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By James Kwak

This is the biggest story of the week. Or the year. Frightening.

I’ve been wondering why the impact of the financial crisis on the overall retirement “system” hasn’t gotten more attention in the media. We already knew the system was in bad shape before September 2008. According to the Fed’s Survey of Consumer Finances, in 2007, only 60.9% of households where the head of household was age 55-64 had retirement accounts . . . and their median retirement balance was $98,000. Given that the stock market has fallen by over 50% from its October 2007 peak - and that, for decades, the standard investment advice has been that stocks do better than any other asset class in the long term - we would be lucky if that median balance were more than $70,000 today.

The Bloomberg article linked to above describes the fragile state of state and local pension systems. These systems suffer from two major problems today. One is that even if they had been managed in a reasonable way, the fall in asset prices over the last year would have blown a huge hole in their long-term solvency.

The second, and the focus of the article, is the perverse behavior that is caused by accounting rules governing pension funds. The key question for a pension fund is whether the assets it has today will be enough to pay off its future liabilities. The assets are relatively easy to value, at least most of the time; the future liabilities are relatively easy to predict actuarially (although unanticipated developments, such as a sudden change in life expectancy, could mess up that calculation); but the hard part is estimating the rate of return on the assets. So . . . public pension funds are allowed to assess their long-term solvency using assumed annual rates of return, generally around 8% per year. Of course, as we know, things don’t always work out that way: the Vanguard Balanced Index Fund (which indexes virtually all U.S. stocks and bonds) has an average annual rate of return of 0.9% over the last 10 years, and even since its inception in 1992 its annual return is only 6.0%.

These optimistic assumptions are bad enough, because they allow underfunding of pensions. But what’s even more bizarre is the behavior this causes. As the Bloomberg article explains, local governments issue pension obligation bonds to raise cash for their pension funds. These bonds usually pay fixed interest rates, say 6%, and the proceeds are then invested in risky assets. But the magical thing is that because you are allowed to assume an 8% return, for pension accounting purposes, the difference between 8% and 6% is free money! Well, it’s free money as far as this year’s assessment of the pension is concerned. In the long term, of course, it’s a crazy investment strategy (and a mistake many people make - comparing a risk-free interest rate you borrow money at with a risky expected rate you hope to earn). And the results in the future are predictable: either higher taxes, or yet more value-destroying pension obligation bonds. Sometimes people get caught saying stupid things, like Christine Whitman saying, “You’d be crazy not to have done this. It’s not a gimmick. This is an ongoing benefit to taxpayers,” but it’s really a systemic problem.

Our retirement “system” has four main legs: Medicare, Social Security, corporate or government defined-benefit pensions, and private saving (IRAs, 401(k)s, etc.). Right now it looks like Medicare and Social Security are the stronger legs.

Note: The Bloomberg article refers disapprovingly to Jon Corzine’s proposal to reduce state pension contributions during the recession. I actually agree with Corzine, at least on principle. When the pension fund’s assets fall because of a recession, you don’t want to force the state to make up the difference immediately, because that would be extremely procyclical - it would cripple the state budget right when you want to be spending more, not less. The converse, of course, is that when the economy is good and tax revenues are high you should over-contribute to the pension fund - not just make up for the recession years, but also build up a surplus. We’ll see if that happens.

Source: Pensions: The Biggest Story of the Week - Or the Year