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Public Pension Promises: How Big Are They and What Are
They Worth?*
Robert Novy-Marx
University of Chicago Booth School of Business and NBER
Joshua D. Rauh
Kellogg School of Management and NBER
December 18, 2009
Abstract
We calculate two present value measures of already-promised state pension liabilities using
discount rates that reflect the risk of the payments from a taxpayer perspective under different conditions.
If benefits have the same default and recovery characteristics as general obligation debt, liabilities across
all 50 states amount to $3.21 trillion. This calculation probably understates the liability, because pension
promises typically have higher priority than state municipal debt. Using zero-coupon Treasury yields,
which are default-free but contain other priced risks that may not be relevant for pension liabilities, total
liabilities are $5.20 trillion. Liabilities are even larger under broader concepts that account for projected
salary growth and future service.
* Novy-Marx: (773) 834-7123, rnm@ChicagoBooth.edu. Rauh: (847) 491-4462, joshua-rauh@kellogg.northwestern.edu. We
thank Jeffrey Brown, Jeremy Gold, Deborah Lucas, Olivia Mitchell, Eduard Ponds, James Poterba, and Steve Zeldes for helpful
discussions and comments. We also thank seminar participants at the National Tax Association Conference on Attaining Fiscal
Sustainability (September 2008), Wharton Department of Risk and Insurance, the Netspar Pension Workshop (January 2009), the
MIT Bradley Public Economics seminar, the Society of Actuaries Public Pension Finance Symposium (May 2009), the June
2009 ICPM Discussion Forum, and the Western Finance Association Meetings (San Diego 2009). We are grateful to Adam
Friedlan and Jerry Chao for research assistance. We thank the Global Association of Risk Professionals (GARP) Risk
Management Research Program, Netspar, and the Chicago Booth Initiative on Global Markets (IGM) for financial support.
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Government accounting rules currently obscure the magnitude of public pension liabilities in the
United States. In particular, Government Accounting Standards Board (GASB) ruling 25 and Actuarial
Standards of Practice (ASOP) item 27 stipulate that public pension liabilities are to be discounted at the
expected rate of return on pension assets. This procedure creates a major potential bias in the
measurement of public pension liabilities. Discounting liabilities at an expected rate of return on the
assets in the plan runs counter to the entire logic of financial economics: financial streams of payment
should be discounted at a rate that reflects their risk (Modigliani and Miller (1958)), and in particular their
covariance with priced risks (Treynor (1961), Sharpe (1964), Lintner (1965)). This paper evaluates the
economic magnitude of state public pension liabilities by applying financial valuation to the pension
liabilities of U.S. states, using appropriate discount rates.
From a unique database on 116 state government pension plans built from government reports,
we compile information on defined benefit (DB) assets and liabilities as reported by state governments.
We then model the prospective stream of payments from state pension promises using each state’s stated
liability, discount rate, and actuarial cost method, as well as information on benefit formulas, the numbers
and average wages of state employees by age and service, salary growth assumptions by age, mortality
assumptions, cost of living adjustments (COLAs), and separation (job leaving) probabilities by age. We
discount these payments at rates that reflect their risk from the perspective of taxpayers.
We begin by focusing only on payments that have already been promised and accrued. In other
words, even if the pension plans could be completely frozen, states would still contractually owe these
benefits. This quantity is known as an Accumulated Benefit Obligation (ABO) or termination liability.
The ABO is not affected by uncertainty about future wages and service, as the cash flows associated with
the ABO are based completely on information known today: plan benefit formulas, current salaries and
current years of service.
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As we explain later, different states use different methods to calculate accrued
liabilities. Our model of prospective payments allows us to calculate the ABO for each state.
We first calculate a measure of the taxpayer obligation represented by these accumulated state
pension liabilities under the assumption that accrued state pension benefits have the same priority as state
general obligation (GO) debt. This assumption implies a discount rate for each payment equal to the
state’s own zero-coupon bond yield corrected for the tax preference on municipal debt (which we call the
“taxable muni rate”). Under this measure, public pension liabilities are $3.21 trillion, which is larger than
the $2.98 trillion obtained by summing the unadjusted liabilities from state government reports. The
harmonization of the liabilities to the ABO method actually reduces the liability slightly, since most states
use a slightly broader measure, but the application of the appropriate discount rates raises liabilities.
