Pension risk was a topic in two recent P&I issues:
- Sept. 17, 2018 – Pension fund stress testing can help states prepare.
- Oct. 1, 2018 – How to overcome public fund risks.
Both the Sept. 17 article and the Oct. 1 editorial had a common agenda and very good ideas on the relationship between risk and pension benefits. Both offered positive observations on pension risk and how to ameliorate that risk.
However, both articles missed one of the main systemic problems in dealing with public pension plan risk: the material understatement of the pension obligations themselves. Both articles had an apparent presumption that pensions should be valued at a discount rate close to and related to their expected rate of investment return. That concept is wrong — especially if an assessment of risk is the goal.
Pensions are a financial promise from the plan sponsor to plan members and their beneficiaries. Benefits are a debt to the sponsor and a promise to pay to the member. Global debt markets are over $80 trillion, of which about $30 trillion is debt in the U.S. That debt is traded daily — to the tune of almost $1 trillion per day! The market price for debt is influenced by duration, quality and tax considerations, but it is a very large and vibrant market. And it is a free market uncontrolled by any individual or organization. The market changes daily — but for debt comparable to pension debt in quality and duration, the rate usually is near 4% recently.
Private plan sponsors are required to account for their plan obligations by comparing their pension obligations to quality debt with comparable durations — and most private plan sponsors use discount rates for this basis around 4% annually. Conversely, most public pension plans use discount rates near 7% to value plan obligations. This difference is quite material — if public plan obligations were stated near 4%, they would be close to 40% higher than stated at 7% annually.
Stress testing is important — and the key determinant to risk is the size of plan obligations both to plan assets and to the size of the plan sponsor. Looked at from a risk point of view, GM prior to bankruptcy was a pension plan that, as a sidelight, made cars and trucks. Early in the 2000s, one of California's public pension programs, CalSTRS, (understated) plan unfunded obligations were less than 100% of payroll. Now their (still understated) unfunded obligations are over 250% of pay. Lots more stress now than 15 years ago.
No one knows what future investment returns will be. But to the tune of $1 trillion in daily trades, we do know what the market value of debt is today. Until public pension plans start to evaluate risk at market prices, they will continue down the path of insolvency. You can't get an accurate assessment of risk without knowing the market's assessment of comparable risk. It is legal to value public pension obligations at 7%, but it is certainly not a prudent valuation of risk.
Clyde Beers
Mr. Beers retired from the firm that was then
Towers Perrin in 2000.
