Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How the Government's Pension Math Hides Billions in Debt
Transcript
- Lucas: So, Luna, I've been digging into the California Public Employees' Retirement System — CalPERS — and I found a number that just stopped me cold. Luna: Which one? Because CalPERS has a lot of numbers floating around. Lucas: The official shortfall is something like two hundred billion dollars. But if you apply what most private pension plans would call a realistic discount rate — say, four percent instead of their assumed seven — that shortfall balloons to nearly five hundred billion. That's not a rounding error, that's a chasm. Luna: And honestly, if that little 'aha' moment made today's commute a bit more interesting, that's the kind of thing we love hearing. If you ever want to keep us going, the link is buy me a coffee dot com slash fexingo. No pressure, just a coffee's worth if it's been worth your time. Lucas: Exactly. It's the smallest ask, and it genuinely keeps this show ad-free. So, back to the chasm — because that gap between two hundred and five hundred billion isn't just a math trick. It's a policy choice, and it's made by every state and city that runs a pension fund. Luna: Right. And I imagine most people don't realize how much those assumptions can swing the numbers. Lucas: They don't. The discount rate is the interest rate used to calculate the present value of future pension promises. The higher the rate, the smaller the liability looks today. CalPERS assumes around seven percent annual returns. But the fund's actual returns over the last twenty years have averaged closer to six and a half percent — and that's with some pretty good bull markets in there. Luna: So they're betting on a future that hasn't shown up in the past. Lucas: Precisely. And it's not just CalPERS. The American Academy of Actuaries did a study a few years back showing that if every public plan used a more conservative four percent rate, the collective shortfall would go from roughly one and a half trillion to over four trillion dollars. That's the difference between a bad problem and a catastrophic one. Luna: But isn't there a reason they use a higher rate? I mean, public funds do have a longer time horizon and can take more risk. Lucas: That's the standard defense. And there's some truth to it. But the problem is, when you assume a higher return, you're effectively deferring costs. If the fund underperforms, the bill comes due later — usually to the next generation of taxpayers. Luna: And that's the hidden tax on growth we talked about in episode 167. Lucas: Exactly. But there's another trick that makes it even worse: smoothing. That's where the fund spreads gains and losses over several years instead of recognizing them immediately. It makes the funded ratio look stable, but it can mask a nasty trend. Luna: Give me a concrete example of that. Lucas: Sure. In 2008, CalPERS lost about twenty-seven percent of its value. But because of smoothing, the reported funded ratio barely moved for a couple of years. It wasn't until 2011 that the real damage showed up. By then, the legislature had already set contribution rates based on the rosier numbers. Luna: So smoothing lets politicians kick the can down the road without anyone noticing the road is actually a cliff. Lucas: Right. And it's not just California. Illinois is a poster child for this. Their pension funds have been underfunded for decades, and they've consistently used optimistic assumptions to keep contributions lower than they should be. Now they're paying the price with credit downgrades and a shrinking share of the budget going to basic services. Luna: But at some point, don't the markets force a reckoning? Like, if the fund actually earns only six percent for ten years, the math has to catch up. Lucas: It does, but slowly. And the danger is that by the time it catches up, the contribution increases are so steep that they crowd out everything else. Look at Chicago: their pension payments have tripled over the past decade, and they're still underfunded. That's money not going to schools, roads, or public safety. Luna: And that's the real cost — not just abstract debt, but the services we all rely on. Lucas: Yeah. And here's a twist: some states have actually moved to lower their discount rates. Colorado, for example, dropped theirs from seven and a half percent to seven percent a few years back. That's a step in the right direction, but it also means their contribution rates had to jump immediately, which creates political pain. Luna: So there's a real tension between honesty and affordability. Lucas: Exactly. But there's a way out, and it's not just raising taxes or cutting benefits. Some places are exploring pension obligation bonds — borrowing at a lower rate to invest in the fund. That's risky, but if done carefully, it can actually improve the funded ratio without slashing benefits. Luna: But isn't that just replacing one kind of debt with another? Lucas: It is, but the bet is that the fund's return will exceed the interest rate on the bonds. If it works, you're better off. If it doesn't, you're deeper in the hole. It's a gamble, and it's not for every state. Luna: I read that some states are also looking at shared-risk plans, like cash balance plans. Are those a viable middle ground? Lucas: They are. Cash balance plans are like a hybrid between a traditional pension and a 401. The employer promises a fixed return, like five percent, and the employee gets a lump sum when they leave. It's more predictable for the employer, and the employee still gets a defined benefit. A few states, like Nebraska, have adopted them for new hires, and they seem to be working. Luna: But the transition is the hard part, right? Because existing employees are already in the old system. Lucas: Right. And that's the political minefield. You can't just change the rules for people who've already earned their benefits — that's likely unconstitutional. So any reform only applies to new hires, which means the old system keeps bleeding for decades. Luna: So what's the one thing a listener should take away from this episode? Lucas: That the next time you hear 'our pension fund is only two hundred billion short,' you should ask what discount rate they're using. Because if it's seven percent, the real number is likely twice as big. And that's not just a math problem — it's a choice about who pays for the promises we've made. Luna: And whether that choice is fair to the teachers, firefighters, and nurses who are counting on that retirement income. Lucas: Exactly. It's not just about the numbers; it's about trust. Public employees are told their pension is safe, and if the assumptions are too rosy, that safety is an illusion. That's the real scandal, and it's happening in every state capitol. Luna: This has been a deep dive. Thanks for walking us through the discount rate and smoothing. Lucas: Anytime. And if you want to see the gap for your own state's pension fund, check out the 'Pension Tracker' from the Pew Charitable Trusts. It's eye-opening.