Joshua Rauh, a finance professor at Northwestern University, caused a big stir last year when he estimated that state and local governments faced a shortfall of $3 trillion in their pension plans. His calculations were based on figures as of July 2009, when stock prices were still close to their bear-market lows. So, one might think that things have improved since then, right?
Wrong, Rauh says in a new blog post. His new figure, which he calls a back-of-the-envelope calculation, is $4.4 trillion. Although the pension funds' assets have recovered, he says, their liabilities have grown even faster because of low interest rates.
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Rauh argues that pension liabilities should be valued using a risk-free interest rate, like the yield on U.S. Treasury bonds. The 10-year Treasury yielded 3.6 percent in mid-2009, and that has fallen to 1.99 percent today. State and local governments typically use a much higher discount rate, like 8 percent, making their official liability figures much smaller than Rauh's estimates.
The official accounting makes no sense, Rauh argues:
The basic economic rationale is clear: the appropriate discount rate for measuring liabilities depends on the risk of the cash flows being discounted. ... The only reason to use a discount rate higher than a default-free government bond yield is if one wants to reflect in the measurement the possibility that taxpayers might be able to default on these promises.
Even the official numbers, though, are scary. The Pew Center for the States looked at them earlier this year and computed a total shortfall of $1.26 trillion.