07/24/2012 05:13 pm ET | Updated Sep 23, 2012

The Real Pension Crisis

A new report by State Budget Solutions shows that the public pension picture is much grimmer than official numbers projected.

When the Governmental Accounting Standards Board (GASB) recently reported that public pensions were underfunded by $885 billion, citizens were astonished that the public pension system had reached historic levels of debt. That figure, however, does not present an accurate view of the whole picture.

In fact, according to State Budget Solutions, the average public employee pension plan in the United States is only around 41 percent funded, while total unfunded liabilities as of 2011 are roughly $4.6 trillion. Unfunded liabilities are actually more than five times larger than the official estimate.

The disparity in numbers comes down to unrealistic assumptions by the GASB, leaving a ridiculously large sum for the taxpayers to bankroll.

When calculating unfunded liabilities, the GASB ignored accounting standards used by economists that require that assumed return on pension fund investments be based on the fact that pension benefits are guaranteed. Public pension funds calculate future debt based on politicians' guesses about the rate of interest investments will earn and how quickly they will grow. Although governments do not have to include pension debt in their budgets, taxpayers must make up any difference between pension fund investment performance and promised benefits.

State Budget Solution's report uses fair market value and risk-free investment returns to determine that the actual unfunded liabilities are $4.6 trillion. That amount more accurately reflects the value of promised benefits taxpayers must fund whether investments perform or not.

The difference in numbers is important to not only economists but also to politicians and to the public at large. By understating the current pension debt, states overstate their budget health and make riskier investments that the state governments cannot afford. In addition, state legislatures do not take the problem seriously enough and procrastinate implementing reform.

Legislators must understand that immediate action is desperately needed. Without government action, states, counties, cities and towns all over America will go bankrupt. That means essential public services must be cut, dedicated government workers laid off, disrupting or eliminating public health, safety and education.

Aggressive pension reform is needed to avoid those drastic service cuts. Pension reform must include moving from defined benefit plans to defined contribution plans, which are similar to the 401(k) plans offered by the private sector. Defined benefit plans guarantee specific levels of service regardless of cost, whereas defined contribution plans establish a fixed payment toward services. Instituting defined contribution plans would end the endless cost escalations of non-salary compensation. A move to defined contribution plans would reduce the risk to taxpayers, provide lawmakers with a reliable cost estimate for budgeting and give state workers control over their retirement funding.

Three cities have championed pension reform and done so without the prompt or push from a larger authority. Voters in San Diego and San Jose elected to enact pension reform that would save their cities millions of dollars and stabilize the rocky pension system. The mayor of Chicago has proposed a pension solution that includes a five-year increase in the retirement age, a 10-year cost of living adjustment (COLA) suspension, and a 1% yearly contribution increase over five years for current employees. These cities should serve as an example to the rest of the country, that reform can be accomplished.

Status quo or incremental adjustments are not options for solving this crisis. Drastic reforms, innovations and political courage are needed to put our states and municipalities back on the path to fiscal survival.

Bob Williams, President of State Budget Solutions, is a former Washington state legislator, gubernatorial candidate and auditor with the Government Accountability Office.