U.S. Public Pension Plans are Different (and Not in a Good Way!)

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Jun 11, 2012

I have written numerous blogs about the frustration that the financial economics community has with the Government Accounting Standards Board (GASB) rules that govern the way we account for public pension liabilities in the U.S.  The basic problem is that GASB standards do not account for risk in an appropriate way (in fact, they do not really account for it at all!)  Instead, they allow public plans to under-state the size of their liabilities by acting as if they have a risk-free approach to investing money at approximately 8 percent per year forever.

On occasion, someone will ask me if this is really just an accounting issue, or whether it actually has real effects on real-world behavior.  Although I can give countless anecdotes for why it affects real behavior, it is always better when a highly respected and disinterested party can provide rigorous empirical evidence to support the claim.

Well, now we have such evidence.   Just last month, three financial economists (Andonov, Bauer and Cremers) publicly released a rigorous new research paper entitled “Pension Fund Asset Allocation and Liability Discount Rates: Camouflage and Reckless Risk Taking by U.S. Public Plans?”  In this paper, the authors use an international database to look at the asset allocation decisions and discount rate assumptions of both public pension funds and non-public pension funds in the U.S., Canada and Europe.  What is particularly nice about this paper is that it is able to show what outliers U.S. public plans really are.  Not only do they look quite different from corporate DB plans in the U.S., but they also look different from both public and non-public plans in other countries.

Specifically, the authors state that “U.S. public funds seem distinct in that they can decide their strategic asset allocations and liability discount rates largely without much regulatory interference, due to wide latitudes allowed in the currently applicable Government Accounting Board (GASB) guidelines. In particular, these guidelines link the liability discount rates of U.S. public funds to the (assumed) expected rate of returns of the assets, rather than to the riskiness of the liabilities as suggested by economic theory.”  As I have written before, this is an intellectually vacuous approach to discounting.  What I had not fully realized is how unique this mistake is to U.S. public plans.  The authors go on to state that in Canadian and European funds – both public and private – liability discount rates are “typically … a function of current interest rates,” an approach which (assuming the interest rate is chosen appropriately) is much more in line with basic economic theory.

The most striking finding is the impact that this difference in accounting has on real behavior.  The authors find that “in the past two decades, U.S. public funds uniquely increased their allocation to riskier investment strategies in order to maintain high discount rates and present lower liabilities.”  This really is a case of the tail wagging the dog – by allowing an intellectually flawed approach to discounting to be codified in GASB standards, we have provided incentives for public pension fund managers and their boards to over-invest in risky assets.

There are many losers from GASB-induced deception.  Public workers end up with less-well-funded pensions.  Taxpayers end up bearing financial risk without realizing it.  Investors in public debt are given inaccurate information about the size of the pension liabilities.  Isn’t it time that we fix this?

The Risk of Ignoring Risk: The Case of Pensions

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Feb 29, 2012

Several news stories about pensions have crossed my desk in recent days, each of which made me realize how poorly the vast majority of individuals – even many highly educated individuals – understand financial risk.  It might not be so surprising if this lack of understanding was limited to the “general population.”  What is more surprising is how often highly educated financial market participants and regulators exhibit their ignorance of fundamental finance principles.  Unfortunately, these misunderstandings can have real consequences.

Let me give two examples.

Yesterday, a piece appeared on the Reuters MuniLand blog under the (confusing) title of “Greece is not Germany, and California is not Vermont.” In the piece, the author made the following statement, in which she refers to research by Joshua Rauh of Northwestern University:

“Rauh insists that when projecting pension fund returns, the interest rate for 10-year Treasuries must be used. Pensions do not allocate their assets 100 percent into Treasuries, though.”

This is an example where you can take two true statements, put them side-by-side, and end up with a false implication.  It is true that Joshua Rauh and his co-author Robert Novy-Marx use a Treasury rate to discount pension liabilities.  It is also true that pensions do not allocate their assets 100 percent into Treasuries.  The problem is that the second statement is 100% irrelevant to the first!

