Stop
Billing the Grandkids: Intergenerational Equity in Pension Plans Is Long
Overdue (column - Girard Miller / Governing Magazine)
BY: Girard Miller | March 8, 2012
Most pension reform discussions begin with two issues: the
huge unfunded liabilities of public sector retirement plans (pension debt) and
the abuses in the system such as pension spiking and enviable early
retirements. The abuses are the easiest to fix, at least on a prospective
basis. Unfunded liabilities are a "sunk cost." Changing the system
for new hires won't eliminate the actuarial deficiencies of pension and retiree
medical benefits (OPEB) plans. And in many states, the burden for those
deficits falls entirely on governmental employers, because most public
employees only pay for part of the normal cost of the plan. The question
now is which generation(s) of taxpayers and employees should pay for the
mop-up.
In its ongoing pension accounting project, the Governmental
Accounting Standards Board (GASB) has squarely addressed the issue of
intergenerational equity. Accountants call it "inter-period equity"
because they focus on fiscal years more than generations, but the concepts are
twin sisters. For those unfamiliar with the concept, it was first articulated
in the academic literature 40 years ago by Richard and Peggy Musgrave in their
classic collegiate textbook Public Finance in Theory and Practice.
Intergenerational equity is the maxim that today's taxpayers should pay for
today's services, so (1) we don't pay for current operations with long-term
bonds, (2) debt repayments such as school building bonds and highway bonds are
aligned chronologically with the benefits derived from the users, and (3)
pension funds and other deferred benefits (such as OPEB) are actuarially funded
rather than pay-as-you-go. In short, one generation should not burden the next
generation for the public services it receives today.
Intergenerational equity is readily addressed by actuaries
when they calculate the "normal cost" of pension and OPEB benefits.
That's the amount of money that must be put aside each year to assure
sufficient accumulated benefits for the employees when they retire. To make this
calculation, actuaries study the plan design to see what is the normal or
expected retirement age, then calculate the likelihood that employees will work
a full career, and then use the expected return on investment assets to
calculate the normal cost. The normal cost of a pension plan is typically
shared between the employer and the employee. Most employers pay 5 to 10
percent of payroll for the normal cost of general employees, and between 10 and
15 percent of payroll for costlier public safety workers who retire at earlier
ages because of the hazards of their work. That's just the normal cost, not the
total cost. The plans with lower pension multipliers and higher retirement ages
tend toward the low end of those ranges, and plans with earlier retirement ages
and richer benefits formulas tend toward the higher end. And of course there
are plans that fall outside those general boundaries for various reasons.
What the GASB has undertaken to evaluate is how to handle
the situation employers presently face when the actuarial assumptions,
especially those pertaining to investment returns, don't work out. When
investments underperform, as they have in the past
decade, the plan becomes underfunded. Now we have a
pension debt, an unfunded liability. The question then becomes: how do we pay
for it?
Historically, the philosophy
of many pension plan officials and public finance professionals was that
pension debt (and I include here OPEB debt which is a similar animal) could be
paid off over very long periods of time. The old-school idea was that the
government employer exists in perpetuity, and therefore we could amortize these
unfunded liabilities over any period we chose. Likewise, the investment horizon
of the pension plan was infinite, because the plan's life is assumed to be
perpetual. So we could use very long-term investment strategies and investment
return expectations, and we could amortize unfunded liabilities over very long
periods. When the GASB's predecessor (the National
Council on Governmental Accounting) wrote the rules before 1984, the accounting
standards then permitted pension funds to amortize their unfunded liabilities
for 40 years, and some states actually built that naïve presumption into their
pension funding laws in what has proved to be a disastrous legacy of kicking
the can. Show me a 40-year amortization plan and I'll show you a distressed
pension system.