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One source of uncertainty that might affect the ABO is inflation. We discuss this effect in Section V.
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This $3.21 trillion calculation recognizes the possibility that plan participants, including those
already retired and receiving benefits, may not receive the full amount of promised benefits in the future.
From the perspective of the taxpayer, assuming that pension liabilities are as risky as state GO debt
credits states for their ability to default on pension promises. The use of the taxable muni rate for
discounting assumes that these pension defaults would happen in the same states of the world as muni
defaults, and that beneficiaries would eventually receive payments proportional to the recovery rates
enjoyed by the municipal bond investors.
Crediting state governments by reducing pension liabilities based on GO default premiums
probably leads to an understatement of the liability to the taxpayer. Most importantly, state constitutions
generally offer protections to benefits that go above and beyond protections to state GO debt (Brown and
Wilcox (2009)). The higher priority accorded to public pension cash flows suggests that they should be
discounted at rates lower than the state GO bond yield. In most states, a pension default is less likely than
a GO debt default. Even if states were to default on pension promises, the law suggests that the pension
obligations should have a higher recovery rate than GO debt. Somewhat offsetting this is the possibility
that states might receive a bailout from the federal government for these pension promises, in which case
taxpayers of a given state might view the pension liabilities as less certain. However, because our focus is
on an aggregate liability calculation across 50 states, this issue would affect the distribution of liabilities
across states but not the total liability to all US taxpayers.
The second main measure we present is a measure that attempts to view the liability as default
free. Given the protections that state constitutions provide to accrued public pension promises,
beneficiaries face a negligible probability of default on benefits they have already earned. Thus, using
some type of default-free yield curve would be appropriate to measure the liability if we were doing so
from the perspective of beneficiaries. If taxpayers are the ultimate underwriters of the default-free
promise, then this calculation also values the liability from their perspective. The approximation we use
for the default-free curve is the Treasury zero-coupon yield curve. Under the Treasury-discounting
measure of liabilities, total liabilities are $5.20 trillion.
There are important caveats about using the Treasury yield curve as a measure of risk in a
default-free pension liability. Although the Treasury yield curve is generally viewed as default-free, it
reflects other risks that may not be present in the pension liability. State employee pensions typically
contain COLAs. If inflation risk is priced (Fisher (1975), Barro (1976), Benninga and Protopapadakis
(1985)), then an appropriate default-free pension discount rate would involve a downward adjustment of
nominal yields to remove the inflation risk premium. This adjustment would further increase the present
value of ABO liabilities. However, a countervailing factor is the fact that Treasuries trade at a premium
due to their liquidity (Woodford (1990), Duffie and Singleton (1997), Longstaff (2004), Krishnamurthy
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and Vissing-Jorgensen (2008)). Pension obligations are nowhere near as liquid as Treasuries. Therefore a
liquidity price premium should ideally be removed from Treasury rates before using them to discount
default-free but illiquid obligations. Given the lack of consensus over the relative size of the liquidity
price premium and inflation yield premium, we use unadjusted Treasury rates to calculate our default-free
liability measures. However, we note that due to these risks priced into the Treasury curve, default-free
public pension obligations are not equivalent to Treasuries.
States set aside assets in pension funds that are dedicated to providing the retirement benefit cash
flows associated with these liabilities. As of the end of 2008, the states had approximately $1.94 trillion in
assets in the plans we study. The difference between assets and liabilities is therefore $1.27 trillion under
taxable muni discounting and $3.26 trillion under Treasury discounting. In this paper, we do not address
the question of optimal funding levels, which is separate from the valuation question.
