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Squandering the surplus

Thanks to arcane accounting rules, state plans can use two-year-old financial data and raid their surpluses to hike benefits.

Thanks to arcane accounting rules, state plans can use two-year-old financial data and raid their surpluses to hike benefits.

By Justin Dini
November 2001
Institutional Investor Magazine

But the surpluses are shrinking fast, and the states are playing with fire.

Before he became the Bush administration's antiterrorism czar as head of the new Office of Homeland Security, Tom Ridge wanted desperately to pass his education program. The then-Pennsylvania governor had placed the three R's at the top of his agenda from the moment he took office in January 1995.

But Ridge faced determined opposition. The powerful teachers' union, and its supporters in the state legislature, lambasted the Republican's plan, which toughened teacher testing standards and offered scholarship money for parochial schools, as merely a stealth program to create "backdoor vouchers."

Finally, after weeks of tough negotiations, the governor found a time-honored way to break the impasse: He bought off his opponents, giving legislators a 50 percent hike in their retirement packages, while the state's 234,000 teachers, and 109,000 other public workers, won a 25 percent increase in their retirement benefits. Critics blasted the compromise as a $10 billion giveaway.

How did Ridge find the money to fund such largesse? Not by increasing taxes; with state elections looming, that was one measure he and everyone else wanted to avoid. Instead, Ridge found his pot of gold in the workers' own pension funds. Fattened by years of bull market returns, the $48 billion Pennsylvania Public School Employees' Retirement System had $9.4 billion of assets more than it needed to cover future liabilities. Ridge decided to raid the surplus.

Simple and pain-free, right? In the corporate world playing around with pension surpluses is pretty standard stuff. Surpluses can flow through to the bottom line as profits. In the 1980s, in fact, until regulators intervened, corporate raiders targeted some companies with overfunded pensions as a source of cash for the very same acquisitions. Down in Washington the budget surplus is fueled in part by an excess of Social Security taxes over current payouts - a state of affairs expected to cease in 2016. That excess is what presidential candidate Albert Gore wanted to secure in his infamous lockbox.

Certainly, Pennsylvania hasn't been alone in its great pension grab. Nor is the use of the funds, by and large, objectionable or frivolous. This year public employee labor unions in 11 states persuaded state legislators to deliver the surpluses to state workers in the form of better retirement benefits. Among the states dipping into the pension trough were Arizona, New Jersey and Texas (first under then-governor George W. Bush in 1999, then again this year under his successor Rick Perry). North Carolina used the surplus to cut its pension plan contributions and close a budget gap.

There's just one obvious problem to this $22 billion spending spree. The bull market is over, as every newly laid off investment banker and former day trader now dishing up Big Macs knows by now. So how are these states still living large? Credit politics, as well as the arcane rules of pension accounting, which allow states to average their assets over several years, a technique known as smoothing. States can bank on surpluses that remain intact, on paper at least, thanks to their use of financial data that is two or more years old.

But in doing so, the states may be playing with fire. The timing of their raids, after all, could not have been worse. The market valuations of their portfolios have shrunk, severely in some cases. Liabilities have jumped, because of the hike in benefits, as well as the decline in interest rates, which accelerates the overall growth in the funds' obligations. Although states have a great deal of latitude in accounting for liability growth, there is little doubt that pension liabilities have risen as assets have dropped.

"We've taken a huge roll of the dice," says Steven Nickol, a Republican Pennsylvania state representative who serves as a trustee of the Pennsylvania Public School Employees' Retirement System and was one of the few legislators to vote against increased pension benefits. "Right now it seems like a case of getting something for nothing. But we have no idea where things will be in ten years."

Ten years? The day of reckoning may be closer to hand. With the bear market biting, benefit increases are likely to create unfunded liabilities sooner than expected - by anyone's mathematics. Institutional Investor calculates that at least four of the 11 states that tapped their pension funds in the past year have moved from surplus to deficit - marked to current market. The change in Pennsylvania's numbers is the most dramatic: Assuming current market valuations, the state, which had a smoothed 123.8 percent level of funding on June 30, 2000, is now at about 97 percent.

