Allison Shrager's Reuter's column on the problems facing public pensions badly misled readers. It noted the pensions reported funding ratios and then told readers:
"But these estimates rely on the assumption that pension assets will earn at least 7 percent to 8 percent each and every year."
This is absolutely not true. The estimates only assume an average return in the range of 7-8 percent. If returns fall below this for a year or two, to stay on target the fund will have to achieve higher returns in future years. There is little risk that even a seriously underfunded pension will be forced to sell assets (i.e. stock) at a major loss, since it will almost certainly have plenty of liquid assets that can meet current obligations.
In fact, given the price to earnings in the stock market at present, the return assumption being made by pensions are very reasonable. It would be difficult to construct return projections that are much lower that would still be consistent with the economic growth projections from the Congressional Budget Office, Office of Management and Budget and other public and private forecasters.
This column overlooked what is probably the biggest cause of the pension shortfalls facing state and local governments. In the years of the stock bubble, when price to trend earnings ratios in the stock market rose above 30, pensions still assumed that it would be possible to get 10 percent nominal returns on stock. While some of us did try to point out that such returns would be impossible, those in positions of responsibility did not want to be bothered by arithmetic.
In particular the bond rating agencies, Moody's and Standard and Poor's, both gave a green light to an assumption that could be shown absurd by anyone familiar with third grade arithmetic. This astounding failure had two major consequences. Many pension funds granted extra benefits based on these assumptions. This was the case in Detroit as was documented in an article last month.
The other consequence was that many state and local governments grossly under-contributed to their pensions in the stock bubble years because the faulty accounting of the bond rating agencies implied that little or no contribution was necessary. When the stock bubble burst in 2000-2002, the pensions suddenly had big shortfalls, but because governments had not budgeted for larger contributions and the recession was already putting strains on budgets, many neglected to make the required contributions. This pattern became a ritual in places like Chicago, where the city failed to make its required contributions for a decade.
This failure of the regulators, the accountants, and the economists must really be featured front and center in any discussion of the current pension situation. Unfortunately, the same people who are responsible for the problems still dominate the public debate on pension policy. As a result, this simple history rarely appears in public discussions of pension policy.
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