As any individual who receives a passing grade in my finance courses should be able to explain, the appropriate discount rate to use when computing the present value of a stream of cash flows depends on the riskiness (generally defined as the correlation of those cash flows with the market) of those cash flows.  In the context of pensions, the discount rate depends on the risk of the pension payments to beneficiaries.  In many states – such as Illinois and California – there are strong constitutional protections in place that make already-accrued benefits risk free.  Thus, what Novy-Marx and Rauh do in their research is to apply basic finance principles to come up with a more accurate measure of pension liabilities than what one gets from using official government statistics.  Cate Long fell into the same trap that so many others have – including the Government Accounting Standards Board (about which I have previously blogged here and here) – of thinking that the right discount rate is a function of the risk fo the assets, instead of the risk of the liabilities.  As a result, she – like GASB – completely ignores an enormous implicit put option that is being dumped onto taxpayers.  Her piece also contained other problems that are discussed Josh Rauh’s response.

A second example comes from the ongoing debate about pension funding policy for corporate pensions. In January, the American Benefits Council put out a press release (which you can read here) basically arguing for “relief” from fully funding pensions (“funding relief” is a political euphemism for not meeting the required funding obligations.)  At the core of the American Benefits Council’s case is that interest rates change, and that the result is that pension liabilities look “artificially high” when interest rates are “artificially low.”  What this argument ignores, however, is that any firm could choose – if they so desired – to nearly completely immunize themselves against interest rate fluctuations by investing in a fixed income portfolio that has the same interest rate sensitivity as do the pension liabilities.  Firms choose not to do this for a variety of reasons, but it is a choice.  Some firms – most recently, Ford Motor Company – appear to understand this.  Most other companies choose to expose themselves to risk in the pursuit of higher returns.  That is their right and their choice, but they should not expect a back-door government bail-out in the form of funding relief when the risk then materializes.

In both of these examples – the choice of discount rates and the choice of asset allocation – the common element is a lack of understanding of risk, how to measure it, and how to manage it.  Unfortunately, such a misunderstanding has real economic consequences, and it always seems to be the taxpayer who ends up paying for it.

What do Newt Gingrich and Public Pension Accountants Have in Common? A Belief in a Free Lunch

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Jan 10, 2012

Given that current Presidential candidate and former House Speaker Newt Gingrich has long been an outspoken critic of government bureaucrats, it may surprise readers to learn that his Social Security reform plan shares an intellectual flaw with public pension accounting.   Namely, a belief in a “free lunch” from the stock market.

Let me explain.  It is widely understood that the U.S. stock market has performed quite well over long time horizons in comparison with other assets, such as bonds.  Nearly all economists agree that the reason stocks have higher expected returns is because stocks are riskier.  Investors need to be compensated for bearing this extra risk.

Most people intuitively understand that stocks are inherently risky, especially after they have witnessed the volatility of the past few years.  On the other hand, many people mistakenly believe that stocks are not risky as long as one is willing to hold them long enough.

This is a great fallacy, and acting upon it is financially reckless.   While there is a long-standing debate in the economics literature about whether stock returns are “mean-reverting” (i.e., somewhat less risky) in the long-run, no serious financial economist would ever suggest that the risk of stocks is zero, even at an infinitely long time horizon.

What does all this have to do with Newt Gingrich and public pension accounting?

Gingrich has offered up a Social Security reform plan that would replace the existing system with a system of personal retirement accounts.  There are many reasons to like personal retirement accounts.  But the most important thing to understand about personal retirement accounts is that they are NOT a substitute for raising revenue or cutting benefit growth to restore fiscal sanity to Social Security.  Newt and his advisors mistakenly think they are.

Gingrich’s campaign policy white paper extols a central virtue of the Chilean system and the old Ryan-Sunnunu reform option by noting that “the government guarantees that all workers with personal accounts will receive at least as much in retirement as they would under the current Social Security system” (emphasis added).

It is the guarantee that is problematic.  Newt seems to believe – in the face of all theory and evidence to the contrary – that a multi-trillion dollar shortfall in the Social Security system can be eliminated by investing contributions in stocks.  He is so confident that it will work, that he is willing to guarantee the return required to provide the same benefits as under the current Social Security formula.

