More on the Public Pension Controversy

The media has fallen in love with the ongoing controversy over public pensions. In the last few weeks, article after article has appeared in major print and electronic media mostly discussing how poorly funded the majority of public pension funds are and placing blame everywhere they can. This is not to say that there are not problems and it's also not to say that there's not plenty of blame to go around, but as in most any controversy, there's more than one side to this issue.

Before delving into it, let me provide some background for those who may not be particularly familiar with public pensions.

Virtually all public pension plans are traditional defined benefit (DB) pension plans in which most, if not all, of the benefit is provided through contributions from the sponsoring governmental entity (some do require significant participant contributions in order to get that benefit). The benefit is typically related to final year's (or the average of the last three or five years) compensation. As a result, spikes in compensation in the final year or years of a career produce much larger pensions. And, when overtime pay is included in those amounts, workers are smart enough to know that their pensions can easily be boosted by getting as much overtime as possible.

As I said, most of these pensions are funded largely through contributions from the governmental entities. Where do those contributions come from? Well, for most of those entities, the very large majority of their budgets come from tax dollars. So, if the recommended, or even legally mandated contributions get too large, there are only two choices -- ignore those requirements or raise taxes (of course in most jurisdictions, future benefits can be reduced prospectively, but that's a different story for a different day).

The current debate centers on public plans in California. What we have recently learned is that the California Public Employers Retirement System (CalPers) values pension liabilities in two ways -- one using what the New York Times referred to as the actuarial value and another referring to it as a market value.

The next two paragraphs briefly discuss a rationale for each basis. For the sake of both simplicity and brevity, both are oversimplified and should not be taken as a precise rationale for either.

The actuarial value discounts obligations using a discount rate at the expected long-term rate of return on plan assets. Proponents argue that this is correct because plans are expected to have a degree of permanence and as assets are invested for the long haul, the obligations that they support should be discounted on that same basis.

Market value discounts obligations using a current settlement rate; roughly speaking, that is the rate at which you could go out to the insurance market to settle those obligations. Proponents argue that in an efficient market, there is no risk premium in investments and therefore, this is the only appropriate basis on which to discount.

What we have read about in the news is that governments that thought that the plans that they sponsor were well funded and that wanted to pull out of the system are learning that to do so will cost them money that they will likely never have.

So, which method is correct? I suppose I could argue that it depends upon which media piece you read. You see, what is happening is that most of the articles have interviewed experts (or self-proclaimed experts) on only one side of the debate. So, they present that side.

The reality is that neither side is correct. It's not as simple a question as the strong proponents on either side would have you believe.

So, here's my take (you knew I would get to it eventually).

Public plan trustees need to understand the true costs of the plans they sponsor. On average, when an employee retires, their pension should be fully funded. This is often not happening. In years when investment returns are good, they use them to reduce contribution requirements. In years when investment returns are poor, they say they can't afford to make the appropriate contributions. It doesn't take an experienced actuary to tell you this is a problem.

I would urge that governments embark on prudent funding policies that build up surpluses in strong years in order to pay for shortfalls in lean years. Doing so will have only minimal effect on the tax base. Studies to understand these issues should be par for the course.

I also urge the popular media to realize that this is not a one-sided issue. While it may make for a great read to tell of the sad tale of a small Citrus District pension plan that is woefully underfunded, it's a small part of the story.

Within the Conference of Consulting Actuaries (yes, I am biased, I serve on the Board of Directors), there is a Public Plans Community that regularly discusses issues such as this. For those who are interested in a view of the problem from people who understand the issues, it's an excellent read.

Lessons From California Public Pensions

Over the last few days, the print media (at least we used to call it print media) has hit hard on public pensions in the State of California. The New York Times hit hard on the differences between the "actuarial approach" and the "market approach." The Los Angeles Times took on a pension deal from the late 90s. Both of these are symptomatic of the issues that all of taxpayers, legislators, workers, and actuaries face in the public pension world.

Let's take a step back. Some of the most generous of all public pensions are those available to public safety officers primarily police and fire. I could give you lots of reasons why this approach is correct and why it's not. You might disagree with my analysis on all of them, but that's not what's important here.

