Should Public Retirement Plans be Fully Funded?

Henning Bohn

NBER Working Paper No. 16409
Issued in September 2010
NBER Program(s):   PE

Most state and local retirement plans strive for full funding, at least by actuarial standards. Funding measured at market values fluctuates and often falls short. A common argument for full funding is that pensions are a form of deferred compensation that does not justify a debt. The paper examines public finance, political economy, and financial market issues that bear on optimal funding, broadly and in a series of models.

In a model where most taxpayers hold debt and face intermediation costs, returns on pension assets are less than taxpayers’ cost of borrowing. Pension funding is costly and hence zero funding is optimal. The model also implies that unfunded pension promises are properly discounted at a rate strictly greater than the government’s borrowing rate. If pension funds serve as collateral, funding can be warranted despite the cost. This is shown in a model with legal ambiguity and default risk. Except in special cases, the optimal funding ratio is less than full funding.

Published: Journal of Pension Economics and Finance (2011), 10: 195-219 Cambridge University Press 2011

You may purchase this paper on-line in .pdf format from SSRN.com ($5) for electronic delivery.

Acknowledgments

Machine-readable bibliographic record - MARC, RIS, BibTeX