Visitors Now:
Total Visits:
Total Stories:
Profile image
By Reason Magazine (Reporter)
Contributor profile | More stories
Story Views

Now:
Last Hour:
Last 24 Hours:
Total:

Report Challenges Standard Actuarial Practices in Public Pensions

Tuesday, October 25, 2016 1:17
% of readers think this story is Fact. Add your two cents.

(Before It's News)

The application of financial economics to pension actuarial practices has been controversial in the American actuarial circles. Hence, people paid attention when the American Academy of Actuaries (AAA) and the Society of Actuaries (SOA) jointly sponsored a pension finance task force to produce a paper about applying financial economics to public pension plans. Unfortunately, the task force was not immune from the politics surrounding public plan funding policies and the joint development of the paper was abandoned and decades running task force was disbanded. After the groups initially said they would not release the commissioned paper, the SOA eventually changed its position and posted a “draft” of the paper on its website. The paper was complete, but was deemed a draft with a caveat that the paper “does not reflect the position of either the SOA or the Academy, or of any group that speaks for the profession.”

Nevertheless, the “unofficial” paper provides valuable information that challenges the standard actuarial practices in public pensions.

To start, the authors of the paper are no outsiders with an ax to grind. The findings and arguments in the paper were instead informed by a range of influences, including those from a former head of JPMorgan’s Global Sovereign Liability Management (Ed Bartholomew), a former SOA vice-president (Jeremy Gold), a former director of Moody’s Analytics (David G. Pitts), and a vice president at Goldman Sachs (Larry Pollack).

According to the paper, a governing principle of public finance is intergenerational equity, the idea that current taxpayers should pay for the benefits of current public employees. Stated another way, taxpayers should pay for the benefits of those who serve them. It is a violation of this principle when future taxpayers pay for today’s benefits or present taxpayers pay for tomorrow’s benefits.

Applying the intergenerational equity principle to public pensions means that current taxpayers should be responsible for covering the costs of current public employees’ retirement benefits. Even though the employees receive the cash benefits in the far future, the defined benefit structure means those benefits are prefunded, and workers earn them as they work. Thus, pension costs must be properly valued so that those costs are fully borne by the relevant taxpayers.

How should pension plans value pension costs? The paper asserts that pension costs should be valued on the basis of amount, timing, and likelihood of future payouts. In other words, pension liabilities should be based on the risk of the plan sponsor’s timely payment of promised retirement checks. Expected investment returns, therefore, are irrelevant to the valuation of pension costs. Valuing deferred compensation based on expected returns makes it “impossible” to apply the intergenerational equity principle.

The paper provides three definitions of pension liability:

  • Budget liability: this is the measure most often used by public pension plans, and it involves discounting liability cash flows at the expected rate of return on pension assets.
  • Market liability: discounting liability cash flows at a discount rate that reflects the timing and probability of payment of promised benefits.
  • Solvency liability: discounting liability cash flows at a risk-free discount rate.

In this framework, the market liability and the solvency liability are the same when the collateral assets and the sponsor credit “are sufficient to render the pension promise effectively guaranteed,” according to the report.

Among these three liability definitions, the budget liability “has no economic meaning,” the authors write. By using the budget liability, most public pension plans understate their obligations and do not have sufficient funding to ensure full benefit security and intergenerational equity.

Citing Brown and Pennacchi, the paper states that market liability should be used for financial reporting, while solvency liability should be used for measuring the funding status and determining appropriate contributions. The market liability is useful in conveying the real value of promised benefits to interested stakeholders. However, it can provide a distorted measure of the funding status due to its odd property of “rewarding” underfunding. The paper therefore recommends keeping pension plans “fully funded on a solvency liability basis.”

Does investing in risky assets reduce pension costs? The paper says no. Investing in risky assets merely shifts contingent costs to future taxpayers. Moreover, having a very long-term horizon does not reduce risks, as argued by Bodie using option-pricing theory.

So how should public plans handle investments? The paper recommends matching assets and liabilities, i.e., investing in long-term bonds that have the same duration and market value as the pension liability. This effectively hedges the pension liability to ensure full funding.

Despite being only a draft, the paper reveals important insights into the current state of public pensions. If the paper is right, the current valuation and investment practices adopted by most public plans are deeply flawed.

The average discount rate used by public plans in the U.S. is around 7.6%, according to CRR, and this is significantly higher than both the risk-free rate and the liability-based risk-adjusted rate for a typical public plan. On the solvency-liability basis using a risk-free discount rate, state plans are underfunded by approximately $5.6 trillion and have an average funded ratio of only 35%. Even on the budget-liability basis, which is economically unsound according to the paper, public plans are only 74% funded, far below the 100% target. Public plans have also invested in an increasing share of risky assets, with equity-like investments accounting for 65% of the total assets, compared to 19% in 1975. All of these practices violate the intergenerational equity principle and greatly undermine funding integrity. 

Report abuse

Comments

Your Comments
Question   Razz  Sad   Evil  Exclaim  Smile  Redface  Biggrin  Surprised  Eek   Confused   Cool  LOL   Mad   Twisted  Rolleyes   Wink  Idea  Arrow  Neutral  Cry   Mr. Green

Top Stories
Recent Stories

Register

Newsletter

Email this story
Email this story

If you really want to ban this commenter, please write down the reason:

If you really want to disable all recommended stories, click on OK button. After that, you will be redirect to your options page.