Will Actuaries Come Clean on Public Pensions?

Link: https://www.cato.org/regulation/winter-2023-2024/will-actuaries-come-clean-public-pensions

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To appreciate the significance of using inappropriate discounting, consider this example: A 45‐​year‐​old public sector employee earns $75,000 per year with no pension plan or other benefits. To help secure her retirement, her employer considers changing her compensation to $73,000 in salary plus a U.S. Treasury zero‐​coupon bond that pays $5,000 in 20 years. The bond is selling in the market at $2,000. The Treasury bond’s implicit annual “discount rate” is thus 4.69 percent, i.e., $2,000 plus 4.69 percent interest compounded for 20 years equals $5,000.

The total compensation cost to the employer would remain $75,000. The employee, in turn, has three options:

  • She can sell the bond and be in an identical position as before.
  • She can accept her employer’s nudge and keep the bond until retirement.
  • She can sell the bond and invest the $2,000 in other assets, e.g., stocks, in the hope of generating additional retirement income, albeit taking the risk that she may end up with less than $5,000.

Now suppose the public employer decides to be more paternalistic. Instead of giving the employee the Treasury bond worth $2,000, it promises her that in 20 years it will pay her $5,000. To fund this liability, the employer could deposit the $2,000 in a trust and have the trust buy the Treasury bond. The promise would then be fully funded by the trust. In 20 years, the Treasury bond would be redeemed for $5,000 and the proceeds forwarded to the employee. In the intervening 20 years, before the bond redemption and payment to the employee, the value of the future payment would increase with the passage of time, and increase (or decrease) as market interest rates decrease (or increase). But the value of the bond held in the trust would change identically to the liability, and the contractual obligation to pay $5,000 at age 65 would remain fully funded at every instant until paid, regardless of what happens in financial markets. Ignoring frictional costs and taxes, the employer’s cost of those actions would be the same as if it had paid the employee $75,000 in cash. And the employee’s total compensation would still be $75,000: $73,000 in cash plus a promise worth $2,000.

But instead of contributing the $2,000 and using it to buy the bond, the public employer could hire a public pension actuary and invest any trust contributions in a “prudent diversified” portfolio including assets, like equities, exposed to various market risks. The actuary would attest that the “expected” annual earnings of the portfolio over the long term is 7 percent (according to a sophisticated financial model). The actuary would then use the 7 percent to discount the $5,000 future payment and certify that the “cost” to the employer is $1,292, which is 35 percent less than the $2,000 cost of the Treasury bond. The actuary would certify that if the employer contributes the $1,292, its benefit obligation is “fully funded” because, if the trust earns the “expected return” of 7 percent (50 percent probable, after all), the $1,292 will accumulate to $5,000 in 20 years. The public employer can then claim it has saved taxpayers $708 ($2,000 – $1,292) by investing in a prudent diversified asset portfolio.

The question is, does it really cost only $1,292 to provide the same value as a $2,000 Treasury bond? Is $1,292 invested in the riskier portfolio worth the same as a Treasury bond that costs $2,000? Of course not. If it is possible to spin $1,292 of straw into $2,000 of gold, why would the government employer stop at pensions? Why not borrow as much as possible now and invest the proceeds in a prudent diversified portfolio expected to earn 7 percent and use the “expected” gains from taking market risk to pay for future general government expenditures?

The public employer is providing a benefit worth $2,000—a guarantee—and hoping to pay for it with $1,292 invested in a risky portfolio. The $708 difference represents the value of the guarantee that taxpayers will make good on any shortfall when the $5,000 comes due. The cost to taxpayers in total is still $2,000, but $708 is being taken from future generations by the current generation in the form of risk. Risk is a cost (precisely $708 in this example). Its price reflects the possibility as viewed by the market that future taxpayers ultimately may have to pay nothing at all if things go well, or a significant sum if they don’t.

Suppose the employer takes this logic one step further and, rather than promising $5,000 in 20 years, it contributes $1,292 to a defined contribution plan that invests in the same prudent diversified portfolio on the theory that the employee will be breaking even because the $1,292 is “expected” to accumulate to $5,000. The employee would be correct to view that as a cut in pay. The $708 cost of risk is shifted to the employee, reducing her compensation, instead of being borne by future taxpayers as in the case of the defined benefit plan.

The employee might complain. Future taxpayers cannot.

The only way for the employer to keep the employee whole with $73,000 of cash compensation plus a defined contribution plan is to contribute $2,000 to the plan. Whether it is invested in the Treasury bond or in riskier assets in the hope of higher returns, the value of her total compensation would still be $75,000.

Table 1 summarizes all these scenarios. The fourth column is the analog of public pension plans. Both the reported annual cost for the future $5,000 payment ($1,292) and the reported total compensation ($74,292) are understated. Investment professionals are paid well for managing risky assets for which high expected returns can be claimed. The actuary collects a fee. The employee has the value of the guarantee and bears none of the market risk being taken. Along with a happy employee, the public employer gets to report an understated compensation cost, freeing up money for other budget items. It’s good for all involved—except for the taxpayers on the hook for $708 in costs hidden by using the 7 percent discount rate.

