A recent report from Stanford University’s Hoover Institution details the “Hidden Debt” and “Hidden Deficits” contained in state and local government pension unfunded liabilities. The report begins by stating:

“despite the introduction of new accounting standards, the vast majority of state and local governments continue to understate their pension costs and liabilities by relying on investment return assumptions of 7-8 percent per year. This report applies market valuation to pension liabilities for 649 state and local pension funds. Considering only already-earned benefits and treating those liabilities as the guaranteed government debt that they are, I find that as of FY 2015 accrued unfunded liabilities of U.S. state and local pension systems are at least $3.846 trillion, or 2.8 times more than the value reflected in government disclosures. Furthermore, while total government employer contributions to pension systems were $111 billion in 2015, or 4.9 percent of state and local government own revenue, the true annual cost of keeping pension liabilities from rising would be approximately $289 billion or 12.7 percent of revenue. Applying the principles of financial economics reveals that states have large hidden unfunded liabilities and continue to run substantial hidden deficits by means of their pension systems.”

unfunded liabilities
Chart via Hoover

By using unrealistic investment targets and only reporting the earned benefits as liabilities, the public pension system under represents the complete picture of its unfunded liabilities.  As of fiscal year 2015, the complete accounting for unfunded liabilities from all cities, states, governments were $1.378 trillion. This is after recently implemented governmental accounting standards. Nevertheless, these accounting methods do not incorporate more market valuation techniques which treat future obligations as a capitalized long term debt. This problem arises because recent reforms in governmental accounting permitted pensions to assess their liabilities based expected return on assets. Thus, there is little allotment for the inherent risk posed by these projections. Especially, when pensions place expected rates of returns at 7.6%(a expected rate return that is proving difficult to obtain) which would mean that they expected the value of their money to double approximately every 9.5 years. These projections create distortions that under state the true cost of the unfunded portion of the pension liabilities. According to the report:

“The market value of unfunded pension liabilities is analogous to government debt, owed to current and former public employees as opposed to capital markets. This debt can grow and shrink as assets and liabilities evolve. From an ex ante perspective, the economic cost of the pension system to the sponsor is the present value of the increase in pension promises (service cost) plus the cost incurred because existing liabilities come due a year sooner (interest cost). Under lower discount rates, the service cost is higher but the interest cost is lower.”

The complete report can be read here