News Story

You are Entering the Government Pension Zone

An alternative universe of finance and accounting practices

Most people don’t understand how government defined-benefit pension systems operate, which is one of many obstacles to reforming the deeply underfunded systems. Part of the problem is that the methods used in pension funding and accounting are very different from anything a regular person ever faces in their own personal finances.

For example, people rarely buy a product, including a financial product, without knowing its cost.

But projecting the cost of pension systems requires making various assumptions about the future to decide how much must be contributed to meet defined-benefit pension promises. Making a wrong assumption can put taxpayers on the hook for billions of dollars in unfunded liabilities. Complicating this, the incentives are strong for policymakers to make “rosy scenario” assumptions that let them get away with paying less now to prefund future benefits.

In the real world, when a family takes on a long term obligation like a mortgage they typically pay it off with fixed monthly payments. In contrast, politicians often choose methods to amortize unfunded pension liabilities in ways that require lower payments now with promises to pay more in the future.

In Michigan’s pension system for school employees for example, this is done by setting annual contributions at a fixed percentage of school payrolls, and then assuming payrolls will perpetually grow. A recent performance audit found that school payrolls increased an average of 2.2 percent annually over the past 20 years while pension managers assumed 3.5 percent.

In the real world – say in a small business – debt schedules carried on the books generally reflect how payments are actually made. With government pensions, reporting and funding can be different. In this case that’s not necessarily a bad thing, because it can make doing the right thing easier. (Make it easier to “stop digging a deeper hole” for example – see below.)

In the real world, when people take on a long term debt they aren’t allowed to set their own repayment terms and then change them when convenient. In the pension zone, the state can and has changed its terms for paying down unfunded liabilities.

In the real world, individuals who don’t make required payments on their obligations face penalties. In the pension zone, the state continues to pay less into the school employee pension system than the amount its own actuarial accountants say is needed to cover future pension benefits without extra penalty.

All these factors have contributed to unfunded pension obligations growing so large they are diverting resources from other vital needs including road repairs and public safety. Yet those who urge a common-sense reform like “stop digging a deeper hole” – close the systems to new employees and give them 401(k)s instead – are put off with false claims of excessive “transition costs.“

When legislators familiar with “real world” financial matters enter “the government pension zone,” they are vulnerable to being hoodwinked by such claims – which somehow all seem to come from individuals and groups who have a special interest in perpetuating the unsustainable status quo.

Michigan Capitol Confidential is the news source produced by the Mackinac Center for Public Policy. Michigan Capitol Confidential reports with a free-market news perspective.