This is a recipe for fiscal disaster.  As has been noted by numerous economists – including a number of pro-accounts conservative economists – a government guarantee of investment returns imposes a potentially enormous unfunded contingent liability on taxpayers.  To paraphrase a quip I once heard:  rather than reducing our entitlement state, Newt Gingrich appears content to become the portfolio manager for the entitlement state.

But Newt Gingrich has plenty of company.  Government accounting standards for public pension plans allow public sector DB plans to engage in this same economic deception.  And, ironically from a political perspective, this approach is eagerly defended by liberal think tanks and labor unions – strange intellectual bedfellows for candidate Gingrich - who want to hide the true cost of public sector pensions.

Let’s take my state of Illinois, home to three of the ten worst funded public pension plans in the nation.  Reform efforts here are severely hampered by the existence of a state constitutional guarantee against the impairment of retirement benefits for public workers.  Newt proposes providing similar guarantees to Social Security recipients.

As I have written elsewhere, the Government Accounting Standards Board (GASB) standards allow states and localities to assume they will benefit from the high returns of having part of their portfolio invested in equities, without accounting for the increased risk.  This allows public pensions to hide the true cost of public pensions from taxpayers, contributing to the massive pension funding crisis which we now face in the U.S.

Newt’s plan and GASB rules are both the direct result of a failure to accurately account for risk when valuing financial guarantees.

Taxpayers are not well-served by government accounting and budget-scoring rules that allow politicians to grow government without being honest about how we will pay for it.  The public should insist that government guarantees be accounted for accurately and honestly.

In the meantime, I look forward to seeing the mental gymnastics performed by both liberal and conservative pundits who try to defend one position while criticizing the other.

Proposed GASB Pension Discounting Standards: Even Worse than Before?

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Oct 2, 2011

I have written on this blog before about the Government Accounting Standards Board (GASB) rules that allow public pension plans to discount their liabilities using the expected return on plan assets.  This is no small technical matter … discounting in this way has the effect of dramatically understating the true economic value of the unfunded liabilities of public pension liabilities.  This single accounting issue may understate the magnitude of the public pension funding problem by trillions of dollars!

GASB has issued proposed new standards and are in the process of accepting comments from the public.  I submitted my comments last week, and thought I would post a few excerpts here.

“As members of the GASB Board may already know, I have been critical of existing GASB guidelines for the computation of public pension liabilities.  I have a paper in the May 2009 American Economic Review (co-authored with David Wilcox of the Federal Reserve Board) in which we explain the basic economic rationale for the appropriate choice of a discount rate.  Economic and financial theory is very clear that the choice of a discount rate depends on the risk of the cash flows being discounted

This is true regardless of whether those cash flows are positive or negative, and whether they are being generated by public institutions, private institutions, or individuals.  There is absolutely no economic or financial basis for discounting one set of cash flows based on the risk of a completely different set of cash flows.  In other words, there is no logic whatsoever for discounting pension liabilities based on the risk of the pension plan assets

A simple analogy illustrates this point.  Suppose that at 9 a.m. on January 1, I borrow $100,000 for one year from a bank at an interest rate of 5 percent.  I immediately invest the full amount in a diversified portfolio of risky assets (such as stocks and bonds) that has an “expected return” of 8 percent.  By the time I have completed this transaction at 9:05 a.m. on January 1, how much do I owe the bank?  Naturally, I still owe them $100,000 (ignoring the 5 minutes’ worth of interest).  At this point, I have not changed by net worth at all.  All I have changed is my risk exposure. 

Suppose, however, that I follow GASB-like accounting rules to calculate my net worth.  Because the expected return on my portfolio is 8 percent, I can use this to discount the $105,000 (principal plus 5 percent interest) that I will owe in one year (December 31).  By this calculation, I would now only value the future liability as $97,222.22 (=$105,000 / 1.08), making it appear as if I have created $2,777.78 of wealth out of thin air.    

Of course, if I tried to tell my lender at 9:05 a.m. on January 1 – just 5 minutes after closing the loan – that they should allow me to give them $97,222.22 and cancel my $100,000 debt, they would look at me with great puzzlement!  And for good reason – I owe them $100,000 now, or $105,000 in one year, regardless of what I do with the funds in the interim!  The transaction just described is absurd from the financial perspective.  But as illogical as it seems, this approach closely mirrors the approach that has been taken by GASB in the past and that is still embedded in the proposed new public pension accounting guidelines.

