Debt Crisis, Part 2 -- Invading the Pension World

Effective July 1 of this year, a new law became effective in the State of Rhode Island which gives municipal bondholders priority in municipal bankruptcy cases. Yes, towns and cities go bankrupt. For those of you who like your citations, you may marvel in the intricacies of Chapter 9 of the Federal Bankruptcy Code. For the rest of us, suffice it to say that it can be done.

There is a smallish town in Rhode Island called Central Falls. It has about 19,000 residents and has been paying out nearly $300,000 per month in pension checks. Starting next month, it will pay out about $100,000 less.

Nobody died. Nobody told the town that he didn't need his pension anymore. Central Falls filed under Chapter 9. Pensioners need to line up with every one else. They are going to get a haircut of about one-third.

Is this legal? I suppose it is, but if you really want to know, you need to ask an attorney who is familiar with Rhode Island law. This is not an ERISA issue. This is a governmental plan. So, while your favorite ERISA attorney in some other state may have a strong opinion, chances are that he or she doesn't know the ins and outs of Rhode Island law and the Constitution of the State of Rhode Island.

I am going to assume that this is all legal. If I assume it's not, then I would have to blog about something else today.

Let's consider the implications. If you are a potential bondholder, municipal bonds in Rhode Island are pretty safe. If you are a rating agency, these same bonds are far safer than the general credit of the town. If you are an investor, you will likely consider municipal bonds in Rhode Island as part of a safe fixed income portfolio. The bonds of these municipalities will probably yield a lower interest rate in the future.

What about the pensions? There has long been a debate in the pension community about the proper funding and funded status of public pensions. On the one side (let's call them the public pension traditionalists or PPTs for short), the argument has been that public pensions don't need to be fully funded. They have an essentially infinite lifetime. Their sponsors have peaks and valleys in tax revenues and the pension plan is just one of the items that must line up for funding along with public safety officials, roads, parks, and the like. In fact, most residents would tell you that those other items deserve priority. They affect every citizen on a regular basis. They make the town livable.

On the other side are the Financial Economists (FEs). They argue that when you offer a pension to an employee, you are, oversimplifying somewhat, taking a loan from that employee. By funding that pension, you are placing into escrow a pool of assets. The FEs would argue that the market value of assets in that pool should equal the market value of liabilities. The PPTs would disagree, perhaps saying that increases and decreases in the market value of liabilities are largely due to external forces (rises and falls in interest rates) that are not overly relevant to this ongoing pension plan.

You know what? For most public pension plans, I can argue that the arguments of both sides have their merits. (By the way, there is a bill (PEPTA) pending in Congress that would purportedly improve disclosure and therefore funding of municipal pensions. It's not the answer, but if you want to read about it, you can read my take on it here.)

In any event, Central Falls is not the only public entity in the US in financial trouble. And, of those, Central Falls is not the only one with a severely underfunded pension plan. In fact, there are many. But, Central Falls is in Rhode Island. And, Rhode Island has this new law. In my opinion, many other states will copy this new law.

Consider what will happen when employees find out. Those often ultra-generous public pensions may not be safe, or at least not as safe as we thought they were. Will public employees insist on higher pay? More generous benefits (other than pensions)? Will they just leave municipal employment for the private sector?

And, what of private pensions? They have more well-defined funding rules. For the most part, benefits in those plans are guaranteed by the Pension Benefit Guaranty Corporation (PBGC). But, there is a lesson to be learned. Let's separate those plans into a few categories:

1. Well-funded ongoing plans of thriving companies where the plan's obligations represent only a small part of the company's balance sheet.
2. Poorly-funded frozen plans of struggling companies that, because of their size, represent a significant drain on the company's balance sheet.
3. Everywhere in between.

With regard to group 1, even the most ardent FEs might tell you that such a company can withstand blips in its pension plans, even large blips. The company runs the pension, but the pension doesn't run the company.

With regard to group 3, it depends on where that company and its pension plan fall on the continuum between groups 1 and 2. Certainly, the PPTs are more likely to be on the side of letting the economy take its course while the FEs will likely want to see assets in high quality fixed income instruments matching the plan's obligations.

As for group 2, they are in trouble. To a large extent, the pension plan runs the company. Due to the relative size of the plan, the company's P&L is driven significantly by pension expense. And, the balance sheet and the company's ability to borrow to run its business will be largely driven by the state of its pension plan. Even the most fervent PPTs would probably admit that something drastic needs to be done to manage this risk.

Private pension funding rules, as most readers know, have lots of smoothing techniques available to them in funding calculations. Smoothing techniques are wonderful tools to help a company manage its cash flow. At the end of the day, however, a plan does have a market value of liabilities. Different individuals may have different opinions on how to calculate that market value, but it is there somewhere. And if that market value of liabilities is getting ready to swallow up the company, then there is truly "Danger, Will Robinson!", significant danger. 

Readers should be reminded that what I write here is usually my own opinion (sometimes I use literary freedom to offer up ideas with which I do not agree), and sometimes not even that, but should in no event be attributed to anyone else. But, the issues in this particular piece are real. I rarely use this blog as an advertisement, but in this case, I am going to, for just a moment. I know of a company that happens to be a leader in helping clients manage their retirement plan risks. In fact, they are good enough to send me a paycheck once a month. Please contact us if any of these issues hit home for you.

To Market Value or not to Market Value

Author's Note: As usual, this blog does not necessarily represent the opinion of my employer, my profession, or any other organization of which I am a member. In fact, by the time I get done, it may not represent my opinion either, but if by the time you get done, I've caused you to think, to ponder, to smirk, and to laugh, then I have done my job well.

As some of you know, I've recently returned from actuarial March Madness sometimes known as the Enrolled Actuaries (EA) Meeting. If you are an Enrolled Actuary and you've never been, you should attend. It's not a boondoggle. It's an action-packed meeting (well, maybe not action-packed, but it is packed with more learning activities per hour of attendance than any meeting that I know of) with lots of expert speakers. At this meeting the last fairly large number of years, there have been three General Sessions (plenary sessions if you like the idea of showing your audience that you can use a fancy word when a simple one will do better) and eight tracks of Breakout Sessions, as well as a usually entertaining luncheon speaker on the first day. That's nearly 13 hours of continuing education in 2.5 days, but since actuaries get to count 50 minutes as an hour for these purposes, we think it's more like 15 hours.

Anyway, Session 002 (or GS-2, if you prefer) was a public pension plan debate. Even if you have been under a rock, you have likely heard that public pensions are in a state of crisis. Hell, everything is in a state of crisis these days. I know that's a fact because I've heard it on TV. The economy is in a state of crisis, the War on Terror is in a state of crisis, Japan (sadly, this is true) is in a state of crisis, the middle east is in a state of crisis, kids are in a state of crisis, adults are in a state of crisis. Well, many of them probably are, but after the EA Meeting, I don't know about public pension plans.

Why is that? Well, as is within the norm for a general session, we heard from three experts, a think tank person who says that public pension plans in the US are about $500 billion in the whole, a think tank person who says that US public pension plans are more than $3 trillion in the whole, and a person who represents the state pension plans in the US who I think told us that it doesn't matter.

I digress. What are think tanks and what do think tank people get paid for? I think that the think tank takes a position and then asks its think tank people to think of things to make people think that this particular think tank has correct thoughts. I can think. Maybe this is something for me to do after I have had enough of my current career.

Anyway, back to the subject at hand. The big difference between the $500 billion thinker and the $3 trillion dollar thinker, other than $2.5 trillion, is that one of them thinks that a concept called market value of liabilities is the only thing that matters and the other one thinks market value of liabilities doesn't matter at all.

Who's right? We'll come back to that later.

First, let's explore what Market Value of Liabilities (MVL) is. Back in the early days of ERISA, and the current days for public pension plans (for the most part), actuaries got to discount pension plan liabilities at a rate representative of the expected long-term rate of return on plan assets. So, if you thought your plan assets could return 10% over the long haul, then you discounted at 10%. Gradually, in the world of corporate plans, that opportunity disappeared. Prevailing wisdom, or at least opinion, among those who legislated and their advisers began to move those discount rates toward a risk-free rate. What's that? Well, for the sake of argument, we usually assume that US Treasuries are risk-free instruments, because if the US government starts to default on its obligations, not much else will matter. And, since nothing else is truly risk-free, even many MVL advocates suggest that discount rates can be tied to the yield on very high-rated (Aa or better from Moody's) corporate debt instruments.

That may all be fine. But, here is where I have a problem. For each purpose (funding, accounting), a plan, usually through its actuary does a valuation of assets and liabilities. And, for each valuation, there is a measurement date. And, we are required to value the assets and the liabilities as of the measurement date. On the liability side, that means that we choose actuarial assumptions, including a discount rate that are appropriate on the measurement date. If the measurement date is December 31, and on December 30, the duration-weighted yield on corporate Aa bonds is 5.75%, but on December 31, it is 5.50%, then we are to use 5.50%, even if it's back up to 5.75% on January 2. This is nuts. I realize that we have to pick something, but why one moment in time should get to ruin a plan/fund/company/city/state for a year is beyond me.

How bad can this example be? Suppose we have a plan that on December 30 of some fine year is fully funded with $1 billion each of assets and liabilities (using a 5.75% discount rate). Let's assume that December 31 is a bad day for pensions. Discount rates decrease by 25 basis points and the value of the funds in the plan's trust fall by 1%. This has happened before, by the way. Then, assuming that the plan's liabilities have a duration of 12 (very reasonable by the way), at the close of business on December 31, liabilities will be approximately $1.03 billion and assets will be about $990 million. Stated differently, our funded status is now barely more than 96% and our plan is $40 million in the hole. So, which one is correct? Are we fully funded or 4% away from that? Are we fully funded or $40 million to the bad?

I think that the answer is neither one, at least not for purposes of reporting to the world at large, and not for purposes of doing calculations that affect the next year. MVL is a nice concept. Choosing assumptions that you think are long-term appropriate is a nice concept. Neither one is perfect; in fact, both have significant flaws. But, just like in every thing else being debated, the vocal ones are those toward the fringes.

In the case of public pension funds in the US, I think they are more than $500 billion underfunded, but I don't think they are nearly $3 trillion underfunded. Assets fluctuate. Discount rates are not static. Assumptions used for many public pension funds are way too aggressive.

Market value accounting is a good guide to choosing reasonable assumptions, just as is a prudent longer-term view. Did you hear that? Both are good guides, but nobody seems to want us to consider both and pick something appropriate. Perhaps it's because they think we've shown we can't. But, there is a bit too much hysteria right now.

It's time for a happy medium. I think we should call it reality value.