According to a recent report by the Pew Center on the States, in 2008 Oklahoma’s unfunded pension liability was $13.2 billion.1

Put simply, this means that the pension obligations owed exceed the assets set aside to pay them by $13.2 billion. To pay for these obligations, in 2008 Oklahoma’s state government was required to pay $1.2 billion but only managed to contribute $986 million. Not meeting these minimum payments only worsens the situation.

Regrettably, this is only the tip of the iceberg when it comes to the problems facing Oklahoma’s pension system.

In a series of path-breaking new analyses, economists Robert Novy-Marx and Joshua Rauh restate the true pension burden and explore ways of reducing it. In this article we will break down their findings in order to facilitate a better understanding of Oklahoma’s pension crisis.

Their first study cast new light on the fact that official pension liabilities are being dramatically underestimated based on current actuarial methods.2 The problem revolves around the “discount rate” or “interest rate” used. For example, a 5 percent interest rate means that $100 today grows to $105 a year from now ($100 time 5 percent). A 5 percent discount rate means that $105 a year from now is worth $100 today. In effect, the discount rate is the opposite of the interest rate.

The authors found that the median discount rate was 8 percent, which, conversely, means that these pension systems anticipate earning 8 percent annually. This is unrealistically high because it does not account for the risk associated with obtaining such high rates of return. For fiscal year (FY) 2008, the authors recalculate state pension liabilities both nationally and by state using lower, more realistic discount rates.

Nationally, they find that the total reported state pension liability for 116 of the largest pension plans was $1.039 trillion. However, using lower, more realistic discount rates yields estimates for pension underfunding ranging from $1.31 trillion to a whopping $3.23 trillion.

Oklahoma’s $13 billion unfunded pension liability increases to somewhere in the range of $23.6 billion to $47 billion. In comparison, they found that Oklahoma’s general obligation (GO) debt totaled $8.7 billion.

More disturbingly, as shown in Table 1, the maximum pension liability ($54.7 billion) is 40.1 percent of Gross Domestic Product ($136.4 billion).

As bad as that news is for policymakers, the authors’ next study painted an even more disturbing picture. Since the reported pension liabilities are being dramatically understated, the current payments to the pension system are insufficient to fully fund the pension system. Not paying the full contribution (as the state failed to do in 2008) only compounds that problem. As a result, the state will at some point have to start cashing in the pension’s assets in order to pay benefits.

According to Joshua Rauh’s calculations,3 Oklahoma’s pension system will run out of money in 2020—just 10 short years from now.

That is the fifth-earliest (tied with Hawaii and Louisiana) date for insolvency in the country.

The study goes on to make an estimate of what payment would be required to make the pension system solvent. In general, they find that the required payment needs to be 75 percent higher than current payments. That means that in 2008 Oklahoma should have made a payment that was $934 million higher than the $1.2 billion required contribution, or $2.2 billion in total.

Implicit in all these pension contribution estimates is that it is up to the taxpayer to cover these gargantuan pension liabilities. The reality is that these pensions are simply unaffordable and will have to be scaled back.

In their most recent study, the authors examine various policy options that can be used to reduce the pension liability.4 While they discuss a number of options, there are really only two that could be used to make a significant dent in pension liabilities.

First, if all cost-of-living adjustments (COLAs) were eliminated, that would shave off more than 22 percent of current pension liabilities. Second, they estimate savings under “Social Security parameters,” which would increase the full retirement age to 67 years, increase the early retirement age to 65 years, and implement early-retirement-age buyouts. Under these parameters, another 22 percent could be saved.

However, as dramatic as these changes will seem to some, the authors conclude on this sour note: “Even relatively dramatic policy changes, such as the elimination of COLAs or the implementation of Social Security retirement age parameters, would leave liabilities (for the 116 largest pension plans in the country) around $1.5 trillion more than plan assets under Treasury discounting. This suggests that taxpayers will bear the lion’s share of the costs associated with the legacy liabilities of state DB (defined-benefit) plans.”

The extent to which any of these changes can be made to existing employees and pensioners varies by state. In this article we are not attempting to detail the political or legal feasibility of these options in Oklahoma; we are merely trying to reveal the extent of the pension hole Oklahoma’s taxpayers face.

In any case, the key to getting the pension liability under control is first to stop digging the hole deeper. The current defined-benefit system must be scrapped and replaced with a defined-contribution system for new employees.

Endnotes

1. “The Trillion Dollar Gap: Underfunded State Retirement Systems and the Roads to Reform,” The Pew Center on the States, February, 2010, http://www.pewcenteronthestates.org/report_detail.aspx?id=56695. Public pension plans include: Oklahoma Firefighters Pension Retirement, Oklahoma Public Employees’ Retirement System, Uniform Retirement System for Judges and Justices, Police Pension and Retirement System, Teachers’ Retirement System, Oklahoma Law Enforcement Retirement System, and the Wildlife Conservation Retirement System. The Pew study, as well as similar studies by the Institute for Truth in Accounting and the Manhattan Institute, have been covered extensively by Patrick McGuigan at CapitolBeatOK.com.

2. Novy-Marx, Robert, and Rauh, Joshua D., “Public Pension Promises: How Big Are They and What Are They Worth?” July 10, 2009, http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1645454_code345896.pdf?abstractid=1352608&mirid=1

3. Rauh, Joshua D., “Are State Public Pensions Sustainable? Why the Federal Government Should Worry about State Pension Plans,” prepared for the Urban-Brookings Tax Policy Center/USC-Caltech Center for the Study of Law and Politics conference “Train Wreck: A Conference on America’s Looming Fiscal Crisis,” January 2010, http://www.taxpolicycenter.org/events/upload/Rauh-ASPSS-USC-20091231.pdf

4. Novy-Marx, Robert, and Rauh, Joshua D., “Policy Options for State Pensions Systems and Their Impact on Plan Liabilities,” prepared for the NBER State and Local Pensions Conference in Jackson Hole, Wyoming, August 2010, http://kelloggfinance.files.wordpress.com/2010/07/nmr_posps_20100718.pdf

Economists J. Scott Moody (M.A., George Mason University) and Wendy P. Warcholik (Ph.D., George Mason University) are OCPA research fellows.