FE1-Lay Translation

I read the August and most of the November working papers and plan additional blogs on several aspects of them that I found confusing, wrong, or insightful but for now, in bullet form, this is how I would present the authors’ thesis to laypeople:

  • Valuing liabilities for public pension plans should be based on the benefits offered and not upon the assets expected to finance those benefits
  • U.S. Treasury long-term bond rates are at about 2%
  • Liabilities for public pension plans should be valued at about 2%

Of course most public plans are now costed in the 8% range so expecting to only get only 2% in trust earnings would explode liability values and contribution ‘requirements’ and a lot of yelling by politicians at their actuaries would ensue – hence the reluctance of anyone currently hired by a government entity to provide them with numbers to embrace this concept.

6 responses to this post.

  1. Posted by AnonActuary on September 14, 2016 at 11:39 am

    You’ve covered the liability side. Expected benefit payments should be discounted using a discount rate that reflects the riskiness of paying them. Since the payments are “guaranteed” (CA rule) there is no real risk of nonpayment, and therefore these cash flows should be discounted using a risk free rate. For this purpose long treasuries are a good proxy. Right now they yield about 2.25%. Most importantly, as you say, the liabilities cannot ever be a function of the plan’s assets or funding level, that is pure nonsense.

    However you’re missing the asset side, where the authors make the case that assets should be selected to match the liability – bonds with similar cash flows as the pension plans. Investing in risky assets does not create value for taxpayers.

    And also the funding side, where (after fully funding the solvency liability, ha!) the annual contribution should be the solvency normal cost (e.g. UC basis, risk free rate).

    Reply

    • Posted by Anonymous on September 14, 2016 at 12:31 pm

      Risky investments in down years deplete the asset base such that when the risky investments rebound they’re appreciating a much lower base. Vicious cycle of chasing returns on a diminished asset base gets you no where.

      Reply

  2. Posted by S Moderation Douglas on September 14, 2016 at 1:34 pm

    John,

    Question about valuing liabilities for public pension plans as it relates to comparing public and private compensation. (As in Biggs and Richwine.) I (sort of) understand the concept of using the risk free rate, but how does that play out over a time period of five, ten, or even thirty years?

    For the sake of argument, say the relative base pay difference remains fairly constant over time. Most studies say on average public workers earn eight to twelve percent less than similar private workers.

    For the study period 2008-20012, Biggs used a rate of 4%. For nationwide statistics, he determined that state workers earned 12% less in salary than similar private workers, but by calculating pensions and retiree healthcare using risk free rate, that turned into a 10% total compensation advantage (nationwide) for public workers. (23% advantage in NJ, CA, IL, RI, etc.)

    Biggs:
    “For instance, a plan with a total normal cost of 10 percent of wages at an 8 percent discount rate would have a normal cost of 34.2 percent of pay using a 4 percent discount rate. If the employee contributes 5 percent of pay to the plan, his net pension compensation would be equal to 29.2 percent of wages.”

    Again, assuming the same relative difference in salary, (8-12%) and assuming no change in pension formulas. What would be the change in total compensation using the 2000 treasury long term rate (near 7%), or the 2016 rates near 2% ?

    Seems like, the same guy doing the same job for the same relative pay could be “underpaid” one year and “overpaid” four years later. Then depending on the Fed, underpaid again four years after that. Does anyone know what long term treasury rates will be in 2020?

    Reply

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