Milliman on Open Amortization

Open amortization is a pernicious funding gimmick designed solely to understate contributions.  It is a generally accepted actuarial practice for public plans.  Milliman in their report criticizing Detroit’s official pension numbers under the heading “Significant deferral of cost built into amortization methodology” provides a textbook criticism of the process:

Each year the entire unfunded liability (on a smoothed basis) is calculated anew on an “open” basis and an amortization amount is determined.  The “level percent of payroll” amortization amount is designed to pay off the unfunded liability over 30 years if the payments in future years increase in proportion to payroll growth each year.  This is the extreme minimum approach permissible under current GASB standards and there are multiple deferral mechanisms built in

  • 30 years is the maximum amortization period allowable under current GASB standards
  • Instead of calculating a level dollar payment over 30 years where some interest and some principal is paid every year, like a standard mortgage on a house, the level percent of payroll approach yields a very low dollar amount up front, with higher dollar amounts back loaded.  The up-front dollar amounts are less than the interest on the unfunded liability, and thus there is negative amortization.  Depending on the assumed returns and payroll growth, it can be 20 years or more until the dollar amount of the unfunded liability actually decreases.
  • But, instead of developing an amortization schedule and sticking to it (“closed” approach), the open approach resets the schedule every year, so the System never gets to the point where the dollars get big enough to start paying down the unfunded liability.  This situation is akin to buying a house, paying less than the interest amount, refinancing the higher balance next year, again paying less than the interest amount, refinancing the higher balance.

In summary, there is no mechanism withing the current amortization methodology that will ever bring the plans to full funding.

You should be aware that this 30-year open amortization method Detroit is using was part of the ‘reforms’ adopted two years ago that I criticized at the time.

You should also be aware of the asset valuation method used by Milliman in their June 30, 2012 valuation of the New Jersey Teachers’ Pension and Annuity Fund (page 43):

Amortization Method Level Dollar, Open until 2018 valuation

which is explained on page 10:

For purposes of determining the statutory contributions, the unfunded liability is amortized over 30 years on a level dollar basis. Since a level dollar method is used, the full amount of interest on the unfunded liability plus a principal portion of the unfunded liability is expected to be paid each year. The amortization period will remain at 30 years until the June 30, 2019 valuation (2021 fiscal year). At that time, the period will be reduced by 1 each year until 20 years is attained with the June 30, 2028 valuation (2030 fiscal year).

This methodology of open amortization is what Milliman has been using in New Jersey and will continue to use until 2019 when it will likely be applied to the full liability since, with a few more contribution holidays surely coming, the market value of assets would have been completely depleted by then (though the actuarial value could still be around $70 billion due to asset smoothing).

5 responses to this post.

  1. Posted by Workisgood4thesoul on August 10, 2013 at 12:19 pm

    So NJ COLA can never be restored if dependent upon reaching the funding level specified in the 2010 pension reforms, as using this methodology, this will never happen. Please fee free to correct me.

    Reply

  2. Posted by Tough Love on August 10, 2013 at 5:57 pm

    I’ve always found it helpful to test or walk through an extreme example to determine with a methodology employed is fundamentally flawed.

    In the situation you describe, with the Market value of assets=Zero, I wonder whether the Plan actuary would have the gall to continue the current practice of using “smoothed” assets greater than zero.

    Reply

  3. Posted by Tough Love on August 10, 2013 at 8:20 pm

    Ooophs …. In the 1-st sentence above, “with” should be “whether”

    Reply

  4. […] and future demands on the fund. BURY: How does this exceedingly rare term rate a definition while Open Amortization, universally used to artificially lower contributions, gets left out by CILG? And if contributions […]

    Reply

  5. […] cabal to understate contributions. Independent observers (or those not being bribed for an opinion) decry open amortization and now we have a scholarly work on the […]

    Reply

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