A good response occurred to me, to those cited by Josh who want to argue that underfunding is a mere $1 trillion. OK, let’s issue the extra $1 trillion of Federal debt. Put it in with the pension assets. Now, convert the pensions entirely to defined-contribution. Give the employees and pensioners their money now, in IRA or 401(k) form. If indeed the pensions are “funded,” then the pensioners are just as well off as if they had the existing pensions. (This might even be a tricky way for states to legally cut the value of their pension promises)
I suspect the other side would not take this deal. Well, tell us how much money you think the pension promises really are worth — how much money we have to give pensioners today, to invest just as the pension plans would, to make them whole. Hmm, I think we’ll end up a lot closer to Josh’s numbers.
That is, one way to value government pensions is to ask workers how much they would be willing to take in the form of an individual retirement account to give up their pensions. Of course, if the government workers believe that their pensions are at risk, they might take a low figure. But if we take that possibility off the table, then workers are likely to demand a lot more money than the current stated value of the pension obligations.
I think others have pointed this out before, but when the subject of Social Security privatization comes up, aggressive assumptions about stock market returns seem reasonable to those on the Right and crazy to those on the Left. But their positions reverse when the subject changes to state and local pension funding. My own preference is to make conservative assumptions about stock market returns for both discussions.
The fees on 401ks are somewhat notorious, and changing from an annuity to an asset would also require an increase due to volatility while the change from late to early vesting would bear heavily on values. Finally poor investor behavior presents defined contribution plans an insurmountable obstacle. So this is really an apple and orange comparison, so while defined benefit assumptions are probably rosy, they are probably far far less rosy than defined contribution plans, as we are seeing.
There are good observations Lord, but miss the overall point.
The point is that any financial scheme which relies on consistently achieving 8% nominal returns seems highly risky (Cochrane shows how risky), and any projections based upon such an assumption are highly dubious.
Most people don’t really believe in the low-risk nature of such assumptions, so when they make statements that seem to indicate that they do so believe, it seems like baloney. The thought experiment of forcing people to choose between two possibilities is like making them bet, which is a tax on baloney. If people had to put their money where their mouths or (prospecti) are, they’d concede ‘underfunded’.
If we’re staking our retirements on such a claim, we are justified in being a bit suspect. Pension plans are doing just that – underpinning their solvency on a dubious assumption and pretending it isn’t a risky one. But the Dow has gone up only a (geometric mean) average of 5.5% over the last 10 years, and NGDP only 4%.
There’s no amount of mischief one can’t accomplish by tweaking an exponential variable. If anything has killed the dream of rational, objective, uncorrupted-by-politicized-manipulation, cost-benefit analysis, it is the ability to play with the estimates of certain critical, compounding variables, to make the result come out any way you want.
As an example of how the kind of things you would have to do to have a pension fund that is both solvent and low-risk, take a look at what the military retirement fund does on page 17 of this document and pay special attention to the discontinuity between 2026 and 2027 – when, we hope, the Treasury has finished adding a net $2 Trillion to the fund and therefore satisfied its ‘amortization of unfunded liability’.
Net cash flow is another story. The Treasury sell bonds, gets cash, gives it to the MRF, which uses it to buy bonds … from the Treasury … well, at least we’re formalizing the liabilities by actually writing them up in the form of actual instruments. I’m reminded of those Dos Equis commercials with ‘the most interesting man in thew world’ – “The Government doesn’t always fund its liabilities, but when it does, it does it in TIPS”.
And when you do it in TIPS (still generous – they’re assuming a long-term 5.75% interest rate – much higher than today), you can see the ratios needed. Look at 2028. The fund itself has to be 25.7 times larger than disbursements. And also keep in mind that the Services and the Treasury are contributing an additional 56% of current payroll costs to keep it all afloat. That’s equivalent to having (.56/1.56) = 36% tax / mandatory pension-contribution percentage on ‘total payroll costs’!
Bottom Line: Almost no other pension plan comes anywhere near these ratios of assets and funding to disbursements.
As an aside, requiring the Treasury to amortize and formalize unfunded liabilities seems a good idea in general. Imagine what would happen to the other giant welfare trusts if those had to follow similar rules.
Great points by both Cochrane and you. Keep in mind one subtle difference between pension discussions and social security privatization: the pension debate usually is about two groups (current workers and retirees) while social security privatization usually centers on current workers. The difference means that the relevant market return is somewhat different (stocks for current workers and bonds for retirees). You’re overall point remains, though, as bond total returns going forward will probably be lower than in the past.
Does anyone know what the private annuity rates look like?
“..aggressive assumptions about stock market returns seem reasonable to those on the Right and crazy to those on the Left. But their positions reverse when the subject changes to state and local pension funding.”
I think you over dot your attempt to be even handed. This “paradox” is a red herring (usually coming from the Left) vis-a-vis the issue of valuing the guaranteed valued of pension funds. The value of the guarantee is driven not by returns but by essentially down-side volatility; this is what the pension funds do not account for; and that is why they are more underfunded than posited. It has little to do with whether you expect the stock market to do X or Y.
Most on the right have not argued for SS private accounts have not called for the program also providing “at the money” guarantees in retirement payments as well. Andrew Biggs has addressed this already.