Balance sheet equation (assets = liabilities + equity) + funded status equation (assets divided by liabilities equals 1)

Even if you failed Accounting 101, you probably recognize Equation A as the balance sheet equation. In the context of a state pension, however, there is no Equity. Removing Equity from the equation and rearranging the terms produces Equation B, which happens to be equivalent to a pension’s Funded Status.

In the late 2000s, an oft-repeated myth was born: actuarial experts determined that a pension with an 80% actuarial funded status was financially healthy. The myth’s origination can be traced back to September 2007, when the U.S. Government Accountability Office (GAO) submitted a report to the Senate Committee on Finance titled “State and Local Government Retiree Benefits: Current Status of Benefit Structures, Protections, and Fiscal Outlook for Funding Future Costs.” From the report:

According NASRA’s Public Fund Survey as of 2007, the most recent reports from 126 of the largest state and local pension plans in the country indicate that over three-fifths of the plans were at least 80 percent funded—a level generally viewed as being acceptable to support future pension costs.44

The first part of the sentence is an empirical finding with a legitimate source. The second, however, is an assertion with the following footnote attached:

44 A funded ratio of 80 percent or more is within the range that many public sector experts, union officials, and advocates view as a healthy pension system.

The defense of your assertion is to repeat it? That is unacceptable1. Especially when it’s coming from a federal accountability office.

At no point has the GAO produced any reliable reference that justifies the 80% figure. However, a few months after the initial report (which is the one typically cited), Barbara D. Bovbjerg, the Director of Education, Workforce, and Income Security at the GAO, gave testimony before the Joint Economic Committee that provided hints at the reference’s true source2.

In the testimony, she repeats the many experts line: “Many experts and officials to whom we spoke consider a funded ratio of 80 percent to be sufficient for public pans for a couple of reasons.”2,3 The footnote does not contain any information about the referenced experts, but does mention the Pension Protection Act of 2006, which states:

IN GENERAL. — A plan is in at-risk status for a plan year if — the funding target attainment percentage for the preceding plan year is less than 80 percent.

Somehow, the GAO reinterpreted “a plan is in at-risk under 80% funded status” as “80% is healthy,” which couldn’t be more misguided. Bovbjerg goes on to justify the 80% threshold with the following statements, which we’ve added our own commentary to:

“First, it is unlikely that public entities will go out of business or cease operations as can happen with private sector employers.”

While rare, roughly 620 municipalities have filed for bankruptcy since 1937 and the disastrous effects of Covid-19 will likely lead to even more.

“State and local governments can spread the costs of unfunded liabilities over a period of up to 30 years under current GASB standards.”

Allowing an unfunded liability to fester by telling your balance sheet that it will happen in 30 years is not helpful. This point effectively states you can hide it for a long time and since you’ll be out of office 22 years before things go south, so who cares?

“It can be politically unwise for a plan to be overfunded; that is, to have a funded ratio over 100 percent.”

You’re unable to articulate the importance of maintaining a funded plan to your political opponents, so you’ll continue to kick the can down the road and ignore it. Great.

Unfortunately, the 80% funded status myth has spread like wildfire across the pension landscape in the years since its origination at the GAO. The proliferation of this falsehood has even infected the PEW Research Center3. However, we are not the only ones sounding the alarm:

In spite of the voices decrying the 80% myth, the majority of the people holding the keys to the kingdom continue to cite the fallacious figure. In fact, not only has this moronic idea been allowed to fester, the worst thinkers have taken it one step further and claim that not only is 80% ok, it is in fact a better goal than 100%. And then other pioneers took that and jumped all the way to 80% is better than 100% and if you suggest 100%, you’re stupid.

Fully charged battery

"All plans should have the objective of accumulating assets equal to 100% of a relevant pension obligation"

- American Academy of Actuaries, July 2012

We have to balance our balance sheet...it's called a balance sheet...

battery

“Our funded status increased a full percent from last year and now stands at 82.4 percent. Industry experts say pension plans funded at 80 percent or greater are financially healthy.” 4

- Donna Mueller, CEO of Iowa PERS, June 2018

Full funding is ideal, but let’s not be too hard on ourselves.

battery

“The resolution directs CFT to sponsor legislation that would reduce the CalSTRS goal from 100 percent funded to 80 percent funded by 2046.” 5

- California Federation of Teachers, 2018 Convention, Resolution 21

Full funding is too difficult so let’s pretend it’s not ideal.

battery

“A funding ratio between 80 and 85 percent is ideal. When retirement funding is about 100 percent, there is usually pressure to increase benefits.” 6

- Bruce Bronner, CEO of Alabama PERS, January 2012

Full funding isn’t ideal because it is politically unwise.

battery

“Full funding of pensions is a waste of money.” 7

- John McTighe, President, Retired Employees of San Diego County
- Jim Baross, President, City of San Diego Retired Employees’ Association
- David Hall, President, City of San Diego Retired Fire and Police Association

Full funding is a straight-up bad idea.

battery

“Quite simply, it has become the mantra of some pension fund administrators, financial consultants that benefit from such schemes and ideological zealots that government pension funds should be 100% funded. These individuals are wrong.” 8

- Joel Pafford, President, Retired Public Employees of New Mexico

If you suggest full funding, you’re a bad person.

