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Knowledge Base

State Budgets: Hidden Debt and Hidden Deficits with Joshua Rauh

Terms You May Have Heard:

Pension or pension plan: A retirement program where an employee and/or an employer contribute funds during an individual’s working years, with the goal of providing income during that worker’s retirement.

Defined-benefit pension: A type of pension plan in which the employee earns the right to receive a guaranteed, promised payout for the rest of their life, beginning at retirement. It is the employer’s responsibility to provide the guaranteed retirement benefit, including measuring progress towards achieving that goal and making up for any shortfalls due to poor investment returns or inadequate past contributions.

Underfunded pension: A defined-benefit pension plan that does not have enough assets and income to pay out the benefits that it is obligated to pay. Underfunding happens when companies or governments fail to contribute enough funds to pay out promised benefits, or when expected investment returns do not materialize.

Employer contribution or employee contribution: The annual amount contributed to the pension fund by the employer or the employee. These amounts are usually determined by actuarial valuations that predict the value of future promises.

Defined-contribution plan: A type of pension plan where employees and/or employers contribute funds during employment, but with no guaranteed payout during retirement. Instead, the total investment balance is owned by the employee to use during retirement or to pass on to family. The employee is responsible for their own retirement savings and bears the gains or losses of their investment returns.

Actuarial assumptions: Multiple assumed factors used to calculate the liabilities of a pension. Predictions on life spans, salary increases, inflation, and investment growth all go into the formula to determine the true size of a liability.

Discount rate: The expected rate of return on investments that is used to calculate the value of liabilities. A higher discount rate assumes a high return on investments and results in a lower calculated liability. A lower discount rate assumes lower returns, which renders a higher amount for a liability.

Expected return: The estimation of long-term expected returns on investment that pension funds need to make in order to plan for future benefit payouts. This estimation is used to determine the total liability, which is the present value of the total benefits the employer will owe in the future. The expected return is also a key ingredient for governments to determine what they believe is the necessary amount of annual contributions to fully fund a pension promise.

Liability-weighted average expected return: The mean of all expected returns weighted by the size of each pension system’s liability. Average expected returns are calculated this way to avoid smaller pension systems gaining the same influence on the average as larger ones.

Market value of the liability (MVL): The total liability recalculated using a zero-coupon Treasury yield curve instead of the stated discount rate/long-term expected return. This expresses the liability to be much higher but generates results that are based on more stable assumptions, without assumptions that high hoped-for returns on risky investments will be achieved with certainty.

Unfunded market value liability (UMVL): The recalculated market value liability minus the stated market value of assets. This works as a replacement for the stated unfunded actuarially accrued liability (UAAL).

Risk-free discounting: Calculating liabilities using the investment returns associated with no risk. Since it is actually impossible to invest with zero risk, returns on US Treasury bills are used as the closest representation.

Private equity: An asset class or investment opportunity generally only accessible to high-net-worth individuals and institutions (such as large pension funds), in which the institution places funds with an investment professional who then acquires majority equity ownership in companies with the hope of selling those stakes later for a profit.

Multiple of estimated total own revenues: One of the two measures of revenues used to detail financial information on state and local government finances. It includes all revenue sources but excludes the “insurance trust” revenues reflecting the returns of pension funds themselves and intergovernmental revenues, which are transfers from the federal government to lower form of government, as well as transfers from state governments to local governments.

Multiple of estimated tax revenues: The second measure of revenues used to detail financial information on state and local government finances. It only includes the tax revenues and excludes fees and charges, most of which are for services rendered. The idea here is to consider how state and local governments could pay for unfunded pensions through traditional taxation sources like income taxes, sales taxes, and property taxes.

Funding ratio: The ratio of total pension assets divided by total pension liabilities. A ratio of 100 percent denotes a fully funded pension. Anything under 100 percent represents an underfunded pension.

Duration-matched treasury yield: The return on US Treasury bills over a set period of time. This number is used to represent the expected return of investing in risk-free assets and involves the minimum amount of risk possible in an investment portfolio that matches the time frame of pension obligations.

GASB: The Governmental Accounting Standards Board, an independent, nonprofit, nongovernmental regulatory body charged with setting authoritative standards of accounting and financial reporting for state and local governments. It requires state and local government to report on the assets and liabilities of their systems in a uniform format.

Statements no. 67 and no. 68: GASB standards that change and standardize the way liabilities for pensions are calculated and that require employers and the state (as a nonemployer contributing entity) to recognize a portion of the liability in their financial statements. For more information, click here.

Intergovernmental revenue: Monies relocated from one level of government to another or involved in transfers within a government body in order to provide needed funds.

Liability: A government, company, or individual’s financial obligations to others.

Market value: The value of a company according to the stock market. It is calculated by multiplying a company’s shares outstanding by its current market price.

Pension deficit: The gap between how much a pension is required to pay out versus how much money is available to pay out.