Another Tool to Measure Pension Health: Net Amortization

One sure fire way to stay in debt is to never pay a dollar towards the principal. It’s something every responsible credit card holder knows. But is something that a large number of public sector pension plans don’t seem to understand.

One of the major reasons that public sector pension plans have seen their unfunded liabilities grow over the past decade is that actuarially calculated amortization payments can often times be less than what needs to flow into that plan in order to fully fund benefit payments. For example, a plan with a three-decade long, open amortization schedule (ex. the South Carolina Retirement System) is almost certainly making unfunded liability amortization payments that are less than the interest accruing on that same unfunded liability, leading to negative amortization. Highlighting such concerns can often require a detailed examination of a pension plan’s actuarial valuation, and a new project by The Pew Charitable Trusts is seeking to make it a bit easier to spot the troubled plans.

The recently adopted GASB 67 and GABS 68 accounting rules require plans to report more data than ever before. The new GASB disclosures include information that can be leveraged to conduct enhanced analysis of plan contribution policies compared with previously available data. Before the change, most researchers and policy institutions primarily relied on the Actuarially Determined Employer Contribution (ADEC) for comparison, which only indicates the estimated contribution level and can sometimes be a less than reliable metric when it comes to signaling plans true fiscal health.[1] Now, the new data included in public pension financial statements, on the other hand, allows for measurement of exact contributions made to the plan and see whether an employer’s contribution policy achieves net amortization.[2]

In a new policy brief, Pew outlines how it has taken GASB disclosures and parsed the data to tabulate what it calls “net amortization.” This measure is intended to provide insights into fiscal health of public sector pension plans.

Net amortization focuses on the level at which employers’ annual contributions are sufficient to pay for both the current year’s normal cost and the accrued interest on pension debt, all after netting out employee contributions and assuming that the plans’ actuarial assumptions are met for that year. Thus, if assumptions are proven to be correct, plans receiving contributions should meet a “net amortization benchmark” and see their unfunded liabilities shrink. If contributions from the employer are not sufficient to pay for normal cost and interest on the unfunded liability, then the net amortization benchmark would not be met and unfunded liabilities would grow (even assuming actuarial assumptions are met). Thus, the net amortization measure provides an alternative assessment of any given plans’ contribution policies without taking into account unexpected actuarial gains and losses.

According to the Pew report, 15 states in 2014 followed policies that meet the positive amortization benchmark (exceeding 100 percent of needed funding) and can be expected to reduce pension debt in the near term. The remaining 35 states fell short of the benchmark.

In many respects the “net amortization” figure could be considered just another way of framing negative amortization — but it captures more than just plans using open amortization schedules. It’s greatest strength is in pinning down how much a plan might be underfunding a basic standard of paying normal cost and at least interest on the debt, all using simple arithmetic from a GASB disclosure. The principal weakness of net amortization is that it is dependent on a plan’s actuarial assumptions. Since the measure uses each plan’s own assumptions, pension plans with higher assumed rates of return will have lower estimated costs of benefits, and lower benchmark as a result. So while the new metric might prove itself to be helpful for policy analysts to track the health condition of public pension plans, net amortization can not be considered as a singular measure of plan fiscal health any more than the ADEC can be considered a perfect measure of fiscal health. Still, net amortization has the potential to be a key tool in the toolbox of benchmarks that state legislators and plan managers can use to evaluate overall fiscal health and consider how to improve their plans’ solvency.

To read the full paper, go here.

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[1] ADEC – formerly Annual Required Contribution (ARC)

[2] Calculation of a plan’s net amortization starts with the employer contribution benchmark: Employer contribution benchmark = service cost plus interest on the prior year’s debt minus employee contributions (with interest). Net amortization = employer and other contributions (with interest) minus the employer benchmark.