Parroting a baseless claim is bad enough, but the fact this is happening while actuary experts definitively disagree makes it even worse. Actuaries seem to be finding themselves in an intellectual place that an increasing number of people can relate to these days: I can’t believe we have to say this, but…

In 2012, the American Academy of Actuaries published an issue brief titled, “The 80% Pension Funding Standard Myth,” in which they reference the GAO report’s errancy and explain that there is no empirical evidence for any funding goal that is not 100%. Furthermore, the largest actuarial professional organization, the Society of Actuaries, held a panel in 2014 where they clearly stated: “Funding entities and plan trustees should strive to fund 100 percent of the obligation for benefits using assumptions that are consistent with median expectations about future economic conditions.”

I can’t believe we have to say this, but you should have enough money to pay what you owe. Suggesting a goal less than 100% actuarial funded status means you either don’t understand actuarial analysis, don’t trust it, or worse yet: both. If actuarial analysis shouldn’t be trusted, that’s fine; explain why and pick another method. Yet continuing to use actuarial figures and lowering the mathematically-defined goal of 100% to 80% is not an option. By dropping the goal to 80%, you are essentially adding Equity to the Asset Liability equation and baking in a loss. Since the loss isn’t directly imminent, today’s management is not going to incur it, but the next generation will.

We aren’t pioneers in addressing the underfunded U.S. pension disaster. The cause of the underfunded pension crisis is much more complex than simply pensions are bad at managing their plans. For example, increasing life expectancy paired with fixed retirement ages results in individuals spending a larger portion of their lives in retirement. Also, decreased fertility rates across the country have resulted in a smaller population of workers to counterbalance protracted retirement. Such confounding variables make 100% funded status difficult, but this is the situation that pensions have inherited. Pretending that an 80% funded ratio is healthy won’t solve anything.

Widespread tolerance of substandard funding status is contributing to the pension crisis. How funded should you be? 100%, obviously. This used to be a rhetorical question. The answer is self-evident; you should have enough assets to actuarially meet your future liabilities.

The problem is that the future is too far away to hold institutions and their managers responsible, and actuarial calculations can be quickly dismissed when they are not well understood. Any process that uses actuarial assumptions is by nature subject to opinion and manipulation. The assumptions greatly change the actuarial funded level. The actuarial return assumption, for example, has a tremendous impact on funded status and is susceptible to severe manipulation. Over 20 years, an assumption of 6% vs. 8% turns $1 billion dollars into $3.03 billion vs $4.32 billion (see graph below).

Growth of Actuarial Liabilities Under Different Discount Rates

Bar graph of the growth of actuarial liabilities under 6% and 8% discount rates

It’s not hard for a cynic to look at that giant discrepancy and think actuarial assumptions are nonsense - who cares how we deal with them, and by extension, funded status doesn’t mean anything. But that is not the right reaction. With great power comes great responsibility, and actuarial assumptions definitely bear great power. The correct response is to wield this power judiciously.

Funded status needs to be elevated back to a position that people respect. Our solution is two-fold:

  • Require pensions to state their methodology for calculating the actuarial return assumption.
  • Define both a short-term (~5-10 years) and long-term (>10 years) return assumption. Both are evidence-based. The short-term assumption is based on the current state of the market (i.e. current Equity E/P ratios and bond yields) and is updated annually. The long-term assumption is based on historical figures, and would be in line with the assumptions generally seen across the pension landscape (see graph below); this figure should rarely, if ever, be updated. The tendency across the pension landscape at the moment is to change this number by increments of 25 bps when it is politically expedient. This has to stop.

Discount Rates of Major State Pensions

Graph on the growth of discount rates of major state pension funds

Our Methodology for Calculating Actuarial Return Assumption

The overarching principle of our methodology is that return expectations ought to be derived from asset allocations. The final figure is the sum product of asset allocation percentages and these calculations.

Visual example of our methodology

References

  1. Many experts agree that defending assertions by merely repeating them is unacceptable.
  2. https://www.gao.gov/assets/130/120599.pdf
  3. https://www.pewtrusts.org/~/media/legacy/uploadedfiles/pcs_assets/2010/TrillionDollarGapUnderfundedStateRetirementSystemsandtheRoadstoReformpdf.pdf (page 3)
  4. https://www.ipers.org/sites/default/files/FY2018%20Annual%20Summary%20%28SAFR%29.pdf
  5. http://laschoolreport.com/california-federation-of-teachers-wants-changes-in-the-pension-system/
  6. https://www.al.com/breaking/2012/01/alabama_house_speaker_wants_ch.html
  7. https://www.sandiegouniontribune.com/opinion/commentary/sd-utbg-public-pensions-funding-20170914-story.html
  8. https://www.abqjournal.com/1404955/gov-takes-toomuchtoosoon-route-to-fix-pension.html