The approach taken to funding public defined-benefit pension plans is “deeply flawed,” a research group said Thursday in a report that urged the federal government and Congress to consider ways to make sure public pension systems function better.

The report, by the Nelson A. Rockefeller Institute of Government, makes recommendations about how to fix the defined-benefit public pension system so that benefits are funded more securely. These include ensuring that pension funds and governments value liabilities using a discount rate that assumes a low risk that obligations will not be paid and pay realistic actuarially determined contributions.

State and local government defined benefit pension systems pay benefits to more than eight million people and cover more than 14 million workers, according to the report. However, they are underfunded by at least $2 to $3 trillion based on standard economic measures — far more than the $1 trillion calculated by measurement practices that are essentially only used by the public pension industry, the report said.

To address their pension problems, governments have been raising contributions, cutting benefits for new workers and even sometimes cutting benefits for current employees and retirees. They are also cutting services and investments in other areas and raising taxes. But these actions have not resolved underfunding and the underlying problems that led to underfunding remain in place, the report said.

“Bad incentives and inadequate rules allowed public sector pension underfunding to develop,” the Rockefeller Institute said in the report “They mask the true costs of pension benefits and encourage underfunding, under-contributing, and excessive risk-taking trapping pension administrators and government funders in potentially destructive myths and misunderstanding.”

One of the main reasons why underfunding has developed is because of inaccurate financial reporting.

The long-standing practice in the United States is to value public pension liabilities using the expected return on pension fund assets. However, there is no direct connection between what retirees are owed and the rate of return on investments, the report said.

Discount rates — or the rates used to determine what future benefits are worth now — that are based on a low risk that retirees won’t be paid tend to be lower than rates based on the rate of return on investments. As a result, liabilities are underestimated by at least $1 trillion to $2 trillion, the report said. Underestimated liabilities and costs of funding make pension funds appear artificially healthy, which has encouraged governments to use “surplus” funds to enhance benefits or take contribution holidays, it said.

Another reason why pensions have an underfunding problem is because state and local governments have incentives to invest pension funds in risky assets.

Flawed financial reporting allows governments to believe that the higher a fund’s assumed earnings on its investments are, the lower the contributions it needs to make. To assume higher earnings, pension funds have to invest in risky assets whose actual returns may be substantially different from their expected returns, the report said.

Additionally, lax rules or a lack of rules have allowed state and local governments to pay less in contributions that the actuarially calculated amounts. In 2012, only 19 states paid at least 100% of their actuarially calculated amounts, the report said.

The risks and potential consequences of funding flaws are greater now than ever before because as public pension funds have matured with the aging population, their assets and liabilities are larger relative to the economy, the Rockefeller Institute said. And state and local governments have a limited number of options to reduce already earned liabilities.

To fix the defined-benefit public pension system, the Rockefeller Institute recommended that for financial reporting purposes, liabilities and expenses should be valued using a discount rate that takes into account the low risk of failing to make expected payments. A practical variation of this suggestion would be for funds to base the discount rate on a high-quality municipal bond rate. By making this disclosure change, “governments, taxpayers and others would know the full cost of promises being made, and what it could take to fund those promises without risk,” the report said.

Another recommendation is for pension funds to more fully disclose the consequences of their investments — the potential consequences of investment risk for governments’ contributions as well as funds’ funded statuses. The Rockefeller Institute encouraged the Actuarial Standards Board, a nine-member board that establishes and improves standards of actuarial practice, to develop standards in this area and for other organizations and pension officials to help with this effort.

The report also recommends that there to be external pressure to lower the levels of investment risk pension funds take. State and local governments should have formal statements of the contribution risk they are willing to bear, and pension funds should consider those directives explicitly, the Rockefeller Institute said.

State and local governments should pay realistic contributions based on realistic assumptions, the report recommended.

State governments can require local governments to make pension contributions and establish mechanisms to enforce this policy, the report said It’s harder for states to force themselves to make contributions and to face penalties for not doing so but legal commitments to fund required contributions, backed with potential legal remedies for employees or retirees if payments aren’t made, could help to create political pressure for states. Legal commitments also could be backed with dedicated revenues sources, the report said.

The report recommended the federal government explore options for making sure that the state and local pension systems function better. The federal government should consider regulatory action by the Municipal Securities Rulemaking Board, the Securities and Exchange Commission, as well as congressional oversight, to enhance reporting and transparency. Additionally, Congress may want to give incentives to encourage transparency in pension fund reporting, disclosure of investment risk and discipline in making contributions, it added.

“If states and standard-setting bodies do not go far enough on their own, the federal government should consider more intrusive action to monitor and police state and local government retirement systems,” the report said.

“A federal role is in the national interest,” the report said.

The report makes the case that “change is imperative in many states,” and Illinois’ pension reform enacted in December could be an example of how to make change, said Peter Kiernan, one of the report’s authors.

“No state has more legal protections for pensions than Illinois,” Kiernan said, and its changes had to be legislative. The state had to get around constitutional hurdles to try to change benefits for current employees and retirees, and the legislation enacted in December makes changes by creating choices for people. The Illinois Supreme Court will likely hear a case at some point about the legality of the pension reform under the state constitution, Kiernan said.

Much attention has been paid to events in Illinois and the bankruptcy matters in Detroit and California. When it comes to pensions “Illinois is by far the most interesting and the most significant,” he said.

Source: The Bond Buyer