The fundamental problem is that the use of “expected returns” as a discount rate is a largely a meaningless concept unless it is also accompanied by a discussion of, and accounting for, the accompanying risk.  

The most straightforward way to do this is to discount pension liabilities based on the risk characteristics of the pension cash flows.  For example, for the accumulated pension obligation (ABO) for a public pension in a state with strong constitutional guarantees against the impairment of retirement benefits, it would be appropriate to use a rate close to the risk-free rate.  In other cases – such as states where pension benefits can be easily changed by the legislature and where the likelihood of change is correlated with broader economic activity – a higher discount rate should be used.  In either case, what must determine the discount rate is the risk profile of the liabilities and NOT the expected return on plan assets.

In the exposure draft for the new rules, GASB seeks to replace the “expected return on plan assets” discount rate with a “blended rate.”  This blended rate is a combination of the expected return on plan assets for the funded portion of the liability and a muni-bond index for the unfunded portion.  Unfortunately, there is no theoretically coherent rationale for the proposed approach.  Indeed, though this approach could be viewed by some as a “compromise,” the result produces an even less coherent outcome than existing policy. 

There are several fatal flaws to the proposed approach, including:

1. There is no clear question to which the proposed measure is the right answer.  Indeed, it is difficult to think of any outcome of interest that is meaningfully described by the output of a cash flow discounting exercise that uses the blended rate as described in the proposed rules.

2. Funded status is not a sufficient measure of the risk of pension liabilities.  To be sure, it may be one such factor – at least insofar as one believes that participants in underfunded pensions are more likely to experience future benefit reductions – but it is far from a sufficient statistic.  Therefore, it is an insufficient basis on which to evaluate the risk of the liabilities. 

3. Even if funded status were a sufficient measure of risk (which it is not), the proposed GASB rules have blended the discount rates in the wrong proportions.  If funded benefits are less risky than unfunded benefits, then the funded benefits should be discounted at a lower rate, and the unfunded ones that should be discounted at a higher rate.  The proposed GASB rules turn this logic on its head, and the result is inconsistent with accepted procedures for risk adjustment.

 4. Even if one wished to calculated a blended rate to account for differential risk based on funding status, the “expected return on plan assets” is not the right rate to use for the “risky” portion of benefits — unless the risk of the liabilities just so happens to correspond exactly to the risk of the asset portfolio, which is highly unlikely.  For example, if  liabilities are discounted using the expected return on a 60/40 equity/bond portfolio, this is equivalent to saying that the distribution of benefit payments to DB pension participants is just as risky as investing in a 60/40 portfolio.  I suspect that few DB plan sponsors intend for their plans to be so risky, and fewer participants believe that their public pension is intended to be so uncertain.

 5. The proposed rules provide an unattractive and dangerous incentive for plan sponsors to take on more investment risk than is optimal.  If plan sponsors invest in a risker portfolio, they will then be able to “justify” a higher expected return under GASB rules.  Indeed when they are permitted to use a higher expected return, they can show a larger share of their liabilities as being “funded.”  This, in turn, also reduces the fraction of their liabilities that will then be discounted using the muni-bond index.  In short, public pensions may be tempted to invest in a riskier asset portfolio in an attempt to shrink the reported size of their unfunded liabilities.    

6. There is a good conceptual argument for using state or municipality’s bond returns as a discount rate for a public entity’s pension liabilities, at least to the extent that pension obligations and bond obligations bear comparable credit risk.  However, this rate should reflect the risk of that particular state or municipality, rather than some aggregate index.  More generally, different states and municipalities should use different discount rates when the risks of their pension obligations differ.      

Because of these and other flaws, I believe it would be a mistake to adopt GASB’s the new proposed discounting rules.  Instead, GASB should adopt standards that based discount rates on the risk of the liabilities.”


