Wednesday, March 2, 2011

Crisis in Public Pensions? Blame the Stock Market

Ezra Klein of the Washington Post had a good article today about the apparent "crisis" in the funding of public pensions.

Klein cites a paper written by Dean Baker of the Center for Economic and Policy Research. Titled "The Origins and Severity of the Public Pension Crisis", Mr. Baker writes that much of the $1 trillion funding shortfall that is usually cited as a "crisis" in the media is actually tied more to the stock market malaise over the last few years rather than any funding shortfall.

As Klein writes (I have added the emphasis):

{The underperformance of stock managers}, not union greed, is what has left state pension plans in apparent crisis. The conventional analysis right now is that pension plans are underfunded to the tune of about a trillion dollars (though there are good questions about how honestly state pension data are reported). If the stock market had simply performed as well as Treasury bonds in recent years, about $850 billion of that shortfall wouldn't exist. Much of the remaining gap is explained by states cutting back on contributions because they need to balance their wrecked budgets.

But Klein goes on to write that Baker warns that we are about to err on the side of being too conservative on the expected level of returns going forward. This is important since the lower the expected return, the higher the apparent funding gap:

But Baker -- who did predict the housing crisis and so has some actual credibility on this subject -- thinks that some analysts have perhaps overlearned the lessons of the past few years. They're predicting rates of return going forward, he argues, that are much lower than what we should expect. He expects returns averaging around 7 percent from 2012 to 2022 -- not the 4 percent or so that some analysts are predicting.

Ezra Klein - What you need to know about state pension systems

One final point that I would make. I wrote last year about the fact that many public pension plans were cutting back on their allocation to stocks in favor of bonds.

I noted that this made no sense, since by definition pension plans should have a very long time horizon, and stocks will almost certainly provide better long-run returns than bonds (especially given the starting level of interest rates).

And that risk remains today. The more conservative the investment strategy that a pension plan adopts, the more likely it is to have funding difficulties in the future.