With stocks floundering, pension funds, like all investors around the country, are feeling pain. The average pension fund has seen its funding fall from 116 percent to 106 percent, according to Wilshire Associates. Now the economy is heading into a recession, and forecasts are gloomy at best for the next 12 months. Beyond that, many observers doubt that the market will ever see the heady returns that propelled most pension funds to surpluses in the years of the tech-stock bubble. New York and Maryland, states that didn't pass benefit increases earlier this year, are facing the prospect of renewing their contributions to their retirement systems to keep them fully funded because of the market drop.

None of this bodes well for funds with declining returns and growing liabilities. As already troubled local finances are strained even further, performance pressure will intensify on the officials overseeing the often giant funds. States usually keep plans adequately funded by increasing their direct contributions when the need arises. But that will become increasingly difficult, if not impossible, as the economy further deteriorates.

"We're entering uncharted territory where the economy is concerned," says Steven Murphy, managing director for public finance at Standard & Poor's. "It's not a good idea to enter uncharted territory with your fiscal options weakened, and that's what these decisions have done. These states are in a box now."

And it's a pretty tight fit in that box. Tax revenues were already dropping before the economy worsened after the September 11 terrorist attacks: 44 states have seen revenues decline this year. To balance their budgets, state governments have to cut services, issue more debt or raise taxes. Fifteen states increased their levies this year, the first to do so since the recession of the early 1990s. Pension funds moving into underfunded status will have to compete for money with a long line of state agencies, like those overseeing public schools, hospitals, public safety and roads.

In a worst-case scenario, states that neglect or strip-mine their funds can wreak havoc on their finances, ultimately even soiling the state's credit rating. In the late 1980s, for example, Louisiana and West Virginia approved sizable benefit hikes, only to create huge unfunded liabilities in their retirement systems that plague them to this day. Both states were forced to pass tax increases to help deal with the unfunded liabilities (along with a host of other budget needs). West Virginia is planning to issue $4 billion in bonds to cover its shortfall, quadrupling the state's debt load. Louisiana was considering a $6 billion bond issue but backed off because of fears among legislators that it would vastly increase the state's debt load (see box).

With such less-than-exemplary precedents in mind, the credit agencies that rate state bonds are keeping a close watch on pension benefit hikes. "An increased benefit means an increase in costs, and that is an additional burden at a time when these states are wrestling with revenue weakness," says Robert Kurtter, a senior vice president for state ratings at credit rating agency Moody's Investors Service. "It is a cause for concern."

No one is saying that Pennsylvania or any of the other states that hiked their benefits will meet the fate of Louisiana or West Virginia. After all, today's benefit boosters, unlike their 1980s counterparts, started off with unprecedented surpluses.

But it is nonetheless startling how quickly their world has changed. Consider how deeply the funds have fallen in little more than a year. Using the most recent market valuations and assuming 10 percent growth in liabilities, Institutional Investor calculates that the Arizona State Retirement System declined from 116.4 percent funding to 95.8 percent; New Jersey's teacher and public employee funds from 109.5 percent to 92.2 percent; the Teacher Retirement System of Texas from 107.4 percent to 93.4 percent. In sum, benefit hikes that weren't supposed to begin cutting into surpluses for another decade may have already done so (see table).

Pensioners aren't in any danger of losing their benefits; the state guarantees them. And state legislators can fix an unfunded liability by simply increasing the amount of money their state pays into its retirement system. The problem is, no state legislator wants to increase taxes, but if they do, they don't want to divert cash that they would rather spend, say, on hiring more cops. A choice between pouring billions into a retirement system that is 90 percent funded or a politically resonant issue like improving public safety is no choice at all.

"None of this would matter if legislators automatically increased contributions to the funds," says Edwin Burton, a professor of economics at the University of Virginia and the former chairman of the board of trustees of the Virginia Retirement System, which successfully fought off a raid on its surplus earlier this year. "But the history is that they don't. And next year, with tax revenues dropping, you're going to see people using actuarial gimmicks as an excuse to lower contributions, not raise them."

