Oklahoma’s Pension Problems Are Worse than You Think

November 5, 2012

As we’ve pointed out numerous times in these pages, Oklahoma’s pension crisis is far worse than the official estimates.

The official estimates are guided by the dictates of the Governmental Accounting Standards Board (GASB). Finally, after years of debate, GASB is taking the first timid steps toward better transparency, which will improve the integrity of Oklahoma’s pension accounting system.

While there are many details to these changes, there are two in particular that will have the most impact on Oklahoma’s pension systems.1

The first change shifts the actuarial smoothing of investment returns in favor of current market valuation of assets. Currently, the Oklahoma Public Employees Retirement System (OPERS) uses a five-year smoothing of investment returns. While this provides a degree of stability in the pension calculations, smoothing is completely unrealistic since assets could never be sold on the market based on their five-year average price.

The second change begins to separate the investment return on assets and the discounted value of pension benefits owed. Currently, pension systems use the long-term investment return on assets, usually around 7 to 8 percent, as the discount rate on pension benefits owed. More specifically, OPERS uses a rate of 7.5 percent.2

However, using the same rate for the investment return and discount value wrongly confuses the vastly different risk profiles of assets and liabilities. On the asset side, pension systems are heavily invested in stocks, which yield a very high investment return at the cost of a having a high-risk profile—in other words, returns can vary dramatically from one year to another.

On the liability side, pension payouts are very predictable and, in most states, are guaranteed by the taxing authority of the state. As such, the risk profile is very safe and more akin to a government bond. Economists such as Robert Novy-Marx (University of Rochester) and Joshua Rauh (Northwestern University) have persuasively argued that the discount rate should be dramatically lower, resembling the risk-free rate of a U.S. Treasury bill.

In fact, using a lower, more realistic discount rate, they found that Oklahoma’s official $13 billion unfunded pension liability (as of FY 2008) is actually somewhere in the range of $23.6 billion to a whopping $47 billion.3 More ominously, their calculations estimate that Oklahoma’s pension system will run out of assets in 2020—only eight years from now (though this estimate was made prior to Oklahoma’s recent pension reforms, which likely pushed that day of reckoning out a few more years).4

GASB does not go nearly as far as Novy-Marx and Rauh have suggested. The new rules will still allow pension plans to tie their investment returns rate to the discount rate as long as assets are projected to sufficiently cover benefit payments. For any years where benefits exceed assets, they will be treated as general obligation debt and discounted by the municipal bond rate, generally around 3 to 4 percent.

Alicia Munnell and her colleagues at the Center for Retirement Research at Boston College recently estimated the impact of the GASB rule changes on 126 pension systems.5 Table 1 shows the results for OPERS.

Despite the very modest changes in the GASB rules, OPERS, on a percentage basis, would see a sizable change in its funded ratio, which represents the percentage of assets to liabilities. A healthy funded ratio is considered to be above 80 percent, which, prior to the recent pension reforms, was never achieved. (Truth be told, as OCPA’s pension expert Jonathan Small likes to point out, the safest and most prudent funding level for both pensioners and taxpayers is a funded ratio of at least 100 percent.)

In the end, these changes being made by GASB are only timid steps toward full disclosure of the looming pension crisis. Oklahoma’s policymakers must not be lulled into complacency, believing that Oklahoma’s recent pension reforms will bring the retirement systems back into solvency. They will not.

There is only one long-term solution to Oklahoma’s pension crisis: ending the current defined-benefit pension system and enacting a defined-contribution plan similar to the 401(k) plans used in the private sector. This change would permanently lift the artificial veil, sanctioned by GASB, which policymakers have hidden behind for far too long.

Economists J. Scott Moody (M.A., George Mason University) and Wendy P. Warcholik (Ph.D., George Mason University) are OCPA research fellows.

Endnotes

1 For the full details of the GASB changes, see: http://gasb.org/cs/ContentServer?site=GASB&c=Page&pagename=GASB%2FPage%2F
GASBSectionPage&cid=1176158721844.

2 For actuarial information on the Oklahoma Public Employees Retirement System, see: http://www.opers.ok.gov/Websites/opers/images/pdfs/2011-OPERS%20Val%20FY%202011.pdf.

3 Novy-Marx, Robert, and Rauh, Joshua D., “Public Pension Promises: How Big Are They and What Are They Worth?” July 10, 2009. http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1645454_code345896.pdf?abstractid=1352608&mirid=1.

4 Rauh, Joshua D., “Are State Public Pensions Sustainable? Why the Federal Government Should Worry about State Pension Plans,” prepared for the Urban-Brookings Tax Policy Center/USC-Caltech Center for the Study of Law and Politics Conference, “Train Wreck: A Conference on America’s Looming Fiscal Crisis,” January 2010. http://www.taxpolicycenter.org/events/upload/Rauh-ASPSS-USC-20091231.pdf.

5 Munnell, Alicia H., Aubry, Jean-Pierre, Hurwitz, Josh, and Quinby, Laura, “How Would GASB Proposals Affect State and Local Pension Reporting?” Center for Retirement Research at Boston College, Working Paper 2012-17, September 2012. http://crr.bc.edu/wp-content/uploads/2011/11/slp_23.pdf.