Monday, March 1, 2010

New working paper: An Options Pricing Method for Calculating the Market Price of Public Sector Pension Liabilities

This is more pension-related than Social Security, but I have a new working paper for AEI titled "An Options Pricing Method for Calculating the Market Price of Public Sector Pension Liabilities." Here's the abstract:

State and local public sector employee pensions are widely known to be underfunded, but pension financial reports do not reveal the true extent of funding shortfalls. Pension accounting methods assume that plan investments can earn high returns without taking any account of the market risk involved. This gives a false sense of the financial strength of public sector pensions and understates risks to taxpayers.

This paper first uses a Monte Carlo simulation of current pension assets and projected market returns to calculate the probability that public sector pension assets will be sufficient to fund accrued benefits. The typical public sector pension has only a 16 percent probability of paying full accrued benefits with assets on hand. A larger number of public pension plans have zero probability of paying accrued benefits than have a probability in excess of 50 percent.

But since accrued pension benefits are legally and constitutionally protected, any pension funding shortfalls must be met by taxpayers. This benefit guarantee amounts to an effective put option on plan investments, the cost of which is not disclosed under current actuarial accounting.

This paper uses an options pricing method to calculate the market value of taxpayer guarantees underlying public sector pensions. The average funding ratio declines from 83 percent under actuarial accounting to 45 percent under this options pricing approach. The typical state has unfunded public pension liabilities three times larger than its explicit government debt. Public pension shortfalls equal an average of 27 percent of state gross domestic product, posing a significant fiscal challenge in coming years.

Accurate measures of public pension liabilities are important for policymakers, taxpayers, investors considering the economic environment in which to start or locate a business, and bond purchasers considering the risk premia appropriate to municipal government bonds that are in practice subordinate to public pension liabilities.

This work (slowly) grew out of earlier work on guarantees against market risk for Social Security personal accounts. The idea in both cases is that government guarantees should be priced the same way they would be in the market, since ultimate the risk of honoring these guarantees is passed off to taxpayers. (Here's a link to a paper on Social Security guarantees.) As this is a working paper that will likely be revised I'm happy to hear any comments.

Click here to view the full text of this working paper as an Adobe Acrobat PDF.

1 comment:

PappyG said...

I'm an embarrassed, "I'm entitled" senior, who for far too long has ignored the other side of my brain, which is screaming "who's obligated" if you're entitled. Government's assault on middle class America created a weapon of monetary destruction (WMD) with the singing of social security reform legislation in 1983, that took social security funding from a pay as you go taxing structure ($1 in - $1 out), to a pay in advance taxing scheme ($5 in - $4 out -save extra $ for now retiring 78 million boomers). 25 plus years later, and the SS taxing scheme has turned a 2.5 trillion dollar (that extra tax $ has grown) potential asset into a 2.5 trillion dollar liability, that will have to be paid again plus interest. That's financial water boarding, and my 15 grand children are entitled to something better than an "I'm entitled" grandpa, hiding behind the skirt of a Tokyo Rose PR campaign put forward by AARP. Working middle class Americans are the horse we all ride to our prosperity, and treating them like rented mules, will result in a society that, well acts like rented mules! To this end, a soon to be launched "community based" solution to the issues surrounding social security has been put forward, and If you have a problem being referred to as “I’m entitled”, or if you have an “I’m entitled” member of your family, then discover a way to shed that image at: