NCPA - National Center for Policy Analysis

The Real Cost of Public Pensions

June 12, 2012

The generosity of public-sector pension benefits has come under increased scrutiny in recent years as state and local governments search for ways to close their budget deficits.  Lawmakers are eager to understand how public-sector pensions compare to their counterparts in the private sector, thus determining if cuts are warranted, says Jason Richwine, a senior policy analyst at the Heritage Foundation.

The problem, however, is that assigning a cost to public-pension compensation is difficult, involving complex analysis of accounting methods and investment behavior.

  • Their cost cannot simply be measured by how much governments spend on them annually because governments often pay less than their advisers tell them to (in effect writing IOUs).
  • Additionally, actuaries struggle to estimate what eventual expenses will be, as these are determined by a worker's number of years worked, average salary and longevity of life.
  • Also, government payments into pension plans are determined in part by their selected discount rate -- the level of performance that they attribute to their investment portfolio that will eventually pay for a worker's plan.
  • These discount rates are often set inappropriately high, thereby encouraging governments to set aside far too little into their pension plans.

The difficulty with discount rates is especially acute, as it is crucial in disguising the true cost of public-sector pension plans and will likely result in chronic underfunding.

  • Many public-sector pension plans assume an 8 percent discount rate; that is to say, they assume their invested funds will generate an 8 percent annual return.
  • While this is a feasible outcome, it must be recognized that performance at that level carries substantial risk.
  • The pension plans' outlays, on the other hand, are virtually guaranteed to have to pay out to workers when they retire.
  • This mismatch between the risk of revenues and expenditures is inappropriate and violates sound accounting principles -- if there is no real risk of the plan escaping its obligations to workers, there should be no real risk in its investment portfolio.
  • Therefore, pension plans should be discounted at the risk-free investment rate (likely government bonds at around 2 to 3 percent) instead of the convenient 8 percent.

When plan actuaries adjust projections and assessments to this appropriate discount rate, the cost of public-sector plans soars beyond their counterparts in the private sector.

Source: Jason Richwine, "The Real Cost of Public Pensions," Heritage Foundation, May 31, 2012.

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