I hope to have time to flesh this out more later, but Megan McArdle has a post on disputes over the degree of underfunding of the Detroit pension plans — Orr, the Emergency Manager, wants to use an assumed return of 7%, and the unions want to use 8%, which would, apparently, better position themselves for a favorable outcome to the negotiations and decisions around the backruptcy.
But the plan is 50% funded, optimistically. The reports linked to by McArdle are proper actuarial valuations for government plans, using funding rules far different than in the corporate world. The biggest difference is that public pension plans use an expected return on assets as the interest rate in their liability valuation, for both accounting and funding purposes, whereas in the private sector it’s a corporate and adjusted government bond rate, respectively.
The “expected return on assets” approach is an outdated approach in the private sector, with one exception: church plans, which are not subject to government funding regulations, may choose to use this as a measure of whether they’re meeting their internal funding targets — or, at least, when I worked on US pension plan valuations, my “church plan” clients used this approach to make good faith efforts to fund their plan.
But does it really make sense to measure pension obligations on an asset-return basis if you’re measuring the liability to put it side-by-side with other liabilities? Certainly the city could never settle the liabilities (that is buy annuities to eliminate liability) on this basis. To the extent that each pensioner is a creditor of the city, a buy-out liability is a more apples-to-apples comparison of what’s due them vs. other creditors.
It also leads to unsuitable asset allocations if the only goal is to justify a high asset return rate, rather than to actually balance return and risk. (And, based on the duration, Detroit appears to have a large proportion of retirees, which should require more conservative, rather than more aggressive, returns.)
But it’s just, all around, a bad situation!
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