Are state pensions underfunded? And if so, what should we do about it?
Tyler Cowen read Dean Baker's take on state pensions and says he prefers Josh Barro's more alarmed assessment. I read Barro's piece and was surprised to find that it agreed, in many respects, with Baker's piece, though the two articles had different emphases and different prescriptions.
In particular, they agree that the central question afflicting pension plans is the returns they'll see in coming years. Barro argues that the commonly quoted figures "understate the cost of benefits to be paid in the future by counting on high investment returns that may not materialize," while Baker argues that the gigantic shortfalls that some observers are now estimating are overstated and that pension funds can "reasonably assume" returns in the 7 percent range. It's worth noting that before the financial crisis, Baker was trying to sound the alarm about pension funds using overly rosy estimations of future returns, so it's difficult to accuse him of being overly bullish. That said, read David Leonhardt making the case for more pessimism on future returns.
The major disagreement comes over the question of what to do next. Barro argues that existing pension promises should be honored. "Short of defaulting on these debts," he writes, "the only way states can eliminate unfunded pension liabilities is to fund them." But going forward, he'd like to see states move to 401(k)-style programs, as that protects taxpayers from having to shell out more cash during economic downturns. Under the current system, he says, "state governments are long in the stock market on taxpayers’ behalf."
Baker strongly disagrees. He argues that the point of an actor such as the state, at least when it comes to pension policy, is that it has a long time horizon and so can ignore cyclical ups and downs in the stock market. "In principle," he writes, "state and local governments will exist into perpetuity, so a period in which the market is depressed need not be of great consequence." Add in, as Teresa Ghilarducci does, that "401(k) management and investment fees are three times higher" than traditional pension plans and "professionals who manage money in pooled pension funds usually get higher returns than workers who manage their own 401(k) accounts," and it's hard to argue that defined benefit plans should be done away with for states, though it's not hard to argue that they should be funded honestly and based on realistic projections for eventual returns. Felix Salmon agrees.
But the bottom line is that the correct questions to ask about pension plans are: 1) Are they estimating a realistic rate of return going forward? 2) If so, are they sufficiently funded? And 3) If not, what should be done? I think there's less disagreement about the underlying nature of the problem here than some people might think. The disagreements, rather, are about the country's likely economic performance going forward (as that will ultimately decide returns) and what our state pension system should look like in general.
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