Category Archives: News

Low Volatility ETFs

The hip new financial product fangirled by every personal finance columnist on the internet is the low volatility ETF.  It is pretty much exactly what it sounds like – an ETF that, while tracking whichever index/industry/etc. it is supposed to, attempts to limit the variability of returns.  You can think of it as a stock with a low beta that moves with the trend of the market but not as severely in either direction during business cycle booms and busts.   Methodologies vary, but techniques are employed to limit the variance of individual holdings as well as the correlation between them.  I analyzed the performance of the PowerShares Low Volatility S&P 500 ETF (SPLV) to see how it stacks up against the market as a whole.

Over the past four years, the S&P500 had both a significantly higher maximum and lower minimum return compared to the PowerShares Low Volatility Index.  The S&P experienced many more extreme returns (+/- 1% daily return), suggesting that returns on SPLV fluctuate less than the market.  The S&P also earned a lower average return with higher variance than SPLV.

Period 5/6/11 to 1/6/15

S&P 500 SPLV
Max Daily Return 4.63% 3.75%
Min Daily Return -6.90% -5.18%
Returns less than -1% 98 62
Returns greater than 1% 110 71
Average Daily Return 0.04% 0.06%
Average Annual Return 0.99% 0.75%
Standard Deviation of Daily Return 10.98% 14.03%
Standard Deviation of Annual Return 15.71% 11.85%

The table below is the same analysis for only the year 2014, during which the US equity market posted more gains.

Year 2014

S&P 500 SPLV
Max Daily Return 2.37% 2.00%
Min Daily Return -2.31% -1.99%
Returns less than -1% 19 14
Returns greater than 1% 19 13
Average Daily Return 0.04% 0.06%
Average Annual Return 0.72% 0.60%
Standard Deviation of Daily Return 10.70% 15.80%
Standard Deviation of Annual Return 11.34% 9.55%

The claim that the PowerShares Low Volatility ETF (SPLV) tracks the S&P with less variability in returns  is corroborated by this simple analysis.  The graph of daily close prices and trading volume below also seems to corroborate this – the S&P500 Index (Yellow) fluctuates around the steady-ish path followed by SPLV (Blue).  The ETF misses out on some gains during the summer months, but outperforms later in the year.

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Interestingly, the fund achieves its low volatility by being overweight in Healthcare and Financials, not the quintessentially low-risk sectors like Telecom or Utilities.



Mortgage Market Update from Calculated Risk

Calculated Risk is a blog that basically aggregates and analyzes up-to-date financial and economic data as it is released, particularly that which applies to the housing market.  The number of economic and financial metrics that are available on the internet is useful in some contexts but often feels more like a confusing, frustrating glut of information that renders answering a pithy question like “What is the rate of foreclosures like in the current housing market relative to pre-crisis times?” difficult to answer.  Trying to get beyond this issue is where I’ve found Calculated Risk really useful – relevant date for a particular issue is laid out, cited, and analyzed clearly in an effective and timely fashion.

I was curious about the housing market after meeting a seemingly overzealous realtor on the train, and here’s what I found via calculated risk.


At the end of Q3 2014, the delinquency rate on 1 to 4 unit residential properties was 5.85% of all loans outstanding, down for the 6th consecutive quarter and the lowest rate since the end of 2007.  The delinquency rate does not include loans in foreclosure, though they as well are at their lowest rate since the 4th quarter of ’07 at just under 2.5%.  Though foreclosures have come down from the stratospheric levels reached during their peak in 2010, they’re still more common than they were before the crisis.  Mortgages that are 30 and 60 days past due, on the other hand, have returned to approximately pre-crisis levels.  

