3:44am

Fri July 20, 2012
Planet Money

Public Pensions Are About To Look Less Healthy

Originally published on Sat July 21, 2012 11:06 am

The health of public pension plans — the retirement plans for teachers, firefighters, police officers and other state and local governments — has gotten plenty of attention lately.

Some plans are hurting, and numbers from state and local governments suggest their public pension plans are underfunded by about $1 trillion.

But that gap between what they owe and what they have on hand today is about to look bigger — much bigger, in some cases.

Take Washington state's retirement system. It has two plans "that are not 100 percent funded," says Matt Smith, the state actuary in charge of the plans.

Translation: The money in the pension fund right now isn't likely to grow enough over time to meet the retirement promises the state has made to all of its current employees and retirees.

That part isn't new. What's changing is the way that number is calculated — that gap between tomorrow's obligations and today's investments. The Governmental Accounting Standards Board, GASB, is a nonprofit group that sets guidelines for how state and local governments report their finances, including for their pension plans.

GASB is changing the way governments calculate their pension liability. Their change gets at a fundamental question — how much money is enough?

The way you answer that depends on a single number, called the discount rate.

"You know that William Carlos Williams poem, 'So much depends on a red wheelbarrow'?" says Joshua Rauh, a professor of finance at the Stanford University Graduate School of Business. "Yes. Well, in my world it is, 'So much depends on that darn discount rate.' "

Right now, most cities and states use a number around 8 percent: They assume their investments will earn at least 8 percent per year.

Dave Urbanek, director of communications for the Illinois Teachers Retirement System, says there's good reason to use that number.

"We set the rate of return based on history and practice," Urbanek says. "The TRS assumed rate of investment return is 8.5 percent over 30 years. And over the last 30 years, our actual rate of return has been 9.3 percent."

But Rauh says it doesn't matter what returns have been historically. Assuming that past good returns will continue is risky — he says there's a good chance returns could worsen, and that pension assets won't perform.

GASB seems to agree. It's changing its guidelines on what the discount rate should be.

Under the new guidelines, some states and cities can no longer use that simple 8 percent number. The rules get complicated, but in certain situations, they'll need to use a much lower number — a rate as low as 5 percent.

And the number you use makes a big difference. A pension fund that seems OK with an 8 percent expected rate of return doesn't seem so great at 5 percent. (The lower the rate, the more you have to sock away today to pay the same pensions in 30 years.)

And if you are a pension fund that is already in trouble, this change is the last thing you need.

Take the Illinois Teachers Retirement System again, which has less than half the amount it needs to pay current and future retirees over the next 30 years. Urbanek says the fund is actually 53.5 percent short of what it needs.

But that number was calculated under the current guidelines, using a discount rate of 8 percent. Under the new guidelines, it's likely to get worse.

"I mean, what's happening is that I've got a burn on my arm," Urbanek says. "EMT tells me third-degree burn. I go into the doctor's office and he tells me it's a fourth-degree burn. We have a problem. Depending on how you calculate it depends on how big the problem is."

Urbanek worries this change will undermine people's faith in the retirement system.

Josh Raus and GASB say it's time to lay the cards on the table so everyone can see them. They say changing this number doesn't change economic reality — it just better reflects what that economic reality is.

Copyright 2013 NPR. To see more, visit http://www.npr.org/.

Transcript

RENEE MONTAGNE, HOST:

We've been hearing a lot about state and municipal pension funds, which are in trouble around the country. According to state and local governments, the country's public pension plans are underfunded by about a trillion dollars. Now that gap between what plans owe and what they currently have on hand is about to look bigger. Caitlin Kenney from our Planet Money team explains.

CAITLIN KENNEY, BYLINE: Here's the question that everyone has for Matt Smith. He's the state actuary in charge of Washington State's retirement system. Does the state of Washington right now have all the money it's promised to pay retirees up till this date?

MATT SMITH: No, it does not. It has two plans that are not 100-percent funded.

KENNEY: Translation: The money there right now won't grow enough over time to meet the promises the states made. That part isn't new. What's changing is the way that number's calculated. The Governmental Accounting Standards Board, GASB, sets guidelines for how state and local governments report the finances of their pension plans. GASB is changing the way governments calculate their pension liability. Their change gets at this fundamental question: How much money is enough? The way you answer that all depends on this single number. It's called the discount rate. Joshua Rauh is a professor of finance at the Stanford University Graduate School of Business.

JOSHUA RAUH: You know, there's that William Carlos Williams poem: So much depends on a red wheelbarrow. Well, in my world it's so much depends on that darn discount rate.

KENNEY: Right now, most cities and states use a number around 8 percent. They assume their investments will earn at least 8 percent per year. Dave Urbanek is director of communications for the Illinois Teachers Retirement System. He says there's a reason we use that number.

DAVE URBANEK: We set the rate of return based on history and practice. The TRS assumed rate of investment return is 8.5 percent over 30 years. And over the last 30 years, our actual rate of return has been 9.3 percent.

KENNEY: But Josh Rauh, that professor, says just because it worked before doesn't mean it's going to work again.

RAUH: What the public sector accounting is doing is it is assuming that that history of having done pretty will continue indefinitely in the future, with certainty. It does not reflect the fact that there is a lot of risk that might not, and that these assets might not perform well.

KENNEY: The Governmental Accounting Standards Board seems to agree. It's changing guidelines on what that discount rate should be. Under the new guidelines, some cities and states can no longer use that simple 8 percent number. The rules get complicated, but in certain situations, they'll need to use a much lower number, a rate as low as 5 percent. And the number you use makes a big difference. A pension fund that seems okay with an 8 percent expected rate of return doesn't seem so great at 5 percent. And if you're a pension fund that is already in trouble, this change is the last thing you need. Take Illinois. The Illinois Teachers Retirement System already has less than half the amount it's promised to pay current and future retirees over the next 30 years. Here's Dave Urbanek again.

URBANEK: At the end of fiscal year 2011, our unfunded liability was 53.5 percent.

KENNEY: Keep in mind, that number was calculated under the current guidelines - 8 percent. Under the new guidelines, Urbanek has this analogy.

URBANEK: I mean, what's happening is I've got a burn on my arm. The EMT tells me it's a third-degree burn. I go into the doctor's office in an emergency room, and he tells me it's a fourth-degree burn. We have a problem. Depending on how you calculate it depends on how big the problem is.

KENNEY: Urbanek worries this change will undermine people's faith in the retirement system. GASB, the people who set these guidelines, they say it's time to lay the cards on the table so everyone can see them. They say changing this number doesn't change economic reality. It just better reflects what that economic reality is. Caitlin Kenney, NPR News. Transcript provided by NPR, Copyright NPR.