A surprising reason dissident actuaries advocate using a much lower earnings forecast for public pension investment funds is “intergenerational equity,” ensuring that the pensions of government workers are paid by the generation that receives their services.
A recent paper by the dissidents does not mention the usual criticism that pension earnings forecasts are too optimistic, not likely to be achieved, and hide massive underfunding. When the earnings forecast is lowered, pension debt or the “unfunded liability” goes up.
For example, the “California Pension Tracker” website shows California public pensions in 2013 with a debt of $281.5 billion when a typical 7.5 percent earnings forecast is used. Drop the earnings forecast to 3.7 percent and the debt soars to $946.4 billion.
The paper’s authors are dissidents because they follow the principles of mainstream financial economics, not standard actuarial practice, when they advocate a risk-free earnings forecast to discount debt for guaranteed pensions, something like a U.S. Treasury bond.
“Our analysis seeks to maximize efficiency and preserve intergenerational equity,” said the paper issued by the dissidents last August. “We conclude that full funding based on default-free discount rates is efficient and fair across generations.”
With little or no risk of loss, investments with predictable yields could closely match the cost of pensions workers earn during a year, minimizing debt passed to future generations. But that would be costly. The yield on the 20-year Treasury bond last week was 2.2 percent.
The $300 billion diversified CalPERS investment portfolio, about half in stocks, is expected to earn an average of 7.5 percent. But after huge investment losses, CalPERS is 68 percent funded with a $139 billion unfunded liability being paid off over 20 to 30 years.
The dissidents contend that under the basic public finance principle of intergenerational equity, each generation should pay for the services it receives. So, for example, the cost of a police officer and a police station should be financed differently.
The total compensation of a police officer, pay and pension, should be paid for out of the current operating budget. But the cost of a newly built police station can be paid off over time because, unlike the officer, the station will serve current and future generations.
Intergenerational equity is not a new notion. When the state briefly delayed contributions to CaPERS, an appellate court ruled in 1997 that orderly payments are needed to ensure an actuarially sound system to assure pension payments and “intergenerational taxpayer equity.”
The concept got a recent boost from new Governmental Accounting Standards Board rules for reporting pension debt. Investment losses should be paid off over five years and other actuarial changes should be paid off over the average time workers will remain on the job.
The “average remaining service life” the California Public Employees Retirement System calculated for its more than 2,000 state and local plans is four years. The California State Teachers Retirement System calculated an average remaining service life of seven years.
Ways to improve pension intergenerational equity have been suggested. A well-known pension expert, Girard Miller, suggested a transition beginning with a 20-year amortization or payment period and slowly moving to the average remaining service life.
A Pensions & Investments editorial (“Intergenerational Fairness,“ June 27, 2016) said public pension boards should have a representative of future generations and adopt the private-sector pension policy of paying off unfunded liabilities over seven years.
“Future generations must be protected from decisions contracted against their interests by the current generation. Keith P. Ambachtsheer in his book, ‘The Future of Pension Management,’ published this year, calls for a legal mechanism to secure such protection,” said the editorial accompanied by this cartoon.
The paper by the dissident actuaries emerged from a joint task force of the American Academy of Actuaries and the Society of Actuaries. The authors are Ed Bartholomew, Jeremy Gold, David G. Pitts, and Larry Pollack.
The paper written by long-time advocates of financial economics principles did not pass a peer review by the two actuarial groups and was not published, drawing criticism in the financial press. The Society of Actuaries released the paper later.
The main dispute is whether the principles of financial economics that apply to the rest of the world’s financial activities, including the capital markets, should also apply to public pension debt.
Traditional actuaries say pensions are an exception to financial economics because there is no regular market where pension debt, with complex risks such as longevity, is bought and sold.
Dissidents say there are other financial tools that can determine pension value and estimate the additional cost of a complex risk. The calculation may be less precise, but it’s not something that can’t be done.
Traditional actuaries tend to focus on avoiding budget-jolting shocks in the annual contribution rates that government employers pay for pensions, less on the debt or unfunded liability created when the rates and investment earnings fall short of the annual target.
