Watch Paul Solman’s report, ‘Is Your Pension Safe? States Struggle With Pricey Challenges.’
Paul Solman answers questions from NewsHour viewers and web users on business and economic news most days on his Making Sen$e page. Here’s Thursday’s query:
Our blog post on pension contributions received a supposed “correction,” which itself generated some reaction. We reproduce “DougMartin10th’s” original comment and my response below. Even further below, two additional takes on DM10.
@DougMartin10th: There is an error in the opening paragraph. The HIGHER the assumed rate of return, the greater the official underfunding of the pension plan, and the more that taxpayers or workers must contribute to make up the shortfall that would arise from a more sober assumption. That is because the HIGHER the assumed rate of return, the MORE the existing assets are projected to grow over time, and the LESS government would have to contribute. When the pension fails to grow that much, it becomes underfunded.The LOWER the assumed rate of return, the LESS the existing assets are projected to grow over time, and the MORE government would have to contribute to make up the difference. That is why pension funds assume unreasonably high rates of return like 8 percent, because the higher rate lowers what government has to contribute, which helps budgets, and results in a structurally underfunded pension when the unreasonably high assumed rates of return are not realized by the pension.
Paul Solman: No error. Just a confusion over the time reference, perhaps.
Leaving aside nuances like inflation and the thought that the government in question might conceivably fold up shop someday, just consider this example. Your pension fund has made a legal commitment to pay out $82.5 million dollars per year to retirees for the foreseeable future. Put aside $1 billion for the eventuality. Assume a return of 8.25 percent on the billion. 8.25 percent of one billion is $82.5 million, right? You’re covered today for all your future promises, since you’ll earn as much every year as you’ll need to pay out.
But because you think 8.25 percent is unrealistically high, you lower the assumed return rate to 7.5 percent. What happens? Your assumption no longer matches your obligation. You’re assuming that your $1 billion will yield only $75 million a year. Yet to be “fully funded,” you need to be earning $82.5 million, an extra $12.5 million a year. The money either comes from taxpayers or you’re officially “underfunded.” Thus, the lower the assumption, the more Rhode Island taxpayers must contribute.
Consider the extreme case: you assume an astronomical rate of return. Then the taxpayers might theoretically have to contribute almost nothing anything.
I think the misunderstanding concerns the time frame being used. We meant “underfunded” in the present, as of the realization that the reigning assumption was unrealistic. As long as that isn’t acknowledged, though, a favorite clichÃ© of the moment clicks in: the can is being kicked down the road. In that case, yes, a higher assumption means less taxpayer contribution – in the short run, but greater costs later, since the money hasn’t been put aside to grow in the meanwhile.
More of the exchange on the ‘correction,’ as it played out in the comments:
ToughLove responding to Doug’s comment:
“Doug, Read it again.
The author means that FOR A GIVEN FIXED LEVEL OF CONTRIBUTION, the lower the assumed rate of earnings, the greater the underfunding and the more that taxpayers or workers must contribute. That’s accurate.
The key is that he’s holding the contribution FIXED.”
Krepiotr responding to ToughLove:
“Doug, Read it again. The author means that FOR A GIVEN FIXED LEVEL OF CONTRIBUTION,”
Wrong. Author means what he means. Future contributions are not reflected in measuring funded status of the plan.
Assumed rate of return is a key factor in calculating the “value” of liabilities. The higher the assumption, the more benefits are expected to be paid by investment returns and not by the sponsor (taxpayers). If you make a low assumption, that you will pay more today and your children will get a free ride (will not have to pay as much for benefits of the future public workers covered under the same plan). If you assume too high – your kids will have to foot the bill for benefits provided to workers serving you. Everybody should want a fair assumption, providing for present generation of taxpayers to pay for benefits of workers serving us with no windfall going to our children and without mortgaging their future.
All the “risk free rate” mambo-jumbo has vary little to do with cost of benefits to taxpayers, it’s about some imaginary “market value of benefits” in a non-existent market. Unless you think that pension plans should stop investing in anything other than Treasuries and want to pay more for the same service.