Saturday’s Wall Street Journal featured an article by David Reily highlighting that most state and local pension systems were sticking to “unrealistic” return assumptions. Most public pension systems assume their assets will return around 8% annually, and the lowest assumption among major public pension systems is 7%. According to the article, only a handful of funds have reduced their return assumptions, despite an environment where such returns seem unlikely. Lowering the assumption would require that more money be set aside today to fund legacy liabilities as well as ongoing pension promises — and in these times the governments don’t have the dollars to spare.
While lower return assumptions would be a step in the right direction, it is important to keep the big picture in mind. This entire system effectively treats the expected return on the pension fund assets as achievable without any risk. When a state assumes, say, 7% instead of 8%, it sets a little more money aside and does a little less gambling on behalf of future taxpayers (our kids and our elderly selves). But the scheme still amounts to making future taxpayers come up with money exactly in those conditions (or “states of the world” as finance academics like to say) when it is most painful — namely when the stock market and other risk-bearing investments have performed poorly. That’s a situation when the other financial resources of future taxpayers — our retirement and college savings accounts — are also diminished.
This situation should sound eerily familiar, because we are living it today. Cash strapped state and local governments have lost money in their pension funds at the same time as their tax revenues are down. The rules say they are supposed to be contributing more to pensions to make up for the new shortfalls. But this is exactly the time when there isn’t any extra money in the coffers. Did any risk managers think of that when they were setting the asset allocation for these funds? If systems just double down in hopes of making 8% returns in an even more unlikely environment, we’re going to repeat the same mistake.
When a state funds a pension at anything less than the risk-free rate, it is exploiting a loophole around the principle that states should run balanced budgets. With underfunded pensions invested in risky assets, the state has set things up so that future generations only have to pay back if the stock market performs poorly. Upon first hearing, that might sound better than just outright borrowing from the kids and our elderly selves, but in fact it is no better. The further the stock market falls, the more we all will have to pay up, and the more painful it is because the less money we have. Finance academics call this idea “state pricing,” where “state” refers to “state of the world” — and it is the core of all finance theory.
It is interesting that the National Association of State Retirement Administrators (NASRA), one of the sources for the WSJ article, is publicizing statistics not just on return assumptions but also on benefit changes. Just like benefit parameters, return assumptions are easier to raise in good times than they are to lower in bad times. Those who want to perpetuate a system of surreptitious borrowing from future taxpayers will be the ones who are most eager to point out the small incremental changes that could allow allow politicians to claim “problem solved” (or “mission accomplished”) when in fact they represent only a very small step forward.
In sum, systems that use 7% are being more responsible than those using 8% — but even 7% is a flagrant violation of the principle that states should run balanced budgets. Already this system has led to state pension debt that when properly measured amounts to $3 trillion across the 50 states, since unfunded pensions were the way that politicians could borrow money out of the view of taxpayers and outside of budgetary requirements.
If going forward we want to actually return to the principle that states should run balanced budgets, there are only two routes for future retirement benefits: 1.) defined benefit (DB) pensions funded at risk-free rates and invested in bonds that match the profile of benefit payouts; or 2.) 401(k)-type defined contribution (DC) pensions like the private sector. Anything else is simply borrowing in disguise.