Public Pensions–A Case Study in Wealth Alchemy

Josh Rauh has an excellent post on Everything Finance about the state of public pensions.  If you are not familiar with his work, along with Robert Novy-Marx, you should check out here, here and here.

Rauh states that:

Most public pension systems assume their assets will return around 8% annually, and the lowest assumption among major public pension systems is 7%. According to the article, only a handful of funds have reduced their return assumptions, despite an environment where such returns seem unlikely . . . This entire system effectively treats the expected return on the pension fund assets as achievable without any risk. When a state assumes, say, 7% instead of 8%, it sets a little more money aside and does a little less gambling on behalf of future taxpayers (our kids and our elderly selves) . . . In sum, systems that use 7% are being more responsible than those using 8% — but even 7% is a flagrant violation of the principal that states should run balanced budgets. Already this system has led to state pension debt that when properly measured amounts to $3 trillion across the 50 states, since unfunded pensions were the way that politicians could borrow money out of the view of taxpayers and outside of budgetary requirements.

If going forward we want to actually return to the principal that states should run balanced budgets, there are only two routes for future retirement benefits: 1.) defined benefit (DB) pensions funded at risk-free rates and invested in bonds that match the profile of benefit payouts; or 2.) 401(k)-type defined contribution (DC) pensions like the private sector. Anything else is simply borrowing in disguise.