Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How Government Pension Funds Are Sitting on Billions in Unrealized Gains
Transcript
- Lucas: If you look at the annual report for CalPERS — California's public employee pension fund, which manages about five hundred billion dollars — you'd see they reported a twenty-one percent return for fiscal year 2024. Luna: Twenty-one percent? That's a great year. Lucas: It is — on paper. But here's the catch: CalPERS actually collected only about six percent of that in cash. The rest is what accountants call 'unrealized gains.' The money isn't there yet. It's an estimate based on what the assets could be worth if sold today. Luna: So they're reporting a return based on market value, not actual cash received? Lucas: Exactly. And this matters because pension funds don't just report returns for bragging rights. They use these numbers to decide how much money the state government needs to contribute. When the reported return is high, the required contribution from taxpayers goes down. But if that return is mostly paper gains, the cash doesn't actually show up in the fund. Luna: So taxpayers get a short-term break, but the risk grows underneath. Lucas: Right. And that's the core of the smoothing rule. Most public pension funds in the U.S. use something called 'asset smoothing' to reduce volatility. Instead of reporting the actual market return each year, they spread gains and losses over a period — typically three to five years. The idea is to avoid big swings in contribution requirements. Luna: Which sounds reasonable in theory. Don't want to spike taxes after a bad year. Lucas: Sure, but it also means that when markets eventually drop, the losses are smoothed in too — but they still have to be paid eventually. CalPERS uses a five-year smoothing period. So the twenty-one percent reported return for 2024 actually includes gains from 2020, 2021, and 2022, blended together. The actual cash return in 2024 was closer to six percent. Luna: Wait, so they're still including gains from three years ago? How does that work? Lucas: The smoothing formula takes the actual investment income from each of the last five years, adjusts for inflation, and averages them out. So if 2022 was a bad year, that drags down the average. But if 2021 was great, it boosts the average. The reported number ends up being a lagging indicator. Luna: And this is all legal? Standard accounting? Lucas: Yes — it's the standard under Governmental Accounting Standards Board rules, specifically GASB Statement Number 67. Every public pension fund in the U.S. uses some version of this. Private-sector pensions don't; they have to use market value. So the same pension, if it were corporate, would look very different. Luna: How different? Give me an example. Lucas: Take the New York State Common Retirement Fund. In 2023, they reported a five-year smoothed return of about seven percent. But their actual one-year market return was negative two percent. That gap means the state government contributed less than it should have, based on real performance. The difference accumulates. Luna: And that accumulation is essentially deferred liability — future taxpayers will have to make up the shortfall. Lucas: Exactly. According to a 2025 report from the American Legislative Exchange Council, state pension funds are underfunded by about one point three trillion dollars total. Smoothing doesn't create that gap, but it can obscure it. Luna: So when does the smoothing end? I mean, if we have a prolonged bear market... Lucas: That's the fear. If the market drops and stays down for a couple of years, the smoothed return will eventually catch up to the losses. But by then, the fund has been spending based on the smoothed, higher number — paying out benefits, assuming contributions are adequate. Then suddenly the required contribution spikes, and taxpayers have to cover it. Luna: It's like a credit card with a low minimum payment. Feels manageable until the balance comes due. Lucas: Exactly. And there's another layer: pension funds assume an expected rate of return, usually around seven percent. That's the target they need to hit to keep the fund solvent. If smoothing hides shortfalls, they might keep assuming seven percent even when actual returns are lower. Luna: So the smoothing rule allows them to avoid adjusting that assumption downward? Lucas: In practice, yes. CalPERS, for instance, lowered its assumed return from seven point five percent to seven percent in 2024 — but that was after years of pressure. Some critics say they should have done it sooner. If they had, the required contributions would have been higher, and the current underfunding might be smaller. Luna: So who benefits from smoothing? Politicians, I assume, because they can keep contributions lower. Lucas: That's the political economy. Elected officials don't want to raise taxes or cut services to fund pensions. Smoothing gives them cover. It's not intentional deception — the rules are public — but the complexity makes it easy to ignore. Luna: And the losers are future taxpayers and public employees who might see their benefits cut if the fund runs short. Lucas: Right. And public employees don't have much control over the fund's investment strategy or accounting. Their pensions are governed by boards that often include political appointees. Luna: Is there any push to change GASB rules? Lucas: There is. In 2024, the Governmental Accounting Standards Board proposed a revision to Statement 67 that would require more disclosure of the difference between smoothed and market returns. But it's still under discussion. The main opposition comes from state and local governments who argue that full market-value accounting would cause too much volatility in their budgets. Luna: Which is exactly the argument smoothing proponents make. Lucas: Exactly. And it's not unreasonable — a year of bad markets shouldn't force a city to lay off teachers. But the trade-off is that smoothing masks the true funding status. Luna: So what's the fix? More transparency? Lucas: I think the most practical step is to require pension funds to report both numbers prominently: the smoothed return and the actual one-year market return. Some already do, but it's buried in the notes. If every annual report had a clear line saying 'We earned X percent in cash this year, but we're reporting Y percent because of smoothing,' it would be much harder to ignore. Luna: That seems like a low-cost reform. Lucas: It is. And a few states like Utah and Wisconsin already do something close to that. They still use smoothing for contribution calculations, but they highlight the market return in their public-facing summaries. It's a step toward accountability. Luna: It's interesting — we spend so much time on tax policy and spending, but the accounting rules that determine what governments owe are just as important. Lucas: Absolutely. And they're less visible, which is why we cover them. Speaking of which, a quick honest thing — a handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what funds making this many of these. Luna: Yeah, no ads, no sponsors — just people who find value in understanding how public money actually works. Lucas: If walking through the economy with us has made something click, that's the place. And now back to pension smoothing — one more point I want to make. Luna: Go ahead. Lucas: There's a specific risk that smoothing amplifies during a market downturn: if funds smooth losses over five years, they might continue paying benefits based on the smoothed value, drawing down cash reserves. That can force a liquidity crunch. Luna: So they're selling assets at bad prices to meet obligations? Lucas: Potentially. If the fund needs cash to pay retirees and the smoothed return says they have enough, they might not adjust their asset allocation in time. Some smaller funds had this problem during the 2022 downturn, though the big ones like CalPERS have enough liquidity to manage. Luna: So smoothing isn't just an accounting gimmick — it has real cash flow implications. Lucas: Exactly. And that's why I think it's worth watching. The next time we have a sustained bear market, the smoothing rule will suddenly be in the spotlight, and taxpayers will bear the cost of decisions made years earlier. Luna: Well, hopefully by then more people will understand how it works. Lucas: That's the goal.