Evernote Camera Roll 20141116 042456

Mortgage Rates 

30-year fixed rate mortgage (FRM) rates are down 1 basis point (.01) from last week at 4.01%, roughly the same level as 2011 but lower than last year’s 4.46%.  Obviously there isn’t “one” mortgage rate – the rate we’re talking about here is the one that applies to the most creditworthy borrowers in the best scenario possibly to receive a loan from the bank.  Though all other mortgages are based on this rate, it’s not exactly a rate one should expect to be offered by a bank.

Evernote Camera Roll 20141116 043840

The relatively small difference between a mortgage quoted at 4.01% and 4.45% has a surprisingly large financial impact on the 30 year FRM.  A $250,000, 30-yr. FRM at a 4.01% nominal annual rate compounded monthly (as is typically the case) necessitates a monthly payment of $1,194.98, whereas the same mortgage at 4.45% would require a monthly payment of $1,259.30.  With the higher payment, the borrower pays an additional $23,155 in interest over the term of the mortgage.

Another post talks about subdued refinancing activity, which I’d guess is the result of relatively static mortgage rates as it’s generally only financially viable to refinance when rates have changed significantly.  Banks could also be offering fewer refinancing options after the crisis, a reasonable assumption given their cautious resumption of lending post-crisis and the role that refinancing options played in exacerbating the housing bubble.  I’m purely speculating, though, and I’ll look into this more later.

Residential Prices

A widespread slowdown in the rate of housing price increases has been steadily taking hold since February of this year.  Residential prices aren’t decreasing, they’re just rising at a slower and slower rate each month, and now sit 20% below their 2006 peak.  This is not to say we should expect or even wish that housing prices should resume at 2006 levels, as such was clearly unsustainable – furthermore, though slow relative to preceding months, the (annualized) 6%+ experienced last month is still pretty strong and obviously outpaces inflation.


Evernote Camera Roll 20141116 050031

Analysis of the U.S. Output Gap by EconBrowser

I mentioned in my previous post that low inflation means substantial output gaps persist in many advanced economies.  Econbrowser’s post analyzing of the U.S. output gap is worth a read; the downside risks borne from the composition of recent economic growth and unjustified inflation concerns are also addressed.

Recent Developments in the World Economy

The first part of the WEO, which gives a broad overview of what’s happened since the previous WEO released in April, is (very) briefly summarized in layman’s terms below.  A technical note: any mention of rates of growth (positive and negative) refers to the annualized rate of growth of output, or GDP, in an economy (GDP isn’t the only measure of output that exists but it is what’s used here).  You can think of output, or GDP, as a measure of aggregate economic activity.  We care about growth in GDP because it leads to more employment (to meet the needs of the expansion of economic activity), and, generally speaking, a higher standard of living.  You can read a more thorough discussion of GDP growth here.

Global growth in the first half of 2014 was lower than the April WEOs projection by 0.4%.  That was the general trend, but the story varies by country:


  • Brazil – Negative growth so far this year (two consecutive quarters, which technically qualifies as a recession) due primarily to a lack of investment and confidence
  • France – No growth in output, reflecting fiscal imbalances and declining competitiveness
  • Italy – Contraction of output, albeit small, for Q1 and Q2, high unemployment (youth unemployment is at its historical peak) issues stemming from tight financial conditions (basically no credit available and thus no investment either)
  • Russia – Lack of growth is, not surprisingly, a result of insufficient investment and confidence


  • China – Relatively strong growth in Q1 despite issues in credit and housing markets that Chinese officials successfully subdued (via lowering required reserves and credit easing aimed at small and mid-size firms) for higher growth in the subsequent quarter
  • India – Stronger growth is resuming after a protracted downturn thanks primarily to much-needed investment
  • United Kingdom – Relatively strong growth (‘strong’ in comparison to what was expected in recent years, but considerably less than growth in China in India in raw number), and a strengthening labor market due to increased business investment

Investment is, unsurprisingly, prevalent in healthy economies and positively related to confidence.  If you’re surprised investors are wary of putting money into Russian markets then you must have been under a rock while Russia invaded Ukraine, and if you’re surprised about Brazil, maybe you didn’t know that it’s run by a feckless imbecile who just (barely) survived reelection.  Just as lack of investment and confidence hampers growth, India proves that  investor-friendly reforms spur investment, and the U.K. has recovered almost completely from the crisis thanks to business investment.

