Tag Archives: Laura Quinby

Pension accounting narratives

The controversy over just how expensive public pension plans are, and are likely to be, is growing more contentious. The reason is that some defenders of the current system cavalierly dispense with insights of financial economics in favor of a story that unravels on closer inspection.

Here is one current narrative. State budgets only require 3.8 percent of total spending to pay for pension obligations. This is taken from a report by the Center for Retirement Research at Boston College by Alicia Munnell, Jean-Pierre Aubry, and Laura Quinby.

Read the report more closely. This claim is based on what states contributed on average in 2008. First, it is an aggregate number. Second it is based on an 8 percent discount rate. That is, this is what states contributed, on average, based on the flawed notion that it is possible to lower the size of your debts by assuming high returns on your assets. Yes, they weren’t contributing very much. Their accounting is set up to ensure they underfund their pensions.

Secondly, some states have made a habit of deferring payments. So, what states contributed in 2008 tells us nothing about what they will need to contribute to make up for the shortfall. The next thing to keep in mind is that while some states are moderately funded, other states like Illinois and New Jersey are very badly underfunded. The aggregate “hides substantial variation” as the authors admit. The authors go on to calculate under more realistic discount-rate scenarios (Alicia Munnell adds one percentage point to the Treasury rate to get to 5 percent), Illinois and New Jersey will need to start contributing 12 to 13 percent of their budget. Now also consider a new report by Willshire Associates indicating no state will be able to meet its assumed investment returns over the next ten years.

The second claim being made by a few opinion makers is so deeply contradictory, I am not sure how it can be reconciled.

It is this. And, I quote two articles in full:

Nor are state and local government pension funds broke. They’re underfunded, in large measure because — like the investments held in 401(k) plans by American private-sector employees — they sunk along with the entire stock market during the Great Recession of 2007-2009. And like 401(k) plans, the investments made by public-sector pension plans are increasingly on firmer footing as the rising tide on Wall Street lifts all boats.

And, from today’s Washington Post:

“Public-employee unions say that although the occasional stories of workers who game the system make for good headlines, the real problem was reckless behavior on Wall Street, which caused the value of pension-fund assets to plummet. To force state and local employees to accept what now passes for retirement security in the private sector would amount to a race to the bottom for all workers, they contend.

AFSCME Secretary-Treasurer Lee A. Saunders said: “401(k)s have been around for a generation and the result is tens of millions of workers who lack retirement security. We need to figure out ways to expand effective retirement programs to more Americans. We gain nothing by destroying the defined benefit plans that public employees agreed to and funded over the course of their careers.”

Now, consider the primary critique of public sector defined benefit accounting. Current public sector pension accounting claims it’s possible to measure pension obligations according to what the assets are expected to return when invested in the market.  This has led plans to apply an 8 percent discount rate to value their liabilities. This in turn has led them to invest increasingly in higher-risk vehicles like hedge funds and real estate. The reason: they need to get 8 percent or better on average in order to have enough assets set aside to pay their obligations, which are already underestimated, because of this circular logic.

Economists have been stating consistently that  public plans should be valued using the yield on Treasury bonds (currently 4 percent) to reflect the safety and security of a government pension. What follows from this? An accurate calculation of the size of what is owed; and a more conservative investment strategy.

But defenders want to cling to the math that has led plans to embrace risk and underfund promises.  Remarkably, and without any sense of contradiction, the same defenders express dismay when the market doesn’t return what they anticipated.

What is so scary about 401(k)s? Investment risk must be borne by the individual worker and it cannot be made to disappear with actuarial alchemy.

Perhaps defenders of the accounting mess really think the numbers don’t matter and underfunding is nothing concerned about. After all, the government has a sure hedge against this risk: the taxpayer.

Do pensions affect state borrowing costs?

The Center for Retirement Research at Boston College has published a new brief that looks at the relationship between pension funding and the cost of government borrowing. Recently Moody’s announced it would look at states’ unfunded pension liabilities along with outstanding debt in its evaluations. (When they did so, Moody’s found Connecticut, Hawaii, Illinois, Kentucky, Massachusetts, Mississippi, New Jersey, and Rhode Island topped the list of state indebtedness).

Authors Alicia Munnell, Jean-Pierre Aubry and Laura Quinby have taken a look at Moody’s ratings process and find that the agency puts more emphasis on the state’s management and finances, than on its economy and debt when assigning ratings, thus pension funding is “underweighted.”

A regression analysis tests the extent to which pension funding (percent of the Annual Required Contribution paid) affects the spread between yields on state-issued bonds and Treasury bonds. They find that it does, and that increasing the percent of the annual contribution paid (by one standard deviation) reduces the required interest rate on state-bonds by 3 basis points – a small impact relative to other factors.

The authors conduct another regression to see what effect Moody’s ratings have. They find that Moody’s incorporation of pensions into their analyses hasn’t had a significant impact on bond ratings.

They caution that as pensions become a larger part of state budgets the magnitude of the ARC’s effect on the spread could increase.