If our recent policy brief on public pensions piqued your interest in the subject, you’re in luck — the Congressional Budget Office has released its own issue brief: The Underfunding of State and Local Pension Plans. I was glad to see it, because it does a good job of explaining the issues involved, in a very readable nine pages.

The paper shows how the discount rate used by states (a median of 8 percent) differs from the fair-value approach (about 4 percent), leading to vastly different estimates of pension underfunding.  As summarized in the Director’s Blog,

The actuarial guidelines essentially assume that future returns on assets are as certain as benefit payments, at least in the long run; by contrast, the fair-value approach views the returns on assets as more uncertain than the benefit payments, even in the long run. By accounting for the different risks associated with investment returns and benefit payments, the fair-value approach provides a more complete and transparent measure of the costs of pension obligations.

Adopting a fair-value approach does pose challenges.  It could trigger a significant increase in funding requirements, further straining government budgets—despite the fact that, on average, a much smaller increase in funding might turn out to be sufficient to cover pension plans’ liabilities. Moving to a fair-value approach could also increase the volatility in reported underfunding and make budgeting for the required contributions more difficult.

CBO calculates that state and local governments’ unfunded pension liabilities in 2009 were $0.7 trillion using an 8 percent discount rate.  The unfunded liabilities grow as the discount rate declines: $1.6 trillion (6 percent), $2.2 trillion (5 percent), $2.9 trillion (4 percent).

As the paper notes, actuarial guidelines

allow the reported value of assets to be an average of the market value of assets over several years, so as to blunt the impact of a large swing in the value of equity holdings in a single year.

Accordingly, Washington smooths assets over a period of eight years.  However, CBO says that

by not smoothing asset values over time, the fair-value approach provides a clearer view of the fluctuations that can occur in long-term funding needs when risky assets are used to finance fixed pension obligations.

Further,

The fair-value approach also gives a more complete picture of the costs of changes in policy, to the extent that such changes would affect pension benefits (and possibly wages) for current employees.

As CBO concludes,

employee compensation packages currently may be substantially distorted by political pressures to favor deferred compensation—to raise pension benefits and postpone the associated costs to taxpayers until some future time.