Biggs: Public Employee Pensions: Do Long Time Horizons Allow for Low, Stable Contributions?

ABSTRACT:

State and local government employee pension plans fund guaranteed retirement benefit using portfolios of risky assets. Plan sponsors value stable contribution rates and attempt to mitigate volatility of contribution rates using policies including smoothing of investment returns and long amortization periods for unfunded liabilities. These policies, combined with the assumption that investment returns stabilize over the long term, seemingly allow plans to offer generous, guaranteed benefits to participants funded by low, stable contributions from employers. But in many cases, plan stakeholders take this conclusion as an article of faith rather than the result of quantitative analysis. I employ a simple model of financing for a mature pension to analyze how market risk and stabilization policies interact to affect annual required contributions. The model shows that stabilization policies can reduce volatility of employer contributions over the short term. But long-term fluctuations in investment earnings ultimately express themselves in contribution rates that may vary significantly from a deterministic calculation based upon the assumption of constant returns. A plan employing typical smoothing policies has a very low probability of becoming insolvent, so long as it makes required contributions at all times. However, plans could expect that, at least once over a 100-year period, required employer contributions would exceed ten times the baseline rate. If a plan is economically unable or politically unwilling to make any and all contributions as required, then insolvency of the fund becomes a possibility.

 

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