June 20, 2010
The vast majority of state and local pension funds are underfunded. The NYT, and especially Mary Williams Walsh, have done excellent work over the years trying to call attention to this underfunding. However, today’s article on the topic definitely goes overboard.
The article is largely based on an analysis by Joshua Rauh, a finance professor at Northwestern University, that calculates the unfunded liabilities of pension funds by assuming that assets only get the same rate of return as U.S. Treasury bonds. By contrast, the standard method for calculating liabilities assumes that pension funds earn a real return of 5.0 percent annually, based on the mix of assets they generally hold.
While the article implies that the state’s assumption is overly optimistic, in fact it is a very reasonable assumption, given the current ratio of stock prices to trend earnings. With the plunge in the stock market following the recession and the financial crisis, the ratio of price to trend earnings is now close to the historic average of 14.5 to 1. This makes it possible for stocks to provide close to their long-run average real rate of return of 7.0 percent. By contrast, assuming a 7.0 percent real return on stocks at their pre-crash price level (which pension funds did) was close to ridiculous.
This makes a huge difference in the assessment of the size of the shortfall. For example, the shortfall of Ohio, the state with the largest shortfall relative to the size of its budget, falls in Rauh’s analysis from $217 billion to $75 billion. The shortfall of Illinios, which is highlighted in the article, falls from $219 billion to $85 billion.
These are still substantial shortfalls and should not be trivialized. However, they are not nearly as unmanageable as the numbers discussed in this article. For example, the shortfall in Illinois would be equal to roughly 13 percent of the gross state product (GSP). This shortfall could be met with a combination of tax increases and spending cuts equal to roughly 0.5 percent of the state’s GSP over the next 30 years. This would involve a substantial, but not unprecedented, budget adjustment.
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