Friday, April 13, 2012

Public Pensions Under Stress : Shining Light on a Dark Corner, Federal Reserve Bank of Cleveland, April 13, 2012

Public Pensions Under Stress :: :: <img src="/Forefront/images/forefront_w.jpg" alt="Forefront" /><br />Spring 2012 :: 04.13.2012 :: Federal Reserve Bank of Cleveland

Public Finances: Shining Light on a Dark Corner

The financial crisis has made it all too clear that regulators failed to see into the dark corners of the financial system. With that in mind, the Federal Reserve Banks of Cleveland and Atlanta have formed a Financial Monitoring Team to study pension funds and municipal finance with an eye toward implications for the wider economy and financial system. What concerns should we have? In this article and other articles from this spring issue of Forefront, we explain where risks could be building and how reforms might help forestall their impact on the broader economy and financial system.

The Widely Ranging Estimates of Pension Underfunding

Just how underfunded are America’s public pension plans? It depends who you ask.
In the language of economics, a pension plan’s promised benefits are liabilities. They will have to be paid for someday with funds from the asset side of the fund’s balance sheet. These future liabilities should be “discounted” so that they are expressed in present-value terms. That way, you can compare the present value of the pension obligations to the current level of plan assets—essentially, a way to measure whether today’s funds on hand will be sufficient to pay for all those retiree benefits when they come due in the future. Often this comparison is expressed as the ratio of the present value of assets over the present value of obligations.
Which method to use in discounting future liabilities—that’s the crux of the issue. Public pension plans follow Government Accounting Standards Board (GASB) guidelines. This allows those plans to use the expected return on their portfolio for deter­mining the present value of their promised payments.
Following GASB guidelines, public pension funds are allowed to discount their future pension obligations by their expected rate of return, which has been in the neighborhood of 8 percent—approximately the average return of their portfolio over the past 30 years.
According to that formula, the nation’s largest 126 public pensions have liabilities with a present value (meaning they were discounted at their assumed rate) in 2010 of $3.5 trillion. The amount of assets they held was $2.7 trillion in 2010, leaving a shortfall of $800 billion.
Some economists, however, have come up with a $4 trillion shortfall. They have pointed out that for most state and local plans, promised pension benefits are protected by constitutional, statutory, or common law guarantees. (See related article, “Navigating the Legal Landscape for Public Pension Reform.”) By definition, this ought to make them riskless obligations to the pensioners. Thus, the appropriate valuation methodology should discount promised benefits using the risk-free interest rate, usually calculated as the yield on long-term U.S. Treasuries.
This method, argued cogently by Jeffrey Brown and David Wilcox in “Discounting State and Local Pension Liabilities” (2009), has the virtue of being supported by both economic and legal principles. It also produces substantially higher estimates of the present value of pension liabilities. Given the currently low yields on Treasury bonds, this approach implies a present value of accrued obligations as high as $6.7 trillion, leaving an unfunded liability of $4 trillion.
John Carlson

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