The Risk of Ignoring Risk: The Case of Pensions

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Feb 29, 2012

Several news stories about pensions have crossed my desk in recent days, each of which made me realize how poorly the vast majority of individuals – even many highly educated individuals – understand financial risk.  It might not be so surprising if this lack of understanding was limited to the “general population.”  What is more surprising is how often highly educated financial market participants and regulators exhibit their ignorance of fundamental finance principles.  Unfortunately, these misunderstandings can have real consequences.

Let me give two examples.

Yesterday, a piece appeared on the Reuters MuniLand blog under the (confusing) title of “Greece is not Germany, and California is not Vermont.” In the piece, the author made the following statement, in which she refers to research by Joshua Rauh of Northwestern University:

“Rauh insists that when projecting pension fund returns, the interest rate for 10-year Treasuries must be used. Pensions do not allocate their assets 100 percent into Treasuries, though.”

This is an example where you can take two true statements, put them side-by-side, and end up with a false implication.  It is true that Joshua Rauh and his co-author Robert Novy-Marx use a Treasury rate to discount pension liabilities.  It is also true that pensions do not allocate their assets 100 percent into Treasuries.  The problem is that the second statement is 100% irrelevant to the first!

As any individual who receives a passing grade in my finance courses should be able to explain, the appropriate discount rate to use when computing the present value of a stream of cash flows depends on the riskiness (generally defined as the correlation of those cash flows with the market) of those cash flows.  In the context of pensions, the discount rate depends on the risk of the pension payments to beneficiaries.  In many states – such as Illinois and California – there are strong constitutional protections in place that make already-accrued benefits risk free.  Thus, what Novy-Marx and Rauh do in their research is to apply basic finance principles to come up with a more accurate measure of pension liabilities than what one gets from using official government statistics.  Cate Long fell into the same trap that so many others have – including the Government Accounting Standards Board (about which I have previously blogged here and here) – of thinking that the right discount rate is a function of the risk fo the assets, instead of the risk of the liabilities.  As a result, she – like GASB – completely ignores an enormous implicit put option that is being dumped onto taxpayers.  Her piece also contained other problems that are discussed Josh Rauh’s response.

A second example comes from the ongoing debate about pension funding policy for corporate pensions. In January, the American Benefits Council put out a press release (which you can read here) basically arguing for “relief” from fully funding pensions (“funding relief” is a political euphemism for not meeting the required funding obligations.)  At the core of the American Benefits Council’s case is that interest rates change, and that the result is that pension liabilities look “artificially high” when interest rates are “artificially low.”  What this argument ignores, however, is that any firm could choose – if they so desired – to nearly completely immunize themselves against interest rate fluctuations by investing in a fixed income portfolio that has the same interest rate sensitivity as do the pension liabilities.  Firms choose not to do this for a variety of reasons, but it is a choice.  Some firms – most recently, Ford Motor Company – appear to understand this.  Most other companies choose to expose themselves to risk in the pursuit of higher returns.  That is their right and their choice, but they should not expect a back-door government bail-out in the form of funding relief when the risk then materializes.

In both of these examples – the choice of discount rates and the choice of asset allocation – the common element is a lack of understanding of risk, how to measure it, and how to manage it.  Unfortunately, such a misunderstanding has real economic consequences, and it always seems to be the taxpayer who ends up paying for it.

Proposed GASB Pension Discounting Standards: Even Worse than Before?

Filed Under (Finance, Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Oct 2, 2011

I have written on this blog before about the Government Accounting Standards Board (GASB) rules that allow public pension plans to discount their liabilities using the expected return on plan assets.  This is no small technical matter … discounting in this way has the effect of dramatically understating the true economic value of the unfunded liabilities of public pension liabilities.  This single accounting issue may understate the magnitude of the public pension funding problem by trillions of dollars!

GASB has issued proposed new standards and are in the process of accepting comments from the public.  I submitted my comments last week, and thought I would post a few excerpts here.

“As members of the GASB Board may already know, I have been critical of existing GASB guidelines for the computation of public pension liabilities.  I have a paper in the May 2009 American Economic Review (co-authored with David Wilcox of the Federal Reserve Board) in which we explain the basic economic rationale for the appropriate choice of a discount rate.  Economic and financial theory is very clear that the choice of a discount rate depends on the risk of the cash flows being discounted

This is true regardless of whether those cash flows are positive or negative, and whether they are being generated by public institutions, private institutions, or individuals.  There is absolutely no economic or financial basis for discounting one set of cash flows based on the risk of a completely different set of cash flows.  In other words, there is no logic whatsoever for discounting pension liabilities based on the risk of the pension plan assets

A simple analogy illustrates this point.  Suppose that at 9 a.m. on January 1, I borrow $100,000 for one year from a bank at an interest rate of 5 percent.  I immediately invest the full amount in a diversified portfolio of risky assets (such as stocks and bonds) that has an “expected return” of 8 percent.  By the time I have completed this transaction at 9:05 a.m. on January 1, how much do I owe the bank?  Naturally, I still owe them $100,000 (ignoring the 5 minutes’ worth of interest).  At this point, I have not changed by net worth at all.  All I have changed is my risk exposure. 

