Dean Baker, of the Center for Economic and Policy Research, released a paper two weeks ago arguing that the growing concern over public pension funding ratios is uncalled for and that the funding gaps in state pension funds are manageable. The crux of his argument is his defense of the discount rates around 8 percent that pension funds use to calculate their liabilities. (I and others have called for lower discount rates, which would imply higher liabilities; see for example my recent National Affairs piece here; Eileen Norcross here; and Andrew Biggs here.)Baker argues that because governments expect to exist in perpetuity, they can responsibly use discount rates that are based on the average returns of volatile, equity-heavy investment pools. This is because they can wait out market declines in expectation of a recovery. Indeed, in a Salon interview about his paper, Baker makes a truly bold claim:
So the logic is that you have an entity that is essentially indifferent to risk in the short-term, and an individual that cares a great deal about risk at a specific point in time. So what the company can do or the government can do by offering a defined benefit pension is give something of great value to workers at very low cost to itself and in principle that is supposed to lead to lower wages than they would otherwise have to pay. [emphasis mine]
Essentially, Baker contends that the government can create much value by assuming investment risk for its employees' retirement savings. I think this claim is wrong. But before I explain why, let's do a thought experiment about what it would mean for it to be right.
If Baker is right, public pensions are not merely sustainable; they are an amazing value creation machine that should be expanded as much as possible. If the government can achieve equity-like returns without concern about risk, why shouldn't the government invest as much money in equities as it can, and finance those investments by issuing safe securities to more risk-averse individuals?
One way to start would be to let any member of the public buy into public employee pension plans. People could simply make upfront deposits of their choosing, and then withdraw them after a fixed term with a guaranteed 8 percent return. Since the beneficiary would fully fund his or her own pension obligation upfront, there would be no fiscal cost to the government.
Pension funds are vehicles though which states do two things: invest money in stocks and bonds, and make promises to pay public employees in retirement. But those activities are not inextricably linked. If state governments are able to create value by investing public money in the stock market, they could finance those activities by raising long-term debt in the public markets at roughly a 5 percent interest rate.
This leads to one of two problems with Baker's discount rate defense. Note that in my proposal, the government would guarantee an 8 percent return to pension "investors." Obviously, that would cost more money than issuing bonds with a 5 percent coupon--and that difference would be an important consideration in accounting for the costs of the program. But this is the same thing we do today with public employees, who accrue a guaranteed 8 percent return on the amounts of their compensation we say we are deferring.
Even if the government has special abilities to create value by investing capital, it does not follow that taxpayers are indifferent about whether the government pays 8 percent or 5 percent interest to raise that capital. Using a lower discount rate would accurately reflect the opportunity cost of our pension financing structure--taxpayers do not receive the equity returns on the assets that government is investing, but instead pay them to public workers as a premium return on their deferred compensation.
The second problem with Baker's argument is that taxpayers are not actually indifferent to market risk incurred by the government. When we say that expected long-range returns on invested pension assets are 8 percent, there are two risks associated with that return. One is the risk that returns will fall short in any given period, even if the long-term average will be 8 percent. The other is the risk that the long-term average return is different from 8 percent.
Baker's paper argues that taxpayers are indifferent to government assuming the first risk. Regarding the second risk, he argues that we have no reason to believe that long-range returns should be lower than 8 percent (or at least, lower by much). The first of these claims is not quite right, and the second one is not on point.
First, on the risk of short-term fluctuations: governments do have some advantage in riding out this kind of risk, though it is not as great as Baker suggests. When a pension funding ratio dips below 100 percent, taxpayers must pay into the pension fund the "normal cost" of benefits (the present value of future pension benefits accrued in the current year by active employees) plus 8 percent interest on the amount of the unfunded liability. If taxpayers contributed only the normal cost, on average the funding ratio would decline each year.
