An unfunded liability is the difference between the net present value of expected future government spending minus the net present value of projected future tax revenue. Two large unfunded liabilities at the federal level are Social Security and Medicare, and ObamaCare is likely to be next.
The federal unfunded liabilities could be catastrophic for future taxpayers and stifle economic growth. At usdebtclock.org, it shows that federal unfunded liabilities total around $127 trillion, which is roughly $1.1 million per taxpayer and nearly two times greater than 2012’s total world output.
This problem also hits closer to home here in the Lone Star State. In Texas, the recent 2013 Employees Retirement System (ERS) Valuation Report outlines the funding shortages this pension system faces and there is some indication it may be unable to pay beneficiaries by 2052.
With about 134,000 active members in Texas’ ERS at the end of fiscal year 2013, the total unfunded liability was $7.2 billion—or $54,000 per active member. Despite the much smaller future net debt obligations in ERS compared with federal programs, there are similarities how we got here.
Laurence Kotlikoff and Scott Burns’ book entitled The Coming Generational Storm: What You Need to Know About America's Future argue federal unfunded liabilities are primarily from a generational accounting problem, in which the dependency ratio of retirees to taxpayers is declining from an aging population.
State pensions across the country also face this generational accounting problem. In addition to an aging population in Texas creating substantial challenges with funding ERS, it is also plagued with a problem faced by many state pension portfolio managers: low rates of return on risk-free assets, such as a one-year Treasury security that returns less than 1 percent.
As portfolio managers nationwide choose riskier investments to gain a higher rate of return, risk—measured by the state deviation of investments to state and local budgets—has increased 10-fold from about 2 percent in 1975 to 20 percent today.
Although actuaries find that the funded ratio of ERS is currently 77 percent, their calculations assume an 8 percent rate of return. The fund’s annual return over the last five and ten years was 6 percent and 7.1 percent, respectively. While these returns are close to 8 percent, small differences accumulate to larger funding problems in the future and increase the likelihood of an even lower funded ratio.
Although marginal changes could be made to address this issue, we at the Texas Public Policy Foundation believe the best long-run approach is to convert ERS from a defined benefit plan to a defined contribution plan, putting the power back in the hands of its members and off the backs of taxpayers.
Although we could wait around and let this problem fester, President Reagan’s words are fitting for this inevitable challenge: “If not us, who? If not now, when?”