Suppose, however, that I follow GASB-like accounting rules to calculate my net worth.  Because the expected return on my portfolio is 8 percent, I can use this to discount the $105,000 (principal plus 5 percent interest) that I will owe in one year (December 31).  By this calculation, I would now only value the future liability as $97,222.22 (=$105,000 / 1.08), making it appear as if I have created $2,777.78 of wealth out of thin air.    

Of course, if I tried to tell my lender at 9:05 a.m. on January 1 – just 5 minutes after closing the loan – that they should allow me to give them $97,222.22 and cancel my $100,000 debt, they would look at me with great puzzlement!  And for good reason – I owe them $100,000 now, or $105,000 in one year, regardless of what I do with the funds in the interim!  The transaction just described is absurd from the financial perspective.  But as illogical as it seems, this approach closely mirrors the approach that has been taken by GASB in the past and that is still embedded in the proposed new public pension accounting guidelines.

The fundamental problem is that the use of “expected returns” as a discount rate is a largely a meaningless concept unless it is also accompanied by a discussion of, and accounting for, the accompanying risk.  

The most straightforward way to do this is to discount pension liabilities based on the risk characteristics of the pension cash flows.  For example, for the accumulated pension obligation (ABO) for a public pension in a state with strong constitutional guarantees against the impairment of retirement benefits, it would be appropriate to use a rate close to the risk-free rate.  In other cases – such as states where pension benefits can be easily changed by the legislature and where the likelihood of change is correlated with broader economic activity – a higher discount rate should be used.  In either case, what must determine the discount rate is the risk profile of the liabilities and NOT the expected return on plan assets.

In the exposure draft for the new rules, GASB seeks to replace the “expected return on plan assets” discount rate with a “blended rate.”  This blended rate is a combination of the expected return on plan assets for the funded portion of the liability and a muni-bond index for the unfunded portion.  Unfortunately, there is no theoretically coherent rationale for the proposed approach.  Indeed, though this approach could be viewed by some as a “compromise,” the result produces an even less coherent outcome than existing policy. 

There are several fatal flaws to the proposed approach, including:

1. There is no clear question to which the proposed measure is the right answer.  Indeed, it is difficult to think of any outcome of interest that is meaningfully described by the output of a cash flow discounting exercise that uses the blended rate as described in the proposed rules.

2. Funded status is not a sufficient measure of the risk of pension liabilities.  To be sure, it may be one such factor – at least insofar as one believes that participants in underfunded pensions are more likely to experience future benefit reductions – but it is far from a sufficient statistic.  Therefore, it is an insufficient basis on which to evaluate the risk of the liabilities. 

3. Even if funded status were a sufficient measure of risk (which it is not), the proposed GASB rules have blended the discount rates in the wrong proportions.  If funded benefits are less risky than unfunded benefits, then the funded benefits should be discounted at a lower rate, and the unfunded ones that should be discounted at a higher rate.  The proposed GASB rules turn this logic on its head, and the result is inconsistent with accepted procedures for risk adjustment.

 4. Even if one wished to calculated a blended rate to account for differential risk based on funding status, the “expected return on plan assets” is not the right rate to use for the “risky” portion of benefits — unless the risk of the liabilities just so happens to correspond exactly to the risk of the asset portfolio, which is highly unlikely.  For example, if  liabilities are discounted using the expected return on a 60/40 equity/bond portfolio, this is equivalent to saying that the distribution of benefit payments to DB pension participants is just as risky as investing in a 60/40 portfolio.  I suspect that few DB plan sponsors intend for their plans to be so risky, and fewer participants believe that their public pension is intended to be so uncertain.

 5. The proposed rules provide an unattractive and dangerous incentive for plan sponsors to take on more investment risk than is optimal.  If plan sponsors invest in a risker portfolio, they will then be able to “justify” a higher expected return under GASB rules.  Indeed when they are permitted to use a higher expected return, they can show a larger share of their liabilities as being “funded.”  This, in turn, also reduces the fraction of their liabilities that will then be discounted using the muni-bond index.  In short, public pensions may be tempted to invest in a riskier asset portfolio in an attempt to shrink the reported size of their unfunded liabilities.    

6. There is a good conceptual argument for using state or municipality’s bond returns as a discount rate for a public entity’s pension liabilities, at least to the extent that pension obligations and bond obligations bear comparable credit risk.  However, this rate should reflect the risk of that particular state or municipality, rather than some aggregate index.  More generally, different states and municipalities should use different discount rates when the risks of their pension obligations differ.      

Because of these and other flaws, I believe it would be a mistake to adopt GASB’s the new proposed discounting rules.  Instead, GASB should adopt standards that based discount rates on the risk of the liabilities.”

 

The Road to Public Pension Hell is Paved with Good Intentions

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Sep 5, 2011

There is an old saying that “the road to hell is paved with good intentions.”  That saying immediately sprang to mind as I read a summary of the new Government Accounting Standard’s Board (GASB) proposal for the public sector pension standards. 

