September 27, 2013
The Washington Post ran an article highlighting new calculations of city pension liabilities from Moody’s, the bond rating agency. Moody’s is probably best known to most people for rating hundreds of billions of dollars’ worth of subprime mortgage backed securities as investment grade during the housing bubble years. It received tens of millions of dollars in fees for these ratings from the investment banks that issued these securities.
The new pension liability figures are obtained by using a discount rate for pension liabilities that is considerably lower than the expected rate of return on pension assets. This methodology increases pension liabilities by around 50 percent compared with the traditional method.
If a pension fund was fully funded according to the new Moody’s methodology, but continued to invest in a mix of assets that gave a much higher rate of return than the discount rate used for calculating liabilities, then it would have effectively overfunded its pension. That would mean taxing current taxpayers more than necessary in order to allow future taxpayers to pay substantially less in taxes to finance public services. Usually economists believe that each generation should pay taxes that are roughly proportional to the services they receive. Moody’s methodology would not lead to this result if it became the basis for pension funding decisions.
It would have been worth highlighting this point about the Moody’s methodology. Most readers are unlikely to be aware of the strange policy implications of following the methodology and thereby assume that governments would be wrong not to accept it.
It is worth noting that public pensions did grossly exaggerate the expected returns on their assets in the stock bubble years of the late 1990s and at the market peaks hit in the last decade. Unfortunately, unlike some of us, Moody’s did not point this problem out at the time. One result was that many state and local governments raised their pensions and made additional payouts to workers which would not have been justified if they had used a discount rate that was consistent with the expected return on their assets.
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