As “Dean Vedder” would sing it (with apologies to Eddie):
Freezin’ pension contributions hurts your long-run, again
Oh, feelin’ maybe we’ll see a little better, P&E rate, ooh yeah
Oh, maxin’ contributions makes too hard on your seniors, ah
Oh, bubblin’, you can’t help, when the market looks insane, hey
Even flow, you’ll avoid the lows and highs
Oh, don’t you know, in the long run a better way
Someday soon, we’ll begin with better management
Pearl Jam’s song is about a man who’s having a hard time of life – but it’s not hard to find accounting techniques that make government finances look bad either. There’s generational accounting, which purports* to show lifetime tax obligations of 80 or 90 percent for future generations. More recently, opponents of Social Security and Medicare have attempted** to use infinite horizon projections to show deficits in the hundreds of trillions of dollars, or calculated a (somewhat more modest) gap in the tens of trillions between benefits promised to current beneficiaries and the current/past taxes paid by these beneficiaries.
These methods all have two things in common: 1) they conceal the fact that relative to future economic growth (i.e. GDP) they aren’t all that large, and 2) the projected costs are driven almost entirely by projections of exploding private-sector health care costs. But by making the government’s financial situation appear far more dire it is, and concealing the underlying problems with the country’s health care system, these techniques can make it look like there are no alternatives save for cutting – you guessed it – Social Security, Medicare and other social welfare programs.
Something similar goes on in economic studies that purport to show large unfunded liabilities in public pensions – in the range of $3-4 trillion, or 3-4 times the unfunded liability reported using by the funds themselves. The difference is simply that by using either the interest rate on corporate bonds or the “risk-free rate of return” on Treasury bonds, which are considerably below the 7.5-8.0 percent return used by pension fund managers, you get a much higher calculation of future liabilities.
So what is an appropriate rule for assessing a public pension’s funding outlook? The answer is: “even flow”. “Even flow” means a rule consistent with a return on holdings conditional on the state of the market. In the short-term, that rate will vary depending on the current ratio of stock prices to corporate earnings, but over the long run it will lead to a more balanced flow of contributions into the fund than basing calculations on a fixed return for assets over time.
An “even-flow” rule helps two ways. During bubble periods, when price-to-earnings (PE) ratios in the stock market grow out of line with historic patterns, it ensures pension funds will be properly funded after the bubble inevitably bursts, avoiding the need for extra contributions to build up reserves. It also avoids an excessive build-up of funds that results from applying a risk-free discount rate to pension funds that actually earned higher rates of return on average.
This paper, by Dean Baker of the Center for Economic Policy Research, describes how such an “even-flow” rule would perform. It uses 135 years of stock and bond return history to simulate the performance of a pension fund using the “even-flow” rule versus that of a pension fund determining contributions by discounting with a risk-free rate of return on the same assets.
*Generational accounting calculations are based on numerous assumptions regarding an unknowable and often far-distant future.
**The American Academy of Actuaries says the “infinite” projection is likely to mislead the public into thinking the system “is in far worse financial condition than is actually indicated,” and therefore should not be used to explain the long-term outlook.
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