PUBLIC PENSIONS ARE UNDERFUNDED
November 11, 2008
There is a two-thirds chance that state pension plans will realize a shortfall in 15 years. The expected conditional shortfall is almost $1.5 trillion in 2005 dollars, say researchers Robert Novy-Marx and Joshua Rauh, researchers with the National Bureau of Economic Research (NBER).
The extent to which public pensions are underfunded has been obscured by governmental accounting rules, which allow pension liabilities to be discounted at expected rates of return on pension assets, according to Novy-Marx and Rauh. Furthermore:
- Over the next 15 years, state pensions are expected to grow to a total of about $7.9 trillion.
- There is a 50 percent chance that the system will be underfunded by more than $750 billion at that time, and a 25 percent chance of a shortfall of at least $1.75 trillion (in 2005 dollars); adjusting for risk, the true intergenerational transfer is substantially larger.
- Insuring both taxpayers against funding deficits and plan participants against benefit reductions would cost almost $2 trillion today, even though governments portray state pensions as almost fully funded.
States back pensions with stocks, bonds, cash, private equity, real estate and hedge fund exposure. But the typical investment strategies, in conjunction with accounting rules, make the pension funding situation look much better than it actually is. Under the government accounting logic, states always could eliminate their underfunding, no matter how large, simply by investing in sufficiently risky assets. In fact, investing in riskier assets may raise expected returns, but it also increases the probability of a severe underfunding.
Under current investment strategies and a standard equity premium of 6.5 percent, there is a two-thirds chance that state pension plans will realize a shortfall in 15 years. The expected conditional shortfall is almost $1.5 trillion in 2005 dollars, say Novy-Marx and Rauth.
Source: Matt Nesvisky, "Public Pensions are Underfunded," NBER Digest, November 2008; based upon: Robert Novy-Marx and Joshua D. Rauth, "The Intergenerational Transfer of Public Pension Promises," National Bureau of Economic Research, Working Paper No. 14343, September 2008.
For Working Paper:
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