Stanford University recently released an analysis of the three big public pension funds in California saying they are woefully underfunded, with a potential shortfall of over $500 billion, much larger than their publicly stated shortfall of $55.4 billion. They based this on assuming a 4.14% return, on what risk-free U.S. Treasuries yield, rather than the 7.5-8.0% the funds themselves estimate they can make long-term.

The stock market yielded a 5.3% annual return in the 20th century. Funds assuming they can make upwards of 8% year after year, while completely legal and permissible, seems a bit fanciful. Interestingly, the accounting rules about this for private pensions are much stricter. They can’t make assumptions like that.

The analysis was commissioned by Gov. Schwarzenegger who is focusing on the cost of public pensions. Here’s the reason why.

By law, public pensions must be funded at 100% even if the fund is losing money.  The pensions currently have the legal authority to mandate that the state and any municipalities make up the difference in pension shortfalls.

That money, of course, ends up coming from taxpayers, some of whom might be a bit grumpy about paying for someone else’s pension when they just lost their job or house. It’s easy to see how this can be (and probably already is) an explosive political issue. Other programs will have to be cut to finance the public pensions.

CalPERS issued a rebuttal, saying their return over the past 20 years averaged 7.91% a year, more than they need to pay benefits. But that’s not really the point. If your fund drops 27% in one year, it’ll take more than 4 years to get back to even.

CalPERS has indeed suffered losses of that magnitude. Using their own numbers, we find their 2008 year end return was -27%, the 3 year return ending 01/31/2010 was – 4.38%, and assets dropped from $251 billion on 6/30/2007 to $203 billion on 12/31/2009.

The bulk of pension money comes from return on investments, not from member and employer contributions. However, in catastrophic years like 2008-2009, CalPERS took in $12 billion in contributions – and lost $55 billion in investments. Ouch.

The Stanford analysis makes a number of recommendations aimed at smoothing volatility and decreasing risk at the funds, noting that had the funds simply bought investment-grade corporate bonds, their return would have been 7.25%, with vastly less risk too. These are, after all, pension funds. Preservation of capital should be the primary goal, not trying to goose returns by making risky investments.

CalPERS managed to lose $500 million in an ill-fated New York City real estate deal recently and another $1 billion in a deal in Lancaster, CA in 2008. They didn’t just lose some of the investment, they lost the entire amount. Why are investments like this even permitted for pension funds?

The accounting rules need to be changed. Public pension fund rules need to be in line with those for private pensions, which govern what expected return they can project into the future.  And there needs to be greater disclosure of unfunded liabilities as well.