Pension Unfunded Jumps from $82 Billion to $168 Billion Due to New Accounting Rules

As I have written many times over the years the $82 billion figure was a made up number, a rosy scenario or a best case scenario. And now GASB agrees with me, Professor Josh Rauh at Northwestern University and Andrew Biggs at the American Enterprise Institute: Illinois’ pension deficit is so large it will most likely never be paid.

The Government Accounting Standards Board (GASB) just released its new rules for calculating unfunded balances for public pensions as of 2014. Under these new rules, IL Pension Benefit Obligation (the amount we owe in total for pensions as of June 30, 2011) goes from $144 billion to $230 billion. If we subtract the $62 billion in assets we have on hand we come up with an unfunded pension liability of $168 billion, more than doubling the already politically inconvenient amount of $82 billion.

How GASB came up with the new number.

There are several ways in which actuaries must change the future allocation of pension liability. Here are the major changes required by GASB for future actuarial reports.

  1. Smoothing is no longer permitted.
    Smoothing is a technique used by pension funds to level off year over year variations in asset values due to ups and downs in the markets. Up until the disastrous years of 2008 and 2009 IL funds did not use smoothing but after losing $25 billion they suddenly came to the conclusion that smoothing would be a good idea because it would make the unfunded look better than it really was. Smoothing works like this: if you were applying for a loan and had $100 in assets at the end of 2007 and only $50 at the end of 2008 then via smoothing you would claim you have $75 in assets in 2008. Think the bank would accept that conclusion?
    Effect on unfunded: Eliminating smoothing adds about $3 billion to the unfunded.
  2. Entry Age Normal (EAN) must be used to calculate pension liability instead of Projected Unit Credit (PUC).
    This is a rather arcane actuarial issue involved with when you recognize a pension liability over an employee’s career. Generally speaking EAN requires using a flat percentage over the entire career (similar to Social Security) while PUC has a much lower rate early in the career and a much higher rate at the end of the career. Think of PUC as the kick-the-can-down-the-road method (which is why IL uses it) and EAN as the common-sense method.
    Effect on the unfunded: Hard to determine because it depends largely on the age of the employees but almost certainly adds to the unfunded. For the state’s purposes actuarial software should be able to determine the amount in short order.
  3. 10-year funding history is taken into account.
    The new rules assume the historic rate of contribution will continue into the future i.e. if the last 10 years’ contributions were low then they will be low going forward and thus effect your unfunded negatively. The 10-year rate is rolling which means it gets recalculated(smoothed so to speak) each year and therefore if contribution rates go up the negative effect would go down over time.
    Effect on the unfunded:Could be significant since if you are only contributing 50% of your required contribution the hole you are in will get deeper and deeper very quickly. This may have contributed to Boston College’s estimate for TRS as being 18% funded or to put another way82% unfunded.
  4. The blended rate: You cannot use 8.5% ROI estimates on assets you do not have.
    Basically the new GASB rules will allow funds to use whatever interest rate they have built into their actuarial assumptions on assets owned but on the assets they don’t own (the unfunded balance) you must use what is called the Municipal Bond Index Rate which is currently about 3.75%. GASB calls the combination of the assumed rate (8.5% for TRS) and the Muni Index Rate the “blended rate”. The actual calculation is a little complicated because it involves future contributions and a run-off of current assets but Boston College has done a preliminary calculation for IL state funds and came up with a blended rate of about 5% vs. the 8% current rate being used.
    Effect on the unfunded:This change is the big Kahuna causing the total unfunded to increase by more than $80 billion.

Let’s hit the “Reset Button” on pension reform.

Now that the world, if not IL politicians, has recognized the pension problem in IL is much worse than the “Rosy Scenario” that has been presented heretofore we need to start over with reform. After all, the first step in all 12 step recovery programs is admitting you have a problem. IL politicians and public sector unions have not done that yet and until they do any reform that passes will be wholly inadequate.

Doing something minor and insignificant and calling it “pension reform” would be the worst possible thing that could happen. Everyone must now admit that these pensions are never going to be paid in full and work backwards from there to come up with a solution.

After all guaranteeing pretend money that is not available now and will never be available in the future is a disservice to both the taxpayers and the public employees of IL. If that point is ignored the resulting financial chaos will negatively affect every citizen but especially younger public employees who have no chance of ever seeing their pensions paid in full.