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Home Publications Blogs Beat the Press More Scare Stories About State Pensions at the NYT

More Scare Stories About State Pensions at the NYT

Sunday, 20 June 2010 10:27

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.

Comments (4)Add Comment
written by izzatzo, June 20, 2010 4:35
The problem is explained in this excerpt from the article by Rauh:

Another way to view the current state pension accounting system is that it does not recognize what financial economists call “state pricing,” the fact that the marginal utility of wealth is higher in states of the world where markets perform poorly. This insight helps to explain why the defense that pension fund asset portfolios should return 8 percent on average in
the future is irrelevant. The states of the world in which the market performs well, and the plans are fully funded, are exactly those where the representative taxpayer’s utility cost of an underfunding is low. The states of the world in which the market performs poorly, and the realized shortfalls are large, are exactly those where the utility cost of an underfunding is high. If the governments invest in assets with high average returns, the probability of underfunding in the future declines, but the underfunding comes when it hurts the most.

Since the marginal utility of wealth is inversely related to market performance, this means not only that each dollar of lost decremental housing wealth was larger than originally understood through falling real prices, but that each dollar of banker bonuses in the opposite direction for creating the losses was larger than understood as well.

It gives new meaning to the phrase, "the rich get richer and the poor get poorer" but at increasing rates. Further, more retired pensioners at younger ages can now live longer on less defined benefits since each dollar is worth so much more under massive market failure, so it's not a problem really.
written by Eric, June 21, 2010 4:38
How can you put 100% of your pension fund in stocks when you have constant cash flow requirements to pay benefits? This would be like having your college fund 100% in stocks when your kid is a sophomore.

I like the tax raising idea though. That's a great solution to keeping 45 year old retirees in clover.
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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.