Strengthening the Security of Public Sector Defined-Benefit Plans by Daniel J. Boyd and Peter J. Kiernan

from The Blinken Report, January, 2014: 

"...If public sector defined benefit plans are to be successful over the long run, these flaws must be fixed by removing bad incen­tives, increasing transparency, and imposing discipline. We rec­ommend the following changes:

Pension Funds and Governments Should Value Liabilities and Expenses with a Risk-Free Rate, for Financial Reporting Purposes:

"Pension funds and governments should value liabilities and calculate costs of benefits, for financial reporting purposes, using a discount rate reflecting the risk that the obligations will not be paid. Funds also should disclose projected cash flows used to cal­culate liabilities so that they can be discounted at alternative rates. As a practical matter, in most cases the appropriate discount rate will be close to a risk free rate (or set of rates from different points on the yield curve). There are some important considerations in­volved in determining precisely which rate to use, in particular whether the rate should be taxable (yes), whether it should have a premium for liquidity (no), and whether it should be inflation-adjusted or not. This last question is not as straightforward — pension benefits are protected to differing degrees from inflation. A pragmatic choice that would get most of the desired result would be to use a nominal rate. Another pragmatic choice would be to base the discount rate on a high-quality municipal bond rate.

"The rate generally should be risk free even though some pen­sion benefits are succumbing to legal attack. It should reflect the fact that, when promised, pension benefits are expected to be and should be honored by governments. The rate definitely should not vary with the creditworthiness of the borrower. For example, it should not reflect the borrowing costs of the governments in ques­tion. Otherwise, it will create the perverse result that the govern­ments in the worst financial trouble (quite possibly because of pension problems) would have the lowest reported pension liabil­ities, all else equal. (If the pension fund discount rate is based on the rates at which the government can borrow, then governments in financial trouble, thereby paying higher rates to borrow, will have lower reported pension liabilities.)

"Even though separate calculation of pension liabilities and benefit costs in this manner are not required to be included in Comprehensive Annual Reports, they should be. Stan­dards organizations — GASB and the Actuarial Standards Board in particular — should revisit their current standards and develop improved guidelines for pension systems and governments. But in the interim, governments and pension systems and governments should do this on their own initiative.

"Discounting at risk-free rates is likely to result in at least a $2 trillion increase in reported liabilities for state and local govern­ments in the United States. The estimate of annual pension ex­pense — what governments would have to pay if they were to fully fund pensions without taking investment risk — is likely to increase by more than $100 billion.

"This change would not be a funding requirement; rather it would be disclosure of pertinent information. This is as it should be: governments, taxpayers, and others should know the full cost of promises that have been made, and what it could take to fund those promises without risk. Full disclosure could be the basis of political support and a predicate for legislative changes.

Pension Funds Need to Disclose More Fully the Consequences of Investment Risk:

"Pension funds are taking considerable investment risk that others bear. This risk must be disclosed far more fully. Pension funds need to disclose the potential consequences of investment risk not only for their funded status, but also for the contributions that participating governments may have to make. When invest­ment returns fall short, they can require very large increases in contributions, and governments make these contributions if they are to keep their side of the bargain. But large increases in re­quired contributions invariably come when governments are least able to afford them, and crowd out other services and investments of government, or required tax increases. And they erode public support for public sector pension benefits, and for the public sector workforce.

"The Pension Committee of the Actuarial Standards Board is headed in the right direction with its current discussion draft of actuarial standards that explores whether actuaries should be re­quired to assess risk more rigorously. The Committee and, ulti­mately, the Actuarial Standards Board should develop standards in this area, and those standards should address the consequences of risk for contributions as well as for plan assets and funded sta­tus. Other professional organizations of actuaries and plan administrators should contribute to this effort. Until then, pension funds and their sponsoring governments should take the lead and disclose the potential consequences of in­vestment risk, on their own initiative.

There Needs to be External Downward Pressure on Investment Risk:

"No matter how professional and well-intended pension fund boards are, and no matter how well they disclose investment risks, current and future stakeholders in government will bear the risk that pension funds take. These stakeholders are not at the ta­ble when pension funds establish their risk tolerance. Because public pension funds have approximately two-thirds of their as­sets in equity-like investments, have become increasingly large, and have increasingly maturing memberships, the potential con­sequences of this risk are far greater now than in the past. There must be external pressure to moderate these risks.

"What is also needed is an effort to dampen incentives for risk taking. Disclosure will help, but governments should develop for­mal statements of the contribution risk that they are willing to bear, and pension funds should consider these statements explic­itly as they develop their investment policy statements and asset allocation policies.

Governments Must Keep Their End of the Bargain and Pay Realistic Actuarially-Determined Contributions:

"Any rules used to estimate liabilities and to fund liabilities are likely to be imperfect and controversial. But the one thing that governments should not do is ignore all rules, and fund benefits on an ad hoc basis. The surest way to turn pension underfunding into a crisis is underpay liabilities. This has happened in Illinois, New Jersey, Rhode Island, Pennsylvania, and several other states, and is happening now to CalSTRS in California... Governments should fund actuarially-determined contributions.

"This is compounded by rules and practices by some funds and governments that allow inordinately long amortization periods for investment losses and actuarial losses, and by extraordinary borrowing mechanisms that allow governments to push the con­sequences of recent losses far into the future. Governments and pension funds should sharply limit amortization periods, in gen­eral not extending them beyond the remaining working life of cur­rent membership. The Actuarial Standards Board should examine standards in this area very carefully, with an eye toward shortening amortization periods.

"State governments have the legal authority to require their lo­cal governments to make contributions, and can establish enforce­ment mechanisms, such as the withholding of state aid, to ensure that they do so. Several states have done so, as illustrated earlier in the report. Other states should do so, too. It is much harder for states to bind their own hands, and im­pose discipline on themselves. Still, a formal legal commitment to funding required contributions backed with a potential remedy, as New Jersey and Illinois have adopted, and dedicated revenue sources as several states have provided for local government con­tributions, hold promise. If governments and pension funds will not do this on their own, the federal government should consider creating incentives to encourage this.

There Is a National Interest, and a Potential Federal Role, in Ensuring Proper Disclosure and Adequate Contributions:

"Because there is a national interest in retirement security and in much of what states and localities do, which can be crowded out by sharp increases in retirement contributions, there is a po­tential federal role in encouraging or establishing rules to help ad­dress the problems caused by failed state and local pension systems and prevent future failures.

"The federal government should explore options for regulatory action by the Municipal Securities Rulemaking Board, the Securi­ties and Exchange Commission, and Congressional oversight to enhance reporting and transparency. Congressional action in re­spect of a variant of the previously abandoned Public Employee Retirement Income Security Act (PERISA) also could be a vehicle of federal attention. Other legislative measures might be neces­sary. We do not advocate federal regulatory attention by the U.S. Bankruptcy Courts (which could introduce confusing, conflicting rulings and broad uncertainty), nor do we advocate additional federal funding to the states for underfunded pensions. If states and standards-setting bodies do not go far enough on their own, the federal government should consider more intrusive action to monitor and police state and local government retire­ment systems."

from the Nelson A. Rockefeller Institute of Government: Strengthening the Security of Public Sector Defined-Benefit Plans