Context From The Talk

Unfunded Pensions

A pension is a promise to pay an employee a certain pre-specified amount. It's like a bond. To measure the cost of delivering on that promise, we have to consider interest rates on very safe bonds. You can ask any insurance company that sells annuities. If you ask an insurance company to go and tell you what is price, or what is the cost of providing someone with a lifetime annuity, they will do it. In fact, if you like the pensions the public employees have and you want one for yourself, you can go do it. You can buy it at an insurance company, which is a private sector institution that can give you that guaranteed income stream. 

It doesn't matter to the insurance company whether their assets are invested in equity, private equity, hedge funds, whatever. The pensions have to be paid no matter what. It's not like a 401K. In a 401K, if I invest in equity in my 401K, if the stock market crashes or doesn't do well, then I can just scale back my spending on my own stuff. If the state invests in private equity, real estate, hedge funds, stocks, in these portfolios, and it doesn't do well, who has to pick up the tab? All you guys. You're the ones to pick up the tab. I don't know if you knew it, but you are writing, personally writing trillions of dollars of insurance that the stock market won't go down. You're doing it on behalf of your state and local government, so thank you for volunteering to do that. I think your officials should tell you that, but they're not telling you you're doing that. They're saying, "Based on history, historical stock market returns, if we get this again, then we might be okay."

The way that insurance companies price these annuities is they would use a Treasury yield of 2.77%. This is for 2015. That's the average Treasury yield for a bond that has the same rough maturity as the average maturity of these pension promises. That's not a forecast of what they will earn in their pension funds. They might earn more. They might earn less, but the only way that they can target a return of more than a Treasury bond yield is to take on risk. In finance, you learn the only appropriate rate to use is a risk-free rate. What I find--here's where the $3.8 trillion number comes back again--it turns out that there are also, when you've calculated correctly, $3.8 trillion in hidden debt to public employees. To put it another way, the conclusion of the work that I've done is that the public debt at the state and local government level was twice the magnitude that they claim that is, if you only look at bonds.

Joshua D. Rauh, 2017 Hoover Institution Summer Policy Boot Camp