Paying Pension Benefits Would Require Massive Tax Increase

A recent study on public pension liabilities concludes that North Carolina would need to raise taxes on every household by $764 for each of the next 30 years just to fulfill its promises to retired state workers — and despite that startling conclusion, the Tar Heel State’s public pension system is in better shape than many of its peers.

The paper (PDF download) for the National Bureau of Economic Research, by Robert Novy-Marx of the University of Rochester and Joshua Rauh of the Kellogg School of Management at Northwestern University, highlights the extent of the funding dilemma: Without changes in pension policies, just to pay retired government workers the benefits they were promised would require 30-year annual tax increases averaging $1,348 nationally. Tax increases would range from about $330 in Indiana to a staggering $2,763 in New Jersey. Those figures do not include funding for state employee health benefits, which are in worse fiscal shape than pensions.

In the paper, North Carolina’s $764 per year ranks 40th nationally in the tax increases per household needed to satisfy pension promises — below neighboring Tennessee ($792), Virginia ($991), and South Carolina ($1,216).

Why the shortfall? As Carolina Journal reported in March, Novy-Marx, Rauh, and other critics of public pension accounting say the Governmental Accounting Standards Board — the panel that evaluates public pension solvency — has exacerbated the problem. Critics say the GASB allows public plans to understate their true long-term liabilities by using inflated rates of return; meantime, private pension systems must use more conservative rates to estimate their solvency.

As a result, even “fully funded” pension plans, like the Teachers’ and State Employees’ Retirement System in North Carolina, are likely to owe a lot more money to retirees than is now on the books.

State Treasurer Janet Cowell notes that TSERS relies on a discount rate of 7.25 percent, which is lower than the median 8-percent rate used by public plans nationally. Using a lower discount rate increases the pension plan’s long-term liabilities. Moreover, the “N.C. pension plan has met or exceeded its expected rate of return for most of the last 13 years, including the 2009-10 fiscal year with a return of 11.97 percent,” Heather Strickland, a spokeswoman for Cowell, told CJ.

Still, independent pension watchers believe the public plans should not base their discount rates on projected investment returns but should use the rates of long-term government securities, such as 15-year or 30-year Treasury bonds, to account for dips in financial markets.

“States have not averaged 7.25 percent or anything near that over the last 10 years,” said Bob Williams, president of State Budget Solutions, a national nonpartisan organization that researches fiscal issues. A more realistic rate would be closer to a 30-year Treasury, he said, around 4.3 percent.

Indeed, while the North Carolina plan did generate a return of 11.97 percent for 2009-10, its 10-year return is 3.65 percent.

A March report (PDF download) by State Budget Solutions compared three studies on pension obligations: One by the Pew Center for the States, a second by the American Enterprise Institute, and a third by Novy-Marx and Rauh. The unfunded liabilities in TSERS ranged from $504 million to $48 billion.

“There’s two ways to approach [solvency]: we can evolve gradual but significant changes to keep the plans going, or we can end up with a revolution,” Rep. Dale Folwell, R-Forsyth, chairman of the House Finance Committee, told CJ.

One possible approach would be to shift from a defined benefit system to a defined contribution system. Instead of employees receiving a pension with a guaranteed benefit based on their years of service, retirement benefits would be similar to those in a 401(k). Retirees would own their accounts and control their investment portfolios.

The City Council of Atlanta recently approved a reform proposal that combines a traditional pension with a 401(k)-type plan and increases the retirement age. The reform would affect newly hired employees, while current employees will have to contribute an additional 5 percent of their salaries to stay in the current defined benefit plan.

“These stress points … are not liberal/conservative, they’re not Republican/Democrat; it’s just math,” Folwell said. “But the solutions have to deal with how we’re going to keep that plane from flying into the ground.”

GASB is expected to release a draft of new accounting methods for public pensions later this week. The new measuring tools could require states to incorporate some elements of market risk when they determine discount rates for pensions, and publish their projected liabilities more prominently in financial reports.

Rick Henderson is managing editor of Carolina Journal. Anthony Hennen is a CJ editorial intern.