As the debate continues over public pension funding levels, we have this headline from the Financial Times this week: “US States need $980 billion to fill pension gap, says Moody’s.” This is not exactly news. A number of studies, including ones from the Pew Trust and the Public Fund Survey, have identified a massive shortfall for public pension funds. In fact, the Pew Trust said that the shortfall in 2010 was $1.38 trillion, so perhaps we should be applauding state legislatures for improving the gap since then.
The shortfall numbers in these studies, to put it simply, are all over the place. There are many variables that go into these models, but the main factor that causes variation is the expected rate of return on the assets in the plans. The official assumed return on the assets that are held in trust to pay pension liabilities is 8 percent, according to the Public Fund Survey. Fiddling with this projected rate of return can cause swings in the amount of unfunded liabilities. The Moody’s study uses an unconventional assumption. According to the Adjustments to state pension liabilities document:
Accrued actuarial liabilities will be adjusted based on a high-grade long-term taxable bond index discount rate as of the date of valuation (of the fund).
Rather than using the average historical investment return rate of 8 percent, Moody’s uses a return on a taxable bond index. This return would be no higher than that on a basket of high-rated corporate bonds ranging from 4.4 to 6.2 percent, the FT says. The problem with using this rate is that we have been in a five-year period of zero-interest rate policy while the Federal Reserve has artificially suppressed interest rates to promote financial stability and spur economic growth.
If we look back over the last 54 years in the Fred chart above, we see that Aaa and Baa corporate bond rates have had higher yields than what Moody’s is using. The historical corporate bond rate is in fact much closer to the rate used by government actuaries. The fact is that using any suppressed bond yield in an easy money period will make future projections unreasonable.