Public Pensions Might Still Be Underfunded, Despite What The Association of State Retirement Administrators (NASRA) Says

See Public Pensions Fire Back on Investment Returns By Andrew Biggs of AEI. It has a good chart. Here is that post:

"Reuters and Pensions and Investments report on a new study released yesterday by the National Association of State Retirement Administrators (NASRA) that supposedly “slams” a 2010 paper by Northwestern’s Josh Rauh and Rochester’s Robert Novy Marx for concluding “that unfunded state pension liabilities total $3 trillion by using inaccurate liability and return assumptions.”

The NASRA study presented a chart similar to the one below that tracked public pension assets over time, arguing that the Rauh/Novy-Marx study was misleading because it focused on pension assets when they were at a low point and ignored their recovery since. This, the NASRA paper argues, shows why pension accounting shouldn’t worry very much about plans’ investment risk. Over time it all evens out, they argue.

NASRA is right that plan assets have recovered from their 2008 lows, if not yet back to 2007 levels. What the paper doesn’t mention is that public plan accounting assumes that investments will earn 8 percent per year, every year. So to truly catch up, pension assets not only need to make up for their dollar losses but also for the assumed 8 percent annual returns that they have been missing. The red line in the chart indicates the level of plan assets assuming 8 percent annual interest.

What the red line shows is that the recovery has been a lot less healthy than you’d think. In 2008, assets were 33 percent below their projected level. By 2009 the gap had been closed to 28 percent, and by 2010 to 27 percent. And those were years with pretty solid investment returns. But even if pensions continued at that pace, which well exceeds their 8 percent expected returns, they wouldn’t catch up to 2007 funding levels until around 2020.

A broader point: NASRA argues that proponents of market valuation for public pension liabilities are saying “that a public pension fund with a diversified portfolio can be expected to return 4 percent to 5 percent over next 20 to 30 years. We believe that is an unrealistically low expectation.”

That’s actually not at all what market valuation says. What it argues is that the value of a liability doesn’t go down if you fund it with riskier assets. If I have a liability in the future that I will fund with assets set aside today, shifting those assets from bonds to stocks changes the value neither of the assets nor the liability. When pensions invest in riskier assets—as they are doing—they lower their current contributions, but place a higher contingent liability onto taxpayers to bail out the pension fund should investment returns go south. The total cost of funding the liability—upfront costs plus contingent liabilities—is always the same. (See my Retirement Policy Outlook from last year for more details. Also see this Reuters story with details of recent congressional hearings.) But since public pension accounting cares only about upfront costs and ignores contingent liabilities, pension managers think that more risk equals better funding. That’s a point of view that seems worth slamming."