Those were the extremes – the rest of the world falls somewhere in the middle.  The United States economy is strengthening, but expected growth has necessarily been revised downward to adjust for the surprising contraction in the first quarter, largely a reflection of temporary factors (harsh weather, inventory accumulation in Q4 ’13, decline in exports), that won’t affect the future much.  In Japan growth continues along weak yet stable path, as the country’s enormous level of public debt inhibits its ability to grow too much despite good signs elsewhere in the economy.  Output nearly stalled in the Euro area as (mostly periphery) countries struggle to emerge from the recession, while some are achieving modest growth (Spain and Germany mainly).

Inflation is below targets in advanced economies which means they’re operating below their potential; meanwhile, inflation in emerging markets hasn’t changed.  Monetary policy is easy/accomodative in advanced economies and will continue to be as the ECB is slated to implement new policies, including targeted credit easing, and the Fed has made clear that it will aim to keep rates low for some time despite having wrapped up its asset purchase program last month.  In response to the Fed’s plans, financial conditions have eased and long term interest rates have decreased a bit, compared to data in the April WEO.  Risk premiums are low and volatility is low in advanced economies, which has some worried that risk is underpriced – but more on risk and its implications in a separate post.

So the global rate of growth or inflation or any other metric doesn’t convey much useful information because conditions are anything but  uniform across countries.  The story of the recovery is and will remain fragmented, with different problems and strengths contributing to a given market’s recovery.  That being said, all economies can expect to adjust to a level of growth that pales in comparison to the growth of the early 2000s.  Potential output, which has been revised downwards for the past 3 years, is too low for the growth rates of old to materialize.  This is due to the legacy of the recession in advanced economies, but growth-limiting structural issues also plays a role in developing economies.  For more on that, directly from the IMF, watch the short video linked below.

Takeaways from the BLS jobs report

Ben Casselman at FiveThirtyEight provides a detailed breakdown of the BLS jobs report.  248,000 jobs were added in September, and figures for July and August were revised upward by almost 70,000.  These data are the talking points you’ll hear on the news, but they’re deficient measures of labor market health on their own.  Casselman delves into the BLS report to corroborate his stance that the report was, in fact, good news – something raw numbers of jobs added can’t do.  (Side note, why is the font on BLS reports so awful?  The color sucks too – it’s like a “my printer is almost out of ink” light grey.)  Anyway, the good:

1) The number of people who gave up on looking for work because they didn’t think any was available is down considerably – less than 700,000 in September, compared to over a million back in 2010.

2) Layoffs are at a 10 year low.

3) The (slight) majority of the unemployed either voluntarily quit their job or (re)started the job search

(1) and (3) show some confidence in the labor market. Fewer people think that a desirable job is totally unattainable given current labor market conditions, and more people are willing to voluntarily quit their jobs because they think better opportunities are out there.  These are good signs.  There are bad signs, too:

1) Many of the jobs added were in Retail, which tends to be low-paying.  More desirable sectors added relatively few jobs

2) There is still no wage growth

3) Lots of people are working part time only because they can’t find full-time employment

(1) is maybe expected, and stems from an issue that has been brewing in the U.S. economy for a while – structural unemployment.  The U.S. economy needs more people with the right skills in the right geographical areas before it can add a decent number of jobs in higher-paying sectors. (Many economists have echoed this train of thought, suggesting that structural unemployment is the driving force behind persistently high unemployment post-recession. One way to investigate this is to analyze the Beveridge Curve.)

