Better decisions by adding up true pension costs


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.

What's new on AEI

AEI Election Watch 2014: What will happen and why it matters
image A nation divided by marriage
image Teaching reform
image Socialist party pushing $20 minimum wage defends $13-an-hour job listing
AEI on Facebook
Events Calendar
  • 27
  • 28
  • 29
  • 30
  • 31
Monday, October 27, 2014 | 10:00 a.m. – 11:30 a.m.
State income taxes and the Supreme Court: Maryland Comptroller v. Wynne

Please join AEI for a panel discussion exploring these and other questions about this crucial case.

Tuesday, October 28, 2014 | 9:30 a.m. – 12:15 p.m.
For richer, for poorer: How family structures economic success in America

Join Lerman, Wilcox, and a group of distinguished scholars and commentators for the release of Lerman and Wilcox’s report, which examines the relationships among and policy implications of marriage, family structure, and economic success in America.

Tuesday, October 28, 2014 | 5:30 p.m. – 7:00 p.m.
The 7 deadly virtues: 18 conservative writers on why the virtuous life is funny as hell

Please join AEI for a book forum moderated by Last and featuring five of these leading conservative voices. By the time the forum is over, attendees may be on their way to discovering an entirely different — and better — moral universe.

Thursday, October 30, 2014 | 2:00 p.m. – 3:00 p.m.
A nuclear deal with Iran? Weighing the possibilities

Join us, as experts discuss their predictions for whether the United States will strike a nuclear deal with Iran ahead of the November 24 deadline, and the repercussions of the possible outcomes.

Thursday, October 30, 2014 | 5:00 p.m. – 6:15 p.m.
The forgotten depression — 1921: The crash that cured itself

Please join Author James Grant and AEI senior economists for a discussion about Grant's book, "The Forgotten Depression: 1921: The Crash That Cured Itself" (Simon & Schuster, 2014).

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