Pennsylvania may already be feeling the pinch. State Representative Nickol says he is now being told by PSERS's actuaries that as a result of a drop in the funded status of the PSERS fund, the state will almost certainly need to increase its contribution from 1.09 percent of payroll in the next fiscal year to between 3 and 4 percent. "To slip that quickly and that dramatically is quite significant, and we are already feeling the impact," says Nickol, who expects the PSERS board to address the issue this month. "This is hitting at a time when we can least afford it. The budget has to be balanced one way or the other."

He predicts that either taxes will rise or services will be cut to provide the needed funding. "The additional $300 million that the state will have to pour into the pension system as a result of the benefit hike will hit local school districts hardest, as they are responsible for covering half the contributions to the fund. To raise the additional money, the school districts will probably have to increase local property taxes, he says. "And in most districts, local property taxes are already through the roof."

Just a decade ago, most public plans were underfunded. In 1990 the nation's public retirement systems reported assets that covered only 80 percent of their liabilities, according to Wilshire Associates, which uses market valuations to calculate its numbers. By January 2000 the average funded status for a public pension fund had reached 116 percent, up from 92 percent in 1996. In those four years total public pension assets increased 20 percent annually, from $825 billion to $1.72 trillion. Liabilities increased at a 13 percent clip, to $1.48 trillion, but not nearly enough to offset the gains.

That rosy picture of fund finances, though, has quickly gone out of date. To understand how, it's helpful to take a refresher course in pension math.

When a state's actuaries calculate a plan's funded status at the close of each fiscal year, they make a series of assumptions. They begin with a plan's total assets as they stand at the end of the previous fiscal year and multiply that sum by an expected annual rate of return. Since the 1980s the anticipated return has ranged between 6.5 percent and 11 percent, though it remained largely flat for the past decade at roughly 8 percent. Actuaries add to that annual base amount a portion of a fund's investment gains or losses.

This "smoothing" allows a pension fund to value its assets based not on their fair market value at any given moment, but on the average market value over, typically, a three- or five-year period. Advocates argue that the process enables states to keep contribution rates stable and predictable. "Smoothing allows a state to add stability to its funding process," says S&P's Murphy. "Otherwise states would be reacting to month-to-month drops and rises in the market, and that would result in chaos."

It's a perfectly reasonable actuarial technique. But it can also obscure bad investment trends and delay a reckoning if it's not scrutinized. Smoothing allows funds that achieved robust returns in the mid- to late 1990s to reap the benefits years later. By the same token, the losses funds took in 2000 and 2001 are only partially felt now.

"I'd estimate that the actuarial value of assets is roughly 10 percent less than the market value of assets," says Stephen Nesbitt, senior managing director at Wilshire Associates. Nesbitt regards using market valuations as a much more accurate of way of determining a fund's fiscal health.

All in all, though, valuing pension assets is fairly straightforward. Determining liabilities can be more complicated. First, actuaries estimate their future obligations: What benefits must the plan pay employees when they retire? This involves an estimate of the future rate of inflation and of the number of years employees are expected to work, as well as their life expectancy. Actuaries estimate the rate of future salary increases, since benefits are based on employees' salaries at the end of their careers.

Once the pension benefit is defined, actuaries calculate its present value. To do that, they work backward, using the discount rate, which represents the interest rate at which pension liabilities could effectively be settled; in other words, the present value of future benefits. The lower the discount rate, the higher the liability.

Unlike corporate funds, though, public plans have a great deal of latitude in accounting for growth in liabilities. Although corporate funds are required by regulators to use discount rates that hew closely to long-term corporate bond indexes, public retirement systems under Governmental Accounting Standards Board rules need only use a "prudent person" approach to determining their discount rates. Most public funds use their expected return on assets as their discount rate.

Actuaries divide the value of assets by liabilities to create a funding ratio that measures the amount of assets available per dollar of liabilities. A funding ratio exceeding 1.0 means that the plan has provided for benefits that have been earned; thus no further contributions are necessary as long as assets grow at the actuarial rate of return. In this case, the plan reports a surplus. Ratios below 1.0 mean that future contributions will be required unless assets earn returns above the actuarial rate; in this scenario the plan faces an unfunded liability.

