In the April 10 edition of The Wall Street Journal, Andy Kessler points out that the bankruptcy situation in Stockton, Calif., “may expose the little-known but biggest lie in global finance: pension funds’ expected rate of return.”

Last June the city of Stockton filed for bankruptcy when it deemed it could no longer continue to fund its core services, repay creditors and make its contributions to the government-run pension systems. And earlier this month, a federal judge said the bankruptcy could move forward after negotiations between the state and bondholders had stalled.

Core to the issue of the Stockton crisis are the failures of the defined benefit system and the assumptions needed to make it work – in particular, the pension funds’ expected rates of return.

For governments like the ones in Stockton and Illinois, government worker pension plans need ambitious investment returns of nearly 8 percent year in and year out to fund the overly generous benefits officials have handed out. And if those returns aren’t met, huge holes appear in the pension funds.

That’s the case for Stockton, a city of 300,000 residents, which has amassed nearly $1 billion in debt to the California Public Employees’ Retirement System. Illinois has an official unfunded pension liability of $95 billion.

Ambitious rates of return are only one of the assumptions that are failing the pension systems. But in an environment where short-term rates are nearly zero, and expected to stay that way, the pension systems’ holes are likely to grow deeper.

In fiscal year 2012, Illinois’ $63 billion in pension investments returned nearly zero percent. That missed investment income of nearly $5 billion means the pension underfunding grew by that amount. But that’s not all.

Because Illinois’ pension systems are underfunded by $95 billion, those missing funds also failed to generate the expected 8 percent investment income. That means another $7.6 billion in foregone income and a higher unfunded liability.

That’s the problem with defined benefit plans. They make promises based on assumptions – high investment returns – that politicians can’t meet or predict.

The Illinois Policy has calculated the true size of the state’s unfunded liability by assuming not the overly ambitious 8 percent returns, but those proposed by Moody’s Investors Services.

Moody’s new rules, and those of the Governmental Accounting Standards Board, require states to use more appropriate investment assumptions. Moody’s rules are based on the yield of high-grade, long-term corporate bonds, set at just over 4 percent for fiscal year 2012.

Under those rules, the five pension funds’ unfunded liabilities grow to more than $200 billion.

Even worse, the funded ratio of the state’s funds drop dramatically – to levels just over 20 percent.

  

As Illinois’ pension hole deepens, it’s preposterous that most of the pension proposals coming out of Springfield preserve what caused the problem in the first place – the defined benefit system.

There is no easy way out of this crisis. With the pension systems’ funding at only 23.8 percent and just one major stock market correction away from insolvency, Springfield’s only solution is to embrace what the private sector has already adopted – defined contribution plans.

Ted Dabrowski is Vice President of Policy for Illinois Policy Institute.