Detroit’s recent bankruptcy filing, the largest of any municipality in U.S. history, has drawn a lot of attention to the sustainability problem that has long been facing many state and local governments.

While the bankruptcy has been attributed to a number of factors, the majority of the city’s $18.5 billion debt can be traced to unfunded liabilities.

The population flight no doubt has played a big role in the city’s ability to generate the necessary revenue to fund these programs. However, Veronique de Rugy of NRO argues that there is a more systemic failure in the calculation of pension funds, which has led Detroit into bankruptcy.

Pension funds need to assume a certain rate of return on their current assets in order to gauge whether or not the assets held today will be enough to pay future benefits. Obviously, the assumed interest rate or rate of return has a major impact on whether a pension plan is adequately funded. Most [private] pension plans would rather play it conservatively and assume a lower rate of return, so that they ensure that the assets they have today will be enough to cover tomorrow’s promised benefits. But the states would rather put less money up front today, so they’re pinning all their hopes of being able to pay benefits tomorrow on an 8.5 percent annual growth rate. If that 8.5 percent growth rate doesn’t come to fruition, either tomorrow’s beneficiaries will see a cut in their benefits or taxpayers will be asked to pick up the tab. It would be much more prudent to assume an adequate risk-adjusted rate of return closer to the rate offered on 15-year Treasury bonds—3.5 percent, say—and fund their plan accordingly.

Prudent, yes. But Detroit has not utilized this level of prudence in its accounting practices, instead opting to project annual growth at 7.9 to 8 percent. Failing to hit that mark results in greater than anticipated debt. What’s worse, Detroit is not alone in having to face up to these realities.

A change in accounting practices to a more realistic projection like that described by de Rugy has just been green-lighted in California, and could potentially double the amount of the state’s unfunded liabilities, bringing the total to $328.6 billion. Facing their respective budgetary realities will also have a significant effect on many municipalities.

The pension changes from Moody’s, and separately the Governmental Accounting Standards Board, scheduled for this month, could result in Los Angeles, San Francisco, San Jose, Azusa and Inglewood joining fiscally troubled Stockton and San Bernardino, among others, as severe credit risks.

Although the ultimate fate of Detroit remains uncertain, California illustrates how important it is for struggling state and municipal governments to take proactive measures in reassessing their liabilities.

Principally, they must consider opting for reasonable projections on their investments, instead of kicking the can down the road until bankruptcy becomes the only option. If not, a recent Senate report succinctly characterized the likely outcome.

When the states with the worst pension systems come knocking at Washington’s door for a bailout, it will ultimately be taxpayers in more prudent states who will pay for the recklessness of the negligent states.

A refrain the American people have surely grown tired of hearing by now.

 
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