Novy-Marx, an Assistant Professor of Finance at the Simon Graduate School of Business at the University of Rochester, and Joshua Rauh, Associate Professor with the Kellogg School of Management at Northwestern University, released a paper entitled “The Revenue Demands of Public Employee Pension Promises” in June. The paper served as the centerpiece for a New York Times story on June 22nd.
The two have previously co-authored similar studies that inaccurately portray the true condition of public pension plans in order to make draconian predictions concerning these plans’ sustainability. For example, in 2010, they released “The Crisis in Local Government Pensions in the United States” and “Are State Public Pensions Sustainable?” In an earlier critique of this work, Keith Brainard writes that they “vastly underestimate projected future contributions to public pension plans and expected investment returns to draw dramatic and improbable conclusions regarding the solvency of these plans.”
In their latest collaboration, they purport to calculate the increases in state and local revenues required to achieve full funding of public pension systems over the next 30 years. They conclude that “Without policy changes, contributions to these systems would have to immediately increase by a factor of 2.5, reaching 14.2% of the total own-revenue generated by state and local governments (taxes, fees and charges).” Put another way, they claim that this would represent a tax increase of $1,398 per U.S. household per year, above and beyond revenue generated by expected economic growth.
Furthermore, in thirteen states, their paper – and an accompanying graphic in the New York Times – finds that these tax increases would be more than $1,500 per household per year. In five states, they claim the increases would be more than $2,000 per household per year.
They conclude that “substantial revenue increases or spending cuts are required to pay for pension promises to public employees, even if pension promises are frozen at today’s levels.” Furthermore, they also state that “A significant finding of our analysis is that the GASB rules significantly undervalues the cost of providing DB plans to state workers, as the true present value of new benefit accruals averages 12-14 percent of payroll more than the costs recognized under GASB.”
However, upon careful examination of their work, it becomes clear that their paper is based upon a number of seriously flawed assumptions. The following are several problems that Mr. Brainard has identified with their paper:
- It discounts liabilities on a risk-free basis;
- assumes future economic (GDP) growth of 1.99 percent, well below the nation’s average rate of GDP growth over the last 60 years and the Federal Reserve’s long-run estimate of 2.5 to 28 percent;
- assumes pension fund real investment returns of 1.7 percent, well below historic norms;
- assumes that non-Social Security employees will join Social Security, and that employers (taxpayers) will pay the full (12.4%) cost;
- discounts or fails to incorporate higher employee contributions implemented in 17 states since last year;
- does not account for reductions in future benefits, particularly COLAs, affecting existing plan participants;
- ignores the 20 percent of state and local revenue that comes from shared programs with the Federal government and the significant revenues that come from other non-tax sources, such as tuition and fees; and it
- implies that pensions must be fully-funded
