An Options Pricing Method for Calculating the Market Price of Public Sector Pension Liabilities

State and local public sector employee pensions are widely known to be underfunded, but pension financial reports do not reveal the true extent of funding shortfalls. Pension accounting methods assume that plan investments can earn high returns without taking any account of the market risk involved. This gives a false sense of the financial strength of public sector pensions and understates risks to taxpayers.

This paper first uses a Monte Carlo simulation of current pension assets and projected market returns to calculate the probability that public sector pension assets will be sufficient to fund accrued benefits. The typical public sector pension has only a 16 percent probability of paying full accrued benefits with assets on hand. A larger number of public pension plans have zero probability of paying accrued benefits than have a probability in excess of 50 percent.

But since accrued pension benefits are legally and constitutionally protected, any pension funding shortfalls must be met by taxpayers. This benefit guarantee amounts to an effective put option on plan investments, the cost of which is not disclosed under current actuarial accounting.

This paper uses an options pricing method to calculate the market value of taxpayer guarantees underlying public sector pensions. The average funding ratio declines from 83 percent under actuarial accounting to 45 percent under this options pricing approach. The typical state has unfunded public pension liabilities three times larger than its explicit government debt. Public pension shortfalls equal an average of 27 percent of state gross domestic product, posing a significant fiscal challenge in coming years.

Accurate measures of public pension liabilities are important for policymakers, taxpayers, investors considering the economic environment in which to start or locate a business, and bond purchasers considering the risk premia appropriate to municipal government bonds that are in practice subordinate to public pension liabilities.

Click here to view the full text of this working paper as an Adobe Acrobat PDF.

Andrew G. Biggs is a resident scholar at AEI.

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About the Author

 

Andrew G.
Biggs
  • Andrew G. Biggs is a resident scholar at the American Enterprise Institute (AEI), where he studies Social Security reform, state and local government pensions, and public sector pay and benefits.

    Before joining AEI, Biggs was the principal deputy commissioner of the Social Security Administration (SSA), where he oversaw SSA’s policy research efforts. In 2005, as an associate director of the White House National Economic Council, he worked on Social Security reform. In 2001, he joined the staff of the President's Commission to Strengthen Social Security. Biggs has been interviewed on radio and television as an expert on retirement issues and on public vs. private sector compensation. He has published widely in academic publications as well as in daily newspapers such as The New York Times, The Wall Street Journal, and The Washington Post. He has also testified before Congress on numerous occasions. In 2013, the Society of Actuaries appointed Biggs co-vice chair of a blue ribbon panel tasked with analyzing the causes of underfunding in public pension plans and how governments can securely fund plans in the future.

    Biggs holds a bachelor’s degree from Queen's University Belfast in Northern Ireland, master’s degrees from Cambridge University and the University of London, and a Ph.D. from the London School of Economics.

  • Phone: 202-862-5841
    Email: andrew.biggs@aei.org
  • Assistant Info

    Name: Kelly Funderburk
    Phone: 202-862-5920
    Email: kelly.funderburk@aei.org

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