California’s Hidden Pension Disaster

The American Interest, 3/5/14.

Few states are truly safe from the pension crisis, which is why most of them have taken measures to put their pensions on stable ground. Unfortunately, these changes aren’t coming fast enough, and time is running out: the longer a state lets these problems grow, the worse the eventual reckoning will be. That’s certainly true in California, where a growing number of state lawmakers on both sides of the aisle are calling on Jerry Brown to do something immediately, rather than waiting until next year (after the election), as the Governor would prefer.

At first glance, the public pension problem doesn’t seem so urgent. California’s pension liabilities as a percentage of revenues aren’t in the top ten (see chart below), and the state has taken some steps toward fixing its pensions. But as Bloomberg Week argues in an excellent new piece, the liabilities on teacher pensions are actually much, much worse than they look. The problem centers around the way “zero coupon” pension debt is accounted for:

Let’s say you borrow $100 at 6 percent a year, due in 30 years. With a normal bond, you would pay coupons of $6 per year for 29 years and then $106 in the 30th year, for a total of $280. With a zero-coupon bond, however, you would pay nothing for the first 29 years and a single “balloon payment” of $574 would be due in the 30th year. That is, the convenience of paying no interest for the first 29 years means you end up paying more than twice as much because of compound interest.

When a corporation issues a zero-coupon bond, it must report (“accrue”) an interest expense on its books each year even though it doesn’t need to make any cash outlays to meet that expense. Accounting for the expense that way is important because otherwise stakeholders (creditors, employees, shareholders and suppliers) wouldn’t know the true size of the company’s expenses or that it had a large obligation for which it will later need lots of cash.

But state and local governments aren’t required to report such future obligations in their annual budgets. Because they get to use “cash-based” budgeting—which reflects only cash that is spent—governments don’t need to show an expense for a zero-coupon bond until the single, final payment is made.

Essentially, this means that the state’s pension liabilities are far worse than the official figures show, as the accrued interest will remain invisible until it all comes due at the end. By 2043, if nothing changes the teacher’s pension system will have a shortfall of $600 billion. (For comparison, today’s shortfall is only $80 billion.)

Governor Brown’s plans to put off making any tough choices until after his reelection is just the latest in a long line of short-sighted political moves that got these states in hot water in the first place.

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