Author(s): Larry Pollack

Publication Date: Winter 2023-2024

Publication Site: Cato Regulation

The Teacher Retirement System of Texas needs to adjust its investment return assumptions

Link: https://reason.org/commentary/the-teacher-retirement-system-of-texas-needs-to-adjust-its-investment-return-assumptions/

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An adjustment of the assumed rate of return down to 7.0% means the plan will recalculate pension debt upwards in 2023, but will also be better positioned to avoid future debt growth over the longer run. The forecast in Figure 2 compares the growth of TRS’ unfunded liabilities under three scenarios: 

  1. Returns meet TRS assumptions;
  2. TRS experiences two major recessions over the next 30 years;
  3. And, TRS makes actuarially determined contributions (also using the two-recession scenario).

With this actuarial modeling of the system, it is clear that statutorily limited contributions will continue to pose funding risks for TRS that will be borne by Texas taxpayers. A proposed 7.0% assumed return will readjust 2023 unfunded liabilities upwards by $6.5 billion, but the plan will suffer fewer investment losses over the next 30 years when the plan inevitably experiences returns that diverge from expectations. TRS’ unfunded liabilities will remain elevated under the rigid statutorily-set contributions. If, however, TRS was to transition to Actuarially Determined Employer Contributions (ADEC) each year, then even by recognizing higher 2023 debt (under a 7.0% assumption) TRS could shave billions off its unfunded liabilities by 2052 ($74.7 billion down from $81.3 billion with current 7.25% assumption).  

Author(s): Anil Niraula, Zachary Christensen

Publication Date: 15 Jun 2022

Publication Site: Reason

What is the State of Pensions in 2022?

Link: https://www.truthinaccounting.org/news/detail/what-is-the-state-of-pensions-in-2022

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State retirement systems in America are still Fragile. 

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Despite state and local plans reporting disappointing preliminary investment returns averaging -10.4% in 2022 , there has been a net positive funded ratio trend on net over the past three years. 

Funded status in 2022 for state and local retirement systems has declined considerably from last year, the sharpest single-year decline since the Great Recession and financial crisis. Investment return volatility is contributing to some significant swings in funded levels, which has been compounded by rising inflation and geopolitical turmoil. 

Author(s): Anthony Randazzo, Jonathan Moody

Publication Date: 26 July 2022

Publication Site: Truth in Accounting

NJ OPEB Update – 2020

Link: https://burypensions.wordpress.com/2022/04/26/nj-opeb-update-2020/

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There are three separate reports for statelocal government, and local education which throw a lot of distracting numbers at you but, when added up, show that after an amazing 1/3rd reduction in the total OPEB Liability (from $110 billion as of 6/30/16 to under $74 billion as of 6/30/19) the state actuaries sharply reversed course.

Author(s): John Bury

Publication Date: 26 Apr 2022

Publication Site: Burypensions

Actuarial Assumptions and Valuations of the State-Funded Retirement Systems

Link:http://www.auditor.illinois.gov/Audit-Reports/Performance-Special-Multi/State-Actuary-Reports/2021-State-Actuary-Rpt-Full.pdf

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The combined total of the required Fiscal Year 2023 State contribution
for the six retirement systems was $10.97 billion, an increase of $0.14
billion over the previous year. Cheiron verified the arithmetic calculations
made by the systems’ actuaries to develop the required State contribution
and reviewed the assumptions on which it was based.

The Illinois Pension Code (for TRS, SURS, SERS, JRS, and GARS)
establishes a method that does not adequately fund the systems, back
loading contributions and targeting the accumulation of assets equal to 90%
of the actuarial liability in the year 2045. This contribution level does not
conform to generally accepted actuarial principles and practices. Generally
accepted actuarial funding methods target the accumulation of assets equal to
100% of the actuarial liability, not 90%.

According to the systems’ 2021 actuarial valuation reports, the funded
ratio of the retirement systems ranged from 47.5% (CTPF) to 19.3%
(GARS), based on the actuarial value of assets as a ratio to the actuarial
liability. If there is a significant market downturn, the unfunded actuarial
liability and the required State contribution rate could both increase
significantly, putting the sustainability of the systems further into question.

Author(s): Frank J. Mautino

Publication Date: 22 Dec 2021

Publication Site: Office of the Auditor General, State of Illinois

Pension Plan Actuarial Assumption Litigation: The End is Not Yet in Sight

Link:https://www.jdsupra.com/legalnews/pension-plan-actuarial-assumption-5162449/

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One recent line of ERISA litigation involves the actuarial equivalence factors used by defined benefit pension plans.  The lawsuits apply both to active defined benefit pension plans and pension plans that have been “frozen” as to future benefit accruals.

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Basically, the lawsuits allege that the plan, through the use of out-of-date and “unreasonable” actuarial assumptions and conversion factors, has “overcharged” participants when converting from the Life Annuity Benefit to payment in an alternate payment form. 

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In many of the cases, the challenge focuses on allegedly outdated mortality tables that do not take improved life expectancy into account.  In some situations, the actuarial factors (including mortality table assumption) were established decades ago and have never been updated.  In essence, the lawsuits allege that the plan (by not using updated factors and tables) is not paying out the full value of the participant’s benefit when the participant has elected payment in an alternate payment form.

Author(s): Gregg Dooge

Publication Date: 20 Jan 2022

Publication Site: JD Supra