The Big Three and Underfunded Pensions

The Big Three auto companies are back in Washington this week, asking Congress for more money to keep themselves afloat — and, of course, to keep their employees employed and their retirees able to draw pension benefits.

The Times reported last week on the state of the automakers’ pension plans. In a nutshell: not as bad as might be expected but, given the recent market meltdown and the companies’ lack of new contributions, potentially headed for big trouble.

A dependable pension is surely one of the great benefits of longtime employment for a company like an auto manufacturer, or for a municipal or state government.

But according to new research by Robert Novy-Marx and Joshua D. Rauh, state pension plans may be in even worse shape than the automakers’:

The value of pension promises already made by U.S. state governments will grow to approximately $7.9 trillion in 15 years. We study investment strategies of state pension plans and estimate the distribution of future funding outcomes. We conservatively predict a 50 percent chance of aggregate underfunding greater than $750 billion and a 25 percent chance of at least $1.75 trillion (in 2005 dollars). Adjusting for risk, the true intergenerational transfer is substantially larger. Insuring both taxpayers against funding deficits and plan participants against benefit reductions would cost almost $2 trillion today, even though governments portray state pensions as almost fully funded.

Here’s more detail from the N.B.E.R. Digest:

The extent to which public pensions are underfunded has been obscured by governmental accounting rules, which allow pension liabilities to be discounted at expected rates of return on pension assets … Novy-Marx and Rauh collected data on the largest defined benefit (DB) pension funds sponsored by U.S. state governments. …

They studied all plans with more than $1 billion of assets. There were 112 such plans at the end of 2005. …

States back pensions with stocks, bonds, cash, private equity, real estate, and hedge fund exposure. But the typical investment strategies, in conjunction with accounting rules, make the pension funding situation look much better than it actually is. Under the government accounting logic, states always could eliminate their underfunding, no matter how large, simply by investing in sufficiently risky assets. In fact, investing in riskier assets may raise expected returns, but it also increases the probability of a severe underfunding. Under current investment strategies and a standard equity premium of 6.5 percent, there is a two-thirds chance that state pension plans will realize a shortfall in 15 years. The expected conditional shortfall is almost $1.5 trillion in 2005 dollars.

Under any plausible discounting assumptions that reflect the true present value of state pension promises, the underfunding in state pension plans is larger than the total magnitude of outstanding state bonds.

This is plainly bad news — except, perhaps, for the Big Three automakers. As Congress beats them up again for their high labor costs and executive salaries, for their lack of innovation and swollen marketing budgets, the automakers can at least show off that, relative to state governments, their pensions are in pretty good shape — and plead that this fiscal prudence should be rewarded with further investment by the U.S. government.