Yes, We Should Worry About Public Pensions

By James Kwak

In the wake of the Detroit bankruptcy, Paul Krugman has a post pooh-poohing concerns about public pensions. His conclusion:

“Nationwide, governments are underfunding their pensions by around 3 percent of $850 billion, or around $25 billion a year.

A $25 billion shortfall in a $16 trillion economy. We’re doomed!”

(Yes, that’s sarcasm.)

I know why Krugman wants to argue that this isn’t a problem. If everyone believes that public pensions are a big problem, then the austerity crew will convert that belief into a push to cut public pensions—just like they have tried to use future shortfalls in the Social Security and Medicare trust funds to insist on privatizing or voucherizing those programs.

But for people who care about retirement security for middle-class Americans—and, more importantly, middle-class Americans who depend on public pensions—public pension shortfalls are a real problem. The public sector is the last major refuge of defined benefit pensions—the kind that provide a guaranteed annual income after retirement—and public employees paid for those pensions with lower wages while working. Shortfalls today mean a higher likelihood that those people will get stiffed when they retire, or at some point after they retire.

How big is the shortfall? Krugman focuses on the annual under-funding amount, which makes sense conceptually. In theory, if governments chipped in an extra $25 billion, then eventually the shortfalls would be made up. (All numbers are from the Center for Retirement Research at Boston College.) But this rests on a huge assumption: that pension plan assets will generate investment returns of 8 percent per year.

Using an 8 percent discount rate is like taking out a second mortgage and investing the proceeds in the stock market. You may think you’re making money, but the higher expected return of the market is entirely due to the fact that you’re taking on more risk. Pension benefit payments, like mortgage payments, are essentially fixed, so they should be discounted at the risk-free rate, not the expected rate of return of pension plan investments. Simply reducing the discount rate of future pension liabilities from 8 percent to 5 percent (still well above the risk-free rate even for thirty years) reduces the funding ratio (current assets divided by the assets necessary to pay future benefits) from 73 percent to 50 percent, which makes the annual shortfall bigger.*

Not setting aside enough for pensions is a serious problem for the millions of people who are relying on those pensions. It’s not a huge problem in the grand scheme of things, but it’s not insignificant, either. Krugman understandably doesn’t want people fastening on pension shortfalls as an argument for cutting benefits or raiding other government programs (like schools). I agree. And balanced budget rules make it difficult or impossible for states to issue debt to meet their pension obligations. So there are no easy solutions. The best (leaving aside federal aid) is probably to increase state taxes—which are modestly progressive, at least in states with an income tax—to make up the gap. But it’s still a problem we need to face.

* The shortfall is based on an “annual required contribution” that includes both new liabilities and an amount required to amortize the current shortfall.