Publisher's note: Agenda 2012 is the John Locke Foundation's charge to make known their wise political agenda to voters, and most especially candidates, with our nineth installment being the "State Unfunded Liabilities," written by Fergus Hodgson, Director of Fiscal Policy Studies,
John Locke Foundation. The first installment was the "Introduction" published here.
When you promise to pay someone in the future, you have a debt with him. However, were you to use cash accounting, as North Carolina's government does, you would not record it as such, because no cash changed hands.
While that may strike you as bizarre, state retirement benefits work in precisely this manner. In North Carolina, for example, state government has promised state employees and teachers a retiree health benefit worth at least $35 billion -- more than two-thirds of annual state spending -- without recording the promise as an ongoing expense. Taxpayers in North Carolina are now indebted for this defined benefit, while lawmakers have put aside just $684 million to cover it, 2 percent of the obligation.
Such deferred expenses are politically convenient because they get around the state's balanced budget amendment. Additionally, they allow governors and state lawmakers to reward interest groups, particularly government employees, while shifting the politically difficult burden of taxation onto future governors and lawmakers.
Retiree health benefits are the state's largest and most vulnerable unfunded liability -- $34.2 billion at the end of the 2010 calendar year (accounting for the 2 percent set aside). Total unfunded state employee liabilities, adding in promised pension benefits and subtracting surpluses in some pension accounts, is officially reported as at least $37.5 billion or $14,740 per taxpayer (in 2012 dollars).
The $34.2 billion for retiree health benefits is up from $29.8 billion at the end of 2008, an increase of $4.4 billion in two years. To put that magnitude into perspective, the increase in retiree health benefits alone constituted about 5 percent of total reported spending in fiscal years 2009 and 2010 combined.
The official measures of state unfunded liabilities published in the Comprehensive Annual Financial Report (CAFR) are underestimates since they confuse a discount rate with a return on investment. The Office of the State Controller discounts from an assumed investment return of 7.25 percent. Analysts from both the Congressional Budget Office and the Institute for Truth in Accounting recommend discount rates closer to 4 percent, and recent declines in the funding levels of state pensions have affirmed this vulnerability.
1. So long as the state maintains pension and other benefit programs for teachers and state employees, they ought to function as defined contributions rather than defined benefits. That means money is set aside now and returns accrue on that money -- rather than promises now without money to match them. The switch will do nothing to reverse the unfunded liabilities that exist, but it will bring an immediate halt to their worsening. The switch is also in the interest of state employees, since it offers portability and guarantees the money will actually be there when they retire.
2. As more government employees retire and the relevant pension funds deplete, a reconciliation of the unfunded liability will have to occur. Given the magnitude of the liability -- more than two-thirds of annual state spending and almost twice the General Fund budget -- the generosity of benefits will have to come down to better reflect the money originally set aside, as opposed to the mere promises made without contributions. As younger individuals ought to prepare for life without full Social Security benefits, so too should government employees prepare for defined benefit plans that cannot eventuate.
3. To more accurately account for unfunded liabilities in the CAFR, use a discount rate that reflects the near certain obligation of retirement benefits. As promoted by the Congressional Budget Office, that would be around 4 percent, if not lower.
To avoid this mess of unfunded liabilities, which arises from cash-basis accounting, state legislators ought to adopt understandable and accurate accounting based on accrued liabilites. The Institute for Truth in Accounting proposes an excellent mode, called F.A.C.T. accounting (for Full Accrual Calculations and Techniques). The organization offers a pro-forma Truth in Accounting Act to formalize the conversion.
Analyst: Fergus Hodgson
Director of Fiscal Policy Studies