Opinion: The $6 trillion public
pension hole that we’re all going to have to pay for, by Ed Bartholomew and
Jeremy Gold, 8/20/18, Market Watch.
Why your state’s public pension plan is
in a much bigger hole than you already fear. Pension plans for state and local-government employees are
in trouble.
U.S. state and local employee pension
plans are in trouble and much of it is because of flaws in the actuarial
science used to manage their finances. Making it worse, standard actuarial
practice masks the true extent of the problem by ignoring the best financial
science which shows the plans are even more underfunded than taxpayers and plan
beneficiaries have been told.
The bad news is we are facing a gap of
$6 trillion in benefits already earned and not yet paid for, several times more
than the official tally.
Pension actuaries estimate the cost,
accumulating liabilities and required funding for pension plans based on
longevity and numerous other factors that will affect benefit payments owed
decades into the future. But today’s actuarial model for calculating what a
pension plan owes its current and future pensioners is ignoring the long-term market
risk of investments (such as stocks, junk bonds, hedge funds and private
equity).
Rather, it counts “expected” (hoped for)
returns on risky assets before they are earned and before their risk has been
borne. Since market risk has a price — one that investors must pay to avoid and
are paid to accept failure to include it means official public pension
liabilities and costs are understated.
The current approach calculates
liabilities by discounting pension funds cash flows using expected returns on
risky plan assets. But Finance 101 says that liability
discounting should be based on the riskiness of the liabilities, not on the riskiness
of the assets.
With pension promises intended to be
paid in full, the science calls for discounting at default-free rates, such as
those offered by TreasurysTMUBMUSD10Y, -0.45% . Here’s the problem:
10-year and 30-year Treasurys now yield 1.5% and 2.25%, respectively. Pension
funds on average assume a 7.5% return on their investments — and that’s not
just for stocks SPX, +0.62% . To do that, they have to
take on a lot more risk — and risk falling short.
Finance 101 says that liability discounting should
be based on the riskiness of the liabilities, not on the riskiness of the
assets.
Much debate focuses on whether 7.5% is
too optimistic and should be replaced by a lower estimate of returns on risky
assets, such as 6%. This amounts to arguing about how accurate is the measuring
stick. But financial economists widely agree that the riskiness of most public
pension plans liabilities requires a different measuring stick, and that is
default-free rates.
Ignoring this risk leaves about half of
the liabilities and costs unrecognized. At June 30, 2015, aggregate liabilities
were officially recognized at more than $5 trillion, funded by assets valued at
almost $4 trillion and leaving $1 trillion or more than 20% unfunded. These
are debts that must be paid by future
taxpayers, or pensioners lose out. Taking into account benefits paid, passage
of time and newly earned benefits, we estimate June 30, 2016 liabilities at
$5.5 trillion and assets roughly unchanged at that same $4 trillion, indicating
a $1.5 trillion updated shortfall.
Now let’s factor in both the cost of
risk and low U.S. Treasury rates. We estimate the 2016 risk-adjusted
liabilities nearly double to about $10 trillion, leaving unfunded liabilities
of about $6 trillion, rather than $1.5 trillion.
Because today’s actuarial models assume
expected returns and ignore the cost of risk, risk isn't avoided; indeed it is
sought! By investing in riskier assets, pension plans’ models then enable them
to claim they are better funded and keep required contributions from rising
further.
Risky assets (like stocks) are of course
expected to return more than default-free bonds. If that weren’t true, no investor
would hold risky assets. But expected to return more doesn't mean will return
more.
Risky assets might well earn less than
default-free bonds, perhaps much less, even over the long term — that’s what
makes them risky. And if that weren’t true, no investor would hold default-free
bonds.
Compounding the problem, today’s
aggregate annual contributions of $160 billion don’t even pay for newly earned
benefits, adding more debt to be paid by future generations.
State and local governments already face making bigger required contributions
even under the measurement approach that ignores risk requiring higher taxes and
crowding out other government spending. That is already happening in Chicago.
In Detroit, Stockton, Calif., and Puerto Rico, bondholders haven't been paid.
Some actuaries argue it’s time to change
this approach. This was spelled out in a recent paper written by several
members of a pension finance task force jointly created by two industry groups
14 years ago. We are two of those authors.
The leadership of the American Academy
of Actuaries, which speaks for its 18,500 members on public policy matters, rejected
the paper. It also persuaded the Society of Actuaries, the other industry
group, not to publish it. On Aug. 1, the presidents of the two organizations issued a joint letter disbanding the task force and
declaring that the authors couldn't publish the paper anywhere.
This is more than just an internal
dispute. Today’s public plan actuaries serve their clients, who want lower
liabilities and costs, even at the expense of future taxpayers and other
stakeholders.
Plans are in trouble. Every year they
are in deeper trouble. Many taxpayers are aware that state and local government
pension plans are underfunded. They generally aren’t aware just how dire the
situation is.
Good numbers don’t assure success, but
bad numbers lead to bad decisions and may invite disaster.
Ed Bartholomew is a former banker and now is a
consultant on pension financial management. You can follow him on Twitter @e_bartholomew. Jeremy Gold is a Fellow of the Society of
Actuaries (and recent vice president and board member) and a member of the
American Academy of Actuaries (and former vice chairman of the Pension Practice
Council. Follow him on Twitter @jeremygold.
Norb Leahy, Dunwoody
GA Tea Party Leader
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