Reformers and critics grounded in financial economics view a pension unfunded liability as a bond-like debt that must be paid off. Actuaries have a different view, citing another reason that pensions are an exception: Most governments can’t go out of business, unlike corporate pension sponsors.
“I’ve spoken with numerous public-sector actuaries and plan administrators whose unshakeable mindset has been that their plans are perpetuities and therefore it’s reasonable to defray accumulated pension deficits (unfunded liabilities) over extended periods that have no relationship to the lives of the retirees and current workers,” Miller, the pension expert, said in a Governingmagazine column on March 8, 2012.
That mindset resulted in the “open” or “rolling” amortization used by some public pensions to pay off unfunded liabilities. The debt is refinanced each year and theoretically might never be paid off, unless booming investment markets produce a period of full funding.
CalPERS has used “rolling” amortization in addition to spreading gains and losses over 15 years to avoid employer rate shocks and “smooth” contributions. It’s radical smoothing, far beyond the typical public pension smoothing period of three to seven years.
In a switch to a more conservative actuarial method resulting in a large employer rate increase, CalPERS adopted “direct rate smoothing” three years ago that pays off gains and losses over 30 years, with rates going up in the first five years and down in the last five years.
Actuaries want pension systems to be moving toward full funding, but getting there is not like paying off a bond. It’s only a projection over decades that employer-employee contributions and the forecast of investment earnings will cover projected pension costs.
CalPERS was 101 percent funded in 2007 and only 61 percent funded two years later in 2009. Heavy losses during the recession and stock market dropped the CalPERS investment fund from $260 billion to about $160 billion.
Not only is full funding a kind of mirage, when as with CalPERS risky investments are expected to cover two-thirds of pension costs, but it also can create political pressure to spend the “surplus” by cutting contributions and increasing pension benefits.
“Relatively small surpluses provide a cushion for benefits being earned (valuation timing) and for emerging gains and losses,” said the dissidents’ paper. “Large surpluses become fodder for the political process, with the current generation likely to increase benefits and/or take funding holidays.”
During the high-tech boom in the late 1990s, all three of the big state pension systems spent their funding “surpluses,” large and small, by cutting employer contribution rates and increasing pension benefits. (See Calpensions post, “What went wrong” 10 Jan 11)
Now despite a lengthy bull market since the recession, CalPERS as noted earlier is only about 68 percent funded. Experts say if funding drops below 40 percent, raising rates and earnings forecasts high enough to project 100 percent funding may become impractical.
Last November CalPERS adopted a strategy to slowly reduce investment risk by slightly dropping its earnings forecast in years with high returns. Some statistical modeling estimates the current 7.5 percent forecast could be lowered to 6.5 percent in two decades.
The strategy will slowly shift CalPERS investments away from stocks to less risky bond-like investments, probably resulting in a rate increase. For California pensions, the CalPERS risk strategy and the dissidents’ paper are a turn back toward the roots.
All pension fund investments had to be in bonds, or something similar, until voter approval of Proposition 1 in 1966 allowed 25 percent of investments to be in blue-chip stocks. Then Proposition 21 in 1984 allowed any “prudent” investment.
Turning back toward intergenerational equity would be costly and a reversal for lawmakers. Legislation 25 years ago (AB 1104 in 1991) created a pension-like investment fund for state worker retiree health care.
But lawmakers never put money in the fund as retiree health care became one of the fastest-growing state costs, creating a $74 billion unfunded liability. Gov. Brown is currently negotiating labor contracts that require state workers to begin contributing to the fund.
Cost containment was the announced goal last year when Brown said he would push prefunding for retiree health care. There was, however, at least one nod toward intergenerational equity as spending on state worker retiree health care neared $2 billion a year.
“Not setting aside funds for retiree health benefits earned during employees’ working lives violates a fundamental tenet of public finance — that costs should be paid in the year when they are incurred,” Legislative Analyst Mac Taylor said in his annual “fiscal outlook” issued in 2014.