(Sean Whaley/Nevada News Bureau) – If the idea that a $9.1 billion long-term unfunded liability in Nevada’s public employee pension plan is cause for concern, then a recent analysis by the American Enterprise Institute for Public Policy Research should really get the attention of state policy makers.
The study by Andrew Biggs, a resident scholar at AEI, says the methods by which unfunded liabilities are calculated by state and local government pension systems are inaccurate and do not show the real risk to taxpayers who will foot the bill if the funds fall short of cash to pay obligated retirement benefits.
A market valuation of pension shortfalls is more accurate and shows the real risk to state budgets and taxpayers, he said. This analysis shows there is only about a 40 percent probability that a fully funded pension plan will be able to pay retirement benefits when bills start to come due, he said. The probability is even lower for plans that are not fully funded, including Nevada’s, Biggs said.
For Nevada’s Public Employees Retirement System, which covers almost all public employees in the state, the shortfall using this analysis is closer to $33.5 billion as of June 30, 2008, Biggs said.
Nevada’s regular employee fund was 78 percent fully funded using the actuarial method of calculation, but only 42 percent fully funded using the market analysis, he said. For Nevada’s police and fire plan, the actuarial method shows it 71 percent fully funded, but only 38 percent fully funded using the market analysis.
The $9.1 billion number is the PERS estimate based on the actuarial method as of June 30, 2009. The actuarial method is currently the accepted practice for pension plans.
Biggs doesn’t quibble with the assumption by the Nevada plan that it will get an 8 percent return on its investments over the long term. But that doesn’t mean the plan will earn 8 percent over a shorter period of time. Annual returns can fluctuate widely, he said.
The actuarial method of calculating the unfunded liability does not include any risk factor, Biggs said.
“For an economist this doesn’t compute,” he said.
His report says: “Current pension accounting methods report plans’ funding shortfalls assuming that pension investments in stocks, bonds, hedge funds, and private equity will produce forecasted rates of return with certainty. Market-valuation methods account for the uncertainty inherent in such investments by recognizing that risky investments cannot produce a guaranteed return.”
“They act as if they can earn 8 percent without any risk, and they can’t,” Biggs said in a telephone interview. “The government has to pay the bills when they come due and they are coming due soon. Baby boomers are retiring from government jobs just as they are in the private sector.”
Without knowing the true cost of the unfunded liability, governments can’t prepare for the day when these funds will likely be in financial trouble, Biggs said.
Biggs said the inadequacy of these pension funds will likely emerge at the worst possible time, when there is an economic downturn and high unemployment making it difficult for state to raise taxes or borrow money to pay the legally obligated benefits.
“It needs real reform,” he said. “Otherwise we will find out the numbers were wrong too late, and the plans should have been properly funded 20 years ago.”
Dana Bilyeu, executive officer of PERS, does not dispute Biggs’ method of calculating the shortfall, but said the actuarial method now being used is the accepted practice for public pension plans. The market analysis used by Biggs has not been accepted by the actuarial profession, she said.
“It is a school of thought related to pension funding,” Bilyeu said. “It is not the majority opinion.”
Bilyeu said the concept suggests that the 8 percent anticipated return carries risk, and that a safer approach would be to use a lower, more conservative number. Changing the assumption to a 4.5 percent return, for example, would of course cause the unfunded liability to balloon to a much higher number, she said.
Bilyeu said the 8 percent projected rate of return is the result of significant analysis that shows the rate is achievable over both the long term and the capital market cycle. Payments are made into the plan each year by public employers and employees based on assumptions made by the PERS board, which in turn are based on recommendations from an actuarial firm, to ensure there is enough funding to pay benefits as they come due, she said.
“I’m happy to disclose at 4 percent or 8 percent or our actual return over 25 years of 9.4 percent,” Bilyeu said.
But making such a radical change to the PERS plan would be disruptive, she said.
“I do object when they say we’re not doing it right,” Bilyeu said. “We follow generally accepted actuarial practices.”
Bilyeu did note, however, that the Governmental Accounting Standards Board is currently reviewing pension accounting and financial reporting standards. A comment period is under way, and changes will likely be coming forward by 2013, she said.
Nevada will of course comply with any changes, Bilyeu said, “But the process needs to be deliberative.”
Biggs also talks about the issue of “smoothing” in his report, where annual market returns are averaged over time, which can mask a bad year in the market. Nevada uses a five-year smoothing period, and this average is used by actuaries to set contribution rates to pension plans, he said.
While a concern, smoothing pales in comparison to the need to accurately reflect the real long-term unfunded liability, Biggs said.
Biggs said a move to a defined contribution plan for new government employees is an option to address the pension funding issue going forward, but it does not eliminate the unfunded liability for current public employees and retirees.
Accurate reporting will give policy makers the information they need to ensure the long-term viability of such plans, he said.