By Joshua Rauh
Paul Krugman and Dean Baker took the Washington Post editorial page to task yesterday for stating that unfunded state and local pension liabilities amounted to $3.8 trillion. They accuse the page of misquoting a study in which the total was cited as only $1 trillion.
The WaPo editorial page did misquote the study, but that doesn’t change the fact that the $1 trillion is a completely mismeasured and fictional number. Unfunded state and local liabilities are around $4 trillion when the liabilities are correctly measured.
Since Professor Krugman’s post links to the study in question, by the Boston College Center for Retirement Research, I am sure he saw that the authors actually discuss these measurement issues at length. The Boston College authors even provide liability estimates under what they agree is a more appropriate methodology, and find that unfunded state and local liabilities are a multiple higher than the uncorrected $1 trillion.
Currently, standard practice measures the funding status of public pensions in the US under the laughable assumption that every dollar in the pension funds will earn compound returns of 7.75% or 8% per year. That’s the basis for the $1 trillion in unfunded liabilities.
But if a state or local government promises a risk-free pension, one that will be paid regardless of how the stock market performs, then that promise is like a government bond and should be measured accordingly. That’s the way pension promises are measured in most public or semi-public plans in countries like Canada and the Netherlands. In the Netherlands, for example, discount rates of 0-4% are used. Even US companies follow this basic principle that a pension is like a bond issued by the sponsor by treating their pension liabilities as corporate bonds for the purposes of their books.
Figure 5 of the study professor Krugman links to shows $3.8 trillion total liabilities at an 8% discount rate, but $6.2 trillion of total liabilities using a 4% discount rate. A 4% rate is much closer to long-term government yields, but still too high a rate given that the benefits are guaranteed and many of them are short-term. If unfunded liabilities are $1.0 trillion under an 8% rate, then they are $3.4 trillion unfunded under a 4% rate.
The study itself advocates that “benefits – for reporting purposes – should be discounted by something closer to the risk-free interest rate.” So in that case the unfunded liabilities implied by the study at a 4% discount rate are $3.4 trillion, and at a truly risk-free rate would be around $4 trillion.
And these unfunded promises are growing every day the governments continue to budget using the inappropriate discount rates, since the governments don’t contribute enough to cover the new promises.
Professor Krugman also argues that on average states and cities aren’t contributing very much of their budgets to pensions, and that therefore pensions are not a major issue.
Let’s apply that argument to household finance. Suppose you had a friend who told you he was only paying $50 per month to his credit card company, a tiny sliver of his total income. That tells us nothing about whether his credit card debts are a major problem or not. He might have $100,000 of credit card debt and be completely ignoring his debts until it drives him into bankruptcy.
The real question then is how much he would have to contribute to actually pay down the debt, and for public sector pensions the amount is around 2.5 times larger than what they are actually contributing. And unlike the Federal government, state and local governments cannot just print money to service their debts.
To make up the shortfalls, governments are soon going to see pension contributions eating up an increasing share of their budgets and crowding out essential public services, just like what happens when governments have to pay down other debts. That crowd-out is already happening around the country. Look at cities like San Diego or San Jose, where pension contributions have had to rise to more than 20% of the city budget. Or bankrupt Detroit, where it is obvious that pensions have created enormous strain on the budget.
Read the rest here.
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