How Public Pension Plans Can (and Why They Shouldn’t) Ignore Financial Economics

Public pension plan sponsors claim that their perpetual existence and taxing power exempt them from financial economics. They therefore ignore current market conditions and rely on patience and intergenerational risk sharing to overcome risk. The author shows that their use of discount rates that far exceed current market levels produces financial opacity, retirement insecurity, and intergenerational inequity, leaving the solvency of these plans dependent on the systematic mistreatment of future generations of taxpayers.Long-term US Treasuries are yielding less than 3%, while US public pension plans are discounting their liabilities and basing their funding on rates of 7%–8%. This article focuses on the United States but notes that similar discrepancies between public plan discount rates and the local default-free rate appear in most developed countries, particularly in Western Europe. These discrepancies produce financial opacity, retirement insecurity, and intergenerational inequity.Insurance companies manage their annuity business roughly in accordance with the principles of financial economics, which call for discounting insured liabilities at rates that are default-free or nearly so. Public plan sponsors ignore these principles. They invest substantially in equities and often in such alternative investments as private equity, real estate, and hedge funds. They estimate, generously, the risk premiums they expect to earn on these investments. They reflect the hoped-for risk premiums in the discount rates that underlie their financial reporting, plan contributions, and pricing of negotiated plan improvements.Public pension plan authorities claim various justifications for their deviations from financial economics, observing that, unlike insurance companies, they have taxing power and will exist in perpetuity. They can share their investment risks among multiple generations of taxpayers—long enough for those risks to become minimal and manageable. Public pension plan authorities can thus count on earning the risk premiums embedded in the higher expected rates of return. In the worst case, they can fall back on their taxing power.This long-term argument implicitly relies on an extreme mean reversion process. It implies that the variance of a risky portfolio’s cumulative return decreases as the measurement period extends, rather than merely increasing more slowly than under a simple random walk model. The idea that risk shrinks over sufficiently long periods has been refuted by financial economists.The intergenerational-risk-sharing argument is also flawed. This article considers a two-period illustration in which the first taxpayer generation funds the pensions earned during its tenure. The discount rate used to determine the pension contribution includes a risk premium—in effect, the first generation uses the risk premium to reduce its contribution. It then exits the scene, having borne no risk and leaving the new generation to settle up in the second period. The second generation enjoys gains or faces losses with an average value of zero; that is, it bears the risk of gains or losses but can expect no risk premium. The risk premium, which can exceed half the true pension cost, has been confiscated by the first generation, which bore no risk. In practice, where immediate settlement is not required, risks continually pass to future generations, with surpluses swept off the table and deficits allowed to run for as many generations as possible.Thus, the true benefit of the long government time horizon is not that it overcomes risk but, rather, that it delivers a steady supply of future involuntary risk bearers on whom the government can exert its taxing power—at least until it runs out of sufficiently affluent generations of taxpayers. In such failures, the victims can include not only taxpayers but also plan members and municipal bondholders.Apart from the risk of demographic collapse, the dependence on future generations of taxpayers violates the fundamental principle of public finance: each generation should pay in full for the services it consumes, without passing either direct costs or funding risks to future generations. Ensuring sustainability and fairness for all generations of plan participants and taxpayers requires economically correct discount rates for financial reporting, determination of contributions, and pricing of benefit increases.Editor’s note: This article was reviewed and accepted by Executive Editor Robert Litterman.