Estimating Massive Public Pension Deficits in California and Across the Nation

State and local public pension systems across the country are struggling with mounting obligations as a result of overly generous retirement benefits, unrealistic actuarial assumptions, and the downturn in pension fund investment performance during the past couple of years as a result of the recession. A recent Pew Center on the States report estimates that states have a combined pension and retiree health care deficit of $1 trillion over the next 30 years. But even this daunting figure is understated, as it was based on a survey of only about 85 percent of state retirement systems and relied upon midyear 2008 data, missing out on additional pension investment losses incurred during the second half of 2008 and early part of 2009.

Several other estimates are much higher. A March 2010 Barron’s cover story pegged the likely pension deficit of the states at about $2 trillion. A Free Enterprise Nation study from earlier this year puts the combined state and local government unfunded liability at $3.5 trillion. And a recent paper by University of Chicago business professor Robert Novy-Marx and Northwestern University finance professor Joshua D. Rauh estimates state pension liabilities alone at between $3.2 trillion and $5.2 trillion.

While public pension troubles are widespread, California has got more than its fair share of pension problems. Novy-Marx and Rauh calculated California’s unfunded liability alone at about $475 billion (see pages 197-199 of the linked document). Similarly, a new Stanford Institute for Economic Policy Research study puts the state’s liabilities around the half-trillion-dollar mark, estimating them at approximately $535 billion. That translates to roughly $36,000 for each California household. These new estimates are much higher than prior reported estimates of about $63 billion in unfunded liabilities.

The aforementioned reports note that the pension funds use overly optimistic discount rates-public pension systems use their assumed annual pension fund investment returns to discount their future liabilities-that do not accurately reflect the risk that actual return rates will be permanently below expected levels, and thus understate pension liabilities.

The Stanford study additionally warned that the state and its pension funds would have to contribute $200 billion just to have an 80% chance of covering at least 80% of their pension liabilities (the 80% funding ratio is largely considered the minimum threshold for a “healthy” public pension fund). That’s nearly two and a half times the size of the state’s entire general fund budget! What’s worse, this analysis was applied to the funds’ values as of June 2008—before they lost a combined $110 billion during the ensuing fiscal year.

In response to the Stanford study, Gov. Arnold Schwarzenegger issued a press release acknowledging the severity of the public pension problem and its consequences for other state programs and priorities:

This study reinforces the immediate need to address our staggering pension debt. According to the study, California taxpayers are on the hook for over a half trillion dollars. That’s nearly six times the size of our entire state budget. The consequences are clear: increasingly large portions of state funding for programs Californians hold dear such as schools, parks and health care will be diverted to pay for this debt. That is bad enough, but without reform, pension debt will only grow.

California’s pension system is broken and unsustainable. In order to stop the bleeding, the state should switch to a 401(k)-style defined-contribution retirement system consistent with compensation received in the private sector for all new government workers. Debts will continue to rack up, however, under existing employees’ benefit formulas, which the courts have ruled cannot be reduced. Tackling these costs will require some real soul-searching and rethinking of the state’s spending priorities and the size and scope of the state government in general. It will also require political courage and leadership that has, sadly, been lacking to date.

Related Research and Commentary:

” Reason public pension study: The Gathering Pension Storm: How Government Pension Plans Are Breaking the Bank and Strategies for Reform (Policy Summary | Full Study)

Fixing the state’s pension mess (published in the Orange County Register)

Is It Finally Time for Public Pension Reform in California?