As GASB took over the job of promulgating accounting
standards, it tightened up the amortization period to 30 years. But it left
open a back door for some can-kickers to amortize over 30-year "open"
actuarial periods — which means that the plan essentially resets the mortgage
clock every year. I call this the "credit card amortization method"
because the debt is never repaid. If you pay off 3 or 4 percent of an
outstanding obligation every year but constantly "refinance," you
never eliminate the debt. And herein lies the problem
facing many public pension plans: they failed to match the amortization periods
with the lives of either the employees working toward retirement, or the
retirees who have already earned their benefits. And when the amortization
period exceeds both the average remaining life expectancy of retirees as well
as the average remaining service lives of the current workers, you've got yourself
an intergenerational equity problem.
"Extended
Smoothing." Some public pension plans presently take great liberties to
smooth out the budgetary impact of stock market fluctuations. Bear in mind that
the average stock market and business cycle in the U.S. since 1926 is 6 years: There
have been 14 recessionary bear markets in 86 years. So any smoothing process
that extends beyond 6 or 7 years is statistically suspect.
Yet some plans have used smoothing periods as long as 15 years, and others
employ so-called "double-smoothing" processes that punt the
investment losses even further into the future. An even more dubious practice
is now used in New York
State, where legislation permits local governments to borrow from the
pension fund to make their contributions.
Imagine that: a bank that will loan you money
to make your minimum credit card payment. It doesn't take a genius to figure out why
that is unsustainable public policy. Besides the obvious intergenerational
inequities this creates, these deferral tactics are even more senseless from an
investment standpoint: The pension fund thereby receives less new money to make
up for losses while the markets are down, and then receives more money to
re-invest when stock prices have recovered. "Let's buy more at higher
prices" is a doomed investment strategy that betrays the
dollar-cost-averaging concept that history has rewarded. In fact, it undermines
the presumed long-term investment rates of return that many of these plans use
today. You won't achieve 8 percent annual investment returns when you
systematically invest new money at the high end of stock market cycles.
Coming
soon: New GASB rules. GASB's latest exposure draft
seeks to address the amortization problem by (1) accounting for investment
gains and losses as "expenses" of the employer over five-year periods
and (2) amortizing other actuarial changes over the average remaining service
lives of employees. The latter standard aligns closely with how private
corporations amortize pension debt under corporate rules of the Financial
Accounting Standards Board (FASB). Their project timetable anticipates a new
pension accounting standard this summer. The GASB standards will apply to
future changes in financial condition, and they haven't really addressed what
they will do with the $700 billion of outstanding pension debt and $1.5
trillion of unfunded OPEB liabilities. The industry will await guidance from
the GASB on how this will be handled.
Funding vs Accounting. As I've reported previously the accounting and the
funding for governmental retirement plans will probably be "divorced"
as GASB sets accounting standards that will be virtually impossible for many
employers to match in terms of their actuarial funding practices. Funding
policies will have to be crafted by the pension community in consultation with
the government finance community (i.e., the CFOs of the states and localities).
And that's where we need a much more thoughtful discussion about
intergenerational equity.
I've spoken with numerous public-sector actuaries and plan
administrators whose unshakable mindset has been that their plans are
perpetuities and therefore it's reasonable to defray accumulated pension
deficits (unfunded liabilities) over extended periods that have no relationship
to the lives of the retirees and current workers. As you might expect, there
are very few public budget officers and even fewer elected officials who want
to bite the bullet and pay off the investment losses of the past decade any
sooner than they are required. But here's the problem with that thinking:
Today's elongated amortization periods virtually guarantee that most retirees
will die before their employers have paid for their benefits, and today's
workers will already be collecting pension checks before the taxpayers finish
funding their pensions and retiree medical benefits. In both cases, that is a
blatant violation of intergenerational equity.
States and localities really need to establish shorter
amortization periods for their unfunded retirement obligations, and begin
working toward those in an orderly, feasible migration. In my written comments
to the GASB, I suggested a transitional provision that would immediately
shorten the amortization period for currently outstanding obligations to 20
years and then begin working downward toward the average remaining service
lives (ARSLs) of current employees. (Explanation: If
pension plans permit retirement upon 30 years of service, then today's average
worker will retire in about 15 years. For aging public safety workers in 25
year careers, the average will be closer to 12 years. And after five years of
government hiring freezes, the ARSLs are probably
even lower.)
