The unfunded obligations of the pension systems sponsored by state and local governments in the United States continue to grow. In this second annual report on the off-balance-sheet pension promises of state and local governments, we study in detail 649 pension systems around the United States, including all of the main pension systems of the states, the largest U.S. cities, and the largest U.S. counties. We report on both their own measurements of their costs and obligations, and how these differ from market valuations that are consistent with the principles of financial economics.

As of fiscal year 2015, the latest year for which complete accounts are available for all cities and states, governments reported unfunded liabilities of $1.378 trillion under recently implemented governmental accounting standards. However, we calculate using market valuation techniques that the true unfunded liability owed to workers based on their current service and salaries is $3.846 trillion. These calculations reflect the fact that accrued pension promises are a form of government debt with strong rights. These unfunded liabilities represent an increase of $434 billion over 2014, as realized asset returns fell far short of their targets. […]

What is in fact going on is that the governments are borrowing from workers and promising to repay that debt when they retire, but the accounting standards allow the bulk of this debt to go unreported through the assumption of high rates of return.

The GASB disclosures provide interest-rate sensitivities for each plan, allowing calculations of the unfunded liability under different discount rates. Among the 649 plans, the liability weighted average sensitivity of total liabilities to a 1 percent change in the discount rate is 11.2 years. The appropriate discount rate for a guaranteed nominal pension is the rate on a government bond with a guaranteed nominal return of that same maturity.

A rediscounting of the liabilities at the point on the Treasury yield curve that matches the reporting date and duration of each plan results in a liability-weighted average rate of 2.77 percent and unfunded liabilities of $4.967 trillion. Since not all of these liabilities are accrued, we apply a correction on a plan-by-plan basis (based on Novy-Marx and Rauh 2011a, 2011b) that results in unfunded accumulated benefits of $3.846 trillion under Treasury yield discounting. These are the unfunded debts that would be owed even if all plans froze their benefits at today’s promised levels. I refer to this measure as the unfunded market value liability, or UMVL.

The market value of unfunded pension liabilities is analogous to government debt, owed to current and former public employees as opposed to capital markets. This debt can grow and shrink as assets and liabilities evolve. From an ex ante perspective, the economic cost of the pension system to the sponsor is the present value of the increase in pension promises (service cost) plus the cost incurred because existing liabilities come due a year sooner (interest cost). Under lower discount rates, the service cost is higher but the interest cost is lower.

The way in which pension costs are often informally discussed is at odds with these underpinnings. The total of general revenue from own sources for all state and local government entities in the United States is $2.268 trillion and total government contributions were $111 billion, so contributions were 4.9 percent of revenue in 2015. While this would have been approximately enough contributions to prevent the GASB unfunded liability from rising if the expected return targets had been realized, they in fact fell short by $182 billion due to the difference between expected and realized returns. In 2015, systems realized average investment returns of only 2.87 percent on beginning-of-year assets. Similarly, under the risk neutral discounting procedure, liabilities would have risen by $178 billion.

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This article republishes a selection from for “Hidden Debt, Hidden Deficits: 2017 Update” by Joshua Rauh, a research project published by Hoover Institute in May 2017.