Historically, people who have chosen careers in police and fire have thought of their careers differently than people in most other professions. Those careers are very risky and they are physically demanding. Many in those professions would tell you and me that lasting more than 30 years or so is just not practical. And, if we take that as a correct statement (I do), then it is reasonable that such public safety officers be eligible to retire from that career earlier than we would expect in most other careers. After all, if you were trapped in a burning building, would you be happy if the people trying to save you were just trying to hang on until normal retirement age at 65, but weren't really physically capable of handling such a demanding task?

Over time, states, cities, towns, and other governmental organizations found the answer. Provide those public safety officers with a significant incentive to retire early (compared to other careers) and if you do that, you don't have to pay them all that much. So, what that has historically achieved is that costs for current public safety employees have been relatively lower and costs have been deferred into their retirements.

That's a problem. It doesn't need to occur. The correct answer for a governmental employer, or other employer, is to realize that deferred compensation (that's what a pension is) is earned during a employee's working lifetime. Therefore, it should be paid for during that working lifetime. After all, once an individual in any profession retires, they no longer provide a benefit to the organization that they previously worked for. Further, the burden to pay for those pensions should not be passed on to future generations of taxpayers.

In the past, I have commented about various actuarial cost methods. An actuarial cost method is a technique for allocating costs to the past, the present, and the future. Looking at things as any of a taxpayer, legislator, employer, or employee (I happen to not be all of those, but even so, I can put myself in the shoes of those that I am not), the correct answer has the following characteristics:

• An employee's pension is paid for (funded) over their working lifetime. Once they retire, the cost of providing their benefit is over. (Understand that actuarial gains and losses make this an inexact science, but we should be close.)
• The cost of providing that employee's pension should be level. That is, it should either be a constant percentage of their pay or a constant dollar amount. As an employer, I can budget for that. 

Let's consider an example of that second bullet. Suppose I pay a public safety officer $60,000 per year (I know -- in some jurisdictions that seems high and in others it seems low) in salary. Further suppose that their deferred compensation costs me 10% of pay annually. Then when I am budgeting for that person, I know how to budget every year. If their pay goes up by 5%, so does the cost of their pension, roughly. This year, I budget $66,000 for current plus deferred compensation. Next year, with that 5% budgeted increase, I budget $69,300 for current plus deferred compensation.

There is an actuarial cost method that does exactly this. It's called Entry Age Normal (EAN). When I entered the actuarial profession back during the days when we used green accounting paper rather than spreadsheets, in my experience, EAN was the actuarial cost method of choice. But, it had its downsides. 

• Neither the accounting profession nor the federal legislators accepted it as the method of choice.
• Employers were advised that their current cash cost would be lower using a different actuarial cost method. It's easy to say you will fix that problem later on.
• Observers understand a method where you pay for benefits as they accrue, but nor one in which you pay for benefits as they are allocated by actuaries.

So, now we have come to a crossroads. Many of the largest public pension plans are horribly underfunded regardless of how you determine funding levels (some have been funded responsibly; others have not). Getting them well funded requires cash which can only come from increasing taxes or from taking money from elsewhere in the budget (dream on). Legislators want to get re-elected which means you don't raise taxes. 

Hmm, I see a problem here.

The problem extends to private pensions as well, but there are  good solutions there. Since EAN is not available as an actuarial cost method anymore (we could choose to have our valuation done using the legally prescribed Unit Credit actuarial cost method, but fund not less than the EAN cost although that is very rarely done), we need to look in other places. 

Plan design is an excellent lever in this regard. Suppose we had a plan design  that even under a Unit Credit cost method allowed us to achieve exactly what we are talking about here. And, suppose that design allowed for all the benefits of defined benefit plans (DB) including market-priced with no built-in profits annuity options, professional investing, no leakage, portability, and virtually no cost volatility. Wouldn't that be an ideal world?

That design exists. And, you can have it now.

