Researchers Robert Novy-Marx and Joshua D. Rauh contend that the true extent of public pension underfunding has been obscured by governmental accounting rules allowing pension liabilities to be discounted at expected rates of return on pension assets. According to the report, while the public pension plans appear almost fully funded under government-chosen discount rates, there is a large probability of significant shortfalls in the future, and the cost of fully insuring future taxpayers and plan participants against these potential shortfalls would approach $2 trillion.
Using a dataset assembled from state government reports, the researchers examined the actual asset allocation of the universe of state-sponsored defined benefit plans, and calculated the distribution of intergenerational transfers that will occur under current funding and investment policy. The researchers conclude that if households form their own financial portfolios taking government pension investment policy into account, then how the government invests pension assets does not matter for intergenerational risk transfers. Also, the extent to which the government taxes current generations to fund pensions, as opposed to waiting to tax future generations, would completely determine the extent of intergenerational risk transfer.
“However, if households do not undo the government’s investment strategy, then investing in risky assets subjects future generations to substantially more risk in the value of their after-tax wealth,” the paper says.
If current investment strategies are maintained for 15 years, the researchers say they estimate (conservatively) that there is a 50% chance of an aggregate underfunding in excess of $750 billion, a 25% chance of an underfunding of at least $1.74 trillion, and a 10% chance of an underfunding in excess of $2.48 trillion (in 2005 dollars). According to Novy-Marx and Rauh, their figures are conservative because they assume that all pension benefits that will be accrued in the future will be fully funded using appropriate discount rates, and they also ignore other post-employment benefits (OPEBs) which total $380 billion in present value under GASB 45 disclosures.
The researchers also contend that the crisis in public pension funds “dwarves taxpayers’ exposure to underfunded corporate pension plans.” According to the paper, as of September 2007, the net financial position of the Pension Benefit Guaranty Corporation (PBGC) was an underfund of $14 billion, with additional “reasonably possible exposure” of $66 billion. The roughly $2 trillion in projected benefit obligation (PBO) pension liabilities of U.S. publicly traded corporations were almost fully funded at the time of the research, and the PBGC is only liable for underfunding on an accumulated benefit obligation basis (ABO), on which basis corporate plans are actually overfunded. “The magnitude of the crisis in state pension plans is much larger,” the paper says.
The researchers set forth a proposal where state pension funds could be shown to be in substantial surplus if only the state government entities would invest pension assets in a ten-beta levered S&P 500 Exchange Traded Fund (ETF). “In that case, the “surplus” that would appear to emerge would justify withdrawals from public pension funds sufficient to pay down all outstanding state bonds and pay a $5,000 dividend to every American citizen,” the paper says.
For a copy of “The Intergenerational Transfer of Public Pension Promises,” go to http://www.nber.org/papers/w14343 .
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