(3) shows us that while employment has accelerated, many of those working are underemployed. (Part time workers generally don’t receive benefits – recent legislation, which you can read about here, is starting to change this, however.)  As the linked article explains, part of the increase in part-time employment could reflect better incentives for part-time work, not underemployment.  Nevertheless, while incentives could have driven the work decision of a portion of part-time workers, many indicated that the only reason they are working part-time is because full-time employment is unavailable – corroborating the underemployment suggestion.

(2) is an issue I wrote about in a previous post, and, I’d argue, the most important of the three.  There will not be sustainable growth until wages grow, and the <2% of the past year simply won’t cut it.  Furthermore, the lack of wage growth implies that there’s still plenty of slack in the labor market.

As a technical aside, below is what I mean by real wage growth, i.e. the wage growth that needs to occur before consumption can rebound and support a robust economy.  When we say real anything in economics, we mean inflation adjusted.  The real rate of wage growth is thus the inflation adjusted rate of growth of wages.  The raw, or nominal, rate of wage growth simply tells us by how much wages increased, ignoring the price level.  This is not all that useful, because wages affect consumption via the purchasing power of consumers – and if we don’t know what the inflation situation is like, we don’t know if consumers’ purchasing power increased, stayed the same, or decreased.

You could easily look up real wage growth (i.e. inflation adjusted wage growth), but for the sake of completeness here is how you can calculate the real growth in wages given the nominal rate of wage growth and a measure of inflation:

Screen Shot 2014-10-08 at 1.29.47 AM

For the nominal rate of wage growth, you could use the % change of Average Hourly Earnings (reported by the fed), and for inflation you could use the CPI % change over the same period.  These aren’t, however, the only metrics that will work – there are plenty of ways to quantify wages and inflation, each suited to a slightly different scenario.

Is the Stock Market a Viable Barometer of Economic Health?

The S&P’s record close of 1992.37 on Thursday begs the following question: what, if anything, does a soaring stock market index, up almost 8% just this year, say about the health of the real economy?  As I’ve mentioned previously, there are quite a few issues in the current U.S. economy that may have to be rectified before the real economy can sustain robust growth – a weak labor force and stagnant wage growth, for example.  If we are to interpret the appreciation in the price of a stock market index as a sign of economic health, as many pundits on TV seem to do, then Thursday’s record close seems to contradict what the assertion that wage growth and a robust labor force are vital to the U.S. economy’s health.  This subject is briefly addressed on page 101 of  Freefall by economist Joseph Stiglitz, an account of the financial crisis, its causes, and aftermath.  He says:

“Unfortunately, an increase in stock market prices may not necessarily indicate that all is well.  Stock market prices may rise because the Fed is flooding the world with liquidity, and interest rates are low, so stocks look much better than bonds.  The flood of liquidity coming from the Fed will find some outlet, hopefully leading to more lending to businesses, but it could also result in a mini-asset price or stock market bubble.  Or rising stock market prices may reflect the success of firms in cutting costs – firing workers and lowering wages.  If so, it’s a harbinger of problems for the overall economy.  If workers’ incomes remain weak, so will consumption, which accounts for 70 percent of GDP.” 

I quoted the preceding passage because it cogently argues that stock market gains are not necessarily emblematic of health in the economy, as the media – particularly on business-oriented news shows – often suggest.  The two scenarios Stiglitz mentions (expansionary monetary policy and firms cutting costs) result in higher stock prices but not a healthier economy.  It is erroneous to conclude that the price of the S&P 500 is a sufficient and reliable barometer of economic health.

Econ Week in Review: 6/9 – 6/15

Emerging markets have lost momentum throughout the past year, as investors adjust to the changing macroeconomic climate. According to news outlets (MarketWatchBloombergLibertyStreet) global risk aversion is to blame.  Though emerging economies are still poised for more GDP growth than their developed counterparts in 2014 – 2.2% versus 4.9% – they aren’t expected to increase that growth rate by much in ’15 and beyond.

