Tuesday, October 16, 2012

Public Pensions Underreporting Liabilities?

Hilary Russ of Reuters reports, Study shows $1.2 trillion gap for public pensions:
The largest 100 public pension funds have around $1.2 trillion of unfunded liabilities, about $300 billion above the nearly $900 billion they reported themselves, according to a new actuarial study to be released on Monday.

The pension systems reported a median funding level of 75.1 percent. The study by the actuarial firm Milliman, which used different ways to value assets and measure liabilities, finds an aggregate level of funding of 67.8 percent.

But Milliman, one of the world largest actuarial firms took a close look at U.S. public pension funding for the first time, and said the multibillion-dollar difference was good news.

Rebecca Sielman, the report's author, said results should reassure the public that America's public pensions in general are accurately reporting their funding shortfalls.

The difference between what public pensions across the United States have reported and what Milliman found wasn't significant, Sielman said. She noted that a relatively small change in the way the figures are calculated could lead to seemingly outsized results because the funds are so large.

"The numbers really didn't change that much," she said. "It really didn't move the needle."

Both the pension funds' reported results and Milliman's findings fell within the range of previous estimates from other studies of the total size of the public pension shortfall in the United States.

With the study, Milliman, stepped into the debate about whether public pensions are underreporting the size of their liabilities.

That hot-button issue revolves around how much money public employers - and, by extension, taxpayers - will have to contribute to cover future payouts for member benefits. It is a key issue at a time of dwindling revenues and tighter budgets for states and local governments.

Pension funds get money from the returns on their assets and from members' contributions. States and cities also pay into the funds, but their contributions are discounted based on how much money they think their investments will make over time.

The 100 funds Milliman studied used a median rate of return for their investments of 8 percent. But the recession slashed into the market, dropping actual median returns to just 3.2 percent for the last five years, according to data from Callan Associates.

The difference has prompted critics to claim that the funds are underreporting their unfunded liabilities, or the gap between what they've promised to pay retirees in the future and what they'll actually have on hand to cover the benefits.

Critics have called for public pensions to reduce their assumed rates of return to as little as 5 percent or less, which would cause unfunded liabilities to soar and likely leave taxpayers having to cover the difference.

But without the change, critics say, future generations will be left to deal with a financial bomb.

FINDINGS WITHIN RANGE OF SIMILAR STUDIES

Other studies have tried to measure the overall size of the problem. The Pew Center on the States found that the shortfall is about $766 billion. Moody's Investors Service said in July that the collective gap would be $2.2 trillion if funds used a 5.5 percent discount rate.

Milliman has studied the health of the 100 largest private pension funds for about a decade. But this is its first study of public plans, conducted specifically to determine whether the systems were using unrealistically high return-rate assumptions as the critics claimed.

"I thought that we would find fairly pervasive use of interest rates that are high relative to current market consensus about future investment returns, and we didn't find that," Sielman said.

The firm, which has done actuarial work for nearly all of the U.S. states in the past, examined each individual fund in the study, using market valuations instead of smoothed valuations to measure assets and recalibrating liabilities based on Milliman's own benchmarks of expected long-term returns.

The firm found that the median discount rate should actually be 7.65 percent, rather than the 8 percent median rate the funds used in aggregate.

A third of the plans were using lower rates than they needed to, Milliman found, according to Sielman.

A small number of plans seriously underreported their liabilities because they use rates that are too high, Milliman found.

Milliman's study did not name the specific plans that underreported their liabilities. Sielman said the firm was not releasing its results for individual plans.
I agree with Sielman, this study is good news as it demonstrates that the discrepancy between what was reported and what Milliman found wasn't significant. 

Nonetheless, it also demonstrates that too many US public pension plans are still using an unrealistically high discount rate based on rosy investment projections. In the Oracle of Ontario, I discussed how Ontario Teachers' Pension Plan is using a discount rate of 5.4%, far below anything US plans are using and even below the average 6.3% other large Canadian plans are using.

Now to be fair, one senior pension fund manager in Canada told me that Teachers' discount rate is lower because of the demographics of their plan members, with many living well into their 80s, 90s, and even past 100. He also told me that determining a discount rate is "more of an art than science" and that Teachers' discount rate is "extremely conservative, overstating their liabilities and understating their funded status."

Perhaps but as one senior pension fund manager at Teachers' told me: "If US plans were using our discount rate, they'd be insolvent." Well, maybe not insolvent but they'd be in dire straits, struggling to close serious pension funding gaps. Even Milliman's proposed rate of 7.65% is high compared to Canadian standards.

I don't want to dwell on pension gaps in US public plans, however. Unfortunately the issue has been politicized to serve a right-wing agenda that wants to crush public pension plans and anything else that's public. The pathetic state of state plans is far more complicated issue and requires not only a rethink on the discount rate, but also a wholesale change in pension governance and states need to keep topping up their public pension plans (go back to read the seven simple truths of public employees' pensions).

Below, Colorado State Treasurer Walker Stapleton on FOX Business News, discussing the impact on the government and US economy of public pension spending. Mr. Stapleton is right about inflated investment return assumptions but take his scaremongering with a grain of salt.