For people watching it from afar, the bankruptcy of Detroit — the biggest municipal bankruptcy in American history — may have brought a sense of relief in the fact that they live somewhere else. But it’s also brought needed public attention to the state of city finances around the nation. While Detroit is an egregious case of municipal incompetence, corruption, and mismanagement, its problems are not unique.
In fact, one of the drivers of debt that brought the Motor City to its knees is common among states and cities: defined benefit pension plans, which guarantee payments independently of the level of the plan’s funding. This week’s cover story in The Economist brings some needed attention to the problem:
Most public-sector workers can expect a pension linked to their final salary. Only 20% of private-sector workers benefit from such a promise. Companies have almost entirely stopped offering such benefits, because they have proved too expensive. In the public sector, however, the full cost of final-salary pensions has been disguised by iffy accounting.
Pension accounting is complicated. What is the cost today of a promise to pay a benefit in 2020 or 2030? The states have been allowed to discount that future liability at an annual rate of 7.5%-8% on the assumption that they can earn such returns on their investment portfolios. The higher the discount rate, the lower the liability appears to be and the less the states have to contribute upfront.
Even when this dubious approach is used, the Centre for Retirement Research (CRR) at Boston College reckons that states’ pensions are 27% underfunded. That adds up to a shortfall of $1 trillion. What is more, they are paying only about four-fifths of their required annual contribution.
On a more realistic discount rate of 5%, the CRR reckons the shortfall may be $2.7 trillion. A similar calculation by Moody’s, a ratings agency, reckons that schemes are 52% underfunded.
This is a huge problem. But to effectively address it requires knowing how big it actually is. That is easier said than done, given that much of the underfunding is the result of fuzzy math that has resulted in discount rates based on overly optimistic investment return projections.
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