Fuzzy Math Behind Pension Liability Estimates

Currently there is much hysteria regarding the unfunded liability amounts being reported as future costs that states, cities, counties, school districts and other public agencies face. Huge amounts are thrown out in various studies as proof that a crisis exists.

When considering this issue and the multitude of unfunded liability figures that are bandied about one should stop and think about the assumptions that have to be made in order to calculate future pension costs. Assumptions? You bet, like how long will a public employee live after he/she retires and how long that employee’s spouse might live. An assumption of a 10 year life after retirement would nearly double the estimated cost of that retiree’s pay in retirement as compared to an assumption of 5 years.

Other things that must be assumed in order to make such a future cost estimate include: what percentage of the work force will retire from a public agency contrasted with leaving the agency before retirement age; average age at which people retire; average wage that retirement pay will be based upon; what the retirement money that is set aside will earn over time; and several other factors.

In this estimating exercise these assumptions are made for the next 30 years! This leads to an estimate of the cost over 30 years. Then an interest rate, called a discount rate in finance jargon, must be applied to this figure to bring that future cost down to a current cost. For instance if someone owes you $100 in 30 years, it is worth much less today. How much would you pay right now for an IOU that will pay you $100 in 30 years? A lot less than $100, that is for sure. The discount rate chosen can drastically alter that estimated future cost to a retirement system. The difference between a 3% and a 6% discount rate can translate into estimates that vary by billions and billions of dollars with some of the larger retirement systems.

So, calculating the unfunded liability of any pension system is a fuzzy process based upon estimates and assumptions. Different people use different assumptions and come up with dramatically different answers. Why some might even deliberately use assumptions that will overstate or understate the situation.

The moral of this story? It is that if there is a consensus that a given pension system has an unfunded liability that is worthy of attention. How big that liability may be though is fuzzy.


About Over But Not Out

A retired Orange County employee, and moderate Republican. The editor seriously does not know OBNO's identity as did not the former editor, but his point of view is obviously interesting and valued.