Word Matching the “Deadly Sins”: #3

In this article, I’ll reveal the third of the seven “sins” introduced in “Word Matching the ‘Deadly Sins’ – #1”. In case you missed the first two articles, we’re matching items from the columns in the diagram below. Each match adds more clarity to a message that our government’s finances are in far worse shape than people think they are.


The discussion here covers the third topic – pension fund accounting. But before I get to accounting and disclose my word match answer, let’s take a quick look at competing views about our economic future. I’ll show how these views affect pension funds in just a moment.

Boom turns to gloom

In the asset bubbles of the last two decades, optimists had a monopoly on big picture economic themes. Remember the “new era economy” of the Internet boom? The Great Moderation? The surge of global liquidity that was believed to bring lasting prosperity?

We still hear upbeat stories today, such as the revival in the energy industry and potential revival in housing. But their scope is limited. When it comes to major themes about America’s future, pessimists have the upper hand. Here are just a few of their gloomy ideas:

  • The service-based economy is an unproductive economy. Services contribute an ever-rising portion of our annual output while manufacturers contribute less and less. At one time, pundits lauded these changes. Service-based economies are at the top of the food chain, the optimists said, and they’re less prone to booms and busts than goods-producing economies. On the other hand, evidence suggests that the critical ingredient for economic advancement – rising productivity – is nearly absent from key service sectors such as education, health care and finance. With the economy increasingly tilted toward these relatively stagnant sectors, long-term growth is in decline. (See this book by Tyler Cowen, this ZeroHedge post and this paper by Robert Gordon, for example.)
  • The secular rise in commodity prices imposes a speed limit on most economies. This is another example of a bullish case turned bearish. Rampant growth in the world’s emerging markets was once held out as a sign of strength for the global economy. Now, people are asking whether there’s enough stuff to go around. Stuff, in this context, is oil, iron ore, wheat, potash, rare earth elements, and so on. For key below-ground commodities, cheap sources of supply are dwindling and forcing extraction costs higher. Above the ground, agricultural production is held back by slowly diminishing amounts of arable land. These pressures seem to push commodity prices up whenever the global economy gathers steam, helping to snuff out the advance and weaken the long-term growth trend.
  • High government debt means slow growth. Although we’re still burdened with political leaders and pundits who downplay the risks of large government deficits, more sensible perspectives are gaining traction. Researchers like Carmen Reinhart and Kenneth Rogoff are making it difficult to ignore ample evidence that we’ll eventually pay a steep price for excessive government borrowing. (See here and here, for example.) And regardless of how we choose to resolve the problem, part of the resolution will be slower growth.
  • The digital revolution isn’t quite as transforming as electricity and indoor plumbing. Experts on innovation are telling us to look at the last thirty or so years of changes in our lives and compare them to the transformations of days past. They’re not denying that advances are occurring, just questioning the economic impact. I-gadgets are nice to have, they argue, but they don’t measure up to the tremendous innovations that occurred from, say, the mid-19th century through to about the 1970s. And if they’re right, the effects will be seen in (once again) diminishing productivity and growth.
  • The rentier (and retiree) face rough times ahead. Liberal economists once called for policies to lower capital investment returns and squeeze out the rentier – those who live off their wealth. And their wish seems to have come true. Short-term deposits no longer offer any return at all, while monetary policy holds down yields on all fixed income securities. Stock yields have also been pushed lower by Fed policymakers, who acknowledge that propping up stocks is now a key objective. But the collateral damage is more, well, damaging than the old-time economists envisioned. Today’s middle class depends heavily on their investments to fund retirement. And zero interest rates and quantitative easing have shattered standard retirement planning methods, with the implication that our growing numbers of retirees face a difficult future.

All of these themes are relevant to the government financial projections discussed in other articles in this series. But their relevance isn’t recognized by government analysts any more than they recognize the risk of unexpected events. For example: Alongside warnings that productivity could be in decline, the Congressional Budget Office (CBO) projects the economy forward with the exact productivity growth that’s been observed in the past. If we experience any decline at all, debt will rise faster than projected and possibly much faster.

The 8% Solution

But let’s leave the CBO alone for a moment and turn to government pension calculations. For states and municipalities, gaping pension shortfalls may be our greatest challenge. And they’re affected by each of the themes above.

The key connection between our economic future and pension liabilities lies in the actuarial assumptions for investment return, which have a massive effect on pension valuation.  This is an inverse effect, meaning that pension liabilities rise when expected returns fall, and visa-versa.  Which might make you say: “Okay, I get it, expected returns have dropped and that explains our pension deficits, right?”

Well, not exactly.

Yes, market yields are at levels that would have been unfathomable just a few years ago.  But have a look at this chart comparing actual market yields to the median investment return assumption in a database of over a hundred state and local government pension plans:


If this article were a print version of The Daily Show, I’d cue up the full repertoire of Jon Stewart’s expressions of confusion. The chart makes you wonder if the people who set return assumptions answer all questions with “8%.”

“Hi, how are you today?”
“Oh, I’m about 8%.”
“What’s the capital of North Dakota?”

The 8% fixation is troubling because even a small reduction in this assumption can significantly increase reported liabilities.

Boston College’s retirement specialists recently tested such a reduction, based on a methodological change recommended in the Government Accounting Standards Board’s (GASB) Statement No. 68, approved in June of last year. Although the new methodology only changes the assumed investment return for a small portion of the pension liability, Boston College estimates that unfunded liabilities would increase by about 30%. And together with another new GASB standard with a similar-sized effect, the aggregate 2010 funded ratio of 76% would be 57% under the new accounting guidelines. Put differently (subtracting both figures from 100%), the funding gap would rise from 24% to 43% – a near doubling in unfunded liabilities.

Clearly, our pension predicament would look much worse if those who set the assumptions acknowledged that the world sometimes changes. Or, the issue may have less to do with acknowledgement than with individual incentives, recognizing that actuarial assumptions can be highly politicized. In either case, I’ll take my word selection from Sigmund Freud and match pension fund accounting to denial.


Check back tomorrow for word match topic #4: Entitlement program accounting.

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