Would it surprise you to learn, that during the new millennium’s first decade, Hawaii’s lawmakers borrowed almost $9 billion from government workers in the taxpayers’ name?

That’s exactly what I discovered in the 85th Annual Actuarial Valuation Report (as of June 30, 2010) to the board of Hawaii’s Public Employees’ Retirement System (HERS).  With little public notice, the actuary’s estimate of how much taxpayers owe government employees for their service and contributions to date went from nothing in 2000, to almost two rail system’s worth of future taxes in 2010. And the amount is only that little, if the HERS board earns 8 percent on the assets it holds.  Otherwise, taxpayers owe much more.

So this series of articles was prepared to explain the HERS, and how the universally adopted “retirement system” design permitted “retirement systems” here and across the U.S., to accumulate so much debt, with so little public notice, taxpayer alarm, or lawmaker action.

First, Hawaii Revised Statues, Chapter 88(PL-88) adds retirement, disability, death and dependent benefits to the compensation of state and county workers that is materially different from all other kinds of compensation like pay, health insurance, and employer contributions to individual account type retirement plans (i.e., 401k type plan).

For all other types of compensation, the exact amount earned in a given year is known, and paid, in the year earned. However, for the PL-88 compensation earned each year i) the payment date is unknown, because there are many retirement age choices, ii) the type of payment is unknown, because earlier termination, disability or death replaces retirement, and iii) the exact amount is unknown, because it depends on the worker’s pay at retirement — not today’s pay — and whether it’s paid on account of retirement, termination, disability, death or to a dependent.

Accounting for all other types of compensation is straightforward, and final, in the year it is earned. But the uncertainty of PL-88 compensation’s amount requires its value to be estimated using “multiple contingent probabilities” and “financial discounting” over the future lifetime of workers and their dependents. That’s what an “Actuarial Valuation” does, and PL-88 requires one as of each June 30.

In a valuation, the actuary estimates today’s value of all future PL-88 compensation payments already owed to workers for service rendered, and contributions made, to date. The value is called the “Actuarial Accrued Liability” (AAL). More simply, it’s the value of compensation taxpayers already owe, but haven’t yet paid.

As shown in the graph, it was $9.7 Billion on June 30, 2000, and grew steadily to $18.5 Billion on June 30, 2010.

It’s a dangerously large liability, and doubly so, because governments use “cash accounting”, instead of “accrual accounting”. That means the AAL isn’t recorded on a government balance sheet as a liability, and that leaves the taxpayer money needed to pay the AAL tomorrow in the hands of politicians to spend on something else today. So, 85 years ago, Hawaii’s lawmakers created a “retirement system” as a separate arm of Hawaii’s government, and required politicians to “earmark” assets equal to the AAL, i.e. transfer assets equal to the HERS as it grew. And that removed them from the politicians’ spending pot as effectively as recording the AAL as a balance sheet liability.

“Accepted Actuarial Funding Methods” are used to calculate the annual amount needed to get, and keep, earmarked assets equal to the AAL, and for its first 80 years PL-88 required a transfer calculated by an actuary using such method. So as of June 30, 2000, earmarked taxpayer assets equaled the taxpayer’s AAL, i.e. the AAL was “fully funded”. (False allegations of 90’s skimming will be addressed later.)

Had lawmakers left PL-88 unchanged, and the HERS board earned 8 percent on the assets it invests, earmarked assets and the AAL would still be approximately equal. But neither did. The HERS board averaged less than 5 percent for the 8 years ending June 30, 2008 (prior to Fannie Mae’s melt down), and less than 3 percent for the 10 years ending June 30, 2010. Lawmakers replaced annual transfers calculated by an actuarial funding method with a lower amount written into the law by “fiat”. So earmarked assets fell almost $9 Billion short of the taxpayer’s AAL, and a 100 percent funded AAL is now barely 50 percent funded.

Note: The graph’s “Theoretical Assets @ 8%” line estimates where assets would be if the board earned 8 percent. The remaining shortfall is due to the lower “fiat” funding (and normal slippage between estimating “assumptions” and subsequent reality).

Future articles will explain the above concepts in more detail. Then they will explore the defects in traditional retirement system design that permits creation of so much debt, so quickly, with so little public notice. And finally explain methods put forward for correcting those defects.

Definitions: If there are terms in this story you would like to better understand, please review our page offering definitions for retirement terms.