It’s well-known that there’s a huge financial hole in state-sponsored retirement plans for public employees, a hole that states will eventually have to fill with tax increases and spending cuts.
There is, however, still considerable debate as to the size of this government debt owed to public employees. In July 2015, the Pew Charitable Trusts released their latest issue brief, reporting that as of 2013, the nation’s state-run retirement systems had a $968 billion funding gap GPS +0.00%, not far from the “Trillion Dollar Gap” they reported in 2010.
The Gap is Actually Bigger
As serious as this sounds, the true magnitude of unfunded pension promises for the systems tracked by Pew is much larger. The system of measurement and budgeting for public pension promises has fallen prey to one of the fundamental fallacies in financial economics: undervaluing a risk-free stream of promised cash flows by assuming that the promises can be met with high, anticipated returns on smaller pools of risky assets.
When I correct the calculations to reflect the expectation of public employees that these promises will be honored, the market value of unfunded liabilities proves to be far larger: $3.28 trillion (as of 2013). Moreover, this figure excludes local government obligations such as those of U.S. cities and counties.
Pew collects its information from state government disclosures. Its 2013 data suggest that, across 237 state-level pension systems, there were $3.43 trillion of liabilities backed by $2.47 trillion of assets. In other words, this implies a net gap GPS +0.00% of around $1 trillion.
These liability measures are far too low. They are based on state assumptions of high assumed returns on risky asset portfolios: the median assumed return was 7.75% (and the liability-weighted average 7.66%). The funding gap amounts to a mere $1 trillion only if the public plans can achieve these high compound annualized returns over the horizon during which these benefits must be paid. Yet governments have promised to pay the pensions regardless of what happens to the pension investments. As such, pension promises should be treated like the senior government debt they are, akin to default-free government bonds.
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For a proper financial market valuation, the promised pensions should first be adjusted to reflect only accrued benefits, or retirement payments that employees would be entitled to receive under their current salary and years worked. This is not how governments do it today, but my 2011 paper with Robert Novy-Marx did this recomputation for most of the plans in the Pew study.