The severity of the pension crisis is quite clear at this point because news and data about it are widely available. However, one thing that hasn’t been prevalent is potential solutions to the problem. Public pensions are starting to put their proverbial heads together to tackle this major issue, but so far, efforts have generally not been enough to protect even the largest pension funds from potential insolvency.
Now one organization has examined the pension crisis as it applies to public funds and offers a number of solutions all of them could easily do to remain solvent. Clearly it will take a lot of work to dig out of the holes most of them have gotten themselves into, but it sounds doable.
Get The Full Series in PDF
Get the entire 10-part series on Charlie Munger in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.
Q4 hedge fund letters, conference, scoops etc
In its report entitled “Unaccountable and Unaffordable 2018,” the American Legislative Exchange Council outlined a number of the issues that are causing pensions’ unfunded liabilities to soar. One of the biggest problems has to do with the actuarial assumptions most state pensions have. According to ALEC, over the last 11 years, state pension plans have averaged an investment rate of return at 6.9%.
However, the average discount rate over that timeframe has been 7.7%. The organization explains that investment return rates and discount rates are not interchangeable, and this is why unfunded liabilities have soared.
“A 1 percentage point difference in discount rate can produce a massive increase in projected liabilities, roughly a 31 percent increase over a 30-year period,” ALEC wrote. “In fact, overestimating investment returns by relying on simple arithmetic averages is a key source of chronic pension underfunding.”
The organization added that simple arithmetic points to an average investment return of 6.5% for state pension funds, which still comes up short of the dramatic returns many pension funds are projecting in a desperate attempt to cut down on their unfunded liabilities.
Minor reforms aren’t enough
The pension crisis is so serious that major reforms are needed to correct the imbalance between liabilities and funding. According to ALEC, states have been attempting various reforms over the last 10 years, “ranging from updating their actuarial assumptions, to creating new hybrid pension tiers for new hires, to transitioning away from defined-benefit (DB) pensions altogether in favor of defined-contributions (DC) plans.”
All of these measures constitute only minor reforms, and the organization said they are viable strategies for the long term—”if they are performed regularly and early.” However, the problem is that many pension funds have let their problems grow so large that major steps must be taken to correct them. What’s worse is that most state pension funds “have resisted all reform efforts, which places retirees and taxpayers in a precarious position,” ALEC added.
One easy step for dramatic improvement… and a caveat
The organization suggested one step most pensions could take immediately is simply reducing their discount rate to the private sector average, “or preferably, to a risk-free rate.”
“…this change would shift the estimated liability from the average amount states would be liable for in the future, to an estimate which covers all potential futures,” ALEC explained. “This change would ensure the constitutional and legal protections afforded to state pension benefits are being met.”
It would also increase the actuarial recommended contributions (ARC) because the target asset would increase to match the risk-free liability. Of course, this step would require funds to actually make their ARCs, although ALEC said earlier in the report that many public pensions haven’t even been making contributions.
However, “If contributions are made in accordance to the ARC, the health of the fund would rapidly improve,” the organization added. “Even a global financial crisis would not threaten the fund’s solvency—it would truly be a guaranteed, ‘defined benefit.’”
One other suggested reform
ALEC also suggests that pensions could set a variable benefit or contribution rate according to the funding of the plan. The organization cited Wisconsin’s pension system as a strong example of how this reform works, adding that it’s “the best funded pension system in the country, controlling for difference in discount rates, because it has a variable benefit rate, meaning the disbursement varies over time.”
“State retirees are entitled to a low guaranteed pension payment paired with a variable payment based off the pension system’s funding ratio,” the organization explained. “Meaning, economic shocks also lower the payments from the fund, allowing the fund to recover.”
Even though Wisconsin’s system has been criticized because pension payments are reduced during economic downturns, it has been able to offer retirement security without many major changes since 1975, the organization added.
This article first appeared on ValueWalk Premium