The Road to Public Pension Hell is Paved with Good Intentions

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Sep 5, 2011

There is an old saying that “the road to hell is paved with good intentions.”  That saying immediately sprang to mind as I read a summary of the new Government Accounting Standard’s Board (GASB) proposal for the public sector pension standards. 

I have written before about the utterly misguided and intellectually vacuous approach that GASB takes to the choice of a discount rate.  But in reading a summary of the exposure draft produced by the Segal company, I was even more struck by the following explanation:

“The “blended” discount rate is not based on the plan’s current funded status, but rather on a projection of plan benefits and assets. That projection includes all future employer contributions that are intended to fund the benefits for current members, including payments towards any current unfunded liability.”  (emphasis added)

Translation: governments would be allowed to mask their pension shortfalls not only by using an artificially high discount rate (which lowers the reported value of the liability), but also by reporting that they intend to make a lot of contributions in the future!  Note that there is no obligation that they actually follow through on their intentions.  I can’t wait to see what kind of creative assumptions governments start using to help obfuscate the real funding status of their pensions.

When Measurement Gets Politicized: The Case of Public Pension Liabilities

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Apr 13, 2011

Many academic economists, including me, often weigh-in on public policy issues.  One of the things we quickly learn is that academic discourse and political debate can be quite different.  One example of this is that academics are quite good at isolating specific questions (e.g., “holding all else constant”), while political debates often combine issues in an attempt to “spin” the discussion for or against a certain idea.

The public pension debate is a prime example.  There are at least four very important – but conceptually distinct – issues that often get discussed.  Three of these are areas where there are legitimate grounds for disagreement.  The fourth, however, is a pure issue of measurement over which there is virtually no disagreement among academic economists (regardless of ideology).  But others have succeeded in politicizing the issue, and the implications of this are important and unfortunate. 

What are the four issues?

Question 1:  Should public sector workers continue to be offered Defined Benefit plans, or should they be offered Defined Contribution plans instead? 

Question 2: If we continue to offer DB plans, should we fully pre-fund them?

Question 3: Assuming we do at least some pre-funding, how should the assets be invested?

Question 4: What is the value – in today’s dollars – of the future pension benefits that we owe?

These are all distinct questions.  Two people could completely disagree on whether public workers should be offered DB or DC plans, but they might still agree that if a DB is offered, it ought to be fully funded.  Or they could agree that they both like DB plans, but then disagree on the optimal portfolio allocation.  Indeed, for each of the first three questions, there are a number of intellectually defensible answers, and smart, well-educated, good-intentioned individuals can disagree simply because they place different weights on different factors.   Fair enough.

But question 4 is unlike the other three.  Question 4 is not a question about values or weights or the perception of pros and cons.  Question 4 is a measurement issue, pure and simple.  Financial economic theory – and centuries of experience with financial markets – provide clear principles on the right way to discount future pension liabilities.  Namely, you pick a discount rate that reflects the risk of the liabilities themselves.  Every academic financial economist I have ever asked (and there are many, including several Nobel Laureates) agrees on this point (and this is true regardless of their personal political ideology).  Furthermore, they agree that the right answer to this question is *completely* unrelated to how a plan invests its assets (question 3), or whether the plan pre-funds (question 2), or whether the individual prefers a DB or a DC plan (question 1).  They agree that it is a simple measurement issue.   Just like 1+1=2, and this is true for both liberals and conservatives.

Unfortunately, a large number of non-academics – ranging from the Government Accounting Standards Board to some plan administrators to some ideologically-motivated “think tanks” – have managed to turn a clear measurement issue into a muddled ideological and political issue.  In essence, they have begun to argue that 1+1 is actually equal to 1.5, not 2.  And they further imply that those who say 1+1 is equal to 2 are just out to destroy DB plans. 

They do this by saying that those who would discount public pension liabilities the correct way (using a risk-adjusted discount rate -which results in an estimate of about $3 trillion of under-funding in public plans – rather than the intellectually vacuous but “official” estimates of about $1 trillion) are just out to make DB plans look “more expensive.”  They accuse scholars of trying to inflate the costs of DB pensions for some political reason, such as a desire to privatize the system.    