Simple math explains why some states may now be pressing their luck. Over the past couple of years, assets obviously have been falling as the market swoons. Meantime, liabilities are rising for two reasons: the benefit hikes and the decline in interest rates, which should lead states to use lower discount rates.

Let's look at the liabilities first. Estimates of the extent of the liability increase vary, but there is no doubt that the rise has been substantial. Wilshire's Nesbitt estimates that since the data in the June 2001 Wilshire report was collected, between the end of 1999 and the middle of 2000, liabilities have probably grown by 5 percentage points, while assets have dipped by 5 points. That would result in a 10-point drop in the funded status of the average plan, down to 106 percent.

Alan Glickstein, an actuary at consulting firm Watson Wyatt Worldwide in Boston, figures that plans have absorbed a 10 percent jump in liabilities during the past year or so. He bases that estimate on the assumption that public funds have seen a decline in the discount rate of at least 50 basis points.

To illustrate how the liability increase takes effect, Glickstein cites the the example of a 50-year-old worker who will retire when he is 60 and die at 80. Glickstein picks the midpoint of his stream of benefit payments - age 70. Assume that the retirement system is scheduled to make a $1 pension payment to this worker when he is 70. Now compare the new discount rate of 7 percent with the old rate of 7.5. Under the old discount rate, the liability would be $1.075, and under the new, $1.07. Take the ratio of those two numbers to the 20th power (to account for the passage of 20 years) and you end up with roughly $1.10 - an increase of 10 percent. That's regardless of any benefit increases between now and then.

But Glickstein's projection of a 10 percent liability increase may be conservative. According to the pension liability index produced by New York-based money manager Ryan Labs, between September 2000 and September 2001 pension liabilities grew at a 14.64 percent clip. And the Salomon Brothers pension liability index, basically a double-A-rated corporate bond index, fell more than 100 basis points between May 2000, roughly around the time many public funds were determining their funded status for the end of their fiscal years, and the end of this September. A 100-basis-point drop suggests a roughly 20 percent increase in liabilities.

Again, plans enjoy a great deal of latitude in calculating their liabilities. While some retirement systems choose to lower their discount rate assumptions and thus increase their liabilities, accounting standards do not require them to do so. Still, Nickol, the PSERS trustee, thinks his fund's discount rate assumption of 8.5 percent is too high, and he will press PSERS's staff to consider lowering it. "We haven't hit 8.5 percent returns in two or three years, and things don't look to be improving," he says.

So much for theory. Consider how the numbers work in the case of individual states. Under Pennsylvania's new law, the state will calculate benefits for employees by multiplying years of service by 2.5 percent, up from the 2 percent the fund had used. Employees who want higher benefits must contribute more - 6.5 percent of their salary, up from 5.25 percent. The new formula, which took effect July 1, makes Pennsylvania, along with New Mexico, the most generous state in the country for pension benefits. (New Mexico's multiplier is 3 percent.)

Pennsylvania calculated that its funds could achieve the annual 8.5 percent return the fund has assumed for the past decade. The legislature figured the fund would stay in surplus for another ten years. Pointing to the funds' strong investment performance, proponents of a benefit hike argued that they weren't asking the plans to perform at an extraordinary level.

In fact, Pennsylvania's performance was only average, but it was good enough to exceed its needs. For the five-year period ended December 31, 2000, PSERS posted average annual returns of 12.4 percent, which placed it in the third quartile of all large public funds, according to Wilshire Associates.

Whether the fund can continue to beat 8.5 percent is a serious question. In 2000 its assets fell by a sobering 1.9 percent, placing it in the third quartile for the year. "What if we're wrong and the economy is flat?" Nickol asks. "We've taken a huge risk for the future. It's anybody's guess where we'll be in 2012."

Says Dale Everhart, executive director of PSERS, "Investment performance of less than 8.5 percent would have an impact."

To calculate its funding status, PSERS uses a three-year moving average as its smoothing device. PSERS was 123.8 percent funded, as of June 30, 2000, up from 89.7 percent in 1995. That percentage is based on a $39.8 billion liability and an actuarial valuation of assets of $49.3 billion. The market value of the fund's assets was then $53.4 billion.

