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Contents : The Liabilities and Risks of State-Sponsored Pension Plans Robert Novy-Marx and Joshua D. Rauh Robert Novy-Marx is Assistant Professor of Finance Booth School of Business University of Chicago Chicago Illinois. Joshua D. Rauh is Associate Professor of Finance Kellogg School of Management Northwestern University Evanston Illinois. Novy-Marx and Rauh are also Faculty Research Fellows National Bureau of Economic Research Cambridge Massachusetts. Their e-mail addresses are rnm@ChicagoBooth.edu and joshuarauh@kellogg.northwestern.edu respectively. 1 Most U.S. state governments offer their employees defined benefit pension plans. This arrangement contrasts with the defined contribution plans that now prevail outside the public sector such as 401(k) or 403(b) plans in which employees save for their own retirement and manage their own investments. In a defined benefit pension plan the employer promises the employee an annual payment that begins when the employee retires where the annual payment depends on the employee s age tenure and late-career salary. When a state government promises a future payment to a worker it creates a financial liability for its taxpayers. When the worker retires the state must make the benefit payments. To prepare for this states typically contribute to and manage their own pension funds pools of money dedicated to providing retirement benefits to state employees. If these pools do not have sufficient funds when the worker retires then the states will have to raise taxes or cut spending at that time or default on their obligations to retired employees. As of December 2008 state governments had approximately $1.94 trillion set aside in pension funds. How does the value of these assets compare to the present value of states pension liabilities Just as future Social Security and Medicare liabilities do not appear in the headline numbers of the U.S. federal debt the financial liability from underfunded public pensions does not appear in the headline numbers of state debt. Government pension accounting should ideally provide citizens and government officials with a sense of how indebted taxpayers are to state employees. If pensions are underfunded then the gap between pension assets and liabilities is off-balance-sheet government debt. We show that government accounting standards require states to use procedures that severely understate their liabilities. States project the payments they owe to retirees but in calculating how much those payments are worth today the states use discount rates that are unreasonably high. In particular government accounting standards require them to discount their liabilities at the expected return on their assets. This approach is analytically misguided as the magnitude of pension liabilities should be viewed as independent of how a pension's funds are invested. In practice these standards set up a false equivalence between pension payments which are extremely likely to be made and the much less certain outcome of a risky investment portfolio. We begin this article by discussing the true economic funding of state public pension plans. Using market-based discount rates that reflect the risk profile of the pension liabilities we calculate that the present value of the already-promised pension liabilities of the 50 U.S. states amount to $5.17 trillion assuming that states cannot default on pension benefits that workers have already earned. Net of the $1.94 trillion in assets these pensions are underfunded by $3.23 trillion. This pension debt dwarfs the states publicly traded debt of $0.94 trillion. We show that even before the market collapse of 2008 the system was economically severely underfunded even though public actuarial reports presented the plans funding status in a more favorable light. While we take no stand regarding the optimal amount of state government debt we do believe it is important to point out that total state debt with pension liabilities included is actually almost 4.5 times the value of outstanding state bonds. A related question is whether taxpayers should be concerned about the fact that state pension funds are invested in risky assets. Under current pension fund investment policy there is a wide distribution of possible future funding outcomes. The outcomes are skewed in such a way that there is a small probability of an extremely good outcome and a large probability of poor outcomes. There are theoretically plausible reasons why taxpayers might not care. We are skeptical however that the necessary conditions for the irrelevance of state pension fund 2 investment policy hold. Regardless we provide the distribution of outcomes so that taxpayers can decide for themselves whether the state is taking an acceptable level of risk on their behalf. It is important to emphasize that state defined benefit pension plans and individual defined contribution pension plans have diff

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