Riordan, Rutten and the Scope of Real Pension Reform

Reading over their response, you can probably get a better idea why so many state and local governments wound up in this mess in the first place--namely because so many people underestimate the complexity of defined benefit pension accounting and the many ways that officials and their hired actuarial hands have gamed the system over the years. Let's consider all that would really have to change to bring taxpayers genuine peace of mind and security.

Riordan and Rutten's one big example of reform, which they repeat again, is that, in exchange for federal guarantees, someone in Washington (presumably Congress) would negotiate with unions for a nationwide discount rate (that is, a projected rate of future investment returns) that pension funds would have to adhere to. This rate would, we assume, would be much more reasonable than the current overly optimistic rates that pension funds currently use (which has the effect of minimizing their liabilities or debts).

Changing this rate would indeed drastically impact the unfunded liabilities of state and local defined benefit plans and bring some sanity to the accounting of these systems. But the discount rate is only one part of the variables in pension accounting these days. There are many other components and variables to plans' accounting that have helped add to the current mess, ranging from:

The methods the plans use to value their assets, including whether they employ long-term 'smoothing' changes to minimize the impact of market downturns on their plans (some plans like Calpers have switched methods in midstream to be able to claim larger assets and reduce annual payments of local governments to the system, defusing criticism of the cost of pensions)

What schedules the plans use to determine how long on average their plan members will live (some plans have magically reduced their liabilities by reducing the estimate lifespan of members)

What method the plans use to determine how much they contribute every year to an active members' eventual retirement (some systems backload the contributions to minimize their current payments, increasing the plan's risks of default)

What time frame the plans use to project paying down of liabilities. Some plans typically restart their time frame every year, creating what MI fellow Rick Dreyfuss calls "rolling amortization" plans that never seek to pay down their liabilities. It's one of a menu of "pseudo reforms" Rick highlights.

Whether states and cities adhere to their own questionable standards in the first place. (More than half of major cities and states, according to a Pew study, didn't contribute fully to their pensions systems even by the accounting standards they employ).

As Rick Dreyfuss points out, in recent years as pension systems have come under more pressure to reform and reduce their liabilities, they've resorted to more and more pseudo reforms that are little more than gimmicks.

Indeed, to get a true sense of the gimmicks and "variations" in accounting that public pension systems use, try reading the Securities and Exchange Commission's cases against New Jersey and Illinois, in which the description of the discretionary accounting techniques go on for pages (The SEC doesn't argue that these are illegal, but merely that by employing them without informing bondholders of the risks involved, the states were violating disclosure requirements). The SEC is currently investigating other states and cities for similar abuses.

To minimize the future hazard for taxpayers (and the federal insurance program), the unspecific Washington negotiators in Riordan and Rutten's plan would have to agree to standards for most of the areas covered in the above bullet points.

Of course, even if you accomplished that using reasonable actuarial standards, the unfunded liabilities you would expose in many of these plans would be staggering, at the high end of most estimates. That would mean that the amount of money the most indebted places would need to borrow (that is, the places most likely to want to take advantage of this program) would also be staggering. Chicago might have to borrow five or six times its annual tax revenues to dig itself out of its hole.

But that only deals with the past debts. The bigger problem is that these new standards would instantly make many current defined benefit plans wildly unaffordable going forward. The amount of money that states and cities would have to contribute to fairly fund new retirement credits being earned every year would double and maybe triple in some places. Actual benefits would have to change drastically to make the plans sustainable.

Maybe Riordan and Rutten understand this and their plan is just some stealth effort to get the unions to the table then hit them over the head with the reality of reasonable accounting standards. But what's just as likely is that in negotiations (again, depending on who is doing the negotiating) some of these accounting areas would be minimized or ignored, the way they are in state and local reform efforts, leaving loopholes in the system that could be exploited because the very nature of these defined benefit plans demands accounting that's full of projections and guesstimates, with the taxpayer as the backstop if the experts get things wrong.

This is why the simpler and safer alternative is to end the madness by offering these very systems aid in return for moving away from defined benefit plans with all of the accounting guestimates involved, and toward some version of defined contribution plans or hybrid plans that feature a modest-capped defined benefit (in places where government workers don't participate in Social Security) with a defined contribution plan. Doing this reduces the moral hazard for taxpayers far more swiftly and efficiently than trying to fix a complex system that is loaded with hidden debt time bombs and which elected officials in some states and cities have been gaming for years.

Of course such alternatives might not be politically acceptable right now in some of these places, which is precisely why some governments are in such trouble. But even Rhode Island, where government unions are powerful, has managed just such reforms, once voters were made to understand the fiscal threat they faced from their current pension system.