In a period when financial markets and institutions have appeared near collapse, the accounting methods used by public employee pensions effectively ignore risk. These accounting methods, which are used by public pensions in Arizona and around the country, allow pension fund managers to assume that high returns can be earned through stocks and other investments without taking any market risk. As a result, the true market value of Arizona pension shortfalls that must be funded by taxpayers is understated by around half of what the pension funds have reported.
If Arizona’s public pension liabilities were priced on a fully risk-adjusted market basis, which most financial economists believe is the best representation of costs to the taxpayer, these plans would be about 41 percent funded, versus the 77 percent level Arizona pension accounting statements report. On a risk-adjusted basis, unfunded public pension liabilities would exceed $50 billion, roughly $8,300 per Arizonan, dwarfing the $10 billion funding shortfall the funds acknowledge. A more accurate depiction of the funding status of Arizona pensions will help policymakers design better public pension policy for the future.
This paper makes three policy recommendations. First, legislators should require that public-sector pensions report the true market value of plan liabilities. So-called actuarial values currently reported by pension plans in Arizona do not truly reflect the risk that premium markets would assign to pension liabilities.
Second, states like Arizona that automatically adjust pension contribution rates based on plan funding measures should set such adjustments according to the fully risk-adjusted market value of plan liabilities, not the actuarial value.
Third, states must shift public-sector pensions toward defined-contribution plans. Under these plans, the government makes contributions to employees’ retirement accounts that are managed by employees. This would be the full extent of taxpayer liability to government employees.
Editor's note: In the original version of $50 Billion Tidal Wave there was a mistake in Table 3 on Page 14. The original number was $45.32. The correct number is $85.85. Also, the earlier version of the report provided an incorrect description of how retirement benefits are calculated for members of the Arizona State Retirement System on Page 5. The correct description is that retirees hired before 1984 have final earnings equal to either on the highest 36 consecutive months or 60 consecutive months in the final 120 months of employment, whichever is higher. Those hired in 1984 or later have final earnings equal to the highest 36 consecutive months in the final 120 months of employment. We regret the errors.