Practical analysis for investment professionals
01 April 2014

The Public Pension Funding Gap: Highlights from the Future of Finance Forum

Retirement security is a key area of focus for the Future of Finance initiative at CFA institute, and on 18 March 2014, we hosted “The US Public Pension Funding Crisis,” an online forum featuring a panel of experts with varied backgrounds and perspectives, to examine the size and scope of the public pension funding gap, debate its causes, and to consider potential solutions.

Andrew G. Biggs, resident scholar at the American Enterprise Institute; Keith Brainard, research director for the National Association of State Retirement Administrators (NASRA); Hank H. Kim, executive director and counsel for the National Conference on Public Employee Retirement Systems (NCPERS); Robert Novy-Marx, associate professor of finance at the Simon Business School, University of Rochester; Ronald J. Ryan, CFA, CEO and founder of Ryan ALM; David A. Stella, president of Pension Management Advisors; and M. Barton Waring, retired global chief investment officer for investment strategy and policy at Barclays Global Investors, engaged in a spirited exchange of ideas over the course of the day.

It’s estimated that more than 20 million Americans participate in public pension plans and, conservatively measured, aggregate unfunded liabilities exceed $4 trillion. Unsustainable pension costs have pushed several municipalities into bankruptcy in recent years and, despite the fact that the US economic recovery is well into its fifth year, the fiscal condition of many states and cities remains dire. Public pension obligations are not the sole reason for the financial woes, but they often are a significant contributing factor, as demonstrated by the Detroit bankruptcy case. With the retirement security of millions at stake, it’s a critically important topic for pensioners, taxpayers, and investors.

The Size of the Pension Gap

While our panel agreed that there is a funding shortfall, opinions diverged as to the size and seriousness of that gap. For panelists who feel we’ve reached “crisis” stage, Governmental Accounting Standards Board (GASB) rules that mask the true size of plan liabilities are to blame. GASB calls for plans to discount projected benefits at the expected return on plan assets due to “the integrated nature of the promise to pay pensions and the accumulation of assets dedicated to the payment of those benefits in a pension plan.” Discounting liabilities at average rates of approximately 8% put the funding gap at close to $1 trillion, manageable in the eyes of Brainard, Kim, and Stella, each of whom represents the interests of public funds.

Biggs, Novy-Marx, Ryan, and Waring each pointed out that the GASB valuation methodology is unique to public pension funds. In Waring’s words, “Only in pension finance do practitioners want to discount low-risk situations at high discount rates. Only in pension finance. Nowhere else.” Indeed, standard financial theory dictates that cash flow streams should be discounted at a rate that is reflective of their risk. Given the near certainty of public pension payments, it follows that the appropriate discount rate is the risk-free rate. Discounting accrued benefits at public pension plans at such a rate yields a $4 trillion shortfall and a funding ratio of approximately 40%.

Brainard, Kim, and Stella dismissed the financial theory at issue as inapplicable, arguing that because states and cities essentially exist in perpetuity (a contention that, as Waring noted, is belied by the bankruptcies of Detroit and other cities), their time horizon is infinite and funding gaps will disappear over time. The GASB compliant funding levels of 70% to 80%, they said, are no cause for alarm. Waring took exception, asking, “Since when is being only funded 70% or 80% on the accrued liability an OK thing?”

The Causes of the Pension Crisis

In a recent CFA Institute poll of more than 1,000 financial professionals, a plurality, 45%, pointed to overly generous benefits as the primary cause of the public pension crisis. Poor plan management was cited by 25%, and flawed accounting standards by just 11%. It would seem that the public plans have a bit of a public relations problem. As evidence, Biggs shared with the panel examples of how public sector plan benefits trump those in the private sector. However, the panelists who subscribe to classic economic theory attributed the crisis to GASB’s lax accounting rules. Ryan put it bluntly, “The true problem stems from inappropriate accounting rules which misled and misvalued public pensions into inappropriate asset allocation, benefit and contribution decisions.”

Novy-Marx, whose paper, “Logical Implications of the GASB’s Methodology for Valuing Pension Liabilities,” made the absurd yet true observation that current accounting rules allow plans to improve their funding status by literally burning money because it increases the expected return on the remaining assets, which decreases the plan’s liability and more than offsets the loss of assets. Brainard called this notion “preposterous” and Novy-Marx agreed, saying, “That is exactly the point” He continued, “Why should we pay any attention to a valuation methodology the gives answers that are preposterous.”

