RENEE MONTAGNE, HOST:
We've been hearing a lot about state and municipal pension funds, which are in trouble around the country. According to state and local governments, the country's public pension plans are underfunded by about a trillion dollars. Now that gap between what plans owe and what they currently have on hand is about to look bigger. Caitlin Kenney from our Planet Money team explains.
CAITLIN KENNEY, BYLINE: Here's the question that everyone has for Matt Smith. He's the state actuary in charge of Washington State's retirement system. Does the state of Washington right now have all the money it's promised to pay retirees up till this date?
MATT SMITH: No, it does not. It has two plans that are not 100-percent funded.
KENNEY: Translation: The money there right now won't grow enough over time to meet the promises the states made. That part isn't new. What's changing is the way that number's calculated. The Governmental Accounting Standards Board, GASB, sets guidelines for how state and local governments report the finances of their pension plans. GASB is changing the way governments calculate their pension liability. Their change gets at this fundamental question: How much money is enough? The way you answer that all depends on this single number. It's called the discount rate. Joshua Rauh is a professor of finance at the Stanford University Graduate School of Business.
JOSHUA RAUH: You know, there's that William Carlos Williams poem: So much depends on a red wheelbarrow. Well, in my world it's so much depends on that darn discount rate.
KENNEY: Right now, most cities and states use a number around 8 percent. They assume their investments will earn at least 8 percent per year. Dave Urbanek is director of communications for the Illinois Teachers Retirement System. He says there's a reason we use that number.
DAVE URBANEK: We set the rate of return based on history and practice. The TRS assumed rate of investment return is 8.5 percent over 30 years. And over the last 30 years, our actual rate of return has been 9.3 percent.
KENNEY: But Josh Rauh, that professor, says just because it worked before doesn't mean it's going to work again.
RAUH: What the public sector accounting is doing is it is assuming that that history of having done pretty will continue indefinitely in the future, with certainty. It does not reflect the fact that there is a lot of risk that might not, and that these assets might not perform well.
KENNEY: The Governmental Accounting Standards Board seems to agree. It's changing guidelines on what that discount rate should be. Under the new guidelines, some cities and states can no longer use that simple 8 percent number. The rules get complicated, but in certain situations, they'll need to use a much lower number, a rate as low as 5 percent. And the number you use makes a big difference. A pension fund that seems okay with an 8 percent expected rate of return doesn't seem so great at 5 percent. And if you're a pension fund that is already in trouble, this change is the last thing you need. Take Illinois. The Illinois Teachers Retirement System already has less than half the amount it's promised to pay current and future retirees over the next 30 years. Here's Dave Urbanek again.
URBANEK: At the end of fiscal year 2011, our unfunded liability was 53.5 percent.
KENNEY: Keep in mind, that number was calculated under the current guidelines - 8 percent. Under the new guidelines, Urbanek has this analogy.
URBANEK: I mean, what's happening is I've got a burn on my arm. The EMT tells me it's a third-degree burn. I go into the doctor's office in an emergency room, and he tells me it's a fourth-degree burn. We have a problem. Depending on how you calculate it depends on how big the problem is.
KENNEY: Urbanek worries this change will undermine people's faith in the retirement system. GASB, the people who set these guidelines, they say it's time to lay the cards on the table so everyone can see them. They say changing this number doesn't change economic reality. It just better reflects what that economic reality is. Caitlin Kenney, NPR News.