Future Contributions Into A DB Plan Should Be Considered An Asset Of The Fund

Recently, Mary Williams Walsh, NY Times, penned an article titled,

“Standards Board Struggles With Pension Quagmire”.

The gist of the article had to do with what role did the actuaries and actuarial accounting play in the current state of public pension funding. Many of the actuaries felt that they were pressed by politicians into reverse-engineering their calculations to achieve a predetermined result (contribution cost). “That can’t be good public policy,” said Bradley D. Belt, a former pension regulator, who is now the vice chairman of Orchard Global Capital Group.

According to Ms. Walsh, “he called for additional disclosures by states and cities, including the current value of all pensions promised, calculated with a so-called risk-free discount rate, which means translating the future benefits into today’s dollars with the rate paid on very safe investments, like Treasury bonds.”

Actuaries currently use higher discount rates, which complies with their professional standards but flies in the face of modern asset-pricing theory. Changing their practice to resolve this is one of the most hotly contested proposals in the world of public finance, because it would show the current market value of public pensions and probably make it clear that some places have promised more than they can deliver.

But, if we are going to require DB plans to mark-to-market their fund’s liabilities, inflating future promised benefits, we should also include future contributions as an asset of the plan. Since many, if not most plans, have a legal obligation to fund the plan at an actuarial determined level or through negotiations, these contributions are likely to be made (NJ is one of the exceptions).

When valuing liabilities at “market” without taking into consideration future contributions, plans are artificially lowering their funded ratio, while negatively exacerbating their funded status. Most individuals (tax payers) would not understand the “accounting”, but they would certainly comprehend the negative publicity of a < 50% funded plan.

Most public pension plans derive a healthy percent of their assets through contributions.  Not reflecting these future assets in the funded ratio creates the impression that these funds are not sustainable, which for most public plans is not close to reality.

We need DB plans to be the backbone of the US retirement industry. Only marking to market liabilities without giving a nod to future contributions doesn’t fairly depict the whole story. We can do better.

“The Truth Will Set You Free”

I continue to be perplexed, befuddled, mystified, and perhaps stumped by the reticence shown by plan sponsors and their consultants in wanting to know the value of the liabilities in their defined benefit plan on an on-going basis!

As a reminder, the defined benefit plan solely exists to provide a predefined benefit to past, present and future employees of the system in a cost effective manner such that contribution costs remain low and stable. Again, the plan exists to meet a liability.  It doesn’t exist to meet a return on asset assumption. Yet, plan sponsors spend 95% of their time worried about the assets in their plan and very little time on how liabilities are being impacted by market forces.

If two pension plans have widely differing fund ratios, say 100% and 60%, should they have the same asset allocation? No, they shouldn’t. They certainly shouldn’t have the same ROA objectives. Why would a plan sponsor of a well funded plan want to live with the volatility associated with an asset allocation designed to support a 60% funded plan?  Plan sponsors should adjust their asset allocation based on the plan’s funded ratio.

A more fully funded plan should have a much more conservative asset allocation than a poorly funded program. However, in order to know what the funded ratio is, one needs a more accurate and current understanding of the value of the plan’s liabilities.  Currently, the only visibility on a plan’s liabilities is through the annual actuarial report, which tends to be provided 4-6 months delinquent. For many plans, they may still only have a view on year-end 2013 liabilities. We can assure you that liability growth has swung wildly in the last 17-18 months, as interest rates fell significantly in 2014, before backing up so far this year.

In a previous blog posting we discussed 2014’s performance for the average pension plan. We highlighted the fact that the average plan slightly underperformed the average ROA, and that based on that performance most sponsors likely felt that it was an okay year.  Unfortunately, that perception would be incorrect as liability growth easily outpaced asset growth in 2014.

In addition, had sponsors taken risk off the table in 1999 when most DB plans were over-funded, they would have adjusted their asset allocations toward fixed income and away from equities. Regrettably, more risk was put into the plans when fixed income allocations were dramatically reduced for fear that the lower yielding environment would reduce a plan’s ability to meet the ROA objective.  As you know, DB plans have missed the last 15 years of a bond bull market, while subjecting those plans to greater equity risk and two major market declines.

Clearly, liabilities and assets have different growth rates. Yet, the industry continues to believe that by achieving the Holy Grail ROA annually that everything will be fine. Unfortunately, that perception is false.

Would you be comfortable playing a football game in which you only knew your score (assets), but had no clue as to what your opponent was doing (liabilities)? How would you adjust your play calling or defense? I suspect that you wouldn’t play any game in which this scenario existed. Then why as an industry are we playing the pension game by only focusing on the assets with no understanding as to how your liabilities are doing?

We can win the pension game, WE NEED TO WIN THE PENSION GAME, but in order to do so we must utilize tools that provide us with all the information that we need to manage these plans more effectively.  Having greater clarity on the liabilities doesn’t have to be a bad thing!  What are you afraid of?