But the market gains that are funding the benefit hike have already turned into losses. Between June 2000 and June 2001, the market value of PSERS's assets fell $5.2 billion, or 9.9 percent, to $48 billion, according to PSERS.

PSERS has not yet released up-to-date actuarial, or smoothed, valuations of its liabilities and assets, but, again, as of June 30, 2000, the liability stood at $39.8 billion. The new benefits would tack on an additional $5 billion to the liability, according to a May 7 report by the Pennsylvania Public Employee Retirement Commission. That report concluded that, based on the June 30, 2000, data and taking into account the additional employee contributions, the fund would still have a surplus of $4.5 billion over its new accrued liability of $44.8 billion.

But consulting firm Wilshire assumes that apart from benefit hikes, liabilities increased on average 6 percent for all funds between last year and this year - mostly reflecting lower interest rates, but also an increase in service costs such as the increase in benefits an employee earned because he worked another year. That would take PSERS's liability closer to $47.5 billion. If Nickol successfully pushes PSERS to lower its discount rate later this month by, say, 50 basis points, the impact would be greater. Watson Wyatt's Glickstein believes that a 10 percent jump in liabilities is the more likely scenario, which would swell the liability to $49.3 billion. With a recent market valuation of $48 billion, that would leave PSERS with an unfunded liability of $1.3 billion, not a $4.5 billion surplus.

In any case, the surplus expected to last ten years would be gone already. Pennsylvania taxpayers will not be compelled to pay higher contributions to the pension fund this year or next, but they may find themselves stepping in sooner than they expected.

The Pennsylvania experience wasn't unique. New Jersey opted for a more modest benefits hike than did its neighbor, but it used a more aggressive accounting technique to do so.

New Jersey officials upped their benefits for current and retired state employees and teachers by 9 percent on June 29. That was just in time for workers to begin enjoying the increase before this month's state elections, when all 120 members of the Republican-controlled state legislature were up for reelection. Under the law, the multiplier for state and local public employees and teachers jumps from 1.667 percent times years of service to 1.818 percent. That results in a $5.2 billion increase in New Jersey's accrued liability.

The new benefits will cost the state $101 million a year, which will come out of the surplus. Should the surplus run out, which legislators expect will happen in ten years, the state will be forced to resume making contributions to the pension funds. New Jersey stopped writing checks to its funds as of July 1, 1999.

Once again, strong investment gains from the past are funding this political gift. For the year ended June 30, 2000, the New Jersey Division of Investment, which oversees the state's public pension funds, returned 11.9 percent; over three years, an average 16.8 percent a year; and over five years, an average annual 17.7 percent. Those gains propelled the plan's smoothed funded status to 109.5 percent by June 2000.

"I don't think our ability to pay for this kind of increase was an issue, simply because the investment gains have been so dramatic over the previous five years," says Thomas Bryan, director of New Jersey's Division of Pensions and Benefits. "The idea was to take advantage of that surplus."

How New Jersey chose to do this turns out to be quite revealing. Smoothing works for and against funds: Stated asset growth lags as market values climb. On the way down, smoothing works to prop up values. In making the case for increased benefits, New Jersey, which was climbing out of a deep trough of underfunding (back in 1995 it was only 88.9 percent funded), chose to ignore its normal smoothing process to embrace market values. And it chose to calculate its surplus by comparing 1999 assets with 2000 liabilities.

New Jersey reckoned its 1999 assets at $58.9 billion, versus $48.6 billion in liabilities as of June 30, 2000. Including $5.2 billion in higher liability costs as a result of the benefit hike, New Jersey's liabilities are now closer to $58.6 billion. The latest market value? $54.1 billion, as of June 29. That leaves its funded status at 92.3 percent.

The "pension assets are revalued to reflect their full-market value as of June 30, 1999," according to a July 11, 2001, report from the New Jersey Legislature's Office of Legislative Services. "The higher values of assets resulting from the revaluation are used to offset the additional liabilities created by increasing the multiplier for their retirement benefit."

Division of Pensions and Benefits' Bryan defends New Jersey's decision to depart from its normal five-year smoothing of gains and losses. "We use rather conservative smoothing," he says, "so this was a way to let employees participate."

