Responses to Wall Street Journal article on state pensions

The Wall Street Journal
printed two letters in response to my article last week on accounting in state pension plans:

Andrew G. Biggs describes how the state of Montana is seeking to minimize the amount of its unfunded pension liability to be disclosed to the public ("Public Pensions Cook the Books," op-ed, July 6). He explains why state and local governments might wish to understate this figure, but says little as to why the various public employee unions -- ostensibly those which should be protecting the future pensions of their members -- aren't themselves insisting on a more honest and realistic calculation of this liability. I suggest there is a very practical reason for union acquiescence to an underestimation of the pension liabilities owed to their members: They have more to gain by maintaining the present system, as opposed to risking any changes to future benefits which might result from an honest accounting of the liabilities.

Generous retirement benefits for teachers and other public sector employees, we are told, compensate them for the relatively lower wages they receive on the job. Long ago, this was likely the case. Yet over time, as teaching and other public sector jobs have increasingly become unionized, that wage gap (to the extent it still exists at all) has been reduced. But the generous benefit structure, from pensions to fully subsidized health care to vacation allowances, has been safeguarded by the unions and the administrators (many of whom are themselves union members). In other words, the pension and benefit systems are at the core of how teaching and other public employee unions maintain themselves.

If the pension and benefit systems look more like the packages found in the private sector, it becomes harder to justify having a union. It seems that maintaining the system is the chief goal of public unions; paying for it is someone else's problem.

W. R. Nelson
Glenview, Ill.

Andrew Biggs's article reflects a misguided understanding of state and local pensions and government accounting, ignores salient facts and distorts key issues. He chastises government pensions for not using a corporate finance model that represents a settlement price, but fails to acknowledge that this is irrelevant to public pensions because they and their sponsoring entities are going concerns, not subject to takeover or going out of business.

Rather than accuse the National Association of State Retirement Administrators of "taking the low road," had Mr. Biggs read our resolution on the subject, he would know our opposition to so-called market-based techniques is logical and fact-based. Further, the application of these techniques to corporations has been a leading cause of pension abandonment due to the extreme volatility they cause in funding levels and required costs.

Mr. Biggs should also recognize that both actuarial and accounting standards support the use of the plan's long-term investment return assumption. This fact animated the state of Montana to insist on actuaries who would not espouse practices in conflict with the state's legal environment and actuarial and accounting standards. It is nonsensical to require state and local governments to calculate a settlement value for plans that are not going to terminate.

The Governmental Accounting Standards Board considered and rejected so-called "market-based" techniques in 1994 when it established standards for calculating and reporting public pension liabilities. GASB instead found that trend-based actuarial measures, consistent with public plans' long-term nature, are a better gauge of a plan's financial condition than the single-point, market-based measures promoted by Mr. Biggs, a group of financial economists and those with a financial interest in the outcome of this debate.

Terrance Slattery
President
National Association of State Retirement Administrators
Santa Fe, N.M.

With regard to Mr. Slattery's letter, let me make this comparison to give a rough idea of what I'm talking about:

Let's say that your pension plan owes $1,000,000 that it must pay 20 years from now. (This is a simplification of smaller cash payments over a longer period, but analytically that doesn't matter.) The question is, how much should you set aside today such that you can say you've "fully funded" that future obligation. Under the logic of state pensions, if you invest in stocks – with an average annual return of 10.7% per year – you only have to set aside $130,933. If that amount today earns 10.7% annually over the next 20 years, it will equal $1,000,000. 'Nuff said, right?

Not really, since stocks are risky. The standard deviation of stocks has been around 18.5% per year. So, using a simple Monte Carlo simulation, I create 1,000 possible outcomes for that investment. Now, the average end balance is right around $1,000,000 – but that average can be very misleading. In fact, in almost two-thirds of cases, the initial $130,933 investment fails to equal $1,000,000 at the end of 20 years. This makes a travesty of the claim that the plan is fully funded. Now, if the plan were empowered to reduce benefits if investment returns were too low, then I could understand where they were coming from. But state pension benefits are generally guaranteed by law – the government can't get out of paying them short of default. If it's certain the benefits must be paid, then you want to discount your future benefit obligations at an interest rate that reflects that certainty. That will require you to set aside more money today, which the plans obviously aren't keen on doing, but clearly makes the plans more fully funded.