Similarly, when a pension plan is overfunded, taxpayers can contribute less than the normal cost without causing the funding ratio to decline. This means that, even if the pension fund can hit its returns on average, there will be some amount of pro-cyclical variation in taxpayer contributions to the fund: low contributions when the fund is flush (and the economy strong) and vice-versa.
While the Governmental Accounting Standards Board permits a 30-year amortization period that smoothes those changes considerably, certain states (e.g. New York and Maine) are bound by constitutional provisions or court decisions that require them to amortize more quickly. And those states that have allowed their pension debts to get wildly out of control (New Jersey and Illinois, most prominently) also will not have the luxury of time: if those states do not drastically increase their pension contributions in the current decade, their funds will come close to running out of money.
What this means is that taxpayers' experience of smoothing out up and down cycles in the market is not always so smooth; right now, governments all across the country are under pressure to raise their pension contributions even though the economy is weak. The severity of that pressure varies, but it is all in the same direction and at an inopportune time.
But the biggest risk is not cyclical but secular: it is possible that the 8 percent long-term expected return is incorrect. I think Baker is probably right that we do not have good reason to believe that 8 percent is a systematic overestimate. (Or rather, that it may be slightly too high because of low inflation in the future, but low inflation would result in offsetting savings because of lower nominal pension payouts.) But the long-term average still may deviate in either direction from our best expectation today, and taxpayers are insuring public workers against that risk.
Essentially, the risk is that the long-term economic growth trend could be lower than consensus estimates by CBO and other economic observers. If this happens, taxpayers will be faced with a triple whammy: pension fund assets will underperform, creating larger unfunded liabilities to be closed with tax dollars; tax receipts will be weak, making it harder for states to appropriate funds to close those gaps; and incomes will be lower, making tax increases more painful.
Of course, the opposite outcome is possible: the economy could overperform in the long term, meaning that pension shortfalls would be smaller than expected, tax receipts more robust, and incomes higher. But this is not a wash: the first scenario involves a fiscal hole forming when we can least afford to close it, while the second would give us a windfall when it is least needed. Which is to say, public pensions are shielding public employees from long-term market risk, but only because it is being shifted to taxpayers.
Baker does not address this risk in his paper (and neither did the Center on Budget and Policy Priorities in January). But this is the key to the argument that pension discount rates are inappropriately high. Proponents of market-value discounting need not argue that pension funds will achieve a lower average long-range return than they currently project. Our argument is simply that, no matter how far you stretch the horizon, there is risk that the funds will fail to achieve our best ex-ante estimate for performance--and taxpayers are insuring over that risk.
Using the 8 percent discount rate implies that taxpayers are indifferent to this risk, but it's hard to understand why they would be; indeed, they would be willing to pay for insurance that shields them from the risk of added pension liabilities that form at the same time that the economy underperforms long-term expectations. This risk premium is the reason to use a lower discount rate for pension fund liabilities.
This relates to the Arrow-Lind Theorem, which says that when funding a public investment, the government can disregard the risks associated with returns on that investment and consider only average returns--but only under certain conditions. Those key conditions include that the investment be small relative to the economy, and uncorrelated with it. The contents of pension funds--trillions of dollars, mostly invested in stocks--do not fit that description.
The Baker paper is notable because, over the last two years, there have been few defenses of public pension discounting practices from the financial economics community; the main voices in defense have been pension actuaries. Indeed, as CBPP's January paper notes, "economists generally support use of a riskless rate in valuing state and local pension liabilities." If these are the economic arguments in favor of the 8 percent discount rate, it's not hard to see why.
Josh Barro is the Walter B. Wriston Fellow at the Manhattan Institute and a regular contributor to PublicSectorInc.org. He is most recently the author of the Manhattan Institute report "Unmasking Hidden Costs: Best Practices for Pension Transparency". He writes bi-weekly on fiscal issues for RealClearMarkets.com and has written for publications including the New York Post, the New York Daily News, National Review and City Journal.