Investment horizons
have similar implications. There's one more conventional assumption that pension
professionals need to rethink: their investment horizons. For decades, we have
assumed that the proper investment horizon for determining the discount rate
used in actuarial projections should be perpetual, because the plan is
perpetual. But that is flawed thinking, especially in times like this when bond
yields are very low and when most investment professionals agree that
stock-market returns in the shorter term are likely to be impaired by global
debt problems and the deleveraging of the American
economy after its debt binge of past decades. A bond portfolio starting today
with Treasurys yielding 3 percent is not very likely
to produce the same returns in the next 15 years that it will over the next 30
years after rates normalize at higher levels. And stock returns in the coming
decade could well be lower than those which result in the much longer term.
Thus, it is appropriate to use a somewhat lower discount rate for that portion
of the liabilities which must be funded sooner than the traditional 30-year
amortization assumptions and lifespan assumptions used by actuaries in many
pension and OPEB plans. Otherwise, these plans are highly likely to experience
continuing investment shortfalls which will only create new unfunded
liabilities and even further burden the future taxpayer.
Unfortunately, this is not news that anybody working with
public pension and OPEB plans wants to hear. Most policymakers want to believe
that investment returns in the coming decade will match historical norms, but
that's not what my research from the comparable "reconstruction" period following the 1930s
shows. History suggests that equity (stock market) returns will likely meet or
beat their historical averages over the next 30 years, but the next decade is
far more risky and less assured. And it's mathematically almost impossible to
produce bond returns of 5 percent in the next decade given today's low rates,
which will result in capital losses for bondholders whenever rates do increase.
It's hard to contrive a scenario in which bonds earn more than their current
coupons before 2020 unless it's accompanied by runaway inflation that causes
even worse problems for pension funds. I have no quarrel with discounting the
liabilities of new hires over 30 years using long-term rates of expected
investment returns, but I can't understand the logic of assuming improbable
(higher) rates of return over the shorter periods when today's unfunded
liabilities must actually be repaid. That just increases the odds that the next
generation will pay higher costs because their elders kicked the can.
In fact, there is a growing risk that pension trustees
clinging to ambitious investment return expectations in their actuarial
assumptions will burden their children and grandchildren with more unfunded
liabilities. What I fear now is that an improving economy will lull pension
policymakers into believing that a few years of above-average stock market
returns "in the teens" will continue indefinitely so they don't need
to change their actuarial assumptions. After watching stock market indexes
double since the last cycle-bottom, some folks are already engaged in a
"willing suspension of disbelief" by assuming that investment returns
in the next ten years will not include a recession down-cycle, despite 85 years
of stock market history showing an average loss of 30 percent in equity prices
when that happens. Unlike Lake
Wobegon,
every year cannot be above average.
It's a fair bet that there is another recession coming
before the end of this decade, and investment expectations need to take that
into account.
Wake-up call for
policymakers. As I've written before, this suggests that pension and
OPEB plan trustees should now be using discount rates closer to 7 percent,
rather than their current levels between 7.5 and 8 percent. A naturally lower
rate aligns with the likely outcome of what the GASB's
proposed "blended" discount rate for underfunded
pension plans may produce anyway. Thus, I would hope to see a "directional
convergence" of policies, assumptions and methodologies in 2013,
especially if GASB follows through on its previous intentions to invoke a lower
discount rate when there are substantial unfunded liabilities. Every pension board,
governor, budget office, county commission, school board and city council
should be discussing the implications of these issues, and confronting their
own demons by plotting a strategy to resolve their unfunded liabilities in a
prudent way that does not burden future generations. Even as budgetary revenues
begin to creep upward as our stagnant economy gathers steam, higher pension and
OPEB costs will crowd out other spending requests —
one way or another, sooner or later. Let's not turn a problem in our hands into
a crisis for our grandchildren.
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