for the rest of the states that Stanford did for California yields an estimated $3.92 trillion nationwide shortfall for the period 2008-2023.
It's no mystery why states got into this fix. Politicians want to court public employee unions with generous promises without having to ask taxpayers for more money. Pretending that investment income will solve the equation helps them avoid hard choices -- though it gives fund managers a strong perverse incentive to take excessive risks in hopes of meeting unrealistic targets. The GASB has been considering a change in its standards to bring them closer into line with requirements in the private sector. The California study provides another strong argument in favor of reform.