Explaining How Pension Assumptions are Bogus

Josh Rauh and Robert Novy-Marx have an excellent blog explaining the wrong-headed logic behind how state and local pensions are valued.

Under current standards, state and local governments value pension liabilities using the expected return on pension fund assets. Arguing that diversified investment portfolios have an 8% expected return, governments typically use a discount rate of around 8%. Under these procedures the 50 states report unfunded liabilities of around $1 trillion.

But this practice misrepresents the cost of the government promises. The value of a financial obligation has nothing to do with the allocation of the debtor’s assets. If a state wanted to pay an investor to take over the pension liability, the amount the investor would accept would not depend on the state’s asset allocation. If a state tells its employees that their pensions are secure — not risky like the stock market — then it should use the yields on safe government securities such as Treasury bonds to discount the benefits.

Do the GASB rules make sense? Let’s consider an underwater homeowner’s financial situation under common-sense financial logic, and then under GASB rules.

Do read the rest of the analogy as it makes crystal clear that the “official” pension obligations are the work of a true Master Wealth Alchemist.