Growth prospects that are relatively weak in comparison to previous estimates (though still strong in comparison to other economies) is one reason why investors are pulling out of emerging market economies, as evidenced by capital outflows in those markets (IMF).  Another is the outlook for developed economies, particularly the United States, which looks much better than it did a year ago.  Now that investors expect the U.S. economy to recover and interest rates move away from the zero lower bound, they expect new financial opportunities to emerge in developed economies as well.  Now that investors think they’ll be able to make a decent return in an advanced economy, there’s less of an incentive to take on the risk associated with emerging markets.  There is evidence of this if you look at capital outflows immediately following Ben Bernanke’s speech in May 2013; it seems that the cautiously positive economic outlook Bernanke conveyed in his speech led to a sell off in emerging markets that has continued for the past year.  Some economists have justified this phenomenon using the VIX as an indicator of risk aversion

Capital outflows put emerging market economies in a tight credit position, constraining their growth potential.  Previously they had enjoyed abundant credit because investors in advanced economies had to go abroad for financial returns.  Furthermore, it has been shown that Quantitative Easing and related policies in the U.S. put downward pressure on interest rates in emerging markets, facilitating even easier borrowing.  This shouldn’t come as a surprise since financial markets are becoming increasingly integrated, but it could pose some problems by limiting the effectiveness of domestic monetary policy (full discussion on if/how us policy affects global market here).  Integrated financial markets are generally a good thing, though , and the fragmentation that currently plagues most of Europe is a pertinent example of that.

I’m going to write a follow-up on QE and the role of expectations in the next week or so (after I finish reading the IMFs global economic outlook), and hopefully delve deeper into the current situation in emerging market economies.

Consumption Choices and Student Loan Debt

The New York Fed shed some light on student loan debt numbers reported in the FBRNY consumer credit panel in a few presentations and an article at liberty street economics.

If you’ve ever seen the news you know that aggregate student debt has been increasing rapidly over the past decade, second only to mortgage debt.  Student loan debt dwarfs aggregate auto loan, credit card, and home equity debt balances, but that doesn’t tell the whole story.  While student debt per borrower is at its highest point ever, total debt per capita for student borrowers hasn’t increased relative to total debt per capita for non-student borrowers in recent years.

Until recently, borrowers with a history of student debt were more likely than their counterparts without student debt to take on home equity and auto loan debt – reflecting the high financial returns to higher education and the ability for college-educated people to participate in the housing and auto markets.  However, that trend has reversed, and a widespread decline in participation in all debt markets is prevalent among those with a history of student debt.

The article proposes a few rationales for why this is the case.  First, college grads revised their expectations about future income downward after the financial crisis and subsequently reigned in consumption.  Second, student debt borrowers may not have access to credit; debt to income ratio requirements have increased in all debt markets as a result of stricter underwriting standards, which may render student debtors ineligible to borrow.

I don’t know enough about underwriting standards to make a conjecture, but the article is worth reading as it provides the full story on an issue the media loves to turn into something it is not.


Econ Week in Review: 5/26 – 6/1

This was meant to be a sort of  “week in review”, but I’m (predictably) late, so it’s more like an assortment of articles about housing policy.

On May 13 the Wall Street Journal reported that mortgage behemoths Fannie Mae and Freddie Mac are being encouraged to make more credit available, according to overseer Mel Watt, who communicated the current administration’s stark policy reversal with his statement.  Until now, post-crisis housing policy had focused on restricting credit to prevent another boom and bust.  Efforts to do so included proposals from Washington such as requiring larger down payments on mortgages, which critics argued would unfairly punish creditworthy borrowers.  Read the article for more details on the so-called Johnson-Carpo bill.  An interesting point is that the bill would repeal “Affordable-Housing Goals”, which require Fannie Mae and Freddie Mac to cater to purportedly “underserved” markets (i.e. inner cities and rural areas).   One really interesting proposal (not a part of the Johnson-Carpo bill, just an idea) is that borrowers and lenders share more risk, allowing lenders to cash in if home values rose and take a hit if they fell (via a subsequent fall in the principal mortgage balance).  It’s radical, which the article admits, but an interesting idea nonetheless.

