Ignoring risk hides pension costs from policymakers

A new rule currently being considered by the Actuarial Standards Board would finally require public pensions to meaningfully account for risk. In a commentary for the Voice of San Diego, I explain how this would benefit all stakeholders.

Future Taxpayers and Public Employees Are Paying for Past Pension Mistakes

As San Diego County sues its own pension fund for the right to slash benefits for new hires, and while taxpayer costs continue their ascent to record-high levels, understanding the true cause of the county’s pension crisis is more important than ever.

While some blame the stock market crash of 2008-09, the real culprit was an explosive growth in the size of promised pension benefits, and the flawed accounting practices that encouraged such recklessness.

Over the past 30 years, the accrued liabilities of the San Diego County pension fund, SDCERA, increased by nearly 1,300 percent — almost four times more than the growth in the county’s total personal income over that same time period.

The willingness to make such large pension promises stems from accounting practices that understate their cost by ignoring risk entirely.

Specifically, by treating assumed future stock market returns as certain — despite acknowledging their investments will underperform expectations roughly 50 percent of the time — SDCERA can “discount,” or minimize, the estimated cost associated with safely funded employees’ future pension benefits.

Of course, ignoring risk on your balance sheet doesn’t make it go away in the real world, which is why this approach is outlawed in the private sector and rejected by public pension plans in more than 100 countries worldwide, with U.S. state and local public pension plans being the only exception from that consensus.

This also reveals why blaming San Diego County’s soaring pension costs on the Great Recession is so misleading. The cost was created when the promises were made, as indicated by SDCERA’s nearly 1,300 percent increase in accrued liabilities, not when they were exposed by a market downturn.

But because defraying costs to future generations is so politically attractive, there has been little interest in reform, despite the urgings of those like Warren Buffet, Nobel Laureate William F. Sharpe and what seems like the entirety of the economics profession.

Thankfully, after years of fierce criticism by prominent actuaries worried about the harm that would befall their profession as a result of its continued silence, the Actuarial Standards Board proposed a new rule that would finally require pension plans to meaningfully account for risk.

While the proposal would simply require plans to disclose the level of risk associated with their funding strategy, government unions are nonetheless howling in displeasure at the idea, terrified at the consequences of making the full cost of their pensions known.

But this reflexive opposition to honest accounting is short-sighted and destructive. As the experience of San Diego County so aptly demonstrates, the damage caused by overpromising is often borne by government workers themselves, particularly future hires.

After having been lulled into a false sense of security by numbers that overstated the health of the fund while understating the cost of increasing benefits, the County Board of Supervisors in 2002 passed a 50 percent benefit enhancement for all county employees.

But when the inevitable market downturn hit — a certainty for any long-term investor like SDCERA — paying the full cost of the 2002 enhancement fell to today’s taxpayers and public employees, who never received any of the benefits they are now being required to pay for.

In addition to forcing both groups to pay more, while getting less, the county also repeatedly cut the benefits offered to new hires to get its soaring retirement costs under control.

After reducing the retirement benefits offered to new hires in 2009 and again in 2013, the county earlier this year approved a plan to cut new employees’ benefits to the lowest level allowable under law, which are worth roughly half as much as those received by pre-2009 employees.

The current lawsuit that has delayed the implementation of this new, bare-bones retirement plan focuses only on how and when that plan will be implemented, not if.

This makes clear that all groups — including government employees — are harmed by the status quo.

Had the Board of Supervisors been informed of the true cost of the excessive and unnecessary 2002 benefit enhancement — and the degree of risk associated with relying on stock market returns to pay for it — this whole mess could have been avoided.

Requiring public pension funds like SDCERA to meaningfully account for risk will make it much harder for policymakers to force future generations to pay for their past funding failures.

And that’s good news for everyone concerned with the fiscal health of the county and the fair treatment of all its citizens — taxpayers and public employees alike.

Robert Fellner is executive director of Transparent California. This commentary was first published by the Voice of San Diego.

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.