Public Employee Pensions: Paper Cut or Death Wound?

A finance professor says U.S. public employee pensions are heading down the drain; other public pension experts say the situation will look better once Treasury rates perk up.

Joshua Rauh, a management school faculty at Northwestern University who holds a doctorate in economics from the Massachusetts Institute of Technology, talked about his concerns about public employee pensions Monday at a hearing organized by the House Judiciary Committee.

The committee is looking into the topic because some members are thinking about developing a bankruptcy system for U.S. states.

State and local governments typically use past returns, rather than the low rates U.S. Treasury bonds are now earning, when they analyze their ability to meet pension obligations, Rauh said, according to a written version of his public employee pension testimony posted on the committee website.

The states say they have about $2.8 trillion in pension assets and about $1.3 trillion in unfunded pension liabilities, or about $11,000 in unfunded liabilities per U.S. household.

“If a state wanted to pay an investor (say, an insurance company) to take over its pension liability, the amount the investor demanded would not depend on the state’s asset allocation or the expected return on its assets,” Rauh said. “If a state tells its employees that their accrued pension benefits are secure – not subject to risk like stocks – then it should use the yields on safe government securities such as Treasury bonds to calculate the pension fund’s net position.”

Many states have pension liabilities that are greater than plan asset levels even on a stated basis, and, using Treasury rates as the discount rates, the 10 states with the biggest unfunded liabilities appear to have unfunded liabilities that are about twice as big as asset totals, Raugh said.

Using Treasury rates to analyze pension obligations, the states unfunded liability totals that are about 50% to 250% the size of their asset totals.

Rauh and a colleague have estimated the plans’ total unfunded liability may be closer to $3 trillion, or about $25,000 per U.S. household, than $1 trillion.

“Congress should not take money from taxpayers in fiscally healthy states to give to public employee unions in a handful of spendthrift states,” Rauh said.

But creating a state bankruptcy option could cause problems by alarming bond buyers and encouraging states that were aware of the bankruptcy option to overspend, Rauh said.

Rauh spoke in support of H.R. 567, the Public Employee Pension Transparency Act bill.