Last week an article ran in the Warwick Beacon that was based on a chart I produced. I have since updated the chart to reflect the most recent FY 2011 numbers contained in the FY 2013 budget. (The first chart was based on the original FY 2011 budget.)
The chart shows Warwick, Rhode Island’s municipal budget (excluding the school budget) carved up according to current costs for funding the town’s pension benefits, Other Post Employment Benefits (OPEB), current employee healthcare costs and General Obligation bond payment. The figures come from official budget documents.
My value-added is that I estimate the additional amount needed to fully fund pensions based on the risk-free discount rate. It’s a ballpark estimate backed into based on the plans’ valuation reports. The actuaries, with access to all the plan data, can model the effect of applying the risk-free rate to plan costs more precisely.
It caused quite a stir.
I think the Beacon article shows the myriad problems with how public sector benefits have been valued, accounted for and funded. The piece underscores the misconceptions and cloudy thinking that surround pension finance.
Let’s go through it.
Here’s the question the chart addresses: If Warwick, Rhode Island were to fully fund employee benefits while paying healthcare costs for current retirees and active employees and make its annual bond payment, how much would be left over to fund everything else in the city budget?
Warwick operates four public pension plans. They are the locally-funded: Firefighters/Police I Pension Plan, Fire II Pension Fund, and Police II Fund. The fourth plan, the Municipal Employees Retirement System (MERS)
is jointly funded by the state and participating local governments. (correction: the MERS plan is also locally operated and funded and is distinct from the state-run MERS plan).
Using these plans’ assumed 7.5 percent discount rate to value the liability, only one plan appears to be in deep distress. The Police/Fire I plan is 22 percent funded and requires an annual contribution of around $14 million. The remaining plans seem to be relatively well-funded. Together they add a further $12 million in annual contributions. In total, according to the pension valuation reports for the town of Warwick, fully funding these four pension systems requires an annual contribution of $26.4 million from the city.
Now, when valuing these four systems using the risk-free discount rate, the picture changes. The risk-free rate adds a further $29 million to the annual required contribution. Valuing these plans on a market basis doubles the annual contribution to $55.7 million. That’s 48 percent of the town’s municipal budget in FY 2011.
Employees also receive Other Post Employment Benefits (OPEB) - largely comprised of healthcare – in their retirement. According to the OPEB valuation Warwick spends $7.2 million to pay for current retirees who are now receiving these benefits. (Note, that the budget gives a slightly different total than the OPEB valuation. In the budget, OPEB ran about $6.68 million in FY 2011) If the town were to fully fund OPEB benefits for their current workers they would need to contribute a further $14 million. That represents the amortization of OPEB taken from the valuation report.
On top of this Warwick is contributing $
12.5 $11.8 million to pay for current employee healthcare benefits in FY 2011 (see, Annual Budget, FY 2013). I added in General Obligation debt (principle and interest payments) of $8.5 million, since I assume this is a non-negotiable expense for the municipality. That leaves Warwick with about 18 percent of its FY 2011 budget remaining.
(Are my numbers wrong? have a look at their reports and let me know if I have made a mistake.)
On the Beacon article, I will underscore three points.
1) The risk-free rate and why it matters. To value and fund a pension plan requires figuring out how much is needed to be set aside today to fund a promised benefit to be paid in future. One must equate the value of a pension to be paid in the future with its value today (the time value of money). That means one must assume a discount rate (i.e., rate of interest) to convert the future value into the present. That enables one to figure out the amount needed to be set aside today to fund tomorrow’s payments.
As most followers of the pension story know, in choosing that discount rate, public sector pension plans look to what rate of return they expect the plan’s assets will return when invested. Most public plans have assumed a rate of return of 8 percent on their assets.
This approach, embedded in GASB 25 and ASOP 27 has been strongly criticized by financial economists as violating several established precepts of economics. Firstly, assets and liabilities should be kept separate for the purpose of valuation, otherwise known as the Modigliani-Miller theorem.
Public pensions represent a secure, government-guaranteed benefit and are not likely to be defaulted upon. Public pensions should be valued like a government bond. The rate to use is the return on Treasury bonds, currently 2.3 percent.
But what policymakers are worked up over is not the economic principles behind discount rate selection. It’s the practical effect that many politicians and plan sponsors protest, as The New York Times story of yesterday highlights. Lowering the discount rate increases the liability and the amount needed to fund the plan. That has a real impact on the budget, as the Warwick chart shows.
The best and most lucid explanation for market valuation of pensions, I think, can be found in Pension Finance, by M. Barton Waring. (whose intent, I might add, is to save the defined benefit plan.) Other excellent explanations are provided by Douglas Elliot of the Brookings Institute, economists Joshua Rauh and Robert-Novy Marx, Andrew Biggs, and Jeffrey Brown.
