State and local governments have assets in their pension funds that they invest and use to pay pensions to their retired employees. The federal government has assets in a trust fund that it will use to help pay for future Social Security benefits. But pension funds put their money in the stock market, and thus assume fairly high future returns: the median plan assumes a future return of 8%, according to a May 2011 "Issue Brief" from the Congressional Budget Office. In contrast, Social Security trust funds can only by law be invested in Treasury bonds, and thus get a much lower rate of return.
There is an ongoing dispute over what assumption is more reasonable. State and local governments can point out that the average rate of return on pension funds over the last 25 years is 9% in nominal terms (6% in real terms). The alternative view is that if these obligations are viewed as certain to happen, then they should be funded with extremely low-risk assets, like Treasury bonds. Using a high-risk asset like investment in stocks to fund a certain future obligation creates a mismatch. In the Fall 2009 issue of the Journal of Economic Perspectives (I'm the managing editor), Robert Novy-Marx and Joshua Rauh make this case.
If state and local pension funds were required to invest in safe assets, then they would need to assume a much lower rate of return on their pension funds. The CBO, for example, says that instead of state and local pension funds being underfunded by $700 million assuming an 8% rate of return, they would be underfunded by $2.9 trillion assuming a 4% rate of return. Conversely, if Social Security was allowed to fund its certain payments by putting 40% of the trust fund in riskier stock market assets and assuming a 6.4% real return (and phasing in this change over 15 years), then the actuaries estimate that the projected 75-year deficit of Social Security would be reduced by about one-third.
A consistent view should favor either that both state and local pension funds and Social Security can put their money in the stock market and assume high rates of return, or that neither should be able to do so. It can't make logical sense to say that for state and local pension funds, it's fine to invest in the stock market and to assume a high rate of return, but for Social Security it's too risky to invest in the stock market and thus necessary to assume only the low Treasury bond rate of return.
Oddly, however, it's common to find that those of a more liberal political persuasion are horrified by the idea of putting Social Security trust funds in the stock market, but would also be horrified by the enormous financial changes that would be needed if state and local pension funds were forced out of the market. On the other side, many of a more conservative political persuasion advocate putting some of the Social Security funds in the stock market, but like to argue that the deficits of state and local pension funds are overstated because they ought to be based on a lower "safe" rate of return.