Why is the housing market so important?  The following article explains why the housing crash raped the entire economy, whereas the dot com crash, though slightly larger in terms of dollars of wealth destroyed, had a much smaller effect – and therefore also explains why so many people care so much about the housing market.  The answer has to do with the distribution of losses, according to authors Amir Sufi and Atif Mian at FiveThirtyEight.  On the same website, Andrew Flowers discusses the potential that a bond bubble is forming and how hard the economy would get screwed if this were in fact the case.  The articles aren’t explicitly related, but it’s easy to apply the rationale set forth in the first article, about the distribution of losses and macroeconomic consequences, to what Flowers says about a potential bond bubble.

The Real Pension Crisis

As the term “Pension Reform” becomes a media buzzword, politicians on both ends of the political spectrum insist that reforming the U.S. public pension system is at the top of their gubernatorial to-do lists. The rhetoric centers around two basic issues: underfunding as a result of insufficient contributions made by local and state governments, and contractual details such as cost of living adjustments, retirement age, and employee contributions. It’s not news that U.S. public pensions are severely underfunded – dismal coverage ratios, particularly in California and Illinois, have been published in recent years. One way to rectify the deficit in pension funds is to cut benefits by changing the contractual details mentioned previously; for example, increasing the retirement age or decreasing cost of living adjustments. Doing this is politically unpopular, however, and as such politicians are generally wary of making any significant structural changes to public pensions out of fear of retribution at the ballot box. Underfunding and the risk it poses for pension benefits is certainly an issue that warrants the public’s attention and outrage, but it is not the biggest issue that plagues the U.S. public pension system. The bigger and lesser-known issue is that the reported state of the system, although dire, severely understates the true degree of underfunding.

Though it has been established publicly that liabilities invariably exceed assets in the U.S. public pension system, a bigger issue is that virtually all of the liabilities are also severely underestimated and will continue to be valued as such until structural reform. Under GASB requirements, U.S. public pension funds can set their own discount rate and asset allocation almost arbitrarily. The rules link liability discount rates to the expected return on assets – that is, the riskiness of assets – and present a clear incentive to invest in riskier assets so as to maintain high liability discount rates. Higher liability discount rates ensure that liabilities are lower on paper, since they are discounted by a higher factor. Thus, politicians can contribute less money in real terms to pension funds and maintain a favorable funding position without raising any more revenue or changing the benefit formula. Of course, the true funding situation hasn’t changed, only the number that is reported to the public.

Given the state of GASB requirements, the facts reveal a clear conflict of interest: stakeholders have a direct incentive to choose a higher discount rate in order to disguise the degree to which plans are underfunded. In terms of pension benefits, the result is that the current value of pension benefits is underestimated and does not reflect what the system will actually have to pay when they come due. In terms of asset allocation, GASB gives stakeholders an incentive to shift towards riskier assets so as to justify smaller contribution levels. Investing in riskier assets has given U.S. public pension funds the ability to maintain high discount rates and present lower liability valuations, both of which correspond to less money that needs to be set today to meet those obligations in the future. This ‘fix’ allows a politician to remedy the pervasive lack of pension funding without allocating another dollar from the state budget. Therefore, no difficult budgetary decisions have to be made and no voters will be upset in the short term. The task of making responsible budgetary decisions is transferred to future generations, the state can report a higher pension coverage ratio without (technically) lying, and there is more money in the budget for politicians to buy themselves yachts and fur coats.