The calculations above use the ABO, a very narrow measure of liabilities in that it considers the
accrued liability to be only what is implied by current salary and years of service. In a typical plan, a
worker accrues the right to an annual benefit upon retirement that equals a flat percentage of his final (or
late-career) salary times his years of service with the employer. If salary increases with years of service
for a given worker, the worker’s ABO grows convexly with years of service. Thus, the ABO delays a
large share of recognized liabilities until late in the employee’s life. The newly accrued liability under the
ABO rises dramatically as a fraction of the worker’s salary as he approaches retirement.
There is substantial debate as to whether the ABO is the most meaningful liability measure or
whether more of the liability owing to future salary growth and years of service should be recognized up
front (Treynor (1976), Bulow (1982), Bodie (1990)). A broader measure than the ABO is the Projected
Benefit Obligation (PBO), which takes projected future salary increases into account in calculating
today’s liability, but not future years of service. An even broader concept is the Projected Value of
Benefits (PVB), which discounts a full projection of what current employees are expected to be owed if
their salary grows and they retire according to actuarial assumptions.
The fact that states cannot freeze pension accruals as easily as companies may argue for
considering a liability measure broader than the ABO in the state pension context. If states had no ability
to limit future pension accruals, the ABO would seem to be an excessively narrow measure. However,
Bulow (1982) explains that the broader measures only make sense if the implicit labor contracts involve
overpaying old workers at the expense of young ones. If labor markets are competitive, there should be no
misalignments between the marginal product of labor and total compensation.
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Furthermore, Bulow (1982) argues that even if labor markets fail to be competitive, there could be other implicit
contract liabilities that are larger when the PBO is smaller. If that is the case then the PBO is not a good measure of
the employer’s total implicit contract liability.
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The actuarial methods used by states are not classified as ABO or PBO. Most states report
accrued actuarial liabilities under the so-called Entry Age Normal (EAN) method, in which new service
liabilities accrue as a fixed percentage of a given worker’s salary throughout his or her career. The EAN
is therefore a measure between the PBO and the PVB. Finally, approximately 15% of liabilities are
calculated using the so-called Projected Unit Credit (PUC) method, which is typically implemented to
yield a PBO.
To calculate our main numbers, we implement calibrations to translate the stated EAN or PUC
liability measures into an ABO for each state pension plan. In addition to the ABO measures, we also
calculate the present value of PBO, EAN, and PVB liabilities. These broader measures have the additional
complication that their evolution depends on the path of future government wages, which may be
correlated with pricing factors, such as stock market returns, over long horizons. If this is the case, the
streams of payments in the broader liability measures (at least those above and beyond the ABO) should
be discounted at higher rates to reflect this systematic risk. Acknowledging that government wages and
the stock market may be correlated at long horizons that are not observed, we see little evidence of this
sort of correlation in the data. However, in order to be conservative, we calculate the broader measures
under discount rates that reflect high correlations between government worker salaries and the stock
market.
We emphasize that considerations about the accrual method affect only the liability for active
workers, whom we calculate are responsible for only around one-third of the total liability. The rest of the
liability comes from retired and separated workers. The accrual standards differ only in their treatment of
uncertainty about future wages and years of service. Therefore, for annuitants (i.e., retirees) and former
employees entitled to future benefits, the liabilities are the same under the different actuarial standards.
Our valuation methodology uses the entire yield curve. It does not rely on a single average
measure of public pension liability duration. It can therefore handle tilts to the yield curve as well as
parallel shifts in yield. Our model of the stream of promised pension payments nonetheless lends new
insight into the duration and convexity of state public pension liabilities overall and of their constituent
components (active, separated, and retired workers). Measurements of the duration and convexity of the
liabilities facilitate understanding the impact of changes in market-based rates on the present value of
liabilities. The effective average duration over the range of discount rates we consider is roughly 15 years,
which is similar to the durations typically assumed for public pension liabilities (Barclays Global
Investors (2004), Waring (2004a, 2004b)). However, our analysis shows that there is a great deal of
convexity in the promised pension payments, as well as large differences in duration between liabilities
posed by active, separated and retired workers.
