As the term “Pension Reform” becomes a media buzzword, politicians on both ends of the political spectrum insist that reforming the U.S. public pension system is at the top of their gubernatorial to-do lists. The rhetoric centers around two basic issues: underfunding as a result of insufficient contributions made by local and state governments, and contractual details such as cost of living adjustments, retirement age, and employee contributions. It’s not news that U.S. public pensions are severely underfunded – dismal coverage ratios, particularly in California and Illinois, have been published in recent years. One way to rectify the deficit in pension funds is to cut benefits by changing the contractual details mentioned previously; for example, increasing the retirement age or decreasing cost of living adjustments. Doing this is politically unpopular, however, and as such politicians are generally wary of making any significant structural changes to public pensions out of fear of retribution at the ballot box. Underfunding and the risk it poses for pension benefits is certainly an issue that warrants the public’s attention and outrage, but it is not the biggest issue that plagues the U.S. public pension system. The bigger and lesser-known issue is that the reported state of the system, although dire, severely understates the true degree of underfunding.
Though it has been established publicly that liabilities invariably exceed assets in the U.S. public pension system, a bigger issue is that virtually all of the liabilities are also severely underestimated and will continue to be valued as such until structural reform. Under GASB requirements, U.S. public pension funds can set their own discount rate and asset allocation almost arbitrarily. The rules link liability discount rates to the expected return on assets – that is, the riskiness of assets – and present a clear incentive to invest in riskier assets so as to maintain high liability discount rates. Higher liability discount rates ensure that liabilities are lower on paper, since they are discounted by a higher factor. Thus, politicians can contribute less money in real terms to pension funds and maintain a favorable funding position without raising any more revenue or changing the benefit formula. Of course, the true funding situation hasn’t changed, only the number that is reported to the public.
Given the state of GASB requirements, the facts reveal a clear conflict of interest: stakeholders have a direct incentive to choose a higher discount rate in order to disguise the degree to which plans are underfunded. In terms of pension benefits, the result is that the current value of pension benefits is underestimated and does not reflect what the system will actually have to pay when they come due. In terms of asset allocation, GASB gives stakeholders an incentive to shift towards riskier assets so as to justify smaller contribution levels. Investing in riskier assets has given U.S. public pension funds the ability to maintain high discount rates and present lower liability valuations, both of which correspond to less money that needs to be set today to meet those obligations in the future. This ‘fix’ allows a politician to remedy the pervasive lack of pension funding without allocating another dollar from the state budget. Therefore, no difficult budgetary decisions have to be made and no voters will be upset in the short term. The task of making responsible budgetary decisions is transferred to future generations, the state can report a higher pension coverage ratio without (technically) lying, and there is more money in the budget for politicians to buy themselves yachts and fur coats.
The preceding information suggests that discount rates are chosen by U.S. public pensions on the basis of political, as opposed to financial, criteria. This suspicion is corroborated in “Pension Fund Asset Allocation and Liability Discount Rates” by Andonov, Bauer, and Cremers, a cross-sectional study of over 800 defined benefit pension funds in three different countries over the course of 20 years, among other studies (see Sielman, 2013, Brown and Wilcox, 2009, and Novy-Marx and Rauh, 2009). In the private sector, liability discount rates decreased over the period, reaching 5.7% in 2010 along a path that closely mirrored the ten-year treasury yield. Private funds retained high rates of 7.5 – 8% throughout the period, despite a systemic decline in interest rates. The only way to maintain exorbitant rates of return when low risk rates such as treasury bills decline is to allocate a larger portion of the fund to riskier assets, a conclusion that Andonov, Bauer, and Cremers confirm in their empirical study. Private funds shifted 20% more to risky assets in 2010 than they did 20 years earlier, whereas public fund asset allocation remained virtually unchanged. The paper also finds that larger funds allocate proportionally more to risky investments. In short, U.S. public pension funds respond to decreasing treasury yields recklessly, by arbitrarily manipulating asset allocation so as to incur enough risk that a high discount rate can be used to meet obligations without actually allocating any more money. Of course, it doesn’t take a financier to see that this method is little more than an accounting trick to appease public employee unions and state auditors simultaneously.
An increasingly popular trend in U.S. public pension fund management is the smoothing of asset returns. The smoothing process essentially manipulates the time frame over which a return is observed in a way that makes returns look less volatile. Asset smoothing is not always a shady manipulation tactic; in circumstances where the measurement period is small, speculators and short-term investors may influence the variance of the sample. In the case where this influence is thought to be so severe that it biases the variance of returns, it may be beneficial to smooth returns over a longer period and thus dampen the effects of short-term volatility. There’s considerable discretion involved in evaluating the validity of this method, and as such it has become a way to disguise the volatility of risky assets in U.S. public pension funds. Congress recently decided that smoothing corporate bonds over a 25-year period was appropriate for U.S. pension funds, thus replacing the previous upper limit of 2 years. It remains to be seen, however, if one single person, whether a congressman, finance professional, or anyone else for that matter, can make the argument that 1988 interest rates are of any significance when discounting future pension liabilities.
For two reasons, U.S. public pension funds are unique in their propensity to mask the financial position of their investments. First, a private firm’s desire for high returns is accompanied by risk. The cost of financial distress for a private firm is an incentive to fund pensions fully, as underfunding could result in enormous payments, required by law, at the time benefits come due. Private firms do not have a tax base to exploit for these payments. Additionally, firms that are overfunded are exempt from PBGC insurance premiums, which lower the true cost of funding pension obligations. While private pensions must choose a discount rate as a function of current interest rates, U.S. public pensions are held to no regulatory standard when determining discount rates. Numerous studies have shown that there is no statistically significant association between liability discount rates and interest rates for U.S. public pensions. On the other hand, the private sector tends to decrease liability discount rates when interest rates decrease, thus accurately adjusting their expected earnings and determining contribution levels accordingly. On average, the discount rate used by public funds is 190 basis points higher than its private sector counterpart.
Robert Novy-Marx and Joshue D. Rauh use discount rates that reflect the risk level associated with pensions to calculate the true present value of pension liabilities that have already been promised by the United States, and their results show the gravity of the GASB shortcomings. In 2007, the total liabilities stated in annual reports for the 116 largest U.S. Public Pension plans were $2.81 trillion, compared to $1.94 trillion in assets. As mentioned earlier, the public outcry would be justified even if this were the true state of underfunding. In discounting liabilities with an appropriate discount rate, however, the authors conclude that the present value of the pension liabilities is $5.17 trillion, which corresponds to a $3.23 trillion deficit. To reiterate, facilitating this cover-up are GASB accounting standards that promote flagrant conflicts of interest and opaque public finances. The result is an issue that is much more serious than the so-called “Pension Crisis” that is reported in the media.
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