Steve posts below about the new paper from Joshua Rauh and Robert Novy-Marx on the cost to taxpayers of fully funding public employee pension plans over the next thirty years. The key to this analysis (and the reason the authors arrive at much higher figures than are typically cited by commentators on the left) is the definition of "full funding."
To be fully funded, you have to have assets on hand equal to the present value of your accrued liabilities. And to figure out your accrued liabilities, you have to choose a discount rate to convert payments due far in the future to present values. Novy-Marx and Rauh use a discount rate based on the Treasury yield curve, meaning in most cases a rate in the ballpark of 4 percent.
Currently, most public pension plans discount their liabilities using a rate around 8 percent. The lower the discount rate, the higher the liabilities, and the higher the cost of providing pensions; as such, Novy-Marx and Rauh find that pension plans have true funding ratios much lower than they report in their financial statements. This is how New York, a state whose pension funds claim to be close to 100 percent funded, landed near the top of the authors' list of states whose taxpayers would have to pay most to bring their plans to full funding.
A while back, Eileen Norcross wrote for us about why funds' current practice is incorrect, and a market-value discounting approach similar to Novy-Marx and Rauh's should be used. However, a Treasury rate is not the only option for the market-value discounting. Indeed, Novy-Marx and Rauh have historically produced estimates using two discounting methods side by side: Treasury-based discounting, and discounting based on taxable municipal bonds.
As I wrote in my paper on pension transparency, I believe this latter practice comes closer to reflecting the true risk experienced by pension beneficiaries. While the use of a Treasury rate assumes that pension beneficiaries face essentially no risk of non-payment, use of a taxable muni rate assumes that they face a very low risk of non-payment, comparable to that experienced by a muni bond investor.
When Novy-Marx and Rauh argue for Treasury-based discounting, they point to cases like Vallejo, where bondholders faced default while pensioners were paid. But there are also counterexamples, most notably laws passed last year in Minnesota, Colorado and South Dakota to reduce cost of living adjustments for vested pensioners. These laws wiped out part of those states' accrued pension liabilities, and bondholders were not forced into a comparable restructuring. It is not obvious whether bondholders or pensioners are more secure in their claims on state and local governments.
The choice of discount rate matters a lot when estimating the true cost of pension
benefits. The exact figures move with the markets, and would vary based on the
demographic characteristics of a pension fund's participants, but a good rule of thumb is that
a taxable muni-based discount rate would be somewhere around 5 percent. That
would result in liability and cost measures somewhat lower than if you used a
Treasury rate, but much higher than if you use the discount rates plans use
today. So a muni-based discount rate would still produce an ugly figure for the
costs of properly funding public pensions, but not quite as ugly as the one that Novy-Marx and Rauh arrived at.
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