On Feb. 11, the Actuarial Standards Board issued a revised Actuarial Standard of Practice No. 4, effective February 15, 2023. The rollout has been low-key. The announcement says:
“Notable changes made to the existing 2013 version include expanding the scope to clarify the application of the standard when the actuary selects an output smoothing method and when an assumption or method is not selected by the actuary.”
But this description obscures a significant new required disclosure, one which follows years of controversy and acrimony within and among actuaries and the public pension plan community at large. The requirement was the overwhelming focus during the drafting and comment period.
The new required disclosure reflects economic reality better than any currently required number.
Actuaries will soon have to calculate and disclose a liability measure much closer to a decision-useful market liability than anything currently required or commonly shown. This liability could, and should, raise awareness of the extent to which reported liabilities for both funding and Government Accounting Standards Board (GASB) financial statements understate what economists and finance professionals would consider economically meaningful measurements, and therefore relevant for understanding the funded status and making decisions like whether to increase or reinstate defined benefit pensions.
The revised Actuarial Standard of Practice No. 4 (ASOP 4) calls the required disclosure the “low-default-risk obligation measure,” abbreviated LDROM.
The new requirement applies to all pension plans, but it was targeted at public plans. There are already accounting and funding disclosures required for other types of plans that would satisfy the requirement. These existing disclosures were imposed from outside the actuarial profession.
Will this help?
The requirement is for disclosure only. It does not, and cannot, mandate any change in plan management. It’s just sunlight. But plan management uses aren’t prohibited. The best result would be for the measure to play a role in decision-making with respect to funding, investments, and benefit structure. If calculated and disclosed in good faith, it will facilitate the understanding and study of public plans among government officials, taxpayers, plan members, bondholders, economists, and others.
A bad outcome that’s plausible, and that I fear, would be for the new disclosure to be belittled and ignored. One reason to fear this bad outcome is that many of the letters opposing the new disclosure claimed that it was confusing and irrelevant because it doesn’t affect funding or GASB accounting. Another reason is the extent and vehemence of the opposition.
In total, the three exposure drafts triggered 93 comment letters—67 for the first draft, 19 for the second, and seven for the third. This appears to be a modern-era record for actuarial standards. A notably large number of these comment letters were from non-actuaries, for example, public pension advocacy groups like the National Conference on Public Employee Retirement Systems (NCPERS), public pension plan officials, and unions, most of whom opposed the additional disclosure. Some letters included ad hominem attacks and predictions of ill-intentioned use by groups who aim to finally eradicate defined benefit plans from the earth.
How is the new liability measure different from existing liability measures?
The most notable and noted difference is the “discount rate,” the interest rate used to discount projected plan benefit payments to the present in calculating a liability. Current discount rates used in the public sector average around 7% and do not vary directly with market interest rates. The rate conceptually represents the 50th percentile of modeled compound returns of the pension investment portfolio over the next two-to-three decades. Despite only a 50% likelihood of attaining the assumed return if the estimation model is accurate, current actuarial methods and practice treat attainment of this return over a long period of time as a certainty.
Current market interest rates, on the other hand, would imply discount rates somewhere between 2% and 4% and would exhibit significant market volatility over time. As with bonds, lower discount rates result in higher present values, or pension liabilities in this context.
Meaningful discounting for pension liabilities are within the purview of financial economics, and financial economists universally call for the use of market discount rates. As Donald Kohn, then vice-chair of the Federal Reserve Board put it in 2008 at the NCPERS Annual Conference:
“While economists are famous for disagreeing with each other on virtually every other conceivable issue when it comes to this one there is no professional disagreement: The only appropriate way to calculate the present value of a very-low-risk liability is to use a very-low-risk discount rate.”
Who should care?
Public pension plans sponsored by state and local government entities in the U.S. have around $5.3 trillion in assets and 35 million members. The aggregate reported funded status of public pension plans — 75.4% for 2021 (probably mostly as of June 30) — would imply liabilities of around $7.0 trillion and underfunding of about $1.7 trillion.
But if the real economic liability were more like $10 trillion, a rough educated guess, the underfunding would be closer to $5 trillion. Shouldn’t the public know of those unfunded liabilities? That level of debt would translate to approximately $15,000 for every man, woman, and child in the United States, or about $38,000 in public pension debt for every American household.
As a result, nearly every group of Americans should appreciate the new required public pension disclosure, including:
- Members of public pension plans who are counting on the pension benefits that have been promised to them to be there when they retire.
- Government officials, public sector union officials and investment officers, and others responsible for asset management and ensuring these pension systems are funded and deliver on their promises to workers.
- Users of government services—including public safety, education, and infrastructure—who may see services cut and funding siphoned away to pay for rising public pension costs.
- State and local government taxpayers who are paying for their respective state and local public pension plans (along with contributions from members) and may face future tax increases to pay for unfunded liabilities.
- Federal taxpayers, who may ultimately be called upon to bail out public pension systems.
- Holders of bonds issued by government entities that sponsor pension plans.
How can the new disclosure requirement be implemented most constructively?
The revised ASOP is now final. There’s no turning back. Actuarial professional organizations, with the encouragement of public pension plan officials and their national organizations, should encourage compliance that will best serve all stakeholders. Such compliance would include fully reflecting basic finance principles in their disclosed liabilities by using default-risk-free discount rates, among other things.
A natural tendency might be to minimize the disclosed number subject to the restrictions in the standard and/or to downplay its meaning. As the number will not generally be used for funding or accounting, the only reason to minimize or downplay it would be to obfuscate economic reality.
The new requirement gives those involved in public plan management an opportunity to meaningfully add to the conversation around public pension systems and facilitate ongoing and future research by interested parties, like think tanks and government research organizations, into levels of public debt and ways to address it fairly. Properly embracing this opportunity for transparency and accountability would ultimately benefit all stakeholders.
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