An independent panel of the Society of Actuaries has laid out a path to strengthen public defined benefit plans, championing the valuation of pension liabilities in a more economically realistic way.
The proposal, presented in a report released Feb. 24, frames the issue of improving funding levels by tackling the conflicting objectives of pension plans, including cost stability vs. investment volatility and intergenerational equity vs. short-term public budgeting pressures.
Depending on the path sponsors take, these areas can contribute to strengthening or weakening public funds. Public retirement systems have tended to favor expedient approaches that lowered pension contributions and liabilities in the shorter term, but in the longer term undermined long-term funding levels and retirement security.
The question is whether the constituencies involved with public funds, including actuaries, pension trustees, and the Actuarial Standards Board, will accept the SOA panel's recommendations.
They should embrace them. But their impulse in the past has been to resist infusing the systems with better economics. When the Governmental Accounting Standards Board sought to change the accounting method for valuing liabilities, it was pressured to moderate its initial ideas.
With the SOA panel's proposals, it is in the interest of proponents of public retirement systems, including actuaries, to change. Otherwise the systems sow their own seeds of vulnerability to building pressures to scrap defined benefit plans and move to defined contribution plans, putting all investment risk onto participants.
The SOA panel's proposal seeks to help public sponsors to make their systems stronger.
One of its key recommendations is that public retirement systems should use a forward-looking rate to discount pension liabilities to give a truer economic picture of plan costs, rather than historical plan returns, which tend to understate liabilities.
The new rate would replace the actual long-term rate of return on plan assets generally used now by sponsors and their actuaries to discount liabilities and set contribution levels.
The panel should have gone further and recommended the use of a risk-free rate — or the rates on the Treasury yield curve — for valuing pension liabilities. In the 68-page ”Report of the Blue Ribbon Panel on Public Pension Plan Funding,” the 12-member panel recognized the superiority of the use of the risk-free rate for such valuation.
“Economic theory suggests that achieving full intergenerational equity means that current taxpayers should pay the "risk-free' cost of services so as not to burden future taxpayers with the cost of investment risk being taken by current taxpayers,” the report said.
“The panel recognizes that most plans prefer the lower current cost achieved by assuming higher expected investment returns (and therefore higher risk taking and a possible shift of costs to future generations), as opposed to preserving pure intergenerational equity.”
Benefits that are riskless, such as those pension benefits protected by provisions in state constitutions that prohibit reductions, should be discounted at the risk-free, or at least a very low, rate to provide for funding adequacy to ensure pension promises are kept.
Public plans believe their sponsoring entities, states and cities, don't go out of business, enabling them to withstand short-term market and funding challenges and use a higher assumed rate. But the bankruptcy filings by Detroit and some other cities reveal the fallacy of that thinking. States cannot seek bankruptcy, but economic challenges might force their taxpayers to do so, or at least be unable to bear further economic burdens, making difficult raising revenue to finance pension contributions.
The SOA panel instead chose a forward-looking rate, which it said would be lower than the rate generally in use now by public sponsors. For forecasting the rate, “it is important to consider the extent to which future economic and market conditions may differ from those of today or of the past,” the report said, noting “the long-term secular decline in interest rates ... strongly suggests that the robust fixed-income performance of the past is not likely to be repeated in the future.”
The panel incorporates the risk-free rate as a risk management tool as part of its recommendations to enhance disclosure of public systems. It recommends using the risk-free rate for reporting purposes to discount liabilities and to compare it against the investment return assumption as a way to gauge the level of investment risk taken by the plan. Such a move would be a good step toward assessing the risks and costs of plans.
The underfunding of plans tends to derive from a lack of contributions and the overpromising of benefits, including cost-of-living increases, rather than from insufficient returns on assets. Many funds have tended to achieve their assumed rate of return over the long term.
“Funding adequacy and intergenerational equity should take precedence over the goal of cost stability and predictability,” the report said. Even though “predictability of cost in the short term is important for public budgeting purposes,” the report said, “allocating a significant portion of investments to higher-risk, more volatile assets will tend to undermine the goal of cost stability.”
In addition, the panel recommends governmental entities responsible for funding and plan trustees “should strive to fund 100%” of pension obligations, rather than the 80% typically considered as adequate. “Financial resources, including both current and future contributions, should be adequate to fund benefits over a broad range of expected future economic outcomes” and “respond to changing economic conditions,” the report said.
Among the recommendations, the report calls for other enhanced disclosure, which would help taxpayers understand the complexities of pension finance and could build support for strengthening plans.
The panel plans to take its recommendations to the Actuarial Standard Boards, which adopts standards of practices for the actuarial industry. The process might take some time to play out, even if the ASB embraces the panel's recommendations.
Trustees should not wait; they should adopt the suggestions. That would take agreement from the funding sources of public plans, especially state and local legislators. But the status quo leaves the plans vulnerable to underfunding.
If public entities want to keep defined benefit systems, they have to make funding a priority. The SOA panel shows them how to do so. n