Public Plan Accounting Rules Can Mask Underfunding Woes

September 24, 2008 ( - Within the next 15 years, state pension plans will be have a two-third probability of being underfunded to the tune of almost $1.5 trillion in 2005 dollars, two academic researchers assert in a new study.

Robert Novy-Marx and Joshua D. Rauh, both of the Graduate School of Business at the University of Chicago, argue in their paper, “The Intergenerational Transfer of Public Pension Promises,” that the danger lies in the current government accounting rules allowing public pension liabilities to be discounted by expected rates of return on plan assets.

That’s because the system can lead to a false sense of security that ends up masking a huge potential funding shortfall in future years. Novy-Marx and Rauh said the shortfall estimate of nearly $1.5 trillion assumed current investment strategies and a standard equity premium of 6.5%.

If current investment strategies are maintained for 15 years, the authors estimate there is a 50% chance of an aggregate underfunding greater than $750 billion, a 25% chance of an underfunding of at least $1.74 trillion, and a 10% chance of an underfunding greater than $2.48 trillion.

Insuring both taxpayers against funding deficits and plan participants against benefit reductions would cost almost $2 trillion today, even though governments portray state pensions as almost fully funded, the study says.

"Under these (accounting) rules, state pensions appear to be nearly fully funded," the two authors contend. "This has led some analysts to the conclusion that the public pension system in its current form is not placing any burden on future generations. As we have shown, this view is misguided. In particular, we show that while the plans appear almost fully funded under government-chosen discount rates, there is a large probability of significant shortfalls in the future."

The situation becomes even more dire in the light of an economic downturn, Novy-Marx and Rauh say.

For comparison sake, the researchers say the potential public plan shortfall "dwarves" taxpayers' exposure to underfunded corporate pension plans. As of September 2007, the net financial position of the Pension Benefit Guaranty Corporation (PBGC) - the nation's private-sector pension insurer - was an underfund of $14 billion, with additional "reasonably possible exposure" of $66 billion, Novy-Marx and Rauh note.

Therefore, the authors contend, public plans could appear to be fully funded by simply adopting a sufficiently risky portfolio that generates higher returns that permit a higher discount rate. "In fact, investing in riskier assets may raise expected returns, but it also increases the probability of a severe underfunding," the authors say.

The report is available  here .