Biggs noted that the University of Chicago’s Booth School of Business conducted a survey of professional economists on the discount rate question, and 98% agreed with the following statement: “By discounting pension liabilities at high interest rates under government accounting standards, many US state and local governments understate their pension liabilities and the costs of providing pensions to public-sector workers.” Brainard challenged the notion that economists had all the right answers, asking, “On what basis do economists contend that their view is somehow better qualified or more important than others, including those members of the accounting and actuarial professions? Waring answered that it was the markets that long ago settled the discount rate issue, not economists. He added, “Basically here’s the deal: if you use the expected return to discount your liabilities, all you are really doing is using a ‘trick’ to reduce your current contribution. This is not a safe way to run a major financial enterprise such as a pension plan.”

But why wouldn’t advocates for pension funds be in favor of conservative accounting methods as a means of protecting the benefits to be paid? Biggs seemed to have the answer. He said, “Because it would show that their plans are less well-funded than they appear, which would increase pressure to raise contributions. No one wants to do this: not employees, not elected officials, not taxpayers. So instead they contribute less, but take more investment risk in the hope that the bet pays off.” He’s not exaggerating when it comes to ramping up risk. Since 1980, funds have increased their equity allocation almost three-fold, to roughly 67%.

The Solution

To solve the funding shortfall, the call was made for increased transparency, adherence to reasonable actuarial assumptions, annual required contributions (ARC) to be paid in full, increased accountability, and managing portfolios to a “custom liability index.”

Novy-Marx predicted that the fix will require “a combination of higher taxes and less government services for a long time into the future.” Biggs agreed, saying, “It’s easy to promise a benefit, but much harder to pay for it. What you promised has to be reconciled with what you’re willing to pay. That’s not just a problem of accounting, but of human nature.”

While we didn’t solve the pension crisis, we did manage to highlight the different viewpoints in the marketplace, and we certainly demonstrated that CFA Institute and the financial profession has much work to do to help secure the retirements of our public sector employees. One forum commenter, having following the action, summed up the challenge by quoting Upton Sinclair:

“It is difficult to get a man to understand something, when his salary depends on his not understanding it.”

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

About the Author(s)
David Larrabee, CFA

David Larrabee, CFA, was director of member and corporate products at CFA Institute and served as the subject matter expert in portfolio management and equity investments. Previously, he spent two decades in the asset management industry as a portfolio manager and analyst. He holds a BA in economics from Colgate University and an MBA in finance from Fordham University. Topical Expertise: Equity Investments · Portfolio Management

5 thoughts on “The Public Pension Funding Gap: Highlights from the Future of Finance Forum”

  1. A great many people, some even in the accounting profession, are coming to the opposite conclusion – that pension funds are adequately funded, but that returns, and perhaps more importantly, projected returns, are being systematically undercounted. In fact GASB rule changes are making projected returns look smaller than they should, not larger (even Detroit’s emergency manage, Kevyn Orr, admitted as much by saying a 2014 GASB rule, which he implemented early in 2013, made projected deficits in the pension fund worse by $1.5 billion).
    Then too, there is undercounting of Bond returns, says Reuters, undercounting of future employee contributions based on future salary raises, projection of liabilities years, even decades out, without corresponding projections of revenues, etc.
    I document some of this, with considerable help form other experts, here:

  2. Chris Tobe says:

    I think these discussions just scratch the surface. As a public pension trustee for a $14 billion plan which is now 23% funded I have lived much of this. In my book “Kentucky Fried Pensions” I point to another element ignored here which is the ramp up in hedge funds and private equity, which in my opinion is fueled by pay to play from politicians. Chris Tobe, CFA

  3. Doug says:

    Wait, let me understand this: First, Waring, Biggs, Novy-Marx, and crew say that a “risk free” rate should be used because of the certainty of payment of public pension payments. Yet, when proponents of the current discount method say that risk free rate financial theory doesn’t apply because the pension funds have a long term horizon (in perpertuity) Waring points to Detroit and other bankrupt cities and says -not so.

    Hmm–seems Waring, Biggs and crew have to abandon their risk free argument if they also want to argue that public entities can shed those pension obligations via bankruptcy.

  4. larrabeecfa says:


    Thanks for visiting our blog and sharing your thoughts. I don’t believe any of the panelists, including Barton Waring, argued, or even suggested, that it would be appropriate for public entities to shed pension obligations via bankruptcy. Their argument for the risk-free rate was primarily based on the certainty associated with those pension obligations. More than anything else, I think they are seeking greater transparency and sound financial planning on the part of state and city governments.


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