Public Plans, Beware What Your Actuary Can and Cannot Do

Thick laws create strange results. Consider for example the relatively new final SEC rule on registration of municipal advisers. As well as I can tell, the intent of this provision (Section 975) of the Dodd-Frank law was to ensure that those who are advising municipalities on things like bond offerings and investments. It never looked to me that actuaries were the target.

I don't know how it looked to the SEC. What I do know is that the final rule specifically exempted "retirement board" members from SEC registration. What I also know is that it did not exempt actuaries.

Why do I care and why might you care? It looks as if there are two situations where actuaries will be subject to registration as municipal advisers and if they are, they will be subject to all the attendant SEC rules:

• If your actuary performs an actuarial study in which the actuary sets any of the investment return assumptions or
• Makes any recommendation about how the governmental entity might address an unfunded liability including advice about the issuance of a municipal financial (debt) product,

 the actuary must register with the SEC.

It seems strange to me that municipal officials serving on retirement boards would be exempted, but actuaries may not be.

I guess it's not the first time that a government agency has confused me.

Pension Miseducation

Like many benefits and compensation professionals, I receive daily my fair share of e-mail blasts from consolidators -- those services that scour the web for tidbits to provide to their readers. Because they have tens of thousands of free subscribers, they are able to sell advertising. That's their business model, as I understand it.

This morning, I opened one of those e-mails and found this article that looked like it was worth a read. In fact, there was some interesting material in there. And then there was this:

That aphorism also suits one frustration of today's pension plan sponsors. Somehow, they have to attain lofty actuarial return goals of 7% to 8%, but the expected returns they have to draw from, for both equities and fixed income, are stuck at ground level.

Hold on a second. Lofty actuarial return goals, you say? This implies somehow that the actuaries set the target and that based on that, plan sponsors and their associated investment committees then struggle to meet that target.

This is backwards. The selection of actuarial assumptions is different for accounting and for funding. In either case, however, the actuary does not just willy-nilly pick a target return on assets assumption. For ERISA funding purposes, the law mandates the selection. For FASB (ASC) purposes, the plan sponsor selects the return on assets assumption with the advice of experts including the actuary and investment adviser for approval by auditors. To the extent that the actuary finds the assumption to fail to meet Actuarial Standards of Practice (ASOPs), the actuary is to disclose such and to provide calculations representing what the amounts would have been had the assumption met the ASOPs.

Those who do not seem to understand this take a different position. The typical process for those sponsors looks like this:

• Look at the expected return on assets assumption.
• Go to the investment adviser and tell them that they need an investment portfolio that will meet or exceed that expected return on assets assumption.

But, the sponsor owns that assumption (if it is for accounting purposes). If it's for government plan funding, usually (state and local laws differ) the sponsoring government has input into the assumption. 

If an actuary has some (or all) purview over the return on assets assumption and (s)he is doing his or her job properly, the actuary will look at the investment lineup together with a capital market model and develop a return on assets assumption commensurate with that lineup. It is not the other way around. If plan sponsors do not think that their investment lineup can return 7% to 8%, then they should lower their assumption for expected return on plan assets. Yes, this will increase their financial accounting costs (and their funding costs for governmental plans). Ultimately, the cost of a plan is what it is. The cost of paying $1 per month for the rest of an individual's life is the same, no matter the actuary.

In my personal experience, for years, many plan sponsors pressured their actuaries to use more aggressive actuarial assumptions in an effort to influence P&L and, back in the days when it mattered for funding costs, to keep required contributions down. Some actuaries agreed to do that, some did not. 

But, when a plan sponsor, including a state or local government, chooses a high expected return on assets assumption, usually to manage short-term costs, that they are unable to find a suite of investments to generate that expected return is not the actuary's fault. Place blame where it belongs.

GASB Improves Public Pension Plan Accounting and Disclosures

Yesterday, the Governmental Accounting Standards Board (GASB) approved  two new standards  related to accounting and disclosure for public retirement plans. GASB 67 will change the plan level reporting and disclosure while GASB 68 will change the employer level reporting. This comes after much debate and public controversy as the media has had many a field day trumpeting the cumulative underfunding of public pension plans.

