Consider a 45-year-old state government employee earning $75,000 per year in a job that provides no retirement benefits. In order to nudge her to save something for retirement, her employer changes her pay package to $73,000 in cash plus a zero-coupon Treasury bond paying $5,000 in 20 years. The bond costs $2,000.
Instead of keeping the bond, this employee could sell the bond and, if she wishes, invest the $2,000 in an S&P 500 index fund and hope to end up with more than $5,000 in 20 years while accepting the risk that she’ll end up with less. Regardless of what she does with the bond, her total compensation remains $75,000.
Now suppose that her employer pays her $73,000 and just promises to pay her an additional $5,000 in 25 years. If the employer is good for it, her total compensation is still worth $75,000.
Behind the scenes, her employer could set up a trust to fund the obligation and contribute the $2,000 bond, which would pay off the promised $5,000 in 20 years.
But instead, the employer hires an actuary who says that investing in a diversified portfolio–including risky assets–means that the employer can expect to earn 7% per annum and, therefore, needs to set aside only $1,292 to “fully fund” the employer’s debt to the employee. In other words, the actuary would use the riskier portfolio to justify discounting the payment using 7% per annum as opposed to the 4.69% implicit in the Treasury bond that perfectly hedges the obligation. The actuary’s report would then show a “liability” of $1,292 instead of $2,000, the actual value of the debt to the employee.
This reasoning is the basis for actuarially-determined contributions as well as financial accounting for public pension plans, the traditional defined-benefit plans sponsored by state and local governments. When state officials trumpet making the “full actuarially determined contribution” to a state pension plan, that means the $1,292 in the example, not the actual $2,000 cost.
However, this rationale constitutes a financial sleight-of-hand. The $708 difference between $2,000 and $1,292 is the current market value of the employer’s guarantee to make good on the $5,000 in 20 years if the $1,292 invested in risky assets results in a shortfall.
Actuarial finance assumes away the cost of the guarantee, but real finance doesn’t work that way.
Consider an alternative world where the employer relies on actuarial finance and instead of a $75,000 salary provides the employee $73,000 along with $1,292 in a defined contribution plan account invested in the diversified portfolio. The employer can offer the actuary’s argument that the employee can “expect” to receive $5,000 in 20 years, but the employee would recognize that she received a pay cut of $708–the value of the guarantee.
In real finance, the discount rates applied to future cash flows to determine their value reflect the amount, timing, and default risk of the cash flows. Two sets of cash flows that have the same financial characteristics – in the example, the promised $5,000 payment and the Treasury bond – must logically have the same current value.
Because “expected” returns on pension portfolios exceed real-finance discount rates, reported public pension debt is understated by trillions of dollars – for 2022, that understatement amounted to $3.5 trillion. While expected-return discounting violates basic finance principles, it is required for financial reporting by the Government Accounting Standards Board and endorsed by actuarial professional standards. This remains true despite decades of criticism from financial economists.
The Actuarial Standards Board, which defines professional standards for actuaries, finally acknowledged the criticisms and adopted a requirement for actuaries to calculate and disclose – starting with funding reports to be published (mostly) in 2024 – a liability measure more consistent with finance principles. The new measure provides valuable information not previously available, although it is not perfect, and, importantly, it will not affect actuarially-determined contributions or financial accounting.
Further, many prominent and influential public pension actuaries are rejecting this opportunity to educate their clients and the public about how much worse the funding of public pensions is versus what’s commonly reported. Instead, these actuaries have aligned with major public pension advocacy groups in developing a toolkit as part of a campaign to help actuaries and public officials divert attention from the significance and implications of the new figure. Among other things, the toolkit provides model explanatory language for actuarial reports, including the misleading assertion that the difference between the new measure and the current one represents “expected taxpayer savings” from investing in risky assets, rather than heretofore hidden public debt.
Underfunded pension obligations will eventually threaten the ability of many state and local governments to provide needed services, make good on their other debt, or pay their promised pension benefits. Actuaries are required by their professional code of conduct to “act honestly, with integrity and competence, and in a manner to fulfill the profession’s responsibility to the public.“ Public pension actuaries should abide by their code and use the new disclosure to help their government clients – and the taxpayers who are ultimately on the hook for paying these promises – come to grips with the real financial health of their pension plans.