Public Pension Promises: A Little Broken or Very Broken?

Public pensions, on the whole, are not doing very well. But, just how bad are they doing? This important question is asked by State Budget Solutions, and their response is "extremely bad". In a recent report, they suggest that the funded status sits at 36% in stark contrast to what they note to be the published combined funded status, according to the filings by the pension plans, of 72.5%. That is one hell of a spread and a funded status of 36% is so low that it raises more than a few questions. Regarding the overall picture, State Budget Solutions states:

The overall picture for state pension unfunded liability is bleak. Many plans are still feeling the effects of the Great Recession, in terms of both lost investment returns and stagnant economic growth. As the economy struggles to get back on track, states' fiscal health also suffers, making it more difficult for state officials to make up for the shortfalls with greater contributions.

As bond yields have suffered due to interest rates being held at historic lows, the fair market valuation of public pension liabilities also took a hit. Part of the reason for the increase in unfunded liabilities is that the comparable bond yields caused us to lower the fair market discount rate from 3.255% to 2.734%. Had we applied last year's discount rate to this year's numbers, it would have still resulted in an increase of nearly $110 billion in unfunded liabilities.

From where I'm sitting, a fair market discount rate of 2.734% (or, 3.255% for that matter) seems oddly low given the typical portfolio of a pension fund. State Budget Solutions goes on to explain how they arrive at this value:

State Budget Solutions uses fair market valuation to determine the unfunded liabilities of public pension plans. Outside of the small world of public pensions, there is near-universal agreement that discount rates based on the assumed rate of investment return are far too risky. The approach SBS uses is to discount liabilities based on the approximate equivalent of a 15-year U.S. Treasury bond yield. This year's number is derived from the 2013 calendar year average of the 10 and 20 year bond yields.

Since pension payments to retired state employees are guaranteed, the discount rate should reflect that. The rate should reflect the type of liabilities, not the risk of the assets in play. This is why SBS uses fair market valuation.

I'm hard pressed to accept that a reasonable discount rate can be computed from the average rate of two treasuries over all of one year. Further, and what is ultimately the most puzzling, SBS is under the impression that the risk of the liabilities (mortality, morbidity, retirement rates, etc.) are somehow linked to a government bond yield in the first place.

What other assumptions do you think are erroneous in the author's report? Do you think using the 2013 average of 10 and 20 year bond yields is appropriate for discounting either the liabilities or assets? How would you look at the pension picture?