During the dark days of the financial crisis, the aggregate funded status of the nation’s public pensions fell to 78%. 1 1 Close Source: Public Plans Database (PPD). The PPD contains publicly available plan-level financial information for 190 state and local retirement systems across the United States. All data sourced directly from the website or is calculated using data downloaded from the website spanning from 2001 to 2018. Funded status national data averages are weighted by plan size. In the decade since, overall returns for public pensions were 9.1%, 2 2 Close Source: Public Plans Database (PPD), Wilshire Trust Universe Comparison Service (TUCS). Return calculated for fiscal years ending June 30th. Returns from 2010 to 2018 are from PPD where national data averages are weighted by plan size. Return for fiscal year 2019 is the median return from TUCS all-plan universe. annualized, well above expectations. Yet the aggregate funded status of these most essential retirement vehicles is now 72%. 3 3 Close Please refer to footnote 1.
What happened? Well, interest rates fell, which is a good thing for home buyers and businesses that borrow, and life expectancy increased, which is a good thing for everyone, but neither is good for pension funding. We all know some plan sponsors didn’t make all the contributions their actuaries said were required to compensate for those lower interest and longer life expectancies (let alone the already existing deficits.) But largely hidden from view, some actuaries used math that didn't even require contributions that would ever lead to better funding.
The teachers who teach our children deserve better math, and our police officers and firefighters deserve better benefit protection.
Some Plan Sponsors Still Haven't Shown Up...
The Government Accounting Standards Board (GASB) lays out a process and methodology for stating and measuring the Actuarially Determined Contribution (ADC) for the calculation of each year’s pension plan contribution. Until 2014, that calculation was known as the Annual Required Contribution (ARC), 4 4 Close In common parlance (if there is such a thing in pension-speak), the “ARC” is still used to refer to what is today the ADC. Since ADC is the currently accurate term, we use ADC to refer to prior ARC calculations as well as more current ADC calculations. and it is meant to be the amount that would pay for both new employee benefit accruals and the amortization of unfunded old ones.
Unfortunately, since 2009, only 63% of plan sponsors were able to faithfully make their required contributions. 5 5 Close Source: AQR, Public Plans Database. Calculated using each plans ADC and the percentage of the ADC the plan actually paid each year from 2001 to 2018. Plans that faithfully made their ADC are defined here as those that actually contributed at least 99% of the required amount. Other sources may use different calculation methodologies to compute funding required contributions. On average, those that couldn’t missed big and fell short by 25%. Meanwhile, sponsoring governments that failed to keep up with payments risked serious consequences for plan funding. Ironically, while states and cities are able to skip contributions in whole or in part in a given year, the employees who are responsible for their personal contribution to the pension plan are never allowed a similar holiday.
...And Some Changed the Object of the Game
Even plans that consistently received their full contribution and netted good investment performance didn’t close their funding gap in certain cases. Resolving that paradox forces us to dig a bit deeper into the ADC’s underlying calculations.
Pension underfunding is like debt, only with fuzzier, plan-actuary-calculated amortization payments. Several amortization methods are available, just as there are for home mortgage debt. Some work well and reliably pay down the debt, while others can leave the bank — or in this case, retirees and future taxpayers — holding the bag.
All actuarial methods for funding plans work, in theory. They calculate some annual dollar amount or some percentage of total payroll that the sponsor will add to contributions for new accruals in order to eliminate the “debt” over 15, or 20, or 30 years. You would hope that that payment would steadily reduce the underfunding over time. But there’s the rub: the actuarial methods may not require enough annual payment to make much, if any headway.
Sometimes the amortization period is recalculated every few years, effectively extending the “principal” repayments further and further out into the future. And sometimes the path of amortization is so back-end loaded that the underfunding grows for years before supposedly larger contributions down the road actually begin to whittle it away. Worst of all, sometimes those two practices are combined and the sponsor isn’t even “required” to reduce the underfunding one iota. In the home mortgage market, we called those “negative-am loans” and they proved to be pretty risky for homeowners, lenders and the financial system when it turned out that some borrowers couldn’t pay them off, ever.
