Better decisions by adding up true pension costs

Reuters

California state worker Albert Jagow (L) goes over his retirement options with Calpers Retirement Program Specialist JeanAnn Kirkpatrick at the Calpers regional office in Sacramento, California, October 21, 2009.

Article Highlights

  • Even if pensions’ peg the long-term return correctly, year-to-year fluctuations increase risk of falling short of it.

    Tweet This

  • The true costs of a public pension plan are significantly larger than one would think.

    Tweet This

  • Policymakers must understand the true costs of public pension plans before they can make key decisions.

    Tweet This

In the debate between economists and actuaries over how to value public sector pension liabilities, it seems we cannot even agree on the simple things.

In a recent commentary, Gary Findlay, executive director of the Missouri State Employees' Retirement System, asks that we consider the following pension financing formula:

Benefits = Contributions + Investment Income - Expenses

Mr. Findlay states that this simple formula is "equally applicable to defined benefit plans and defined contribution plans." If DB plans have lower expenses or earn higher investment returns, which seems likely given economies of scale and professional fund management, then they are presumably a more efficient vehicle for generating retirement income.

Except for one problem: the most meaningful formula for a public sector DB pension plan is something like this:

Liabilities = Stocks + Put option - Call option = Benefits discounted at riskless rate

Public pensions invest in stocks and other risky assets, whose returns they count upon to meet their benefit liabilities. Even if pensions' peg the long-term return correctly, year-to-year fluctuations mean that even over periods of decades they have at least a 50 percent chance of falling short of it. But because public pension benefits are guaranteed, they must be paid with 100 percent certainty.

This mismatch between the risk of the plan's assets and its liabilities means that the government -- and therefore the taxpayer -- has a contingent liability to backstop the plan's financing should investment returns fall short of forecasts. This is effectively a put option, whose value can readily be priced. Findlay's exposition ignores this contingent liability, essentially treating a DB pension as if it were a DC plan where the employer's obligation ends once the pension contribution is made. That, obviously, is not the case.

On the other hand, if investment returns exceed projected levels, the plan can keep the excess to fund future benefits. These gains are equivalent to selling a call option, which lowers the cost of funding future benefits. In practice, of course, excess returns often have been used to increase benefits rather than buttress the program's own finances.

The core insight of this formula, which economists and market participants recognize but pension managers and public pension actuaries ignore, is that the value of the implicit put option far exceeds that of the call option, meaning that the true costs of a public pension plan are significantly larger than one would infer from examining current contributions alone.

The reason is simple: bad outcomes for investments correlate with bad outcomes for the economy as a whole, so -- as we have seen throughout the country over the past several years -- taxpayers would be called upon to increase pension funding when tax revenues are weak and unemployment high. As the Risk Assessment published by Washington's State Actuary stated, "Weak economic environments were correlated with weak investment returns. Lower investment returns created the need for increased contributions at a time when employers and members could least afford them."

So-called "put-call parity" states that the sum of the initial investment, the put and the call will equal the value of the future benefits discounted to the present at the riskless rate of return. In other words, this formula -- which accurately presents what actually goes on in a public sector DB pension -- points straight toward the so-called "market valuation" that pension managers, actuaries, investment advisors and public employee unions oppose.

Viewed through the lens of fair market valuation, which at least roughly captures the approach taken in the private sector and for public employee plans in Canada and Europe, generous benefits funded with risky investments no longer seem to be such a bargain. Only once the true costs of public pension plans are understood can policymakers decide whether reduced benefits or increased taxpayer and employee contributions are appropriate.

Andrew G. Biggs is a resident scholar at AEI.

 

Also Visit
AEIdeas Blog The American Magazine
About the Author

 

Andrew G.
Biggs

What's new on AEI

Defeating ISIS: AEI experts weigh-in before the president’s address on Wednesday
image Degrading, defeating, and destroying the Islamic State
image Wealth Building Home Loan: Building wealth through homeownership and retirement savings
image The $3 iPhone
AEI on Facebook
Events Calendar
  • 15
    MON
  • 16
    TUE
  • 17
    WED
  • 18
    THU
  • 19
    FRI
Tuesday, September 16, 2014 | 5:00 p.m. – 6:00 p.m.
The Constitution as political theory

Please join us for the third-annual Walter Berns Constitution Day Lecture as James Ceasar, Harry F. Byrd Professor of Politics at the University of Virginia, explores some of the Constitution’s most significant contributions to political theory, focusing on themes that have been largely unexamined in current scholarship.

Event Registration is Closed
Wednesday, September 17, 2014 | 8:10 a.m. – Thursday, September 18, 2014 | 1:30 p.m.
Third international conference on housing risk: New risk measures and their applications

We invite you to join us for this year’s international conference on housing risk — cosponsored by the Collateral Risk Network and AEI International Center on Housing Risk — which will focus on new mortgage and collateral risk measures and their applications.

Event Registration is Closed
Thursday, September 18, 2014 | 2:15 p.m. – 3:00 p.m.
Speaker of the House John Boehner on resetting America’s economic foundation

Please join us as Speaker John Boehner (R-OH) delivers his five-point policy vision to reset America’s economy.

Friday, September 19, 2014 | 9:15 a.m. – 11:00 a.m.
Reforming Medicare: What does the public think?

Please join us as a panel of distinguished experts explore the implications of the report and the consumer role in shaping the future of Medicare.

No events scheduled this day.
No events scheduled this day.
No events scheduled this day.
No events scheduled this day.