Facilitating the Dreams of Politicians

I’m a life actuary, not a pension actuary, so take my musings here as the rant of a relatively well-informed amateur.  I have reviewed the book Pension Dumping, and will review Roger Lowenstein’s book, While America Aged, in the near term.

First, a few personal remembrances.   I remember taking the old exam 7 for actuaries — yes, I’ve been in the profession that long, studying pension funding and laws to the degree that all actuaries had to at that time.  I marveled at the degree of flexibility that pension actuaries had in setting investment assumptions (and future earnings assumptions), and the degree to which funding was back-end loaded to many plan sponsors.   I felt that there was far less of a provision for adverse deviation in pensions than in life insurance reserving.

I have also met my share (a few, not many) of pension actuaries who seemed to feel their greatest obligation was to reduce the amount the plan sponsor paid each year.

I also remember being in the terminal funding business at AIG, when Congress made it almost impossible for plan sponsors to terminate a plan and take out the excess assets.  Though laudable for trying to protect overfunding, it told plan sponsors that pension plans are roach motels for corporate cash — money can go in, but it can’t come out, so minimize the amount you put in.

The IRS was no help here either, creating rules against companies that overfunded plans (by more than a low threshold), because too much income was getting sheltered from taxation.

Beyond that, I remember one firm I worked for that had a plan that was very overfunded, but that went away when they merged into another firm which was less well funded.

I also remember talking with actuaries working inside the Social Security system, and boy, were they pessimists — almost as bad as the actuaries from the PBGC.

But enough of my musings.  There was an article in the New York Times on the troubles faced by some pension actuaries who serve municipalities.  For some additional color, review my article on how well funded most state pension and retiree healthcare plans are.

Pretend that you are a financial planner for families.  You can make a certain number of people happy in the short run if you tell them they can earn a lot of money on their assets with safety — say, 10%/year on average.  Now within 5 years or so, promises like that will blow up your practice, unless you are in the midst of a bull market.

Now think about the poor pension actuary for a municipal plan.  Here are the givens:

  • The municipality does not want to raise taxes.
  • They do want to minimize current labor costs.
  • They want happy workers once labor negotiations are complete.  Increasing pension promises little short term cash outflow, and can allow for a lower current wage increase.
  • A significant number of people on the board overseeing municipal pensions really don’t get what is going on.  It is all a black box to them, and they don’t get what you do.
  • You don’t get paid unless you deliver an opinion that current assets plus likely future funding is enough to fund future obligations.
  • The benefit utilization, investment earnings, and liability discount rates can always be tweaked a little more to achieve costs within budget in the short run, at a cost of greater contributions in the long run, particularly if the markets are foul.
  • There are some players connected to the pension funding process that will pressure you for a certain short-term result.

Even though I think pension plan funding methods for corporate plans are weak, at least they have ERISA for some protection.  With the municipal plans, that’s not there.  As such, more actuaries and firms are getting sued for aggressive assumptions, setting investment rates too high, and benefit utilization rates too low.

The article cites many examples — New Jersey stands out to me because of the pension bonds issued in 1997 to try to erase the deficit they had built up.  They took the money and invested it to try to earn more than the yield on the bonds — the excess earnings would bail out the underfunded plan.  Well, over the last eleven years, returns have been decidedly poor.  The pension bonds were a badly timed strategy at best.

Now, like auditors. who are paid by the companies that they audit, so it is for the pension actuaries — and there lies the conflict of interest.  One of my rules says that the party with the concentrated interest pays for third-party services, so it is no surprise that the plan sponsor pays the actuary.  I’m not sure it can be done any other way, unless the government sets up its own valuation bureau, and tells municipalities what they must pay.  (Now, who will remind them about Medicare? 😉 )

The suits against the pension actuaries and their firms could have the same effect as what happened to Arthur Andersen.  These are not thickly capitalized firms, and many could be put out of business easily.  For others, their liability coverage premiums will rise, perhaps making their services uneconomic.

Finally, the flat markets over the last ten years have exacerbated the problems.  Partially out of a mistaken belief that the equity premium is large (how much do stocks earn on average versus cash), actuaries set earnings rates too high.  The actuarial profession offers some guidance on what rate to set, but the reason they can’t be specific is that there is no good answer.  With all of the talk about the “lost decade,” well, we have had lost decades before, in the 30s and 70s.  Even if the statistics are correct for how big the equity premium is, equity performance comes in lumps, and in the 80s and 90s, when we should have taken the returns of the fat years and squirreled them away for the eventual “lost decade,” instead, politicians increased benefits as if there was no tomorrow.

The states and smaller government entities have dug a hole, and they will have to fill it somehow.  Lacking the ability to print money, they will raise taxes as they can, and borrow where they may.  We are seeing the first pains from this today, but the real crisis is 5-10 years out, as the Baby Boomers start to retire.  You ain’t seen nothin’ yet.