Gauging the health of public pension funds has become something of a contact sport, with rating agencies, nonprofit budget reform groups and others weighing in with wildly differing calculations.
Actuaries, budget watchdogs, unions and pension fund managers have for years debated the correct method for calculating a pension fund’s future liabilities. While actuaries say they use standards set by the Government Accounting Standards Board, unions see recent changes by the GASB that pump up those obligations as a way to stoke public sympathy for cutting benefits.
The debate is raging from coast to coast, with recent hot spots, Rhode Island, Detroit and California, in the news.
The methods used to predict the future of a pension fund’s assets make all the difference in the figure put on future liabilities.
The nonprofit budget reform watchdog State Budgets Solutions claimed a few days ago that all the unfunded liability owed by state pension funds added up to $4.1 trillion. Does that sound like a lot? It should: It’s equal to one-quarter of the national debt.
State Budgets Solutions calculates that even the most well-funded pension plan – Wisconsin’s – came in at 57 cents on the dollar.
The ratings agency Moody’s used its own set of metrics to report in June that, in total, pension liabilities came in at 48 cents on the dollar. The states themselves were more optimistic, reporting a figure of 74 cents on the dollar.
Moody’s offers a glimpse of how big a difference changing underlying assumptions matters.
In California, where Gov. Jerry Brown pushed through a package of controversial pension reform measures, Moody’s estimate of the state’s unfunded liabilities grew from $128 billion in 2011 to about $329 billion in April.
The reason for the difference? Moody’s had abandoned the use of an 8 percent discount rate states use to predict investment gains. Instead, the ratings service chose the rate of return generated by high-grade corporate bonds for the basis of its predictions. Those rates are lower, generating a bigger funding gap.
Right or wrong, states cling to the higher discount rate.
And then there’s the State Budget Solution’s calculation. To arrive at it, the nonprofit group used a fair-market value method.
Boston College’s Center for Retirement Research looked at the issue of how best to determine a pension fund’s liabilities. In a 2010 paper, authored by Alicia H. Munnell, it concluded that using a so-called riskless rate was the best option for public pension funds.
The riskless rate relies on investments more conservative than the ones the states typically buy. Munnell is among those who advocate using a rate similar to that seen in Treasury yields. Part of her reasoning is that benefits in public pension are guaranteed. (This can be seen in California and Detroit, where legislative changes to pensions negotiated through collective bargaining are being challenged in the courts.)
“The argument is compelling that the liabilities of public pension plans, which are guaranteed under state law, should be discounted by a rate that reflects their riskless nature,” Munnell wrote. “Such a change would produce a large number. Liabilities would rise from $3.4 trillion to $4.9 trillion, and with $2.7 trillion of assets on hand, unfunded liabilities would rise from $0.7 trillion to $2.2 trillion.”
A paper published in 2012 by the Mossvar-Rahmani Center at Harvard’s Kennedy School of Government looked at the various methods used to determine the viability of pension funds. The lead author of the paper, Thomas J. Healey, wrote that they include the historical approach used by the standards board; the fair value approach; and the risk-free formula.
The standards board last year changed some of its rules for measuring a public pension’s unfunded liability. In the past, it had approved the use of the 8 percent rate of return. Now, as in the Moody’s re-evaluation of CalPERS, the California public pension system, it requires a lower discount rate be used.
“The new standards will improve the way state and local governments report their pension liabilities and expenses, resulting in a more faithful representation of the full impact of these obligations,” said GASB Chairman Robert H. Attmore. “Among other improvements, net pension liabilities will be reported on the balance sheet, providing citizens and other users of these financial reports with a clearer picture of the size and nature of the financial obligations to current and former employees for past services rendered.”
The rarely used fair value system, meanwhile, calculates the market value of a fund by determining the price its assets would fetch if sold to an insurance company or some other financial services business.
With an aging population, the debate over how to properly calculate pension obligations will continue. The stakes are high. If more pension funds fall short when benefits must be paid, taxpayers might be on the hook, or public employees may face cuts.
“To date, many public pension plan sponsors, along with public-sector unions, have resisted attempts to use lower discount rates in the valuation of public pension liabilities,” Healey wrote. “Reaction to suggestions that they do so has often been dismissive. This debate is a complex and nuanced one, and it deserves significant consideration given the myriad risks at hand.”