October 14, 2013
By Liz Farmer
When the 2008 stock market crash slashed investment and retirement accounts in the public and private sectors, it opened the door to a seething debate that up until that point had largely stayed within the confines of actuarial circles. The debate was over how best to approach governments’ pension liabilities and what rate of return should fund managers use to help lawmakers allocate the right amount of money each year?
Those who support the traditional pension system say pensions are under an ideological attack that’s dressed up as an argument for better accounting practices. Their opponents say more conservative accounting measures should be used because pensions are a financial promise that governments must pay out. It may at first seem like a mathematical quibble – but as more experts weigh in on each side and governments have begun the process of reforming their pension systems, it has ballooned into a war between two ends of the spectrum with no clear resolution in sight. [EXPAND Read more]
“It is very political – the long knives are out on anything to do with pension issues on both sides,” says Chris Hoene, executive director of the California Budget Project. “You have ideologues on both sides who are seizing this debate and using it to further their own interests.”
The latest piece of evidence capturing this divide is a recent report commissioned by Campaign for America’s Future, a left-leaning think tank, and written by outspoken political commentator David Sirota. Titled “The Plot Against Pensions,” Sirota blasts efforts by the Pew Charitable Trusts and the Laura and John Arnold Foundation for what he calls “the right’s ideological crusade against traditional pensions [while helping] billionaires and the business lobby preserve corporations’ huge state tax subsidies.”
Sirota’s report gets at a longstanding complaint of traditional pension advocates: that any problems with the system’s sustainability are being grossly distorted by those who want to abolish it altogether. That, but for the market crash, very few people today would be asking whether the system is unsustainable. “I do think a number of forces in the pension debate are not acting in good faith and I think the way policy choices have been presented in such a limited fashion, it shows that there is something more than objective pragmatism going on here,” Sirota tells Governing. He adds: “The big problem in this whole debate is ideology is masked under the veneer of actuarial language.”
First, who is doing the debating? The divide generally falls between economists and actuaries and it dates back to before the recession. Economists have argued that pension funds’ rate of return, or discount rate used to determine a system’s unfunded liability, should follow financial theory: that a liability should be discounted in a manner that’s commensurate with its riskiness. Therefore, since a public pension liability is generally required to be paid by governments, it should be discounted on the basis of an interest rate that is risk free, or nearly so. That rate, the market rate typically associated with low-risk investments like bonds, is in the 3 to 4 percent range.
The public pension community, however, believes that the way to discount liabilities and determine the funding costs of public pension plans should reflect the long term expected rate of return based on prior performance. In this case, is the expected rate of return over 20 to 30 years has typically been between 7 and 8 percent.
Of course the difference of a few percentage points when calculating a pension fund’s liability (the difference between what it has promised its members in total retirement payments and what it currently has in investments) creates two very different pictures of pension funds. One says that most are doing fine and the other says the entire system is perilously unstable.
Herein lies the divide. The market valuation proponents dispute the claim there is any ideology behind their push to use a so-called risk-free rate of return. To their way of thinking, it’s irresponsible to assume that the good times in the past will return and even out after what has been a rocky half-decade for investments. “It’s the best way of guaranteeing that benefits can be paid to employees in the future,” said Cory Eucalitto, a pension expert for State Budget Solutions (SBS), a nonprofit that partners with free market, business-oriented organizations to advocate reform of governments’ approach to budgeting. “There are a host of legal protections that directly guarantee pension benefits once they’re earned. So if you’re using a discount rate that’s too high, you’re never going to meet that.”
Indeed, corporate pension plans in the late 1980s began moving toward valuating liabilities using a market rate. By 2006 all plans were required to incorporate market costs into their funding scheme and it wasn’t long afterward that the attention turned to doing the same for public pension plans.
SBS recently released a report using the risk-free rate to calculation pension liabilities across the country – its total for 50 states topped $4 trillion, a far cry from the $1.3 trillion figure (or sometimes lower) commonly used by those within the public pension system. “It’s a problem that can’t be ignored and the problem’s just going to get worse,” Eucalitto said, citing the $4 trillion figure. “So the longer you try and mask the pension problem by dealing with other issues, that pension problem’s not going to go away. It is a disservice to employees and retirees – they’re the ones who are going to be hurt most in the future.”
But that mindset ignores a crucial fact from the public pension community’s point of view: that today’s most hard-up plans (Chicago and the states of Illinois and New Jersey come to mind) are largely that way because governments failed to make their annual contributions to the system every year. Again, ideology comes into the picture:
“After the economy crashed in 2008, it left funds where lawmakers failed to pay (the annual contribution) particularly vulnerable,” says Jordan Marks, executive director of the National Public Pension Coalition. “That is part of what drives it. But other part is a very calculated, coordinated effort to undermine public workers.”
Additionally, they argue, the practical matter of how much governments should contribute to their pension plans should not be left up to economic theory – it should be based on past experience. “This is a relatively new phenomenon,” says Keith Brainard, director of research for the National Association of State Retirement Administrators, of the risk free rate. “This is the first time there’s been such a gap between current interest rates and the current return assumption.”
Still, in a recent National League of Cities survey, seven of 10 city finance officers cited pensions and related healthcare costs as two of their top three negative drains on their budgets (infrastructure was the third). This would suggest that at least the cost of pensions are a force to be reckoned with. Illustrating this is San Jose, Calif. -– by the time it passed cost-cutting pension reform (now being litigated) last year, the benefits had grown to account for 27 percent of the city’s general fund budget. But the California Budget Project’s Hoene notes that examples like San Jose are in the minority and pension spending is projected to remain a fairly small (less than 10 percent) share of government spending over the next 30 years. Hoene and others also point out that cutting tax breaks for big businesses could also help fill any financial gaps governments may have in their pension obligations.
So where does that leave the debate over liabilities? In recent years, more neutral organizations have raised the issue, giving credence to the idea that governments need to at least take a second look at how they evaluate their plans. This year, Moody’s Investor Services adopted an approach more in line with economists and is evaluating pension plans using a rate similar to the risk-free rate. The Government Accounting Standards Board (GASB) also instituted a change this year and public plans will have to apply a risk-free rate to any portion of their plan that is not funded. The change will have the effect of seemingly exacerbating the pension problem for any plans that are not well-funded, but has generally been accepted by public pension plan proponents as a more reasonable view over Moody’s.
Each end of the spectrum of course believes that the next ten years will favor their view. Eucalitto predicts the momentum will continue for 401(k)-style plans as more governments will declare their system unsustainable. The traditionalists believe that an improving stock market will quiet the naysayers and win their argument for them.
The truth, as usual, is probably somewhere in between. We’re now dabbling in an age with lots of different pensions numbers, Brainard says and “policy managers need to understand who’s calculating the number for what purpose and for what audience.” But in the very least, the debate is causing just about everyone to think twice.
“I think the sort of rational place to land is that the truth is somewhere in the middle here,” says Hoene. “If you want to be cautious going forward … you take a look at your rate. But you’re not going to come out with the riskless rate.” [/EXPAND]