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The Agenda

NRO’s domestic-policy blog, by Reihan Salam.

The End of Retirement



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Joshua Rauh reminds readers that unfunded state and local pension fund liabilities are far larger than advertised by state and local governments:

Currently, standard practice measures the funding status of public pensions in the US under the laughable assumption that every dollar in the pension funds will earn compound returns of 7.75% or 8% per year. That’s the basis for the $1 trillion in unfunded liabilities.

But if a state or local government promises a risk-free pension, one that will be paid regardless of how the stock market performs, then that promise is like a government bond and should be measured accordingly. That’s the way pension promises are measured in most public or semi-public plans in countries like Canada and the Netherlands. In the Netherlands, for example, discount rates of 0-4% are used. Even US companies follow this basic principle that a pension is like a bond issued by the sponsor by treating their pension liabilities as corporate bonds for the purposes of their books.

Figure 5 of the study professor Krugman links to shows $3.8 trillion total liabilities at an 8% discount rate, but $6.2 trillion of total liabilities using a 4% discount rate. A 4% rate is much closer to long-term government yields, but still too high a rate given that the benefits are guaranteed and many of them are short-term. If unfunded liabilities are $1.0 trillion under an 8% rate, then they are $3.4 trillion unfunded under a 4% rate.

(See Allison Schrager for more.)

Leaving aside the difficult question of how state and local governments will meet their pension obligations, it is worth thinking through the implications of Rauh’s informed pessimism about the future of stock market returns:

And please, don’t give me that argument that the past returns of pension funds have been that high, so we can assume that their future returns will be as well. The 20th century in the US saw an unprecedented bull market in stocks, and was also accompanied by substantial inflation as well. Everyone knows that past returns are no guarantee of future performance. In contrast, state and local governments have guaranteed their pension promises — at least until they become insolvent and unable to pay.

And let’s also not pretend that stock market price ratios tell us that the future is rosy for the stock market, so that stock returns will somehow bail us out from all of this. The Shiller P/E ratio is 24.7. That is somewhere between the 80th to 90th percentile of the highest price-earnings valuations in history. Those levels were last seen in the mid 2000s, the mid 1990s, and the mid 1960s, times after which medium-term performance was at best modest and at worst poor. [Emphasis added]

Basically, Rauh is telling all of us — not just public sector employees – that the era of relatively easy above-inflation returns is probably over, which in turn means that the 20th century dream of a decades-long retirement is also kaput. This isn’t necessarily a bad thing, particularly since those who work longer tend to also live longer. But it is a sobering thought for those who’ve come to expect retirement in the early 60s as a kind of natural law. Suffice it to say, those who work the most strenuous, physically demanding, or demoralizing jobs will tend to exit the labor force earlier than those who do not, via disability benefits, etc. Yet fairness will demand that theirs will not be a lavishly-feathered nest. 



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