The preceding information suggests that discount rates are chosen by U.S. public pensions on the basis of political, as opposed to financial, criteria. This suspicion is corroborated in “Pension Fund Asset Allocation and Liability Discount Rates” by Andonov, Bauer, and Cremers, a cross-sectional study of over 800 defined benefit pension funds in three different countries over the course of 20 years, among other studies (see Sielman, 2013, Brown and Wilcox, 2009, and Novy-Marx and Rauh, 2009). In the private sector, liability discount rates decreased over the period, reaching 5.7% in 2010 along a path that closely mirrored the ten-year treasury yield. Private funds retained high rates of 7.5 – 8% throughout the period, despite a systemic decline in interest rates. The only way to maintain exorbitant rates of return when low risk rates such as treasury bills decline is to allocate a larger portion of the fund to riskier assets, a conclusion that Andonov, Bauer, and Cremers confirm in their empirical study. Private funds shifted 20% more to risky assets in 2010 than they did 20 years earlier, whereas public fund asset allocation remained virtually unchanged. The paper also finds that larger funds allocate proportionally more to risky investments. In short, U.S. public pension funds respond to decreasing treasury yields recklessly, by arbitrarily manipulating asset allocation so as to incur enough risk that a high discount rate can be used to meet obligations without actually allocating any more money. Of course, it doesn’t take a financier to see that this method is little more than an accounting trick to appease public employee unions and state auditors simultaneously.

An increasingly popular trend in U.S. public pension fund management is the smoothing of asset returns. The smoothing process essentially manipulates the time frame over which a return is observed in a way that makes returns look less volatile. Asset smoothing is not always a shady manipulation tactic; in circumstances where the measurement period is small, speculators and short-term investors may influence the variance of the sample. In the case where this influence is thought to be so severe that it biases the variance of returns, it may be beneficial to smooth returns over a longer period and thus dampen the effects of short-term volatility. There’s considerable discretion involved in evaluating the validity of this method, and as such it has become a way to disguise the volatility of risky assets in U.S. public pension funds. Congress recently decided that smoothing corporate bonds over a 25-year period was appropriate for U.S. pension funds, thus replacing the previous upper limit of 2 years. It remains to be seen, however, if one single person, whether a congressman, finance professional, or anyone else for that matter, can make the argument that 1988 interest rates are of any significance when discounting future pension liabilities.

For two reasons, U.S. public pension funds are unique in their propensity to mask the financial position of their investments. First, a private firm’s desire for high returns is accompanied by risk. The cost of financial distress for a private firm is an incentive to fund pensions fully, as underfunding could result in enormous payments, required by law, at the time benefits come due. Private firms do not have a tax base to exploit for these payments. Additionally, firms that are overfunded are exempt from PBGC insurance premiums, which lower the true cost of funding pension obligations. While private pensions must choose a discount rate as a function of current interest rates, U.S. public pensions are held to no regulatory standard when determining discount rates. Numerous studies have shown that there is no statistically significant association between liability discount rates and interest rates for U.S. public pensions. On the other hand, the private sector tends to decrease liability discount rates when interest rates decrease, thus accurately adjusting their expected earnings and determining contribution levels accordingly. On average, the discount rate used by public funds is 190 basis points higher than its private sector counterpart.

Robert Novy-Marx and Joshue D. Rauh use discount rates that reflect the risk level associated with pensions to calculate the true present value of pension liabilities that have already been promised by the United States, and their results show the gravity of the GASB shortcomings. In 2007, the total liabilities stated in annual reports for the 116 largest U.S. Public Pension plans were $2.81 trillion, compared to $1.94 trillion in assets. As mentioned earlier, the public outcry would be justified even if this were the true state of underfunding. In discounting liabilities with an appropriate discount rate, however, the authors conclude that the present value of the pension liabilities is $5.17 trillion, which corresponds to a $3.23 trillion deficit. To reiterate, facilitating this cover-up are GASB accounting standards that promote flagrant conflicts of interest and opaque public finances. The result is an issue that is much more serious than the so-called “Pension Crisis” that is reported in the media.

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