Cate Long, the MuniLand blogger from Reuters, wrote a blog post yesterday that misses the entire point about pensions and spreads gross misunderstanding about the cost of pension promises to taxpayers. The risky assets that pension funds invest in and the returns they have achieved historically have nothing to do with the cost of making these promises. The reason pension promises should be discounted at a default-free rate such as the Treasury rate is that governments are telling public employees that they will get their pensions no matter what happens to the pension funds’ risky investments in stocks and alternative assets.
Certainly if Ms. Long wants to credit state and local governments for their option to default on these promises in the event that asset returns are poor, then a higher discount rate than a default-free rate could be used. But then the contracts with public employees should specify that in fact they may only be paid a fraction of what they are owed and the discount rates should be motivated accordingly, not with historical asset returns.
For deeper analysis, I would refer readers to my paper The Liabilities and Risks of State-Sponsored Pension Plans with Robert Novy-Marx and my Congressional testimony of February 2011.
Finally, the piece by Ms. Long also refers to a statistic that approximately three percent of state and local government spending is used to fund pension benefits for employees of state and local governments. As I have blogged about before, this is very misleading. First, many governments are not making contributions they ought to be even under their own accounting. Under correct default-free measures essentially no government is contributing enough to claim they are truly paying pension costs. Second, the figure cited as a fraction of spending, not revenues. Since states are running deficits, as a share of revenues, pension contributions are higher. Finally, the denominator includes the hundreds of billions of state and local revenues that are direct transfers from the federal government. The right question is not how much is being paid now, but how much would have to be paid in order to claim that states are balancing their budgets. That figure is substantially higher, and amounts to 14% of total revenue excluding federal transfers and 23% of tax revenues.