CEPR: Market Decline Is the Major Cause of Pension Funding Shortfalls

Dean Baker, co-director of Center for Economic and Policy Research (CEPR), defends his position in recent study he authors that finds reports of a public pension funding crisis are greatly exaggerated.


The reports of a public pension funding crisis are greatly exaggerated, according to “The Origins and Severity of the Public Pension Crisis,” released in February by the Center for Economic and Policy Research (CEPR).

The study argues that the 2007-2009 stock market decline caused most of the current funding gap. “If pension funds had earned returns just equal to the interest rate on 30-year Treasury bonds in the three years since 2007, their assets would be more than $850 billion greater than they are today,” the paper says. “This is by far the major cause of pension funding shortfalls. While there are certainly cases of pensions that had been underfunded even before the market plunge, prior years of under-funding is not the main reason that pensions face difficulties now.”

State and local governments’ total pension shortfall equals less than 0.2 percent of projected gross state product over the next 30 years for most states, the paper says. “I do not think there is anything resembling a crisis,” says Dean Baker, the study’s author and a CEPR co-director, in an interview. “We had extra falloff in the market in 2008 and 2009, much of which has been recovered.” A lot of the recent funding discussion has been misleading, he says, as opponents of defined benefit plans for public employees try to use the situation “to dismantle public pensions.”

There has been plenty of talk lately that a big part of the problem stems from public funds’ accounting rules, especially allowing them to discount their liabilities using an assumed rate of return on their assets. However, that approach “is the appropriate way to do it,” Baker says. “If you assume a risk-free rate, if you invest in equities and do better than that, in effect you have pre-funded pensions: You have the taxpayer pay more today so the taxpayer pays less later. But you generally want to distribute the tax burdens evenly over time.”

Did the market tumult hurt pension funds in part because they took on too much risk in an attempt to earn their assumed rates of return? Baker does not think so. Many of the funds he looked at had about a 60 percent equity allocation and 10 percent to 15 percent in private equity, he says, which he considers reasonable.

Baker sees no need for fundamental changes to most public pension plans. “You do have outliers like New Jersey and Illinois where there clearly are issues of underfunding. They will need additional contributions, and they may want to change the structures,” he says. “But most other states would be fine, basically, if there would not have been the market decline.”


But current public pension accounting standards “are just not in touch with reality,” believes Andrew Biggs, a resident scholar at the American Enterprise Institute for Public Policy Research. The problem is not so much that public pension officials set the assumed rate of return, he says—it is that they use the assumed rate of return on assets to discount liabilities in the first place. “The expected return on assets is not the rate they should use to discount their liabilities,” he says. “They need to use a discount rate that is based on the risk characteristics of the liabilities, not the assets they set aside to fund the liabilities. The value of the liabilities is independent of whatever plans they have in place to earn returns.”

The current accounting approach “ignores risk, and that is just dumb,” Biggs says. “To think that taking more risk makes you better funded is stupid.”