NCPA - National Center for Policy Analysis


August 21, 2006

Because their size and complexity offer such a wide field for abuse, state and local retirement systems pose a significant moral hazard -- threatening the long-term fiscal stability of many of their sponsors, says E.J. McMahon, senior fellow at the Manhattan Institute.

In determining a system's necessary funding levels, methods vary greatly between private and public plans:

  • Private plans are required to discount their liabilities based on corporate bonds, which are usually lower than these plans' projected returns on investments. 
  • Public funds, however, are allowed certain accounting twists, which discount their long-term liabilities based on the assumed annual rate of return on their assets -- which, for most public funds, is pegged at an optimistic 8 percent or more.

If the liabilities of public pension funds were valued on the same basis as private funds, funding requirements would be dramatically higher, says McMahon: 

  • Even "fully funded" systems like New York's would find themselves tens of billions of dollars in the hole. 
  • In total, estimates of the nation's real public pension funding shortfall range from an added $500 billion for state retirement systems to at least $1 trillion for all public systems.

Thus, the overriding concern of public pension reform should be to reduce the taxpayers' exposure to accounting and financial risk -- now and in the future.  According to McMahon, four essential steps towards that goal include:

  • Shift to defined contribution plans for all future workers.
  • Immediately recognize and fund the full cost of any benefit increase.
  • Expand financial reports to include alternative funding assumptions.
  • Gradually lower the expected rate of return -- and invest accordingly.

Source: E.J. McMahon, "Public Pension Price Tag," Wall Street Journal, August 21, 2006

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