Here’s an example of what happens when a plan periodically re-opens its amortization period:
A plan that elects to use the “level-dollar” approach to steadily pay down its unfunded liability uses a 30-year amortization period. Let’s say it has a $10 billion unfunded liability and uses a 7% discount rate. As long as all goes as planned (returns hit the target, discount rate assumptions don’t change, mortality rates are constant, etc.), the plan should be fully funded in three decades. But now let’s say that every five years, the plan re-opens its amortization schedule and recalculates a new 30-year amortization schedule. What’s the balance three decades later? It’s still near $7 billion! 6 6 Close Source: AQR. Hypothetical remaining unfunded liability based on an annual payment recalculated every 5 years using a 30-year amortizing period, and 7% discount rate, and initial $10 billion present value. Result also assumes that other factors affecting liabilities remain consistent with actuarial assumptions.
But it can get worse. There are other ways to calculate that amortization schedule, the common alternative to level-dollar being the "level-percent of payroll” method. This method presumes that the annual contribution, tied to a growing workforce payroll, will grow larger each year, and eventually large enough to amortize away the unfunded liability in later years. In the near term though, the payroll often isn’t quite big enough to pay for even the interest on the unfunded liability, and the actual unfunded balance doesn’t shrink, it grows.
Now if we combine that very back-loaded, negative amortizing method with a periodic re-opening of the amortization period, then voila! We’ve kicked the can down the road to its inevitable destination.
These manipulations can have terrible effects; by greatly increasing the amount you need to pay in the future as the price you pay for lowering the amount you need to contribute today, they expose plan beneficiaries to an awful lot of credit risk. When contributions today are lower, CIOs and investment staffs have fewer assets to compound over time to help meet those liabilities. We think legislatures and actuaries need to calculate the ADC in a responsible way. Their mandate should be to guide our states and cities to “make the ADC” but not to “fake the ADC.”
Let’s Play by a Better Set of Rules
To see how much weak amortization methodology means to the health of the pension system, we calculated across 180 public plans 7 7 Close Source: AQR, Public Plan Database. 2009-2018. Plan-level data used in each year when the data required for the calculation was available. Not every plan has data available in every year. the yearly aggregate gap between actual plan contributions and ADC (however a fund calculated it). We also calculated the larger gap between contributions and what the aggregate ADC would be if plan actuaries all used level dollar amortization of the unfunded liability and didn’t periodically allow themselves to start over (i.e., non-rolling). To calculate the level-dollar payment, we assume each plan would amortize its unfunded liability over 30 years.
The chart below shows the annual shortfall in historical actual contributions relative to the ADC as then calculated (dark blue bars), and relative to a hypothetical, level-dollar calculation (green bars).
Since 2009, public plans have fallen an average of $14 billion short of the ADC as they have calculated it, though in recent years they have been doing a better job paying it, narrowing the gap to about $8 billion. 8 8 Close Please refer to footnote 1. That would be pretty good, but those same contributions have fallen far short of the contributions that would be required were a more serious attempt to amortize unfunded liability be in place. During this post-GFC period, that gap (between actual payment made and the payments that would have been made if the ADC had been calculated more straightforwardly) has ranged from $37 billion to $59 billion in any year. 9 9 Close Please refer to Figure 1. It’s an important chunk of the approximately $1,450 billion of total pension debt -- and explains a lot of the widening of the funding gap during this high return period. 10 10 Close Using available 2018 data as of August 2019. Refer to footnote 1 for additional information.
On the bright side, the use of the can-kicking open amortization has fallen from over 50% of plans to less than 25%. 11 11 Close Source: Public Plan Database. Funding methodology payment based on the funding method described for each plan in the database. The method has two key parameters: 1) the amortization payment type: whether the amortization payments will be level in dollar amount or level as a percent of payroll and 2) the amortization period type: whether the period over which the UAAL must be fully amortized is open (the full funding date is extended each year) or closed (the full funding date is fixed). Not all plans report their funding method every year. Less encouraging is that the back-end loaded percent-of-payroll contribution method has remained the dominant choice, with approximately 75% of plans since 2009. 12 12 Close Please refer to footnote 12.
Every jurisdiction should be making all of its required contribution, but we also need to determine the size of that contribution using a method that puts us on a sounder path to a healthier funded status. We think that method is the level-dollar method without the occasional resetting of amortization horizon. We aren’t arguing actuarial alternatives don’t, in theory, pay off the debt. We are arguing the methods actually employed by many of our states and cities are often designed with seemingly no intention of paying down the debt, ever.
So, while actuarial science may be dull, it’s also important. The retirement security of our public employees depends on it.
Charles E.F. Millard is a consultant to AQR Capital Management, LLC.
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