Gary Palmer: Whistling past the fiscal graveyard

  With all the talk of proration and deep cuts in state spending, most people in Alabama are well aware of the dire financial condition of the state of Alabama. What they probably do not realize is that the situation is even worse than it appears and is getting worse.

  Alabama, like almost every other state, is carrying massive unfunded liabilities for state and education employee pensions and health benefits that are requiring massive payments to remain solvent. Almost $1 billion of the $5.6 billion 2011 education budget passed during the last legislative session was to keep Alabama’s pension programs funded. Just over $1 billion more was appropriated to keep the health benefits programs funded.

  While Alabama has an unfunded liability of about $16 billion for health benefits, the greatest concern for Alabama and other states are the unfunded liabilities for state retirement plans because states are required by law to pay them. According to a February 2010 report from the Pew Center on the States, the Retirement Systems of Alabama (RSA) reports for 2008 a total liability of $40.2 billion for state and education employee pensions with $31 billion in pension assets, leaving $9.2 billion in unfunded liabilities. Another study published in April 2010 by the Center for Retirement Research at Boston College entitled The Funding of State and Local Pensions: 2009-2013 projects that the percentage of Alabama’s pension that is funded will decline to about 73 percent for 2009.

  Depending on the report you read, the total unfunded pension fund liabilities for all 50 states is between $750 billion and $3.23 trillion. For years these unfunded liabilities were hidden, but that changed when the Governmental Accounting Standards Board (GASB) issued rules requiring state and local governments to show these liabilities. Because these liabilities were hidden, state legislatures, including Alabama, did not appropriate adequate funding on an annual basis to keep the pension systems adequately funded resulting in pension plans with assets well below their liabilities. Not only has the Alabama Legislature failed to adequately cover the unfunded liabilities, they made the situation worse by approving Cost of Living Adjustments (COLAs) without appropriating funds to cover them, including a seven percent increase in 2006 that alone added over $817 million to the state’s pension obligation.

  Even with the new requirements for reporting unfunded liabilities, states can still present a fiscal picture for pension obligations that is not totally transparent. To a certain extent, states can minimize the impact of increases in obligations such as the increased cost of COLAs and of major investment losses by using an accounting procedure called “smoothing” to spread losses out to future years.

  In addition, Alabama and other states have used overly optimistic growth projections to reduce the size of the unfunded liability. In Alabama’s case, the RSA projects an eight percent annual growth rate for its pension fund investments which greatly discounts the amount of money needed in the fund now to meet future obligations. By contrast, private sector pension plan managers project returns of only 6.4 percent. In fact, Warren Buffet is projecting investment returns for Berkshire Hathaway of only 6.9 percent.

  Other pension fund analysts contend that states should base their investment return projections on the interest rates paid on U.S. Treasury securities. According to a study by University of Chicago Assistant Professor of Finance Robert Novy-Marx and Northwestern University Associate Professor of Finance Joshua D. Rauh, the RSA’s stated liability is $41 billion with pension assets of only $22.3 billion. According to Novy-Marx and Rauh, if the RSA based its projections for return on investments on Treasury bills the $41 billion liability reported by the RSA would soar to almost $79 billion.

  For Alabama to continue to use accounting and asset management methods to reduce the incentive for the state legislature to adequately fund state pensions or at least reduce the unfunded liability is the equivalent of “whistling past a fiscal graveyard” because eventually those liabilities must be paid.

  There are solutions to the problem including raising the retirement age from 55 to 60, increasing employee contributions and capping benefits at a set percentage. But the solutions are all long-term which means some tough decisions must be made in the near-term.

  As Dr. David Bronner, Chief Executive Office of the RSA, warned in the January 2010 edition of the RSA’s monthly newsletter Advisor, “The next two years are going to be the most difficult that I have witnessed.” Regardless of who the people of Alabama elect as the next governor and elect to the state legislature, they will be faced with a tremendous challenge of getting Alabama’s fiscal house in order.

  About the author: Gary Palmer is president of the Alabama Policy Institute, a non-partisan, non-profit research and education organization dedicated to the preservation of free markets, limited government and strong families, which are indispensable to a prosperous society.