Monday, January 23, 2012

More on pension fund return assumptions

The PBS Newshour reports that state pension funds are faced with a dilemma - most have based their promises to retirees on an unrealistic 8% portfolio return, but as funds have failed to earn this return, states have been left with ever larger pension plan shortfalls.

The NPR video shows the State of RI Treasurer debating with various consultants and interested parties over what that state's new return assumption should be.  The advisors are calling for 7.5%, but representatives of the retirees oppose a lower rate.  They argue that this lower rate will result in either more taxes, more contributions from workers and lower promised benefits.   But their position is fundamentally flawed.  By setting the assumed investment return rate too high they are guaranteeing a more severe funding deficit in the future.  Just covering their ears and shouting "8%" won't change reality.

The article interviews two economists.  The first, Zvi Bodie, argues that 7.5% is too high and the fund should use 4.5% - basically a risk free rate.  His rationale is based on the fact that the liabilities of the pension fund are guaranteed  - they are riskless.  Therefore, the funding of a certain liability should be done with very low risk assets.   Bodie is correct.

The second Economist, Dean Baker, argues that because State funds are infinitely lived they should use a higher rate - at least 7.5%.  He goes on to say that because most investors assume some risk, so should the state.  But this argument misses the point.  An individual who invests in risky assets bears the risk that his or her portfolio won't cover his/her retirement needs.  If that individual's portfolio falls short, then he/she will have to suffer the consequences.  In effect the individual is funding a risky liability with risky cashflows.   The state however, has promised retirees a certain payout.  If the fund falls short, then the state must either renege on that promise or tax the children of those retirees at a much higher rate.

I've blogged on this quite a few times, and I think that it is a very serious problem that nobody wants to deal with.  This problem can either be fixed now or later.  But either way, it is going to have to be dealt with.  Just assuming a higher rate of return won't make it go away.

link to PBS video via Zvi Bodie's tweet