Jane the Actuary Retirement

Forbes post, “Public Pension Funding Crisis: Who Was Jeremy Gold And Why Should You Care?”

Originally published at Forbes.com on July 17, 2018.

 

The bottom line:  public pension plans’ poor funding levels would be even worse if they were accounted for the way that private pension plans are, the fact that their accounting methods differ has contributed to the funding crisis, and Jeremy Gold was either a prophetic or foolish in attempting to call attention to this fact.

Let’s start with more actuary-splaining:

Actuarial valuations . . . in the corporate world

In the corporate pension world, there are two types of actuarial valuations:  accounting valuations and funding valuations.  The former determine what liabilities and expense are recorded on the company’s books, and the latter determine what contributions the employer will make to the pension fund, or define a range of choices.

The interest rate — or, in actuarial terminology, the discount rate (since you’re discounting to the present, the present value of a future benefit) — for accounting valuations is pretty nearly the corporate bond rate; once upon a time, it was just a generic bond rate; then more attention was paid to ensuring that the duration of the bond rate is equivalent to the duration of the plan liabilities (that is, simply defined, that the weighted average of the future payouts of the bond index match the future payouts of the pension plan); now most companies use a yield curve to determine the discount rate.

The consequence of this is that liabilities can increase substantially in periods when corporate bond rates are low in a given country.   Incidental fun facts:  internationally this can be a bit tricky.  What do you do about countries where there are very few long-dated corporate bonds?  Sometimes you use government bonds instead, and sometimes you can add a bit of an adjustment to represent what you think the discount rate would look like if there were enough corporate bonds.  What about a country where there are no long-dated government bonds? To be honest, my colleagues and I never really had a good answer, but just made some reasonable estimates and tried to persuade the client that they weren’t material.

But I always preferred to go back to the original text of FAS 87, the first FASB statement on pension accounting, which says that

that is, the rate at which an employer could purchase an annuity from an insurance company for the benefit.  And that’s always felt right to me.  If you have to assign a value to a piece of property, you base it on how much you could sell it for in the market.  If you have to value a liability, it makes sense to assess its value in the market, by how much it would cost to “exchange” that debt, in this case, by purchasing annuities.  Conveniently, group annuity rates are more or less the same as corporate bond rates, so that the corporate bond rate has become the norm.

Pension funding?  That’s a bit different. In the United States, there used to be a fair bit of flexibility in funding, with a defined minimum and maximum funding level, the former to ensure adequacy and the latter to ensure that employers didn’t take advantage of the ability to avoid taxes by making (tax-deductible) contributions to their pension funds.  In this idealized world employers would fund their plans more generously in good years, less so in lean years.  And because the expectation was that employers were setting their annual contributions with the full understanding that, as a business, they were taking risks, and that they’d have to make up any shortfall in the future, they were allowed to use an interest rate that matched their expected return on assets.  But that’s in the past — the Pension Protection Act of 2006 prescribes specific rates that must be used in funding valuations, based on government bond rates, so the “choose your interest rate” is really more of an idealized approach, or what a church plan (exempt from funding requirements) might do.

. . . and in states and municipalities

But the rules are different for government pension plans.

There are, of course, no federal government rules for how much states and cities must fund their pensions — states might instead define some funding target (“100% funding target . . . in 50 years”) and pledge to contribute the required amount each year; and those states may or may not actually do what they say they’re going to do, and the method of calculating the contributions needed to get to that funding target may be more or less fanciful depending on who’s deciding the assumptions.

But even government financial accounting rules are different, as defined in GASB 67.  A plan that’s unfunded, and that never has any intention of being funded, is valued based on

A yield or index rate for 20-year, tax-exempt general obligation municipal bonds with an average rating of AA/Aa or higher

that is, not much different than a corporate pension plan.

But a plan that is funded, and whose actuaries determine that the combination of funds already in the plan, as well as contributions scheduled to be made by the state or local government in the future (whether or not they’re actually made is another story), are enough to pay out benefits in the future, has different rules, using

the long-term expected rate of return on pension plan investments that are expected to be used to finance the payment of benefits.