I have written before about the utterly misguided and intellectually vacuous approach that GASB takes to the choice of a discount rate.  But in reading a summary of the exposure draft produced by the Segal company, I was even more struck by the following explanation:

“The “blended” discount rate is not based on the plan’s current funded status, but rather on a projection of plan benefits and assets. That projection includes all future employer contributions that are intended to fund the benefits for current members, including payments towards any current unfunded liability.”  (emphasis added)

Translation: governments would be allowed to mask their pension shortfalls not only by using an artificially high discount rate (which lowers the reported value of the liability), but also by reporting that they intend to make a lot of contributions in the future!  Note that there is no obligation that they actually follow through on their intentions.  I can’t wait to see what kind of creative assumptions governments start using to help obfuscate the real funding status of their pensions.

Pension Discounting: The Brits Have It Wrong Too

Filed Under (Retirement Policy) by Jeffrey Brown on Apr 27, 2011

Today’s Financial Times has reported on a letter signed by me, my Illinois colleague George Pennacchi, and 21 other pension experts in the U.S., the U.K., and Australia explaining why the Chancellor of the Exchequer needs to re-think how pension discounting is done in the U.K.  It seems the U.S. is not the only nation having trouble grappling with basic financial economics.

When Measurement Gets Politicized: The Case of Public Pension Liabilities

Filed Under (Retirement Policy, U.S. Fiscal Policy) by Jeffrey Brown on Apr 13, 2011

Many academic economists, including me, often weigh-in on public policy issues.  One of the things we quickly learn is that academic discourse and political debate can be quite different.  One example of this is that academics are quite good at isolating specific questions (e.g., “holding all else constant”), while political debates often combine issues in an attempt to “spin” the discussion for or against a certain idea.

The public pension debate is a prime example.  There are at least four very important – but conceptually distinct – issues that often get discussed.  Three of these are areas where there are legitimate grounds for disagreement.  The fourth, however, is a pure issue of measurement over which there is virtually no disagreement among academic economists (regardless of ideology).  But others have succeeded in politicizing the issue, and the implications of this are important and unfortunate. 

What are the four issues?

Question 1:  Should public sector workers continue to be offered Defined Benefit plans, or should they be offered Defined Contribution plans instead? 

Question 2: If we continue to offer DB plans, should we fully pre-fund them?

Question 3: Assuming we do at least some pre-funding, how should the assets be invested?

Question 4: What is the value – in today’s dollars – of the future pension benefits that we owe?

These are all distinct questions.  Two people could completely disagree on whether public workers should be offered DB or DC plans, but they might still agree that if a DB is offered, it ought to be fully funded.  Or they could agree that they both like DB plans, but then disagree on the optimal portfolio allocation.  Indeed, for each of the first three questions, there are a number of intellectually defensible answers, and smart, well-educated, good-intentioned individuals can disagree simply because they place different weights on different factors.   Fair enough.

But question 4 is unlike the other three.  Question 4 is not a question about values or weights or the perception of pros and cons.  Question 4 is a measurement issue, pure and simple.  Financial economic theory – and centuries of experience with financial markets – provide clear principles on the right way to discount future pension liabilities.  Namely, you pick a discount rate that reflects the risk of the liabilities themselves.  Every academic financial economist I have ever asked (and there are many, including several Nobel Laureates) agrees on this point (and this is true regardless of their personal political ideology).  Furthermore, they agree that the right answer to this question is *completely* unrelated to how a plan invests its assets (question 3), or whether the plan pre-funds (question 2), or whether the individual prefers a DB or a DC plan (question 1).  They agree that it is a simple measurement issue.   Just like 1+1=2, and this is true for both liberals and conservatives.

Unfortunately, a large number of non-academics – ranging from the Government Accounting Standards Board to some plan administrators to some ideologically-motivated “think tanks” – have managed to turn a clear measurement issue into a muddled ideological and political issue.  In essence, they have begun to argue that 1+1 is actually equal to 1.5, not 2.  And they further imply that those who say 1+1 is equal to 2 are just out to destroy DB plans. 

They do this by saying that those who would discount public pension liabilities the correct way (using a risk-adjusted discount rate -which results in an estimate of about $3 trillion of under-funding in public plans – rather than the intellectually vacuous but “official” estimates of about $1 trillion) are just out to make DB plans look “more expensive.”  They accuse scholars of trying to inflate the costs of DB pensions for some political reason, such as a desire to privatize the system.    

All of this is nonsense.  Many of these same economists disagree on the answers to questions 1, 2 and 3, but we all agree that we ought to at least start with an accurate measurement of the size of the pension liability. Whether one believes DB plans are the greatest human invention of all time, or the worst sin ever committed, should have no bearing whatsoever on how we calculate the present value of our future pension liabilities.  It is also true that how we invest our assets has no bearing on the size of the liability (after all, a dollar invested in stocks today is still worth the same as a dollar invested in bonds today). 

Unfortunately, this politicization of a fundamental economic principle is not merely an intellectual frustration to academic financial economists.  Understating the true economic costs of future pension promises has real consequences.  It distorts decision-making.  It artificially stacks the debate in favor of some reform options and against others.  It promotes excessive risk-taking.  And, perhaps worst of all, it disguises the true cost of government to current taxpayers.