Two actuarial associations did not publish a controversial paper by their joint task force, reflecting a split in the profession over whether public pension debt should be measured with risk-free bonds or the earnings forecast for stock-laden investment funds.

Using safe but low-yield bonds to offset or “discount” future pension obligations would cause pension debt to soar, creating pressure to raise the annual rates paid by state and local governments that are already at an all-time high for many.

Critics have been contending for a decade that overly optimistic pension fund earnings forecasts conceal massive debt and the need to take even more money from government budgets or find a way to cut pension costs.

The leading California critics, now mainly at Stanford University, are not professional actuaries. They have backgrounds in finance, like David Crane, and in academic economics, like Joe Nation and Joshua Rauh.

The paper of the joint Pension Finance Task Force paper of the American Academy of Actuaries and the Society of Actuaries, which did not make it through the usual peer review process, was based on the principles of financial economics.

“One of the assertions of the paper is that public pension plans are purported to be default-free obligations so they would be valued using default-free interest rates,” an anonymous former task force member told Pensions & Investments.

Although not as well publicized as criticism from outside the profession, a group of actuaries has been urging the adoption of a risk-free discount rate for about a decade, said Paul Angelo of Segal Company actuaries in San Francisco.

Angelo, chairman of the California Actuarial Advisory Panel, does not favor the use of a risk-free discount rate. He agrees with not publishing the task force paper, saying it lacked the “science” to support the change and relied only on assertions.

For the first time, Angelo said, the actuaries urging a risk-free discount rate went beyond simply reporting debt and seemed to be advocating its use to set the annual payments to the pension fund made by government employers.

The California Public Employees Retirement System and the California State Teachers Retirement System currently assume their pension fund investments, expected to pay two-thirds of future pensions, will average 7.5 percent a year in future decades.

The systems use the 7.5 percent long-term earnings forecast to reduce or “discount” the cost of future pensions, as if it were money in the bank. Thirty-year U.S. Treasury bonds, regarded as risk free, were yielding 2.23 percent last week.

When a much lower rate is used to discount future pension obligations the pension debt or “unfunded liability,” the shortfall in the projected money available to pay future pensions, balloons to a much larger amount.

An example is shown on the “California Pension Tracker” website directed by Joe Nation at the Stanford Institute for Policy Research.

The debt of California public pension systems in fiscal 2013 using a 7.5 percent discount rate is $281.5 billion. Using a lower discount rate of 3.723 percent (the CalPERS rate in 2013 for terminating plans) the pension debt more than triples to $946.4 billion.

California Pension Tracker

California Pension Tracker

The giant California Public Employees Retirement System, covering half of all non-federal government employees in California, is deep in debt even when using its 7.5 percent discount rate.

CalPERS has not recovered from a $100 billion investment loss during the financial crisis. Its investment fund was $260 billion in 2007, dropped to about $160 billion in March 2009 and was $306 billion last week.

In 2007, CalPERS had 101 percent of the projected assets needed to pay future pensions. Now after weak earnings during the last two fiscal years, its funding level is lower than the outdated 75 percent reported in a previous Calpensions post.

A CalPERS spokesman said the funding level for the last fiscal year ending June 30 is an estimated 68 percent. Nearly a decade later, that’s not much higher than the CalPERS funding level of 61 percent in 2009 at the bottom of the financial crisis.

The reassurance that CalPERS long-term earnings average more than 7.5 percent has eroded, dropping to 7.03 percent for the last 20 years. And the outlook is dim: The 10-year earnings forecast from Wilshire and other CalPERS consultants is 6.64 percent.

Girard Miller is probably not rethinking a line from his widely circulated Governing magazine column in 2012 debunking a dozen “half-truths and myths” used by both sides in the public pension debate:

“Pension funds are not going to invest their entire portfolio in 3 percent Treasury bonds right now — or ever — so the risk-free model is not even descriptive of reality and has little normative value.”

The current Economist magazine says (“No love, actuary” Aug. 13-19 issue) it has seen a draft of the joint pension task force report and thinks the two actuary associations should allow the paper to be published.

“American public-sector deficits are more than $1 trillion, even on the most generous of assumptions,” said the magazine. “This is an issue in which debate should not be stifled.”

Some of the debate was aired when the Governmental Accounting Standards Board spent several years developing new rules that took effect in 2013 and 2014. Pension systems can use their earnings forecasts to discount future pension obligations.

But if the projected assets fall short of covering the pension obligations, the system must “crossover” and use a risk-free rate to discount the remainder of the pension obligation. CalPERS did not have to crossover.

The new accounting rules require pension systems to use the “blended” rate to report pension debt. But they can continue to use the previous method based only on their earnings forecast to set the annual rates paid by employers.

The California Actuarial Advisory Panel agreed with the blended rate and suggested a few tweaks in a letter to GASB on Sept. 17, 2010, from the chairman at the time, Alan Milligan, CalPERS chief actuary, who is retiring this year.

An independent “Blue Ribbon Panel” commissioned by the Society of Actuaries issued a report in 2014 that, among other things, endorsed the use of some version of a risk-free discount rate.

“The Panel believes that the rate of return assumption should be based primarily on the current risk-free rate plus explicit risk premia or on other similar forward-looking techniques,” said the panel report.

Angelo said the influential Actuarial Standards Board, which was essentially neutral in Actuarial Standards of Practice issued in 2013, may revisit the risk-free discount rate issue, possibly within a year or so.

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Originally posted at Cal Pensions.