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Now that Wisconsin Gov. Scott Walker has signed a bill eliminating collective bargaining for most public-sector workers in that state, the political spotlight is shifting back to the issue that first provoked the conflict: the cost to taxpayers of public pensions.
Rep. Devin Nunes (R-CA) provided a new focal point for the discussion when he introduced the Public Employee Pension Transparency Act. This measure would require state and local governments to report certain information about their pension plans to the U.S. Treasury once a year, including how they expect to eliminate any current unfunded liability in their plans.
They would calculate that liability in two ways: using the actuarial assumption they currently use, which is usually discounted based on the expected long-term rate of return on plan investments; and again using a “risk-free” discount rate using U.S. Treasury bond yields. Any state or local government that failed to submit these reports would lose their right to issue tax-exempt bonds, potentially damaging the market for state and municipal debt.
The Nunes bill, which is supported by some leading House Republicans including Budget Committee chair Paul Ryan of Wisconsin, was also endorsed last month by Moody's Investor Services. It would “provide new incentives to state and local governments to take action to ensure public-employee pension plans' long-term viability,” the rating agency said in a statement.
Both supporters and critics of the Nunes bill agree it would have a significant impact on investors in public-sector bonds and on public pension funds themselves as investors. But they disagree sharply on what that impact would be. Proponents say using a “risk-free” rate of return as the discount rate for pension obligations yields a truer – and quote sobering – picture of their funded status. It would also bring much-needed attention to the investment policies of public-sector pension funds, which critics say have tended to chase returns in recent years in order to make up for funding shortfalls.
Opponents say a discount rate based on Treasury bonds is inappropriate for public pensions, distorting the picture of their funded status by tying employer contributions to volatile, unrelated shifts in interest rates. This would make a manageable set of problems look much less soluble, presenting state and lawmakers with two equally problematic alternatives: either to contribute much larger amounts to the pension plans, possibly resulting in overfunding; or to phase out the plans altogether. Critics of the Nunes bill also defend public funds' investment strategies, which they say have not been to chase returns but rather to seek long-term balance by creating more diversified portfolios.
Public pensions currently have some $2.8 trillion in assets, which by their own calculations gives them about $700 billion less than they need to cover liabilities over the next three decades. The current discussion about the discount rate began with a paper published in Fall 2009 by two academics, Joshua D. Rauh of Northwestern University's Kellogg School of Finance and Robert Novy-Marx of Booth School of Business at University of Chicago. They argued that the current discount rate used by public plan sponsors was much too conservative, and that in reality the plans' unfunded liability was much larger – as high as $3.23 trillion.
Deciding who's theory to rely on could make a huge difference for taxpayers. State and local governments currently devote an average 3.8 percent of their annual operating budgets to pension funding, according to a study the Center for Budget and Policy Priorities. That includes a small number – New Jersey, Pennsylvania, and Illinois most prominently – that had let extremely large shortfalls develop. To close a $700 billion liability gap over 30 years, public employees would have to contribute 5 percent to pensions, which the CBPP estimates would not be unduly burdensome once the economy has recovered. If the gap was more than four times that large, according to a study by the Center for Retirement Research at Boston College, the requirement could rise to 9%.
Who's right? In an argument that formed the basis of thinking in the Nunes bill, Rauh and Novy-Marx contended that only a risk-free discount rate – one based on Treasury bond yields – is appropriate to public pensions, because their liabilities consist of guaranteed payments to retired workers. Currently, most public plans use a discount rate based on an assumed long-term investment return of about 8% on the plan's assets. That is not appropriate, Rauh and Novy-Marx argued, since those returns come from risky investments that do not match the variability and timing of the plans' liabilities.