How to Commit Fraud and Not Go to Jail

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By John D McGinnis,
PhD, Finance
Representative House District 79

What if we had an honest accounting of where the taxpayers stand with respect to our state pensions? The state pension systems, PSERS and SERS, report that they are currently underfunded by $47 billion, for which taxpayers are fully obligated. But the situation is really much worse. It’s past time that our government is honest about this debt, which, in fact, is nearly equal to the total debt of the state government and all municipalities in Pennsylvania combined.

The debt calculation is no more complicated than a simple balance sheet. On the one side, the value of assets is reported, while on the other side, the value of liabilities is reported. When actuarial accountants subtract the latter from the former, they report $47 billion of underfunding. But that is NOT an accurate calculation of the true shortfall.

Actuarial accounting distorts reality in two significant ways. On the asset side, the market value of investments currently owned by the pensions is not reported, but rather a moving average of those assets over several years. When assets have been declining in value, as has been the case with the pension assets in recent years, this gives a higher value than actually exists. This distortion currently is about $11 billion; that is, the pensions have $11 billion less in assets than they are reporting, which means that the underfunding would be $58 billion and not $47 billion.

Except that worse accounting mischief is happening on the liabilities side of the balance sheet. The proper way to account for promises made for the future (promises that are guaranteed by the full faith and credit of Pennsylvania’s taxpayers) is to value those promises with a discount rate appropriate for guaranteed returns. But actuarial accounting rules allow pensions, such as PSERS and SERS, to use the rate of return they expect to get on their assets as a discount rate for their liabilities. That expectation now is set at 7.5%.

The idea that you can value liabilities based on what you think assets will earn is complete folly. It’s like setting the speed limit at 80 mph on a curving, one lane dirt road because you have a car that can go 80 mph. Discounting liabilities at the expected rate of return on assets is entirely counter to a basic principle of financial economics: cash flows should be valued according to their risk.

Since the pension liabilities get the highest priority to taxpayers’ wallets, the proper rate of return to value liabilities is something close to the U.S. Treasury rate, which is near 2%, not 7.5%. When valuing the liabilities appropriately, we find that they are at least $60 billion higher than SERS and PSERS are reporting.
So the $47 billion problem that is being talked about is $58 billion if you properly mark assets to market and well over $100 billion if you also properly value liabilities.

I have recently introduced House Bill 1471in the Pennsylvania House of Representatives. If passed into law, it will require SERS and PSERS to include in their annual financial reports a balance sheet showing the market value of assets and the market value of liabilities. The difference between these two numbers determines the true value of underfunding for which the taxpayers have been made entirely responsible.

I am not clear on how we legislators should ultimately address the underfunding crisis of Pennsylvania’s pensions, but the first step is honesty–with the pensioners, the public, and ourselves.

Citizens Alliance of Pennsylvania (CAP) is a non-profit organization founded to raise the standard of living of all Pennsylvanians by restoring limited government, economic freedom, and personal responsibility. By empowering the Commonwealth’s employers and taxpayers to break state government’s "Iron Triangle" of career politicians, bureaucrats, and Big Government lobbyists, this restoration will occur and Pennsylvania will prosper.