David W. Wilcox, the director of research and statistics for the Federal Reserve Board has stated:
These [public pension benefits] happen to be really simple cash flows to value. They’re free of credit risk. There’s only one conceptually right answer to how you discount those cash flows. You use discount rates that are free of credit risk. This is one of those things where it just really is that simple.*
Now for a few common objections to the risk-free rate. These are perennial and have been very elegantly addressed elsewhere by economists.
2) “But, the private sector uses…”
Private sector defined benefit plans suffer from their own set of accounting and moral hazard problems; and, they use a variety of discount rates for a variety of reasons.
Pension plans governed by the Taft-Hartley Act are collectively bargained-for plans. These plans use the return on assets (7.5%) to value the actuarial liability. According to a March 2012 analysis by Credit Suisse, such discount rate “hocus pocus” means Taft-Hartley plans are now “crawling out of the shadows” with an unfunded liability of about $369 billion when using the corporate bond rate.
Other corporate pension plans are covered by the Pension Protection Act of 2006 and governed by FASB guidance 158. They use a composite return on corporate bonds to value their pensions, currently in the 5 percent range, which is lower than the rate used by public plans. The corporate bond is closer to a low-risk (though not a guaranteed) rate. Public plans carry a stronger guarantee, as they are backed by government, and therefore should be discounted using lower rates than used by the private sector – not a higher one – as is current practice.
“So, why do public and private plans get to value their pension liabilities differently?” (Quick answer: exactly!)
If the Law of One Price is correct (which holds that in an efficient market there must be only one price for similar assets, otherwise opportunities for arbitrage exist) then then salad bar approach to selecting the discount rate is absurd.
The Long Answer:
Actuarial practice has not incorporated the lessons of modern portfolio theory into pension accounting. In the 1960s and into the 1970s the harm was not visible. Pensions were more heavily invested in bonds. The ticking time bomb that ‘high risk’ discount rates presented to defined benefit plans was not really revealed until the behavior it encouraged began to manifest. These behaviors included the shifting of pension asset portfolios into more risky investments, enhancing benefits, and skipping payments during the 1980s and 1990s. The result was growing funding gaps that accompanied market downturns in the late 1990s, the early 2000′s, and lastly in 2008. Each of these episodes is a demonstration of the problem of valuing liabilities based on risky asset returns.
For some insight into how actuarial science remained largely frozen in time, Jeremy Gold and Lawrence Bader discuss the gap between corporate finance and actuarial practice.
3) “We’ll get the expected 7.5 percent”.
This is another recurring defense of the current public sector accounting. But, an investor doesn’t “get” the expected return. The investor realizes a random and uncertain draw from an increasingly wide distribution of possible realized returns (Waring, 2012).
An oft-expressed rejoinder is, “…but the market returned an average of 8 percent over the past 20 years.”
This statement alone should be cause for alarm. There is always a chance you will either do better, or worse, than expected. Yet, by virtue of ASOP 27 and GASB 25 the risk of not achieving 8 percent annually, is simply ignored. (Or more accurately it is borne by future taxpayers and younger retirees.) Discounting benefits at a risk-adjusted interest rate captures the cost to taxpayers of having to supplement pensions should projected returns not be realized and the plan’s assets fall short.
The coming years will satisfy a proposition of Waring’s that I think is worth stating again:
Measures of the pension plan based on conventional accounting methods will always follow measures based on economic accounting, even with a lag. The accounting will follow the economics, sooner or later.
The economics on this issue is non-controversial. One can review the work of Nobel-Prize economists Bill Sharpe (one of the developers of the Capital Asset Pricing Model), Robert Merton, (expansion of Black-Schoeles option pricing model), as well as the contributions of finance professors Roger Ibbotson (Yale) and Olivia Mitchell (Wharton, UPenn) for further reading.
The policy message the economics points to is unsettling. Defined benefit plans are in trouble and they will require more funding and difficult budget and policy decisions starting now.
And, who really wants to hear that?
So, the best I can do to drive home the importance of market valuation is to re-state the analogy. You don’t calculate the employer’s annual payment to the pension system based on how the plan’s assets are expected to perform. Just as you don’t value your home mortgage based on what you think your 401K might do. This video developed by Nobel-Prize winning economist Bill Sharpe makes the case perhaps better than I can do in this blog.
*Wilcox, David. Testimony before the Public Interest Committee Forum sponsored by the American Academy of Actuaries, September 4, 2008. Novy-Marx and Rauh present a similar argument; see Novy-Marx, Robert, and Joshua Rauh, “The Liabilities and Risks of State-Sponsored Pension Plans,” Journal of Economic Perspectives, vol. 23, no. 4 (Fall 2009), pp. 191–210. In analyzing federal employee pensions, the CBO used a discount rate 1 percentage point above the Treasury rate. However, the CBO explicitly noted that this was because federal pensions lack the legal protections that state pension plans like the WRS are entitled to.