Andrew Biggs On Why Dean Baker Is Wrong On State Pension Funding

This is from the AEI Blog. Here are the first two and last two paragrqaphs:

"Dean Baker of the Center for Economic and Policy Research is pushing back against financial economists’ call for reform of public-pension accounting rules. Baker says that the “market valuation” argument, which says that pensions should value their benefit liabilities using low interest rates to match the guaranteed nature of those liabilities, is wrong because it ignores government’s superior power to bear and manage investment risk. Dean argues that it’s appropriate for pensions to continue discounting their liabilities at the much higher expected returns they project for their investment portfolios, usually around 8 percent.

To begin, though, Dean misstates the market valuation argument. The argument is not that public pensions are overestimating their returns, say, by predicting 8 percent average returns when they’ll actually be 7 percent. (They may be doing this and I have my suspicions regarding certain plans, but that’s not the argument.) The argument—in fact, it’s really not so much an argument as a simple statement of how economists thinks about these issues—is that the value of a liability is independent of the expected return on the assets used to fund that liability. This is nothing other than the Modigliani-Miller theorem; if Dean wants to take issue with that, he has a Nobel Prize waiting for him."

"The larger point of Modigliani-Miller is that we need to view risks and returns not from the point of view of “the government,” some anthropomorphized entity that bears risk and pays the bills, but from the view of the stakeholders of government, who include taxpayers, bondholders, public employees, beneficiaries of government programs, and so on. As the Congressional Budget Office has put it, government doesn’t bear risk so much as transfer risk between different stakeholders. As a result, we should value risk the way the stakeholders themselves do.

And those stakeholders are today paying the price for the risks that public pension funds took. The “government” hasn’t borne those risks; rather, as a result of declining pension funding, taxpayers and public employees are now paying more in pension contributions at the time that they’re least able to afford it. In some cases, public employees face reduced future pension benefits because governments will have to dedicate more money to covering past unfunded liabilities. To the degree that pension costs squeeze state and local budgets, some public employees may lose their jobs. If these stakeholders aren’t indifferent to risk—and I assure you, they’re not—then the accounting used to value risks borne by these stakeholders shouldn’t be indifferent either."