NCPA - National Center for Policy Analysis

State and Local Accounting Standards Encourage Risky Investments

March 24, 2011

The accounting standards applied to public sector pensions are far more forgiving than those required for use by private sector pensions or those that economic theory and the financial markets would recommend.  Put simply, public pension accounting standards encourage state and local governments to promise too much, fund too little and take too much risk with their investments, says Andrew Biggs, a resident scholar at the American Enterprise Institute.

To illustrate, consider a pension that owes a lump sum of $500 million 15 years from now.  It has $100 million in assets today with which to fund that liability.  How well funded is it?

Under current accounting standards, that depends on what those funds are invested in.

  • If the plan holds $100 million in stocks with an expected return of 10 percent, then it discounts the future liability by a 10 percent annual return, generating a present value of $120 million.
  • The plan is considered 85 percent funded and has an unfunded liability of about $20 million.

But now imagine that the plan shifted its assets to U.S. Treasury securities yielding 4 percent.

  • This would alter the discount rate applied to the future liability, generating a much higher present value of around $275 million.
  • The plan would now be considered only 37 percent funded, with an unfunded liability of almost $180 million.

This exercise is what public pensions go through every day and is in part accountable for why pension assets have shifted increasingly toward equities, foreign investments, hedge funds and private equity.  The more risk you take, the better funded you look.  It is not an exaggeration to say that rising debt should be a central focus of public policy at the federal, state and local levels over the next decade, says Biggs.

Source: Andrew G. Biggs, "State and Municipal Debt: The Coming Crisis? Part II," American Enterprise Institute, March 15, 2011.

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