Since the Great Recession in 2008, warnings of an impending pension crisis have been splashed across the business pages of newspapers across the country. Despite these boisterous decrees, America’s public pension funds are stable. We explore the roots behind the false pension crisis narrative and examine the facts.
Public pension plans have existed for more than a hundred years. Beginning in the late 19th century, cities and states started offering defined benefit pensions to ensure their employees would be able to retire with dignity. Especially from the employer’s perspective, traditional pensions also facilitate an orderly transition out of the workforce, allowing older workers to retire and younger workers to gain positions of leadership and responsibility. This system has worked well for teachers, firefighters, nurses, librarians, government office clerks, and other public employees in cities and states across the nation.
Although nearly every public pension fund took a hit to its investments during the 2008 financial crisis, so did individual investors with 401(k)s and IRAs. The losses during the financial crisis affected some public pension funds more severely than others, but the majority of public pension funds are recovering well from the recession. Recent strong returns have benefited the Oklahoma Teachers Retirement System and the Virginia Retirement System, to give just two examples. In a recent survey, NCPERS found that the average funding level for public pension plans is 76 percent.
You may have heard, however, that there is a “pension crisis.” Critics of traditional pensions peddle a false, “sky-is-falling” narrative based on questionable and misleading numbers. Some of these critics are simply hostile to public employees. Others have a financial interest in converting defined benefit pensions to 401(k)-style, defined contribution plans.
Unfortunately for promoters of the pension crisis narrative, they have been proven wrong at every turn. One of the most outspoken proponents of the pension crisis narrative is Stanford professor Joshua Rauh. Back in 2010, Rauh famously, and wrongly, predicted that several states would “exhaust” their public pension funds within ten years and run out of money. Not a single state has reached “pension exhaustion”, despite Rauh’s prediction.
Why was Rauh so incredibly wrong in his predictions? Because he is the chief promoter of public pension plans using what he calls a “risk-free” discount rate. What does that mean? Public pension funds earn the majority of their revenue, sometimes as much as three-fourths, from returns on their investments. However, since pension benefits are paid out over a long timespan, the people who manage pensions need to estimate what return they will achieve on their investments over the course of twenty or thirty years. To do this, they calculate what is called a discount rate. The people who manage pension funds are constantly evaluating and adjusting the discount rate based on the performance of the financial markets. At one time, the average discount rate was close to 8 percent. Recently though public pension plans have been lowering their discount rates and the average is now around 7.5 percent.
Joshua Rauh, however, thinks pension funds should use the “risk-free” rate of U.S. Treasury bonds, which currently is around 2.5 percent. If pension funds invested all their assets in Treasury bonds, they would basically be saying they do not plan to earn any returns on their investments. At that point, it would become a pay-as-you-go system, where benefits are paid out of the general fund with no investment for the future. Another effect of using a “risk-free” discount rate would be to dramatically increase the amount of money required by public employees and state and local governments to contribute to the pension fund, since the fund would no longer be earning any investment returns, the source of the majority of its revenue. Using a “risk-free” discount rate would undermine the very nature of defined benefit pension plans and, as a result, would dramatically increase costs for both public employees and taxpayers. This would certainly create the very pension crisis Rauh is so keen to warn about.
The so-called pension crisis is a myth promoted by people who are either hostile to public employees, have a financial interest in moving from pensions to 401(k)s, or both. All of the evidence indicates that the claims of these doomsayers are untrue and most of their predictions have been proven wrong. The real pension crisis in the United States is the lack of pensions by most working people. Many Americans are at risk of falling behind their standard of living in retirement. The move away from pensions to 401(k)s has made this worse, not better. Next week we will examine another false claim peddled by those pushing the pension crisis narrative.