And if a plan is partially funded, they use a weighted average of the two rates.

Which leads to some peculiar outcomes, such as that reported at Wirepoints, in which the pension plan for the city of Chicago almost-magically is in a better financial position this year than last, not because of an increase in contributions or a decrease in benefits owed, but because the city council’s most recent budget includes a new schedule of contributions which intends, by means of increases each year in the future — which may or may not actually happen — to arrive at a funding level sufficient to shed the lower discount rate requirement.

Does this sort of manipulation sound any more reasonable to you than it does to me?

The more you think about it, the more bizarre it becomes, that the valuation of a future debt should depend on how aggressive you are in your plan to save up to pay for that debt.

Understated liabilities have consequences.

In the corporate world, asset return-based funding discount rates had been allowed with the expectation that companies could catch up out of future profits, if necessary, and that they didn’t have any particular obligation one way or the other, as long as their accounting is correct and disclosed to shareholders, regulators, and the financial community, to have greater or lesser levels of debt.  But when a corporation goes out of business, it can no longer make up the difference between its pension fund and the cost of annuity purchases, and the federal government is left holding the hat.

But when a government body uses the GASB-defined asset return rates, it creates all manner of potential for misgovernment, using the device of assuming higher asset returns (either simply by declaring it so, or by investing in riskier assets) to create artificial reductions in liability and as a means of justifying inappropriately low contributions.  It makes pensions seem cheap compared to actually giving employees wage increases in the here-and-now, and (see my earlier actuary-splainer) enables lawmakers to effectively borrow money to pay wages, asking the next generation to pay for the wages of this year’s teachers and toll-takers and other state workers.  And it means that when, as in the case of Detroit, the municipality is no longer, in corporate-speak, a “going concern,” the money’s not there.

What would Illinois’ 40% funding rate look like if the state were obliged to use the same accounting regulations as corporations?  It wouldn’t be pretty – but it would be honest.

And Jeremy Gold?

That’s where, finally, Jeremy Gold comes in.  New reports that he passed away on July 6th may not have made their way much outside the actuarial world, but Gold was an actuary who watched the pension fund raids of the 1980s and then embarked on a mission, iconclastically warning for more than 25 years about the risks of pension underfunding caused by too-lax funding and accounting methods.  In a Forbes article in 2015, “Where Are The Screaming Actuaries?“, he took actuaries, or specifically, the actuarial profession to task for not ensuring that professional standards required actuaries to provide more appropriate values:

The actuarial profession acknowledges, but does not fulfill, its duty to the public. . . .

The public will get the best estimates only when the Actuarial Standards Board requires the actuaries, who do have the data, to produce economically pertinent and decision useful numbers.

a refrain he elaborates on in an article at ConcernedActuaries.com. Yes, actuaries follow accounting standards and the requested scope of work by the governments engaging them, but Gold’s message is that actuaries have a professional duty, and a duty to the public, to disclose “true” liabilities whether or not the accounting standards or the legislature calls for it. If you’re even more interested, Mary Pat Campbell has even more information on the man and his life’s work at her blog.

So what will Gold’s legacy be?

 

December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.

Jane the Actuary Retirement

Forbes post, “Why Public Pension Pre-Funding Matters (An Explainer)”

Originally published at Forbes.com on April 3, 2018.

 

In the news lately:

“Puerto Rico gov defies board, rejects reform, pension cuts,” April 2, 2018, ABC News (AP).

The powers of a federal control board overseeing Puerto Rico’s finances could soon be tested as the U.S. territory’s governor on Monday defied its calls to implement more austerity measures amid an 11-year recession.

Gov. Ricardo Rossello rejected demands that his administration submit a revised fiscal plan to include a labor reform and a 10 percent cut to a pension system facing nearly $50 billion in liabilities.

“Kentucky teachers to skip work after lawmakers’ ‘bait and switch’ on pension reform,” March 31, 2018, CNN.

More than 20 Kentucky counties had schools close Friday after the state Legislature approved changes to their pension the day before.

Educators, who are furious over the pension issue, called out of work sick or requested substitutes in protest.

The bill, which overhauls the state’s pension, passed mostly on party lines and heads to Gov. Matt Bevin, who supports reforming the system. State leaders say it’s critical to fix the pension crisis, which ranks as one of the worst in the US.

“Court strikes down Chicago Park District pension plan,” April 2, 2018, Chicago Tribune.

Chicago Park District pension fund overhaul that Mayor Rahm Emanuel once held up as a model of city-union cooperation has been struck down by a judge, in a ruling that could produce more vexing financial challenges for both the mayor and taxpayers.

Circuit Court Judge Neil Cohen ruled that a January 2014 state change to the district’s pension system was unconstitutional because it diminished benefits by raising the retirement eligibility age and reducing both cost-of-living increases and disability benefits.

Cohen then ordered that the district return to workers the higher retirement contributions they’ve made as a result, with 3 percent interest tacked on. He also ordered the district to make payments covering reduced disability payments, plus interest.

Three separate news items, each a reminder of the perils of underfunding public pensions.  But let’s backtrack a bit.

Years ago, as an actuarial student, preparing for actuarial exams, I learned the ins and outs of pension plan funding methods and funding requirements, and I have a vague memory of reading about public pensions, which were not a part of my day-to-day work.  I remember pretty much two items:  first, the eye-popping idea that state constitutions promised state and local employees that they could keep their existing benefits, not just for past service accruals, but for all future years of employment; and, second, the notion that it was generally accepted for public plans to be un- or underfunded because, after all, unlike private employers, whose very real risk of bankruptcy was highlighted by the Studebaker plan failure that was the motivation for the Erisa pension funding legislation of 1974, public employers posed no such risk to their employees since state and local governments would always be around.

Now, that particular reading has long since been consigned to the recycling bin, so I can hardly cite chapter and verse on that statement.  Did the author say, “It’s perfectly fine for public pension plans to be unfunded” or maybe just “It’s not as bad a problem as for private employers” or even “Some people might claim that it’s OK”?  I don’t know. In any case, the idea seems antiquated in 2018.

But these various recent news items suggest that now is as good a time as any to actuary-splain a bit: Yes, it matters that public pensions are funded, and, no, it’s not just a matter of greedy pension-cutters using underfunding as an excuse to destroy pension benefits.

 Legacy costs

One key assumption underlying the explicit acceptance of underfunded pension plans, or the indifference to remedying the situation, is that, in fact, public employers will always be there.  Yes, they might declare bankruptcy, either by name or in practice by defaulting on bonds, but no city or state is just going to shut down like a factory closing.

But the first new article above is an instance of this very thing occurring:  the population of Puerto Rico peaked in 2000 at 3.8 million, then declined slowly in the first decade of the 21st century, then precipitously through 2016.  The long-term effects of Hurricane Maria aren’t yet known, but one economist, Lyman Stone, has presented forecasts of population declines in which the population is halved by 2060.

And this is, of course, what has already happened with the city of Detroit:  from a peak of 1.8 million residents in 1950, it has now dropped to less than 700,000 (estimated) in 2016.   It is plain to see that whatever cost of pensions one might consider affordable for a tax base of 1.8 million, cannot possibly be so for less than half the population, nor is it possible to predict whether one’s one state or municipality will be booming and prosperous or shrinking and struggling — at least not with enough time to plan ahead.

Fiscal responsibility

We know the story of what happened with Detroit, or, at least, a brief search brings up the denouement:  retirees took a 4.5% cut in pensions, new employees were moved into hybrid plans, and the major foundations in the city came to the rescue of pensioners and the Detroit Institute of Arts, the collection of which was at risk of being liquidated to pay creditors, in a “Grand Bargain.”

