Low balling projected rates of return on public pension plans is a sure-fire way for critics to paint a needlessly dire picture of US cities and states collapsing under the weight of their promises to police, fire fighters and teachers.
The reality is not so ominous. Applying indefensibly low rates of return to pensions over the next 30 years is a political exercise, not an actuarial one.
When the Hoover Institution, Stanford University’s conservative think-tank, recently pegged the pension funding gap at a headline-grabbing $3.4tn, hardly anyone focused on the underlying assumption that portfolios would grow at an average of 2.66 per cent for decades.
That rate is based on current 30-year Treasury yields.
The estimate is flawed because pension funds are not Treasury bonds. They are diversified investment pools that are professionally managed over 25 years, 30 years, or more.
These pension funds invest in equities, property, corporate bonds and other investments with returns that historically far exceed government bond yields. They use modern risk management tools to reduce volatility and preserve principal.
The investment-return projections that pension funds use are not plucked from thin air. They are developed by actuaries and investment professionals who specialise in pensions and they are ratified by trustees.
The estimates are based on past and present experience, careful projections of future returns, and the specific circumstances of individual state and municipal pension plans.
Actuaries and investment professionals have independently arrived at an average annualised rate of return of 7.62 per cent on pension assets over 30 years, well within the realistic range. The average is the result of rigorous analysis that is free of bias.
That cannot be said of the lowball estimates used by those with an anti-pension bias. These estimates err by imposing a theoretical market price on future pension obligations.
Paul Angelo, senior vice-president at Segal, the actuarial consultancy, has demonstrated that the market-value approach, used by the authors of the Hoover study, is inconsistent with the nature and purpose of a public pension plan, which essentially is a permanent entity that operates over decades.
By contrast, the Hoover approach measures the market value of a pension plan, reflecting the immediate cost of shutting it down. But pension plans are not for sale, and neither they nor their sponsoring governments are going out of business.
Mr Angelo, with most other public pension actuaries, believes the appropriate measure is one that reflects not a current, spot market price, but rather the long-term experience and horizon in which public pensions actually operate.
We cannot be surprised that the view from the aftermath of a financial crisis tends to be clouded by pessimism, but experience counsels more optimism.
The National Association of State Retirement Administrators recently noted that public pension funds beat their assumed rates of return over the past 25 years, notwithstanding three economic recessions and four years when their investment returns were negative.
Most states and municipalities are solidly on track with their pension funding, but a few have significantly underfunded public pensions. They broke their promises to make timely payments to pension funds — even though workers made their payments on time — and there will be a cost for that decision.
Constantly fiddling with the numbers, as opponents seem intent upon doing, is a tactic designed to make the real issue of pension underfunding seem impossibly large and unsolvable. It is neither.
We can start by having those few state and municipal governments that have not contributed fully or regularly meet their funding obligations on time and without exception.
States and municipalities can help pension plan managers do their jobs by meeting quarterly and annual funding obligations. Pension managers, in turn, will fine tune their strategies as new information becomes available, as they have always done. And that information will be actual, verifiable performance data, not politically driven estimates.
Hank Kim is executive director of the US National Conference on Public Employee Retirement Systems