Yeah, I know, exciting topic \u2014 but really: it\u2019s actually timely and relevant to provide a bit of background on pensions.<\/p>\n
Public pensions are quite a bit in the news \u2014 in particular, how underfunded they are, and the fact that their liability valuations, under accounting principles for government, uses a discount rate based on the expected return on plan assets, so, typically about 7 \u2013 8%. As an actuary accustomed to private-sector pension plans, this just feels bizarre. Of course, in the case of a fully-funded plan, if the plan assets reached this return expectation over the long run, there\u2019s a certain logic in saying that this is a measurement of the funding status and a tool to determine required contributions, and, in fact, for many years the standard funding calculations for private-sector plans used such an approach. <\/p>\n
But we\u2019re not talking about funding. We\u2019re talking about how to measure liabilities in a more absolute sense, irrespective of whether or to what extent these plans are funded. In such a case, for private-sector plans, FASB presecribes the use of \u201chigh quality corporate bonds\u201d to set the discount rate, which at the moment produces rates of about 5%. It\u2019s been higher \u2014 when I first started as an actuary I think rates were more like 7% \u2014 and it\u2019s been lower, dipping down to 4% over the past couple of years. <\/p>\n
The original FASB statement on how to account for pensions, FAS 87, issued in 1985, prescribed the use of a rate that represented the discount rate at which the liabilities could be settled \u2014 in other words, the idea was not to use a coporate discount rate, but to use the rate at which a company could purchase annuities to offload their liabilities. Only later did interpretations specify that the rate to be used is the bond rate, which, in general, should reasonably approximate the cost of purchasing group annuities (note that some large companies, such as GM, have made the news, at least in the pension consulting world, for buying annuities for their pension liabilities, concluding that the cost of annuities isn\u2019t really that much more than the liabilities on their books, and a good deal when considering the risk and administrative cost of the pensions). <\/p>\n
Internationally, the funny thing is that discount rates for different countries differ based on the bond rates in that country \u2014 which can lead to quite goofy results, when a company\u2019s liabilities are valued at 15% because that\u2019s what government bond rates look like (and there are no corporate bonds to speak of in the country), or (in one case) we\u2019ve thrown in the towel completely and used economic growth rates because there are no reasonable government bond rates to use! <\/p>\n
In any event, permitting asset-return-based discount rates produces any number of unpleasant real-world consequences.\u00a0 In Illinois, back in the days of Rod Blagojevich, the state failed to fund its pension obligations \u2014 but in 2003, decided to issue $10 billion in bonds, paying the low rates for state-issued bonds, and fund the pension plan with the aim of obtaining more aggressive returns.\u00a0 Magic, eh?\u00a0 Practically free money \u2014 or, at least, it genuinely did improve the balance sheet because of this accounting method, even though no sensible person would take on debt in order to invest in stocks.\u00a0 <\/p>\n
But I can also understand, to a certain degree, why government accounting differs:\u00a0 a company, at any time, can go out of business, or shrink substantially (again, think General Motors:\u00a0 until the settlement, its pension obligations were massive because its workforce had shrunk so massively).\u00a0 A government entity is assumed to be a more \u201cpermanent\u201d entity, with its\u00a0population, and\u00a0state workers, growing or remaining stable,\u00a0more or less \u00a0\u2014 so that its obligations can be dealt with on a pay-as-you-go basis and the state will always be around to meet its obligations.<\/p>\n
Of course, we\u2019ve now learned that this isn\u2019t true \u2014 in the case of cities, at least, population, and sustainable levels of government workers, can shrink substantially, down to half, or even a third of their peak size (Detroit dropped from 1.85 million in 1950\u00a0to 0.7 million in 2010).\u00a0\u00a0 And even if it were, it violates basic principles of pension accounting, that costs be recognized in the period in which they occur.<\/p>\n