Are pensions underfunded?

Education Sector's Chad Aldeman has posted the results of a thought experiment he ran trying to prove that states' assumptions about 8 percent returns on their pension portfolios are not overly optimistic. He seems convinced that states are being conservative in assuming 8 percent returns; I'm not so sure. I don't think it's wise to brush aside the results of academics in finance and accounting in favor of a simplistic analysis that misses some key factors.

First, the mantra of investment professionals is: past performance is no guarantee of future returns. In order to determine whether pensions are adequately funded, we need to understand how markets will perform going forward. This is tough to do reliably ? if Chad or I knew the answer, we wouldn't be working at think-tanks. Many academics are fretting about whether American capital markets will continue to outperform other countries going forward, however.* Second, the 1926-present time period used in Ed Sector's analysis? includes the post-WW2 boom years, which are unlikely ever to be repeated. Third, pension funds look nothing like the balanced portfolio Chad uses in his analysis. In particular, they are heavily weighted in the direction of private capital investments that behave very differently from public markets.

The most important question is whether defined-benefit pensions are good for teachers at all, though. We know that politicians are prone to skip pension contributions to fill other holes in state and local budgets. Illinois has provided us a perfect example of this flaw in public pensions over the years. As I mentioned last week, pensions as currently structured also take a big bite out of total compensation that could be converted to salary or savings for taxpayers. This would help attract better young teachers and keep high performers. Finally, it makes little sense to have states run the risk that a down year in the markets will blow a big hole in their budgets. At the end of the day teachers, not politicians, should have control over how their retirement wealth is managed.

Update: Chad points out in an update to his post that Education Sector has made recommendations along the lines of my last paragraph above in the past, including their report Better Benefits.

?Chris Tessone

* One of the seminal papers on this is "Global Stock Markets in the Twentieth Century" by Philippe Jorion and William Goetzmann in the Journal of Finance.

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