Statement 67, according to the GASB press release, enhances note disclosures and required supplementary information for public defined benefit and defined contribution plans. Among the new requirements are annual money-weighted rates of return and 10-year supplemental information schedules.

Here I warn the reader, particularly the unknowing one, about the value of the new requirement as compared to the cost of providing it. Any of these 10-year projections will be supplied by actuaries. Actuaries, as a group, are smart people. I am proud to say that I am an actuary. So, to be sure, I am not denigrating my profession here.

However, when an actuary presents various measures of plan liabilities and forecasts of future costs to a plan sponsor, be it a public sponsor or a private one, one thing we are sure of is that the numbers are not perfect. What they are is a best estimate based upon a set of actuarial assumptions and methods. Based upon our experience and training, our estimates will likely be better than yours, but the likelihood that the plan liability that we calculate will be a precise measure of the present value of benefits accrued to date is essentially nil.

So, consider what happens when, even with our level of training and experience, instead of looking one year into the future, we look ten years into the future. I don't know anyone who knows what will happen to the economy over the next ten years. The last 10 years or so illustrate this well. Suppose I had asked you on June 26, 2002 whether interest rates would increase, decrease, or stay relatively steady over the next 10 years. What would you have said? Well, in July 2002, I did ask that question to a group of roughly 100 professional asset managers. As a group, these people were pretty savvy about the economy. About half a dozen of them thought that rates would stay relatively steady over the next ten years; the remainder thought they would increase and most thought they would increase significantly.

Statement 68 makes three significant changes to accounting for public pensions:

• Projections of benefit payments will now include assumed projections of pay increases, projection of service credits, projections of automatic cost-of-living adjustments (COLAs) and projections of ad hoc COLAs if those ad hoc COLAs are nearly automatic. Over time, a meaningful number of public employers have kept their reported liabilities down by providing annual ad hoc COLAs rather than automatic ones. While they were essentially the same, the reporting for them was very different, but no more.
• Perhaps the single most key actuarial assumption used in calculating a pension liability is the discount rate. Statement 68 will allow generally well-funded public pensions (there aren't too many of them right now, but they do exist) to use an expected long-term rate of return on assets to discount the liabilities so long as the assets are invested in such a way as to reasonably expect that rate of return to be achieved. Plans that do not meet the criteria to use a long-term rate of return must use what is essentially a risk-free rate for governmental entities -- a yield or index rate on 20-year AA or higher-rated municipal bonds.
• Finally, plans are to be valued using an entry age [normal] actuarial cost method. To the extent that a plan is pay-related, this method should produce roughly a level percentage of pay annual cost. If the plan is not pay-related, the method should produce roughly a level dollar amount annual cost. To my mind, this is a significant improvement and a step that other rule-setting bodies including the United States Congress should [have taken] take a lesson from.

What will this ultimately do for public pensions? I suspect that we will see a better picture of the levels of underfunding of public pension plans, but will not unfairly punish those that have been funded responsibly. The new standards are not perfect, but in my opinion, this is a step in the right direction.

Public Pensions Are Not the Problem

I hear it all the time: public pensions are a big problem. On TV, I hear that "we" just have a 401(k) plan, why should government workers have a pension plan? I'll answer that question and talk about the real problem that public pensions have been made to become.

Understand as I write this that I am a fiscal conservative by nature. While there is a place for some benefits that are more socialized than some others might think, I don't, for example, espouse that our employers, public or private, should be responsible for our entire welfare.

That having been said, let's consider a young potential worker, Kelly (I figured I would use an androgynous name because I haven't decided yet if I want to make Kelly male or female, or if I even care). Kelly is considering two job offers, one with a private employer and one with a public employer. This may not be an unusual scenario.

The private employer offers Kelly a nice package to start with. It includes all this:

• $60,000 base pay
• 2 weeks paid vacation and 10 paid holidays
• A consumer driven health plan (Kelly doesn't know what that means, but does know that it is a health plan) where the employer pays 75% of the total cost
• A 401(k) plan with a match of 50 cents on the dollar for the first 6% of pay that Kelly contributes

Assuming that she (I decided to make Kelly female) elects the health plan and defers at least 6% of her pay to her 401(k) plan, the total annual employer cost of the package being offered to Kelly is approximately $60,000 (base pay) + $4,615 (paid time off) + $4,500 (health plan) + $1,800 (401(k)) = $70,915.

