US public pension plans’ accounting gimmicks exposed

I’ve written previously on the staggering consensus of experts who reject the accounting methods utilized by U.S. state and local public pensions plans to understate the true size of their debt. It’s worth reiterating that this approach is rejected by all other pension plan providers — which includes the U.S. federal government, U.S. private pension plans and both public and private plans in Canada and Europe.

A new paper by four of the nation’s premier pension experts does an incredible job of articulating why the approach currently used by U.S. public pension plans is flawed. Here is how Reason’s Truong Bui describes the authors:

To start, the authors of the paper are no outsiders with an ax to grind. The findings and arguments in the paper were instead informed by a range of influences, including those from a former head of JPMorgan’s Global Sovereign Liability Management (Ed Bartholomew), a former SOA vice-president (Jeremy Gold), a former director of Moody’s Analytics (David G. Pitts), and a vice president at Goldman Sachs (Larry Pollack).

The effect of adopting proper accounting methods reveals why so many governments are reluctant to do so: combined U.S. public pension debt would rise from $1.7 trillion to more than $5.6 trillion!

The cost to service this debt would most likely cause a wave of defaults, like what has already happened in the commonwealth of Puerto Rico and cities like Detroit, Michigan and Stockton, California.

The paper can be read here.

 

Unfunded liabilities as quicksand: Why it is so difficult to return to funded status

PensionTsunami.com brings us these remarkably insightful remarks from David Crane that explain why – when already carrying an unfunded liability – a pension system needs to outperform, not merely hit, their investment target in order to reduce their deficit:

Recently newspapers have reported that CalPERS earned 2.4% over the last twelve months and contrasted that return with its 7.5% assumed rate of return. But what those newspapers have not reported is that CalPERS needs to earn much more than 7.5% per annum for its unfunded liability not to grow.

This is because (i) under US public pension fund accounting, liabilities grow at the assumed rate of return and (ii) currently, liabilities exceed assets. That means assets have to grow faster than the assumed rate of return in order to keep up with liabilities.

As a simplified example, let’s say a public pension fund has a 77% funding ratio, which means that it has assets equal to 77% of liabilities. For greater simplicity, let’s say it has assets of $77 and liabilities of $100, and therefore an unfunded liability of $23 (100-77). Because of item (i) above, liabilities grow 7.5% per annum. That means liabilities that today equal $100 will in one year equal $107.50. For the unfunded liability not to be larger than $23 at that time, that means assets have to grow from $77 to $84.50 (107.50-84.50 = 23). That means that the pension fund needs to earn 9.7% ($77 times 1.097 = 84.50). Anything less and the unfunded liability will grow.

This is why it’s so hard for US public pension funds to catch up once they fall behind. See this relevant article from The Economist.

Nobel Laureate: Public Pensions are a “Disaster” and Rely on “Idiotic” Accounting

Nobel laureate William F. Sharpe spoke to the Financial Analysts Journal on how public pension plans use inappropriately high discount rates to understate their true liability:

Are public pensions a problem? You bet. Is this a disaster? You bet. The true liabilities of the public pensions in the United States—by which I mean governmental pensions—are, according to the actuaries, much larger than the assets. Using any sensible economic view of the value of those liabilities, the difference in value is astronomical. It’s a crisis of epic proportions.

Let me describe this more clearly. If the state has promised a worker certain payments in the future for having worked at least up to this date—so-called accrued benefits—and it is certain that those payments are going to be made, anybody, any economist, and probably most of you in this room would ask, how do you value that? It’s simple. You find US Treasury securities that would provide cash flows to match those payments. That is how you should value the liability.

As most of you know, that is not what the Governmental Accounting Standards Board and the state and local systems do. They value those liabilities at 7.5% or 8% on the grounds that they are pretty sure they’ll earn that in the long run. This is crazy. It gets even worse. Because they want to minimize the reported value of the liabilities, they want to use a high discount rate, and in order to justify it, they have to build really risky portfolios.

Consequently, they believe that one of the great things to do is put money in private equity, or maybe a hedge fund, because then they can assume an extra 300 or 400 bps of expected return for an illiquidity premium (or just because hedge fund managers are so smart). So, the tail wags the dog. Idiotic accounting drives even worse investment decisions.

This is the classic case of an organization that borrowed money while issuing purportedly guaranteed payments and then used the money to invest in risky securities. Where have we recently heard that this is not a good thing?

Of course, you can point to the politics to see why politicians might give benefits that are very large to employees, especially those who may be able to influence elections in various ways. By making sure the benefits are mostly in the future, politicians can pretend that they cost a lot less than they’re going to cost. It’s a very bad situation.

Sharpe’s view is shared by virtually all professional and academic economists, the Federal Bureau of Economic Analysis, the Federal Reserve Board, the Congressional Budget Office, and Moody’s Investor Services.

For example, Donald Kohn, then-Vice Chairman of the Federal Reserve Board, declared in a 2008 speech on public pensions:

While economists are famous for disagreeing with each other on virtually every other conceivable issue, when it comes to this one there is no professional disagreement: The only appropriate way to calculate the present value of a very-low-risk liability is to use a very-low-risk discount rate.

See the “Sidebar 1: What do experts say about pension accounting rules?” section of this paper for more quotes and citations from each of the organizations cited above.

A  recent paper published by the Federal Reserve Bank of Cleveland also confirmed the strong consensus that public pension plan’s discount rates are far too high, and highlighted a recently implemented GASB rule that states a 3.2% discount rate should be used to value pension liabilities. If California’s public pension plans were to adopt this rate, their liabilities would more than triple.

Public pension plans and their actuaries are the only group that disagrees with this consensus.