April 13, 2016
There has been a flurry of recent articles touting recent work by Stanford Business School Professor Joshua Rauh, arguing that state and local pension fund liabilities are far larger than generally reported. Rauh puts the unfunded liabilities of state and local pension funds at $3.4 trillion, more than three times the figures that the pensions themselves calculate. He predicts looming crises with many local governments driven into bankruptcy.
The reason for the difference between Rauh’s $3.4 trillion number and the shortfall of roughly $1 trillion using the pension fund’s methodology is the rate of discount used to evaluate pensions’ liability. Pension funds calculate their liability using their expected rate of return as the rate of discount. This currently averages just over 7.0 percent on their assets. In contrast, Rauh uses the risk-free rate of interest for discounting, using the current 2.5 percent yield on 30-year Treasury bonds. The lower interest rate puts a much higher value on projected funding shortfalls 20-30 years in the future.
While many would like the public to be scared by Rauh’s calculations, there are a few points worth keeping in mind. First, the return numbers that pension funds use are not pulled out of the air. They reflect projections of investment returns based on actual experience and a range of standard economic projections. They will of course not be exactly right, but they are also unlikely to be hugely wrong.
As a recent report from Pew Research Center points out, the main reason that some pension funds are in serious trouble is not that they were overly optimistic about investment returns, the pensions that are into serious trouble were the ones that failed to make their required contributions. In states like New Jersey and Illinois, not making pension contributions became almost a sport among politicians. The same was true for the city of Chicago under Mayor Richard M. Daley. If governments don’t contribute to their pensions, they will be underfunded regardless of what returns are assumed.
This brings up a second point: most pensions are reasonably well funded. As of 2013, the most recent years for which data have been compiled; there were fourteen states with funding ratios in excess of 80 percent of liabilities, the conventional threshold for a safe funding level. Five of these states have funding ratios over 90 percent of liabilities. The overall average is 72 percent. There are cities and states that will have problems addressing their shortfalls, but these are the exceptions. Most states will be able to meet their obligations without major changes to their benefit or contribution structure.
One reason that the plans funding ratios are not higher is that they typically average the value of their assets over the prior five years. In 2013 this five-year window would have included 2009 and 2010 when the stock market was badly depressed following the financial crisis. As these years are replaced with the much higher stock market values of 2014 and 2015, the funding status of these pensions will look considerably stronger.
There is much to be said for a patient approach to the projected shortfall. Rauh was also warning about pension shortfalls in 2010, when the unemployment rate was still near 10 percent. If state and local government had followed his advice and either raised taxes or cut spending in order to meet pension obligations, it would have slowed the economy and increased the unemployment rate. If all public pension funds had simultaneously adopted Rauh’s preferred accounting methodology and made pension contributions accordingly, it would have lowered GDP by more than 3 percentage points ($540 billion in today’s economy) and cost the economy more than 4 million jobs. This would have been a massive imposition of austerity at a time when the economy badly needed stimulus.
It is also worth noting that the funding position of pensions has substantially improved since 2010. Unfunded liabilities for state pensions were estimated at $1.38 trillion in 2010, compared to $968 billion in 2013. Measured as share of GDP the drop was even larger, from 13 percent to 7 percent. (Since these shortfalls can be made up over the 30-year planning period, the correct denominator would actually be projected GDP over the next three decades.)
In short, there is little new in Rauh’s analysis. We have been hearing it for many years. State and local governments have been wise not to allow it to guide their policy with regard to public pensions. This should continue to be the case.
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