If
the Actuarial Standards Board enacts recommendations from its Pension Task
Force, actuarial valuations for state and local government pensions will report
unfunded liabilities of over $5 trillion and funding ratios of just 39 percent.
The public pensions industry will hate it, but those figures are the best
available measures of the costs of public employee retirement plans.
A
Pension Task Force established by the Actuarial Standards Board (ASB)
has recommended rules changes that would
require all pension actuaries to calculate and disclose the “market value” of
retirement plan liabilities, a step that has been fought hard by the
public pensions industry. Proponents of market-value liability figures, which
include most economists as well as many policy
analysts concerned about pension funding, argue that current actuarial methods
understate pensions’ true benefit liabilities and encourage pensions to take
excessive investment risk.
While
the ultimate decision on actuarial standards lies with the Actuarial Standards
Board, it would be difficult for the ASB to reject the recommendations of its
own task force on such an important issue. So this could mean a big change in
how we view state and local government employee pension funding.
Under
current practice, a state or local government employee retirement plan “discounts” its benefit liabilities using the assumed
return on the investments held by the plan. At first glance, this makes sense:
if we discount liabilities using the assumed return on investments and we make
contributions based on that discounted value, then – assuming the plan’s future
investment returns are equal to the assumptions made today – the plan should be
able to pay all the benefits it owes. Most state and local pensions hold about
75 percent of their investments in risky assets such as stocks, private equity
or hedge funds and they assume annual investment returns of about 7.6 percent.
Based on this methods, state and local plans today are about 74 percent funded and
have unfunded liabilities of about $1.4 trillion.
But
here’s a fact that should tell you something: almost no other pension plans in
the world are allowed to use the kind of accounting
that U.S. state and local plans can. Corporate pension plans can’t discount
their liabilities using the assumed return on investment. Nor can most public
employee pensions in other countries.
Here’s
why: defined benefit pensions promise a benefit that’s guaranteed. Legally
it’s very hard to cut benefits that have already been earned and in the public
sector it’s tough even to reduce the rate at which employee earn future
benefits. Many state constitutions guarantees benefits, as reformers in
Illinois, Oregon and elsewhere have discovered.
What
this means is that if a pension plan’s investments don’t meet up to their
assumed returns and there’s a very good chance this won’t happen then the
taxpayer has to step in to make up the difference. The average “required
contribution” for public pensions more than tripled from 2001
to 2013, mostly because investment returns have been sub-par.
So
the true liability for taxpayers isn’t merely the obligation to make
contributions on the assumption that those contributions will earn 7.6 percent
returns. It’s to make whatever contributions
are necessary to pay benefits, regardless of how the plan’s investments might
fare. The way to measure that kind of liability is to discount the plan’s
future benefit payments using the interest rate from a guaranteed investment
like U.S. Treasury bonds. As of mid-2015 when figures were last produced for
state and local pensions – the average yield on Treasuries with durations of
between 10 and 20 years was about 2.6 percent. (The logic behind using a
risk-adjusted discount rate isn’t always intuitive; here’s an effort to make it slightly more
understandable.) U.S. corporate pensions must discount their liabilities using
a corporate bond
yield, which conveys that corporate
pension payments carry about the same risk of default as corporate bonds. Overseas pensions usually discount using some
variation on a government bond yield.
This
“market valuation” approach tells us several interesting and useful things.
First,
it shows that state and local pensions aren’t nearly as well-funded as you’d
think. Let’s assume that we valued public pension liabilities using the 2.6
percent average of 10- and 20-year Treasury yields. Instead of state and local
plans being 74 percent funded with $1.4 trillion in unfunded liabilities, as
they state using a 7.6 percent discount rate, using the Treasury yield these
plans are about 39 percent funded with unfunded liabilities of about $5.2
trillion. That $5.2 trillion is the number most economists would think is most
relevant to considering the costs of public sector pensions. For context, the
total national debt including the Social Security and Medicare trust funds is about $19 trillion, so for
state and local governments to face shortfalls one-quarter that size just for
their employee pension programs is worrying.
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