By: Jeremy Gold
Jeremy Gold is an actuary and economist studying pensions with an emphasis on financial economics, corporate finance, and investments.
When Detroit went bankrupt in 2013, estimates of pension shortfalls multiplied overnight. The city’s regular actuarial firm had reported pension underfunding at $600 million. A special study performed by a second actuarial firm showed underfunding of $3.5 billion.
So which is it? Why two such different estimates? In a recent talk I gave at MIT, I explained the details.
Pension plans covering the employees of state and local governments are in trouble throughout the U.S. The California cities of San Bernardino, Stockton, and Vallejo filed pension-fueled bankruptcies in recent years. Prichard, Alabama simply ran out of money and stopped paying pension benefits. Illinois and New Jersey have become the poster states for public pension plan troubles, while Kentucky and Connecticut plans may be even more poorly funded. It is hard to tell which state plans are in the most difficulty and it is hard to know which Detroit estimate is better than the other.
Actuaries estimate future pension payout cash flows based on demographic and economic assumptions. They calculate “liabilities” by discounting pension cash flows using the expected returns on risky plan assets (presently in excess of 7%). But Finance 101 says that liability discounting should be based on the riskiness of the liabilities, not on the riskiness of the assets. Pension payouts, which are not supposed to be risky, should therefore today be discounted at rates below 3%. A payment of $1,000 due in 20 years has an actuarial (7% discount) value of $258 today. That same payment has a financial value (3% discount) of $554 today. It is the financial value that should prevail in any arms-length transaction in the world’s financial markets.
For many years, actuaries have mismeasured the value of pension plan payouts and therefore not produced economically pertinent nor decision-useful numbers. Actuarial reports further obscure the relevant values by applying actuarial methods that reassign the costs of already-earned pensions into the distant future. This deferral of costs means that benefits earned by today’s workers will have to be paid for by future taxpayers, not by those consuming their services today. Such consistent lowballing of pension costs over the past two decades has made it easy for elected officials and union representatives to agree on very valuable benefits, for very much smaller current pay concessions.
There are, however, measures of pension liabilities and plan funded status that are economically sound and decision useful. The present value of benefits already earned, based on current salary and years already worked, discounted at default-free rates, is both informative and easy to calculate. The New York City retirement systems have published this value for many years. NYC’s largest pension plan, 138% funded in 1999, had declined to 49% funded by 2013. The time series of funded ratios reveals the true volatility of funding progress over time, providing insight into the risky relationship between plan assets and liabilities, a relationship that is obscured in standard actuarial valuations. Economists Robert Novy-Marx and Joshua Rauh have estimated similar numbers for public pension plans nationwide. Although their work is well-respected by economists, it is unlikely to influence decisions in jurisdictions that don’t want to see large liabilities and poor funding ratios. Furthermore, Novy-Marx and Rauh must rely on official actuarial reports from which they estimate their alternative numbers. Plan actuaries, working with basic plan data and specialized software could, if they or their clients wished (or if they were directed to do so by the actuarial profession), produce more precise numbers like those in NYC.
So why haven’t actuaries been telling the world what’s going on? Why aren’t they screaming in these burning theaters? The answer is that they don’t have to! U.S. Actuarial Standards of Practice (ASOPs) endorse the lowball estimates discussed above. The U.S. Code of Professional Conduct calls upon actuaries to be loyal to their clients. In the case of public plans, the clients are usually the boards of trustees that administer the plans; the state and local governments that sponsor plans and the unions representing public employees also may hire actuaries. None of these clients wishes to hear a $554 financial value when they have difficulty paying the back-loaded and understated costs associated with meeting a $258 actuarial value.
The actuarial profession acknowledges, but does not fulfill, its duty to the public. So Detroit, which is it – $600 million or $3.5 billion underfunded? Based on numbers calculated by the second actuarial firm in Detroit, I have estimated that the city’s economic unfunded liability for benefits already earned exceeds $7 billion. It could also be as much as $9 billion, and I could be more precise if I had better data.
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.
This piece was originally posted on November 20, 2015, on the Pension Research Council’s curated Forbes blog. To view the original posting, click here.
Views of our Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania.