The economic recovery is fragile enough. Should we force public pension funds to cut their investment return assumptions in half in order to comply with economic theory? The move may cost taxpayers $2.9 trillion.
The trouble is the assumptions that state and local pension plans make for their investment returns are too high.
Arizona’s Public Safety Personnel Retirement System expects to make 8.25 percent on its investments this year.
Colorado’s Public Employees’ Retirement Association will make 8 percent. And the Virginia Retirement System anticipates 7 percent returns.
Eileen Norcross of the Mercatus Center at George Mason University in Arlington, Virginia, and Andrew Biggs of the American Enterprise Institute say such assumptions are optimistic, and should be much lower, in the 3 percent range.
In a June report on New Jersey’s pension system, they also advocate the adoption of corporate accounting rules, and converting public pensions from defined benefit to the defined contribution plans now common in business.
Government pension plans across the nation assume they will make between 7 percent and 8.50 percent, with the median for 126 plans surveyed being 8 percent, according to the National Association of State Retirement Administrators. Moving to the lower investment assumptions of corporate accounting would force taxpayers to come up with $2.9 trillion to bridge the gap between assets and liabilities.
The Governmental Accounting Standards Board, which sets guidelines for state and local governments, in June rejected a corporate makeover in publishing “preliminary views” on pension accounting and financial reporting. That won’t make the argument go away.
Governments and public labor unions are going to resist this idea to reform the system, and I don’t blame them.
This latest battle in the public pension wars pits those who call themselves “financial economists” against practitioners of “actuarial accounting.”
The economists’ argument was summed up by Donald Kohn, former vice chairman of the Federal Reserve Board, quoted in the Norcross/Biggs report on New Jersey: “The only appropriate way to calculate the present value of a very low-risk-liability is to use a very low-risk discount rate.”
In other words, if you want to figure out how much you will need to pay your retirees -- a low-risk liability, meaning, states and localities always pay -- you must put your money in very safe, low-risk assets. When New Jersey discounts its liabilities at 8.25 percent, the state reports that its pension systems are underfunded by $44.7 billion. If New Jersey discounts the liability at 3.5 percent, the rate you can get on U.S. Treasury securities, its unfunded obligation is $173.9 billion.
“The suggestion that public funds should discount their liabilities at a so-called risk-free rate is terribly misguided,” Keith Brainard, research director of the Washington-based National Association of State Retirement Administrators, said in an e-mail. “That standard is partly responsible for the demise of corporate pensions, as it makes the required costs of the plan highly volatile and uncertain.”
Brainard said, “Nonetheless, it is a defensible arrangement in a corporate environment, in which a company at any point could go bankrupt or be acquired, and hand its pension liabilities to taxpayers or shareholders. But considering the very long life -- essentially perpetual -- of a public-sector entity, and its ability to stay invested throughout market cycles, requiring their pension plans to value their liabilities as if they’ll earn a return consistent with that provided by a conservative bond portfolio, is nonsensical.”
$3 Trillion Liability
And costly. If you discount the nation’s public-pension plans by 3.5 percent, the unfunded liability rises from $452 billion to $2.9 trillion.
Proponents of the corporate-valuation method say it would have kept states and localities out of the pickle they are now in. They would have put more money away, and they would have promised less to public employees. If it were adopted now, the sheer size of the numbers would scare lawmakers into doing the right thing, and reforming public pensions along business lines.
Opponents say state and local governments are already making substantive changes to their pension plans, in cooperation, for the most part, with labor unions.
The National Association of State Retirement Administrators says governments don’t just pull investment-return assumptions out of the air. There is some history. Over the past 25 years, median public-pension returns were 9.3 percent, over the last 20 years, 8.1 percent, according to Callan Associates, a San Francisco-based investment consulting firm.
Public-pension plans are in the spotlight right now, and that’s a good thing. But forcing them all to adopt corporate-style accounting is more reform than we need, or can afford.
(Joe Mysak is a Bloomberg News columnist. The opinions expressed are his own.)
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