The public employer offers Kelly a very different package. It includes all this:

• $50,000 base pay
• 3 weeks paid vacation and 15 paid holidays
• A traditional indemnity health plan for which the employer pays 90% of the total cost
• A defined benefit pension plan that if funded ratably over a full career for Kelly will cost the employer (on average) about 5% of pay

Again, assuming that she elects the health plan, the total annual employer cost of the package is about $45,000 (base pay) + $5,769 (paid time off) + $9,720 (health plan) + $2,500 (pension plan) = $67,989.

NOTE: I have taken fairly wild guesses on the costs of the health plan. They should not be used as representative of any particular plans nor should the be used as representative of the costs of any particular plans.

The values of the two packages are close enough that Kelly may have some career and lifestyle choices to make. But, we will leave Kelly for the moment as her career decision does not really matter to us.

The first thing that does matter, however, is that the two potential employers have similar costs of employment, however, they choose to allocate those costs very differently. The second thing that matters is the pension plan. Note that I said that the public employer was going to fund that benefit ratably over a full career. When this is done on a percentage of pay basis, it typically comes from an actuarial cost method known as (Individual) Entry Age Normal. In this case, the 5% of pay is what is known as the normal cost, or the annual cost of the benefits being allocated to the present year.

Wow, that was an earful. I'll slow down the technical stuff.

My point is that a public pension plan, at least in every jurisdiction of which I am aware, can be funded rationally. As part of that rational funding, the plan sponsor (whoever represents the sponsor) must first allow the plan's actuary to choose reasonable actuarial assumptions, including those for discount rate, salary increase rate, rates of termination, disability, retirement, and death, and any others that are appropriate to the plan and its population. Second, the plan must be funded using an actuarial cost method that takes into account future pay increases and is reasonable in its allocation of benefits to an employee's past service, current service, and future service with the employer. Third, regardless of the leeway allowed by the law, the sponsor must ensure that the plan is funded rationally every year. The cost is the cost. You don't take a year off from funding so that you can build a new skate park, especially since the mayor's son is a competitive skateboarder. 

The problem is that most public plan sponsors have not taken this approach. They have been neither reasonable nor rational. Much like the US government, especially under the last two presidents, public plan sponsors have taken the approach of running up obligations that perhaps could have been paid for as they were accrued, but were instead left for a future generation.

Therein lies the problem. The public pension is only its face.

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.

Public Employer Pension Funding Bill Introduced

Yesterday, three Republican Congressman (Devin Nunes and Darrell Issa of California, and Paul Ryan, incoming Budget Committee Chairman from California) introduced the Public Employee Pension Transparency Act (PEPTA). Under PEPTA, sponsors of public pension plans would need to disclose the following:

• Funding status including:

• Plan's current liabilities as measured for accounting purposes
• Plan assets available to pay for that liability
• The amount of unfunded liability
• The funding percentage
• A schedule of contributions for the year indicating which are counted in disclosed plan assets

• Alternative projections based on regulation from Treasury
• 20-year forecast of 
• contributions
• plan assets
• current liability
• funding percentage
• other information required by Treasury
• Using assumptions specified in regulations
• And specifying assumptions used for
• funding policy
• plan changes
• workforce projections
• future investment returns
• Statement of actuarial assumptions and methods
• Participant counts, including active, retired and deferred vested
• 5-year history of actual investment returns
• Statement explaining how the sponsor plans to eliminate the plan's underfunding
• Statement explaining to what extent the funding policy has been followed for the last 5 years
• Statement of pension funding bonds outstanding

Failure to comply will make the sponsor ineligible to issue federally tax-exempt bonds. 

You can find the PEPTA language here: http://nunes.house.gov/_files/NUNES_068_xml.pdf

The informational posting on Congressman Nunes' web site is here: http://www.nunes.house.gov/_files/PensionTransparencyTrifold.pdf