We are currently engaged in a project for a large city pension plan with >$3 billion in assets and a funded ratio approaching 20%. The analysis and solutions that we prepared showed that their pension system would be able to meet all future obligations (benefit payments) with significantly reduced contributions of >$10 billion, a revised return on asset assumption (ROA) of 5.8% (current ROA is 6.75%), and reduced funding costs of the Retired Lives Liability by nearly $420 million. In addition, this plan would still have roughly $570 million in assets in 2055.
The plan sponsor was quite pleased with our analysis and solutions, especially where we reduced contribution costs by 26%, but he was confused as to why assets were so reduced at the “last” liability payment date. With $3 billion currently in AUM, his questions were: “How are we going to meet future obligations and won’t this mean that we are back in the poor financial position that we are today?” Under FASB and GASB accounting rules and actuarial standards, actuarial projections of benefit payments differ depending on the type of plan.
Public pension systems operate under GASB, which uses an Accrued Benefit Obligation (ABO) methodology when forecasting future benefits. In this framework, only current staff is included with no projection of salary increases. As a result, public pensions are a zero-sum game where actuarial projections are based on investment returns on the current assets and contributions fully funding benefits and expenses (C+I=B+E). This methodology would fully exhaust all assets when the last liability is paid. Importantly, new employees would require new contributions or asset growth. Please note we provided an excess asset cushion in 2055 of nearly $600 million.
In the case of a corporate plan, they operate under FASB and the accounting is a Projected Benefit Obligation (PBO) projection of benefits that also doesn’t include new staff, but the benefits take into consideration salary increases. Actuarial projections again are a zero-sum game. Are you confused, yet? Just wait, it gets better.
Ideally, all pension systems should use an Economic Benefit Obligation (EBO) accounting for future benefits. This methodology includes forecasts for both increases in staff and salary, but this is a very difficult exercise and often creates a lot of actuarial noise around such estimates. As a result, it is seldom used. An actuarial friend of our firm added the following: “The problem of the EBO analysis lies in the lack of acceptance by the actuarial community of the economic principles of Law of One Price that lead to Cash Flow Matching and/or Risk Recognition from Asset/Liability mismatches.” Lastly, and likely most important is the fact that this methodology leads to increased contributions which is the consequence of the EBO mathematics using standard actuarial models.
Based on the above information, it isn’t too difficult to understand why the plan sponsor involved in our project was concerned about the “loss” of assets in 2055 versus their plan’s market value of assets today. He should have been thrilled with the conclusions that we presented, but he was confused instead. This isn’t surprising given the many different ways that future benefits can be estimated. Why do we have so many methodologies to calculate benefits? Worse, why do we have two different methodologies in GASB and FASB when the world uses IASB? We’ll save our thoughts on that subject for another blog post.
We’ve invested enough time on all this actuarial stuff. You are probably wondering how a public pension system could “save” significant future contributions, while reducing funding costs and the ROA necessary to fund this plan, especially given that U.S. interest rates are at historic lows and equity valuations near all-time highs. We’d be happy to speak with you about our proposal. Call us.