Public pensions overly optimistic about returns News added by Benefits Pro on July 10, 2014

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By Chuck Epstein

Many of the nation's public pensions are using an assumed rate of return that is overly optimistic and, as a result, may eventually be unable to meet their obligations to retirees, according to a study by the Competitive Enterprise Institute, a conservative think tank and policy group.

In its report titled, “Understanding Public Pension Debt, A State-by-State Comparison,” free market economist Robert Sarvis asserts that states should rely on a more realistic rate of return.

“The discount rate used in the valuation of pension liabilities should be a low-risk rate, because of the fixed nature of pension liabilities. Ideally, this should as low as the rate of return on 10- to 20-year Treasury bonds, which is in the 3 to 4 percent range,” Sarvis wrote.

The problem is that states assume rates of investment return in the neighborhood of 7 percent to 8 percent annually. This

, Sarvis said, “usually leads to state and local governments making lower contribu­tions, in the expectation of high investment re­turns making up for the gap. However, while such returns may be achievable at some times, they need to be achievable year-on-year in order for a pension fund to meet its payout obliga­tions, which grow without interruption.”

The problem has, in fact, been well-documented.

Last year, the Pew Center on the States estimated said there is at least a $1 trillion gap between what states are setting aside for public employees’ retirement benefits and how much those benefits will cost in the future.

An expert at Northwestern University predicted that pension funds in seven states could fail to meet obligations by 2020 because of insufficient contributions from employers and lagging investment income.
In a February report issued by the Society of Actuaries, the “Report of the Blue Ribbon Panel on Public Pension Plan Funding,” the actuaries said there is “a broad consensus among financial experts that public pension systems systematically mis-measure their assets and liabilities. That’s politically convenient, as it lowers annual pension obligations, but it results in chronic under-funding and encourages riskier investments.”

The core of the accounting debate addressed in their February 2014 report concerns the interest rate, or discount rate, that public funds use to calculate the cost of future benefits in today's dollars.

“They can assume they’ll earn 7.5 to 8 percent annually," the acturies said. "That high rate reduces the current value of those future benefits, allowing government employers to set aside less money today to meet them.”

But, of course, that return is hardly guaranteed, and many experts argue for the use of a so-called risk-free rate, comparable to the yield on U.S. Treasuries. The impact of doing so would be huge, adding as much as $2 trillion to the liabilities public pension funds face around the country, according to some studies.

The Sarvis report found that the states with the greatest officially reported pension debt levels as a percent of state GDP were New Mexico, Alaska, Mississippi, Kentucky and Ohio.

Last month, Bloomberg News reported that some U.S. public pensions, which lack savings for $1.4 trillion of promises to retired government workers, will record wider gaps in fiscal years starting after July 1 because of changes in accounting rules.

Pensions in Illinois, Kentucky, Pennsylvania and other states will see funded levels decline, in some cases by more than half, as they comply with new Governmental Accounting Standards Board rules that for the first time will require future pension costs to be included on balance sheets and change how they must calculate their underfunding.

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