fully revealing, last year about three - fourths of public pension systems were underfunded, and about one - third were funded at less than 80 percent. lengthening life expectancies and tight public budgets are making existing pension promises ever more difficult to keep – and the problem is significantly magnified if promised health benefits are included. the funding situation puts systems under a great deal of pressure to reach for higher returns by investing in riskier assets. but as has been so clearly and forcefully demonstrated over the past year, there is no free lunch with risk - taking : the price is volatility, the extent of which should be well disclosed and the implications of which should be well understood. the generally high weight on equity and real estate investments in the typical public pension fund portfolio has increased in recent years. part of that exposure has come from increased investment in private equity, real estate investment trusts, and hedge funds. indeed, some funds have allocated 25 percent or more of their portfolios to these " alternative " categories. with exposures like those, public pension systems should maintain formal risk - management procedures that are independent of the selection and evaluation of managers and that are carefully designed to minimize conflicts of interest that can weaken the risk - management function. i mentioned earlier that current measures of pension liabilities might be less than fully revealing. why might that be so? the chief reason is that public pension benefits are essentially bullet - proof promises to pay. we all have read about instances in which benefits were lost when a private - sector pension sponsor declared bankruptcy and terminated the plan. in the public sector, that just hasn't happened, even when the plan sponsor has run into serious financial difficulty. for all intents and purposes, accrued benefits have turned out to be riskless obligations. while economists are famous for disagreeing with each other on virtually every other conceivable issue, when it comes to this one there is no professional disagreement : the only appropriate way to calculate the present value of a very - low - risk liability is to use a very - low - risk discount rate. however, most public pension funds calculate the present value of their liabilities using the projected rate of return on the portfolio of assets as the discount rate. this practice makes little sense from an economic perspective. if they shift their portfolio into even riskier assets, does the value of the liabilities backed by their taxpayers go down? financial economists would say no, but the conventional approach to pension accounting says yes.

donald l kohn : the economic outlook speech by mr donald l kohn, vice chairman of the board of governors of the us federal reserve system, at the national conference on public employee retirement systems annual conference, new orleans, louisiana, 20 may 2008. the original speech, which contains various links to the documents mentioned, can be found on the us federal reserve system ’ s website. * * * these have been challenging times for the u. s. economy. homebuilding and house prices have gone through prolonged and deep declines ; the resulting broad pullback in financial markets from risk - taking and credit extension has transmitted some of the weakness in the housing sector to other types of spending. at the same time, a substantial run - up in the prices of petroleum and other commodities has simultaneously increased inflation and damped spending on other goods and services. i don't need to tell you that challenging times for the economy are also challenging times for those entrusted with managing pension funds. so i thought you might find it useful this morning for me to review where i think the economy is and where it might be going. that, in turn, depends critically on developments in financial markets, and i'll have something to say about those developments as well. finally, i'll end with a few thoughts about what the recent turbulence in financial markets may imply for the administration of public pension funds. 1 recent economic developments economic activity this year has been quite sluggish. the weakness in activity continues to be shaped by the fallout from the contraction in housing markets that began two years ago. the demand for housing continued to decline early this year, and sales could fall even further in coming months, given the tightness in mortgage lending. nonprime mortgages have all but disappeared from the mortgage market. moreover, with only limited securitizations of prime jumbo loans, rates on those loans are relatively high, and their share of total originations has shrunk significantly since last july. rates for fixed - rate conforming loans have dropped to close to 6 percent. but even there, the good news is tempered somewhat because, with delinquencies on prime mortgages rising, the government - sponsored enterprises have tightened their standards for conforming loans and added fees for borrowers with lower credit scores and less collateral. all prominent measures of house prices are now showing declines. although lower prices would eventually help bolster housing demand, the expectations of further declines in prices may currently be exacerbating