August 10, 2010
Even though the dispute over public pension accounting methodologies may seem like technical hairsplitting, the policy implications of the ongoing debate are enormous. If states decided to play it safe and set aside an additional $3 trillion instead of $1 trillion in order to fully fund employee pension plans, that decision would have a huge ramifications, such as significantly reduced benefits and higher contribution rates for hundreds of thousands of state employees.
Public pension managers continue to defend the use of traditional actuarial methods to calculate assets and unfunded liabilities. Keith Brainard, research director at the National Association of State Retirement Administrators, responds to criticisms like Minahan's by pointing to the long-term performance of state pension assets relative to assumed rates of returns. While returns have indeed fluctuated wildly over the past few years — last year brought a positive return of 20 percent, while the past three years have seen an overall loss of 1 percent — the median rate of return over the past 25 years has been 9.25 percent, which actually beats the common actuarial estimate of 8 percent.
Using either valuation method, however, state pension plans are still underfunded relative to federal guidelines. The Government Accountability Office considers current and projected assets covering 80 percent of all present and future liabilities to be a healthy funding level for public pension systems. Traditional actuarial methods suggest that current and projected assets cover about 70 percent of all present and future promises nationwide. Methods supported by Minahan and other economists however, suggest that the aggregate funding level is actually closer to 40 percent.
Ultimately, market performance may settle the ongoing debate between state actuaries and economists. If Grantham Mayo Van Otterloo chairman Jeremy Grantham's forecast of 3.5 percent returns for a balanced 60/40 equity fixed income portfolio over the next seven years is correct, states would be wise to hew to the more conservative approach of Minahan and other economists. In that case, continuing the assumption of 8 percent annual growth would force pension managers to invest in even riskier portfolios than they currently own. That might be fine if pension funds had an unlimited time horizon, like university endowments. Pension funds, however, must be able to meet the liabilities of employees as they retire, which suggests an average time horizon of 20 or 30 years. A more endowment-like approach to investing — and a trend toward ever-riskier assets — could therefore be disastrous for public pension funds if the next few decades are like the last quarter century, during which stocks actually earned less than bonds.
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