Underestimating the Pension Bomb’s Impact

Today’s Wall Street Journal discusses why both corporations and governments are sticking to “unrealistic return assumptions” in forecasting their pension liabilities. The majority of pension plans expect an 8 percent return and have clung to this expectation, “through thick and thin.” These estimates the WSJ notes are partly due to the high returns witnessed in the 1990s bull market years. Indeed over a 25 year period pension plans had an annualized median return of 9.3%. Over a 10 year period that fell to 3.9%.However, it’s not the number they’re selecting that matters, it’s the rationale.

Part of the difficulty of lowering the discount rate lies in what happens as a result. Reducing the discount rate increases the size of the  liability and the contribution needed to ensure adequate funds. That is one reason states are moving slowly. New York, New Jersey, and Colorado have all reduced their discount rates from the 8 percent to the 7 percent range.Virginia cut its investment return from 7.5% to 7 percent to avoid an even worse strategy – investing the funds in more risky assets to make up for losses.

The discount rate issue will continue to be a big challenge for government pension systems in part due to GASB’s guidance.

We will be discussing this and other issues facing state pension systems this Friday at Mercatus.  Speakers include myself, Dr. Andrew Biggs of AEI, Scott Pattison, Executive Director of the National Association of State Budget Officers, and Utah State Senator Dan Liljenquist. You can register for the event, or view it online.