Using June 2009 data, Robert Novy-Marx and I measured a $3.1 trillion gap in state and local pension systems, arising from $2.3 trillion in assets and $5.4 trillion in liabilities.
Since then, the situation has evolved in several ways. First of all, the stock market continued to recover from the financial crisis. Based on the correlation between broad equity market indices and the changes in state and local pension assets, a reasonable estimate is that pension fund assets today are higher by about 14.5% than they were in June 2009.
More importantly, the true financial value of the liabilities that have been promised have grown substantially due to much lower bond yields. Pension liabilities are greater when market interest rates on securities of comparable risk are lower. The basic economic rationale is clear: the appropriate discount rate for measuring liabilities depends on the risk of the cash flows being discounted. So while reports from state governments continue to discount pension liabilities at 8%, a financial valuation needs to take today’s market interest rates into account, and in particular interest rates on very safe assets such as government bonds. The only reason to use a discount rate higher than a default-free government bond yield is if one wants to reflect in the measurement the possibility that taxpayers might be able to default on these promises.
Assuming that accumulated pension promises will be paid, liabilities were $5.4 trillion in June 2009 using Treasury discounting. But at that time, the yield on the 30-year Treasury bond was 4.4%, the yield on the 10-year Treasury bond was 3.6%, and the yield on the 5-year Treasury bond was 2.6%. Today, in October 2011, these rates are all approximately 150bp lower, which assuming a duration of 15 years would imply that liabilities are 23% larger.
Together with the estimates of assets, these calculations imply an unfunded liability in October 2011 of $4.0 trillion.
This is a lower bound, however, as liabilities as reported by state and local governments seem to creep steadily up with each report due to “actuarial losses” or overly generous assumptions about mortality and worker behavior. In recent years, these have added growth of about 4-5% per year to total liabilities. It is reasonable to think that such increases will have continued, as most reforms to pension systems in recent years have affected only new hires, not the current workforce.
Assuming an additional 4% per year liability growth due to these factors, the total unfunded liability is $4.4 trillion.
These updates are still back-of-the-envelope calculations. It is interesting that financial reporting on corporations allows for accurate estimates of corporate pension liabilities to be kept current, and indeed there has been extensive financial reporting on the rapidly deteriorating funding of corporate pension systems in 2011. The same factors are also impacting public systems. They are simply hidden from plain view.
