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Economists: State, local pension funds understate shortfall by $1.5 trillion or more

By Peter Whoriskey
Washington Post Staff Writer
Thursday, March 3, 2011; 8:08 PM

The pension funds for state and local workers in the United States are understating the amount they will owe workers by $1.5 trillion or more, according to some economists who have studied the issue, meaning that the benefits are much costlier than many governments and taxpayers thought.

Doubts about government pension accounting have been voiced by analysts for years, but with shortfalls in state and local pension plans exacerbated by the recession, the push to refigure pension fund shortfalls has gained political momentum.

The trillion-dollar gap arises from the government method of accounting, which several experts say significantly underestimates the cost of future pension payments.

"It's been a perfect storm," said Alicia Munnell, director of the Center for Retirement Research at Boston College. When the pension liabilities are correctly tallied, "you get a very, very large number."

The cost of pension plans for the approximately 17 million state and local government workers have come under heightened scrutiny in recent weeks, particularly in Wisconsin, New Jersey and other states where governors are struggling to balance budgets and reduce costs.

In Wisconsin, for example, Gov. Scott Walker (R) wants state workers to pay 5.8 percent of their wages to fund the pension.

Even under current accounting methods, state and local governments are facing massive pension shortfalls - at least $344 billion, according to calculations by the Center for Retirement Research and other groups.

But when the accounting is revised to value future payments more accurately, in the critics' view, the amount that pensions are underfunded grows to more than $1.9 trillion, according to Munnell's calculations for 126 large plans.

Those calculations have been published in part in a working paper for the National Bureau of Economic Research.

By comparison, the entire federal debt held by the public is $9.3 trillion.

"By virtually any measure, that's an enormous number," said Jeffrey R. Brown, a finance professor at the University of Illinois who has studied the issue. "When you're short that much money, at some point you have to pay the piper."

If the pension obligations are as enormous as critics say, virtually every state and local government running a pension will have to invest more in its pension plan - either by cutting services or raising taxes - or gamble that it will achieve a high rate of return on its investments.

Eight percent

Most government pension plans assume they will earn about 8 percent a year on their investments. Some have achieved those returns over certain periods, but critics think that the assumption is too optimistic.

Among them is billionaire investor Warren E. Buffett, who in a 2008 letter predicted that taxpayers will pay the price when the forecasts prove wrong.

"Public pension promises are huge and, in many cases, funding is woefully inadequate," he wrote. "In a world where people are living longer and inflation is certain, those promises will be anything but easy to keep."

(Buffett is a member of the Washington Post Co. board.)

Henry J. Aaron, a senior fellow at the Brookings Institution who specializes in public finance, said, "Most economists would consider the 8 percent excessive."

The potential damage to state and local budgets could be widespread.

Already, in Illinois, for example, pension payments amount to nearly 13 percent of the general budget. The state has had to borrow money to make the payments for two years in a row. Even under the current rules, less than 40 percent of the pension costs are funded.

In a place such as Wisconsin, where pensions have been fully funded under current rules, the revised accounting would create billions in new liabilities.

The core of the dispute involves how much money should be set aside today to make pension payments in the future.

Proponents of the current pension accounting method in essence assume that the pension funds will achieve an 8 percent return on their investment over the long term. They argue that state and local governments should just put in enough money now and depend on that rate of return.

"I don't think 8 percent is a really high number. It's a reasonable number," said Dean Baker, co-director of the Center for Economic and Policy Research, which recently issued a report about the issue.

Moreover, Baker and other economists noted that the trillion-dollar figure is so large because it represents pension expenses over decades. On an annual basis, pension payments presently represent only a small percentage of states' annual budgets, so increasing pension contributions should not cripple government finances, they argue.

Some states and cities have serious shortfalls, but pension costs on the whole are a "modest" demand on state and local budgets, Aaron said.

Even so, the sums involved are large.

Huge shortfalls

Although Munnell has reported a $1.9 trillion shortfall, others, such as finance professors Robert Novy-Marx and Joshua D. Rauh, have calculated higher figures.

These critics say the current method of calculating pensions is wrong not only because many doubt that the pension investments will return 8 percent but also because it understates the risks of investing, as pensions do, in the stock market.

Although the issue of pensions often divides Democrats and Republicans, the group of economists who support revising the pension calculations includes members of both parties.

Economist David W. Wilcox, who co-wrote a paper calling the current method of estimating pension liabilities an idea "foreign to most economists who have studied the issue," served as an assistant secretary of the Treasury during the Clinton administration. His co-author on that paper was Brown, the University of Illinois professor and a former George W. Bush appointee.

Munnell was a member of the president's Council of Economic Advisers during the Clinton administration.

Whatever the politics, critics of current pension accounting have been gaining momentum.

On Capitol Hill, Rep. Devin Nunes (R-Calif.) is pushing a bill that would require state and local pension funds to report pension liabilities using the method that yields the higher figure. And the body that oversees government accounting practices, the Government Accounting Standards Board, has taken up the issue and proposed a compromise.

"If it was just an accounting argument, it would be hard to get exercised about this," Brown said. "But accounting drives the information available to people, which drives decisions. And there is a lot of money at stake."

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