All of this is nonsense.  Many of these same economists disagree on the answers to questions 1, 2 and 3, but we all agree that we ought to at least start with an accurate measurement of the size of the pension liability. Whether one believes DB plans are the greatest human invention of all time, or the worst sin ever committed, should have no bearing whatsoever on how we calculate the present value of our future pension liabilities.  It is also true that how we invest our assets has no bearing on the size of the liability (after all, a dollar invested in stocks today is still worth the same as a dollar invested in bonds today). 

Unfortunately, this politicization of a fundamental economic principle is not merely an intellectual frustration to academic financial economists.  Understating the true economic costs of future pension promises has real consequences.  It distorts decision-making.  It artificially stacks the debate in favor of some reform options and against others.  It promotes excessive risk-taking.  And, perhaps worst of all, it disguises the true cost of government to current taxpayers.

Gambling with Borrowed Money: The Case of Pension Obligation Bonds

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Mar 9, 2011

Over the weekend, my colleague George Pennacchi and I published an op-ed in the Champaign News-Gazette trying to explain why the City of Champaign (Illinois) would not really be saving any money by issuing pension obligation bonds, the proceeds of which would be used to contribute to the police and fire pension funds.  You can read it by clicking HERE.

Why the Illinois Pension Funding Hole is Even Deeper than You Think

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Oct 13, 2009

It is well-known that Illinois has one of the worst track records of funding its public pension plans of any state in the nation.  What is less well-known is that the problem is far, far worse than the official statistics would indicate: indeed, the extent of under-funding may be 2.5 times larger than what is typically reported!


To be clear, this is not because anyone in Illinois state government is doing anything unethical – those responsible for calculating the pension liabilities are presumably doing so in accordance with Government Accounting Standards Board (GASB) procedures.  Even so, there is near unanimity among economists (and yes, unanimity among economists is rare) that GASB rules themselves are deeply misguided. 

This is a complex topic, but I am going to over-simplify for brevity’s sake.  As noted in at least two prior posts, the Illinois state constitution provides a rock-solid guarantee that pension benefits will not be reduced or impaired in any way.  That makes the benefits that participants have accrued virtually risk-free.  It also means that it makes the liability to the State of Illinois risk-free.


Simple (and also advanced) finance theory is unambiguously clear that the appropriate way to discount a risk-free stream of cash flows is to use a risk-free interest rate.  While there is not a perfect risk-free asset available for this purpose, municipal bonds and U.S. treasury securities offer reasonable proxies.  (I have written on this subject in more depth in a paper with David Wilcox published in the American Economic Review, and I will simply refer readers there for a more in-depth discussion).


Instead of using this clear and rigorously grounded approach, GASB allows public pension plans to discount their liabilities using the expected rate of return on plan assets. There is not a shred of logic to this as an approach for valuing liabilities unless one believes that the liabilities share the exact same risk characteristics as the portfolio in which one is investing (and that is certainly not the case in Illinois.  We have riskless liabilities but invest in diversified portfolios of risky assets).


How big of a difference does this make?  A relatively new paper by Robert Novy-Marx (University of Chicago) and Joshua Rauh (Northwestern University) estimates the size of the liabilities when calculated using appropriate discount rates.  (Read their paper here) What do they find?


In 2008, the four large public pension plans in Illinois had combined assets of $65.7 billion.  The combined liabilities of these four plans (calculated under flawed GASB rules) were $151.1 billion, for a shortfall of $85.4 billion.  

If one uses a more theoretically appropriate rate on treasury yields, the present value of the liabilities is $284.8 billion, for a shortfall of $219.1 billion!  That is more than 2.5 times greater than the official statistics indicate!


What do these numbers really mean?  If the state of Illinois wanted to be certain it had enough money set aside today so that it could meet all public pension benefit obligations that have already been accrued, it would need to set aside an additional $219.1 billion.  For perspective, that is about 1/3 of Illinois GDP, about 1/3 of state revenues, and about four times the outstanding state debt.   

Any amount less than this means that the state would have invest in riskier assets in order to fund the benefits, a strategy that might work … or might make the problem worse. 

We’ve all heard to old adage that the first thing to do when you find yourself in a deep hole is to stop digging.  In this case, we also need to stop denying just how deep the hole is.