Bryan dismisses the contention that the fund is now underfunded and says he is confident the state will not need to increase its contributions to the retirement system for at least the next 18 months. "Thereafter, it is going to depend on the performance of the economy and the stock market."

"It was very convenient that they picked those 1999 numbers," says Alan Kooney, the budget and finance officer of New Jersey's Office of Legislative Services, who was critical of the hike. "We were sitting on this big pile of excess funds in the pension plan, and legislators were looking at it kind of covetously."

New Jersey is no stranger to unfunded liabilities - between 1994 and 1998, the state reduced contributions to its public pension funds by $4 billion, resulting in a $4.2 billion liability. As part of a complex plan to refinance that liability, former New Jersey governor Christie Whitman pushed through a $2.9 billion pension bond offering in 1997. That led directly to the pension fund's surplus.

For Pennsylvania and New Jersey, both union strongholds, there was never any question to whom the surplus belongs: the state workers. North Carolina and Virginia legislators took a different tack: For them, the surplus belongs to the taxpayers, not the public employees.

In January newly elected North Carolina Governor Michael Easley declared a fiscal emergency and seized the pension surplus when it became clear that North Carolina was facing an $850 million shortfall in its budget for the fiscal year ended June 30, 2001. It was the state's worst fiscal crisis in a decade. Easley, a Democrat, froze all scheduled state contributions to the Teachers' and State Employees' Retirement System of North Carolina between February and June. The value of the forgone contributions: $151 million.

The governor argued that the retirement system could comfortably afford the contribution cutback because it was 106.4 percent funded. That number reflects values as of the end of 1999, when the state last calculated its funded status.

"By actuarial standards, it is unsound," says Michael Williamson, North Carolina's deputy treasurer and the director of the state's retirement system. "But will $150 million break the system? No."

Williamson points out that the fund's actuaries predict that if the cuts to the system are not restored, the diversion of $151 million, compounded by interest, will cost the retirement system 33 basis points annually over the next nine years. In comparison, a 1 percent increase in benefits for, say, cost of living would cost the system 28 basis points. "If you ask the retirees if that 1 percent is a big deal, they'll say yes," Williamson says.

Moreover, it is doubtful that the fund is in surplus today. "It is a fair assumption that our balances won't be what they had been in the past," Williamson says. "Our investment returns have gone down." As of June 30, 2001 (the most recent available number), North Carolina's assets had a market value of $44.5 billion, down from its high of $48.9 billion in January. The state's most recent liability figure dates back to December 31, 1999, when it stood at $45.7 billion. If liabilities grew 10 percent annually since 1999, that would put North Carolina's current liabilities at $54.9 billion. Its new funded status? Roughly 83 percent. Williamson disputes that number, though. "Even with the downturn in the markets, we are going to be overfunded when our new valuation numbers come out later this year," he says. "I don't anticipate that we will need to increase contributions to the fund anytime soon."

How's that? Smoothing will ease the blow of the downturn in the markets, and the state can be aggressive in its liabilities calculation. But the fund is almost certainly not as healthy as it was two years ago.

"These are unprecedented and somewhat volatile times," Williamson says. "This is the first time in our history that we've had an undistributed gain. It is hard to say what the appropriate action is. Sustained actions like this would cause us to be concerned regarding the long-term stability and health of the fund."

Governor Easley is gambling that the economy will rebound next year, but who knows how that bet will pay off?

The State Employees Association of North Carolina sued the state in March for what it calls an "illegal raid" on the system, saying that Easley lacked the authority to withhold the funds. A state judge tossed out the lawsuit in May. SEANC has appealed the decision.

"It sets a very dangerous precedent that a governor can usurp the powers of the General Assembly and take money scheduled to go into the retirement fund," says Dana Cope, executive director of SEANC.

Virginia came close to raiding its pension surplus; ultimately, legislators backed off.

In February Virginia Governor James Gilmore, a Republican, proposed a move that would effectively shift the $63.4 million earmarked for the Virginia Retirement System to other parts of the budget, accelerating a phase-in for his pet political project, the elimination of Virginia's so-called car tax, a personal property tax on vehicles. The proposal emerged as part of a larger debate over amendments to the $48.1 billion 2000-'02 budget.

