Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / The Trillion Dollar Question Behind Public Pension Funds
Transcript
- Lucas: Luna, quick question. If I promise you a hundred dollars a year from now, how much is that promise worth to you today? Luna: Depends on interest rates. If I can get five percent on a savings account, then maybe ninety-five dollars. Lucas: Exactly. And that's the logic behind how public pension funds value their future obligations. But here's the thing — a lot of them are using a rate that's closer to seven percent, and that single number is quietly reshaping state budgets across the country. Luna: Seven percent seems optimistic, especially in a world where ten-year Treasuries are yielding around four. Lucas: Right. And before we go deeper — and I say this because it's genuinely honest — this show exists because a small group of listeners chips in monthly through buy me a coffee dot com slash fexingo. No ads, no sponsors, just listener support. If you've gotten something out of these episodes, that's what keeps it going. Luna: Yeah, it's a pretty simple model. And it means we get to follow these numbers wherever they lead, without worrying about a sponsor's feelings. Lucas: Exactly. So let's follow this one. The assumed rate of return — what a pension fund thinks it'll earn on its investments — is the single most consequential assumption in public finance. Move it half a percentage point and you're talking about billions in contributions, either from taxpayers or from future retirees. Luna: So what's the standard number they use? Lucas: For decades, the median public pension fund assumed seven percent or higher. CalPERS, the big California fund, was at seven and a quarter for a long time. And the logic isn't crazy — they hold a mix of stocks, bonds, real estate, private equity, and they've historically earned around seven percent over long periods. The problem is the gap between the assumption and what's actually happened recently. Luna: And that gap is what creates the shortfall. Lucas: Right. If a fund assumes seven percent but only gets six, it's already short. And because these promises are guaranteed — or nearly so — the state has to make up the difference. That means higher contributions, which means less money for roads, schools, or tax cuts. It's a direct transfer from other budget priorities to cover pension returns that didn't show up. Luna: So how big is the total shortfall across all states? Lucas: Well, estimates vary, but it's in the trillions. If you use a more conservative rate — say, the risk-free rate — the unfunded liability balloons to something like four and a half trillion dollars. At the current assumed rates, it's more like one and a half trillion. So the number you pick changes the story completely. Luna: And who picks the number? The fund itself? Lucas: Usually the board, but they're under political pressure. Lowering the assumption means acknowledging a bigger shortfall, which means the state has to contribute more immediately. Politicians hate that. So there's a temptation to keep the number high, defer the pain, and hope the market delivers. Luna: Hope is not a strategy, as they say. Lucas: And some states have been burned. Illinois is the poster child. Their pension funds are around forty percent funded, and the state's credit rating has suffered for it. They've been making the contributions, but the hole is so deep that it's hard to climb out. Luna: Kentucky had a similar crisis a few years back. Their systems were among the worst funded in the country. Lucas: And what's interesting is that when Kentucky finally lowered its assumed rate from seven point five to six point two five, the reported shortfall jumped by billions overnight. Nobody's money actually changed, but the accounting reality caught up. It's like admitting you have a bigger credit card bill than you said. Luna: So the number isn't just a technical detail — it's a political decision. Lucas: Exactly. And there's a real debate about what the right number is. Some economists argue pension funds should use a risk-free rate, like the Treasury yield, because the benefits are guaranteed. Others say that's too conservative because the funds invest in risky assets and can expect a higher return. The math gets philosophical. Luna: But the practical effect is that a higher assumption lets states underfund today and leave the bill for later. Lucas: Right. And that's the core tension. If you lower the rate to something more realistic, you're asking today's taxpayers to pay for promises made decades ago. If you keep it high, you're betting that markets will bail you out. It's a generational fairness question wrapped in actuarial jargon. Luna: And the markets haven't exactly been cooperative this decade. We've had a pandemic crash, a bear market in 2022, and now we're in August 2026, with returns running below the seven percent assumption for many funds. Lucas: Exactly. And the trend is slowly moving down. Even CalPERS dropped its assumption to 6.8 percent a while back. But there are still funds out there assuming seven and a quarter. It's a slow-moving train. Luna: So what would happen if every fund suddenly switched to a realistic rate? Lucas: It would be a fiscal shock. States would have to come up with hundreds of billions in additional contributions over the next few years. That means either big tax increases or deep cuts to other services. Some cities have already been through that — Chicago's had to raise property taxes just to keep its pension funds afloat. Luna: So there's no easy answer. Lucas: No, but there is a growing consensus that the current approach isn't sustainable. And it's not just about the rate. It's about the structure of the promises themselves. Defined benefit plans give retirees a fixed payment, which is great for them, but the risk sits entirely with the government. Private sector has largely moved away from that. Luna: So the question is whether public pensions should follow. Lucas: Some places have tried. Alaska and Michigan moved new employees to defined contribution plans, like a 401. But that just shifts the risk to workers, and it doesn't fix the existing shortfall. The money's still owed. Luna: Seems like there's no way out without someone taking a hit. Lucas: That's the uncomfortable truth. But the longer we kick the can, the bigger the hit gets. The seven percent assumption is a bet that the stock market will keep delivering. And it might. But when it doesn't, the bill comes due — with interest. Luna: And that's why pension reform is such a hot potato in state politics. Lucas: It's the third rail. Touch it and you lose an election. But the numbers are what they are. As of this year, the average funding ratio for state pension funds is around seventy-three percent. That means for every dollar promised, there's only seventy-three cents in the bank. It's not a crisis today, but it's a slow bleed. Luna: Seventy-three percent. That's like a retirement account that's a quarter short. Lucas: Exactly. And the gap is concentrated in a few states. Illinois, New Jersey, Kentucky, Connecticut — they're all below sixty percent. Meanwhile, Wisconsin and South Dakota are above ninety-five. The difference often comes down to whether they've made their required contributions consistently and whether they've used realistic assumptions. Luna: So it's a choice, not an accident. Lucas: It is. And that's the takeaway. The seven percent assumption is a choice. It's not written in stone. And every year that states choose to keep it, they're making a bet that tomorrow's markets will be kinder than today's. Sometimes that works out. But when it doesn't, the next generation pays the price. Luna: And we're all that next generation, one way or another. Lucas: Yeah. So next time you hear about a pension crisis, remember it's not just about the stock market. It's about a single number that everyone chose to believe. And whether that belief is justified is the trillion-dollar question.