How to Low-Ball a $4.4 Trillion Pension Hole

James Greiff is an editor for Bloomberg View. He was Wall Street news team leader at Bloomberg News and senior editor for Bloomberg Markets magazine. He previously reported on banking for the St. Petersburg Times and the Charlotte Observer.
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Last week's report that Philadelphia borrowed $50 million to open its schools on time was another chapter in the tale of the city's industrial decline, middle-class flight, population loss and racial segregation. What was interesting, though, was this line in a New York Times article, reporting that the school district has a projected deficit of $304 million:

As was the case with Detroit, the district's full debt is even worse than what is known because retiree health and pension obligations have not been disclosed. That is about to change, though, because of new accounting rules that require them to be made public.

There are a couple of components to this. Although the changes adopted last year don't require disclosure until 2014, the rulemaking body that governs government accounting missed a chance to lift some of the fog on the sublimely opaque matter of pension accounting, by failing to require pension funds to say just how much of a future deficit they might be facing.

The easy part is disclosure. Under rules passed by the Governmenal Accounting Standards Board, governments will have to incorporate their unfunded pension and retiree obligations into their financial statements. These figures now are segregated in separate footnotes to the financial statements. The effect probably will be to make the debt of states such as Illinois and New Jersey, which haven't adequately funded their pensions, look worse.

But understanding how much money governments really need to put into their pensions -- and how much of a hit is coming to taxpayers -- will be as murky as ever.

Because pensions are paid out in the future, fund managers make a couple of assumptions. One is the value of a payout made years from now as if it were in today's dollar, or what's known as the discount rate. A bigger discount rate magnifies the value of current dollars, so you can guess how most municipal and state governments have leaned on this one.

Some governments, though, have abused this discretion and are at risk of running out of money to pay retiree benefits in the future. The rule changes will force these funds to use a stricter discounting method, making their status look worse. By one estimate, funds that as of 2010 had 76 cents for every dollar owed to retirees would have just 57 cents using the more stringent methods.

The flip side of this are the assumptions about how much the money accumulated in a pension fund earns, which goes into the discount rate calculation. Most funds still count on a return of 7 percent to 8 percent. This might have been a realistic range back in the dot-com era, but the figures bear little resemblance to reality today. Just one example: The Standard & Poor's 500 Index had no gain between the end of 2000 and the end of 2012. Of course, the higher a pension fund's assumed return, the less taxpayer money it needs.

The new rules will require governments to say how they calculate the discount rate and assumed returns. But the rulemakers still let local governments pick and choose numbers that don't add up.

What the rulemakers should have done is recognize that, outside of bankruptcy, a pension is a legal obligation that must be paid no matter what. So pensions should be matching one sure thing -- the benefit pay out -- with another sure thing in terms of investment return. And what's the most reliable investment out there? U.S. Treasuries usually fit the bill, and right now they yield anywhere from next to nothing for a three-month bill all the way up to a lofty 3.86 percent for the 30-year bond.

U.S. pensions are underfunded by as much as $4.4 trillion, according to a 2012 study by the Kennedy School at Harvard. How will it ever be possible to make headway in filling that hole if the people who run state and local pensions funds can base their projections on the rosiest numbers they can dream up?

(James Greiff is a member of Bloomberg View's editorial board. Follow him on Twitter.)

Corrects name of Governmental Accounting Standards Board in fourth paragraph.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

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