Essentially, Gilmore proposed accelerating a contribution reduction that had been scheduled to go into effect this July 1 and making it retroactive to July 1, 2000. In 2000-'01 the state contributed 6.02 percent to the system, and for 2001-'02, that would go down to 4.24 percent. After all, a VRS surplus beckoned: As of June 30, 2000, the system was 105 percent funded.

Ed Burton, then still the chairman of the board of trustees, fired off a letter to the legislature on February 2, attacking Gilmore's move. That would "amount to a direct drawdown from the Fund itself," Burton wrote. "The trend here is clear and alarming. The integrity of the funding outlined in law is in considerable danger of being undermined by these actions."

Ultimately, the raid was halted not by Burton's threats but by the very thing that had drawn the governor and the legislature to the VRS funds to begin with: the stock market. Since last June, when the fund's portfolio hit a high of $42 billion, it has dropped to $35.2 billion, a 13 percent decline in value. In May the Senate's finance committee said it wouldn't support Gilmore's maneuver to reroute the state contribution to the VRS over fears that the system couldn't afford the cut.

Burton, whose term as chairman has since ended, expects another raid on the system next year. "These folks always come after the system, because there's a lot of money there," he says. "$36 billion is an awfully juicy target when you're looking for a couple of hundred million dollars."

"These are public policy choices," says Moody's Kurtter. "My question is, How do decisions regarding the pension fund affect the bottom line of the state budget? If a state has to increase its contributions to the pension fund at a time when its revenues are falling, that will probably mean it won't be able to increase spending in other areas, like education or health care. These are the choices policymakers have to make." Or have already made. A badly managed retirement system can not in itself cause a state's fiscal collapse. But it can certainly cause severe financial stress, as every credit rating analyst knows. "Management of these pension liabilities is a factor in every sponsor's overall rating," says Parry Young, S&P's director of public finance ratings.

Back in 1998 he predicted that as many pension systems approached fully funded status, a "hidden danger" would appear: intensified demands for improved benefits, which could cause state plans to run unfunded liabilities. In many states those demands have since been satisfied. The question now: How much longer will the dangers remain hidden?

Surplus politics

Increasing pension benefits or decreasing plan contributions can wreak havoc with a state's finances for years to come. Just take a look at what happened in West Virginia and Louisiana.

In the late 1980s and early 1990s, West Virginia's legislature slashed the state's contributions to the West Virginia Teachers' Retirement System to help cover major shortfalls in its budget. At the same time, West Virginia doled out generous pay hikes to those same teachers, vastly inflating its pension liabilities. That dangerous combination produced a $3.8 billion unfunded pension liability that still plagues the state, despite strong investment returns. To help shore up the fund, West Virginia intends to float a $4 billion bond offering sometime in the next 12 months, which would quadruple the state's debt load.

"The budgets that [former governor Arch Moore] submitted during the late 1980s did not contain anything close to sufficient funding for the teachers' retirement system, either on an actuarial basis or as measured against the funding formulas in the law," says Thomas Heywood, who served as chief of staff under Moore's successor, Gaston Caperton. "We're still feeling the aftershocks of those decisions today."

The state of Louisiana labors under the burden of similar decisions made throughout the early 1980s, when legislators voted to increase benefits for teachers without fully funding them. The state found its credit ratings downgraded in the early 1990s, largely as a result of shoddy management of its retirement systems. That in turn drove up the state's borrowing costs. Despite robust returns on its investments for most of the 1990s, the state's pension assets still cover only 75 percent of its liabilities.

In January Louisiana Governor M.J. (Mike) Foster Jr. proposed refinancing the $5.6 billion unfunded liability, which isn't scheduled to be paid off until 2029, with a $6 billion debt offering that he argued would free up $135 million to fund other state priorities. "When all the complications are stripped away, this is nothing more than refinancing a home at lower interest rates," he told legislators in a March speech.

State legislators didn't buy that argument, though. They believed that the plan would needlessly inflate the state's debt, and the governor backed off. Still, Foster vows to return to the issue next year.