But why did it get that bad?  Here’s the Washington Post, in 2013 (quoting the Detroit Free Press to which it links with an invalid link):

Detroit officials have also made a habit of convincing unions to accept pension sweeteners — shorter terms of employment required, more generous multipliers, or a “13th check,” essentially an annual bonus — rather than pay increases.

And this is the story that’s repeated over and over again.  Pensions are made more generous — with high accrual rates, low retirement eligibility ages, generous cost of living provisions — as a means of providing more generous compensation to state and local employees, without actually needing to pay anything from the current year’s budget.  Costs are deferred until well after current legislators have themselves retired.

Fundamentally, that’s what’s going on in Kentucky: the state’s governor, Matt Bevin, has now recognized the importance of funding pensions, and is maybe a bit embarrassed at the state’s tied-for-last-place pension funding status, but because the past generosity of pensions had been effectively borrowing from future generations, even if without the explicit label of “debt,” there is no money available to shift into better present-day compensation instead.  (See this extensive backgrounder for more.)

And pension debt is even worse than ordinary state debts, for instance, bond issues for building up infrastructure.  Pension debt is nothing other than borrowing to pay for present-day employee salaries.  And, worse, legislators can pick and choose when and whether to “pay off” the debt or allow it to grow (that is, by making, or failing to make contributions to the pension funds).

Sound governance

Third, pension funding is fundamentally a matter of good governance.  The Chicago Tribune article on the Chicago Park District pension reform attempt is just the latest development in the Illinois Tale of Pension Woe.  In fact, it’s actually it’s a counter-example to the usual case in Illinois, in which individual municipalities, school districts, and the like, determine their teacher compensation and pay the corresponding percent-of-pay contribution requirements to the appropriate pension funds, and have no further obligation, with the state taking on the obligation to make up for any underfunding, whether due to failure to make the state’s own contributions, or due to investment losses, or losses due to unfavorable actuarial experience.  Only in Chicago does the city bear full responsibility for deficits — a responsibility which produced, on the one hand, in the case of the Park District, a union agreement for pension reductions, as touted in the above article, and, on the other hand, a lawsuit by the city against the state with the claim that the state’s picking up the underfunding for non-Chicago pensions was “separate and unequal” system of funding.  (What happened in the end?  The usual horse-trading.)

But Illinois has long been dogged by issues of pension spiking, by all of the other government entities who bear no further responsibility after their contributions are made.  As the Chicago Tribune reported back in 2015, the state passed a law as far back as 2005 to counter the regular instances in which teachers received substantial pay increases (e.g., 20%) to boost their pensions at little cost to the local schools; from then on out, local schools were required to pay the additional actuarial cost of the increased pensions resulting from high late-career pay increases in excess of 6%.  But, as the Tribune reports,

The Teachers’ Retirement System of the State of Illinois, known as TRS, used legal exemptions to waive almost 75 percent of penalties for local districts across Illinois, a Tribune investigation found. The waivers shifted the cost of those penalties to taxpayers statewide.

What’s more, at a time of low inflation, the 6% cap still provides a lot of room, and local school boards are maximizing the advantage they take, as reported in 2017, by giving teachers the maximum pay raise in the years preceding retirement, to boost their pension, however much it exceeds that of younger teachers.

It’s a no-win:  if the local government that sets pay levels is the one that bears responsibility for the cost of future pension obligations, the risk of legacy costs overwhelming a town’s budget increases; if the state government is liable, they’re at risk of skyrocketing costs when others game the system.

Finally, I titled this article, “Why Public Pension Pre-Funding Matters,” and, in fact, a well-funded plan goes a long way toward remedying the risk of legacy costs — if the funding valuations and asset allocations are based on assumptions that are sufficiently conservative so as to minimize the risk of future adverse experience.  But it’s not an easy solution to the problem of a legislature that too easily succumbs to the temptation to defer funding, or local school boards that are too eager to game the system.  And pension funds can themselves be at risk of further problems, when the state uses the funds to dole out political favors by means of investment choices or management firms.  But I’ll save for another day the debate about what retirement provision for state and local workers should look like in the first place.

 

December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.