STUMP » Articles » Public Pensions Primer: Funded Ratios and Comparisons » 9 June 2015, 06:19

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Public Pensions Primer: Funded Ratios and Comparisons   

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9 June 2015, 06:19

I screwed up on twitter after posting about Kentucky’s ERS, which has an execrable funded ratio.

Here are the tweets:



When I wrote that tweet, this is what I was looking at:

That’s a screenshot from the Public Plans Database Interactive Browser which is just plain AWESOME. I gave up on trying to repair the screwed-up .csv extract I got and I’m just pulling the fields I want in the browser, directly.

There will be lots more number-crunching to come from the Database.

But I screwed up. West Virginia Teachers does look bad there… but check out the valuation years. 2001 – 2004, not the most recent valuation. Ooops.


That’s filtering only on 2014. Yes, Kentucky is the worst…. when you look at official funding ratios.

Because there’s big problems with comparing pension plans this way.

WHAT DOES THE FUNDED RATIO MEAN?

If you’re at all familiar with my 80 Percent Pension Funding series, you will know that people try to point to the funded ratio as some indicator of pension health.

Here is a good example:

A. The funded ratio places the unfunded liabilities in the context of the retirement system’s assets. Expressed as a percentage of a system’s liabilities, the funded ratio is calculated by dividing net assets by the actuarial accrued liabilities. The result is the percentage of the accrued liabilities that are covered by assets. At 100, a system has sufficient assets to pay all benefits earned to date by all its members. A funded ratio of 80 is generally considered to indicate that a pension system is in sound fiscal condition.

Plan Name Funded Ratio
Illinois JRS 31.5%
Illinois SERS 35.6%
Illinois TRS 46.5%
Illinois SURS (Defined Only) 44.3%
Illinois GARS 21.2%
Source: All funded ratios are from each systems’ Fiscal Year 2011 Comprehensive Annual Financial Report, which are available online.

No, it’s not.

But here, let me point to something about funded ratios in general, from another actuary.

Please note that even if the funded ratio is above 100%, that does not guarantee that the assets will be adequate to meet the liability of retirement, even if the assets achieve the assumed rate of return over the whole period. The reason for this can be summarized as the “sequence of returns” risk. Quite simply, a low (i.e. highly negative) returns period at the beginning of retirement has far worse consequences than the same returns occurring at the end of retirement.

And here’s the deal: the funded ratio is just taking the value of the assets (and sometimes that’s difficult to value) divided by the value of the liabilities (that’s really difficult to value).

DIFFERENCES IN ASSUMPTIONS

The problem is that the liabilities are promises of future cash flows. How should those cash flows be measured, especially when you don’t know exactly when they’ll start or end, or even how much they will be?

For fixed immediate annuities, you will know what the amounts will be, but depending on whether it’s life (ends with the annuitant’s or annuitants’ death(s)) or certain (a specified period), one may not know how long it goes. And even when you know the cash flows exactly, what interest rate should you discount at?

When it’s an insurance company, they’re told by regulators what they have to use to discount the cash flows. They’re told what mortality rates they have to use. (these are somewhat changing with principles-based approaches, but you still have to support deviation from the “standard” with experience data.)

Even private pensions are told (now) what assumptions they have to use to value the liabilities with.

But when it’s public pensions, the people sponsoring the plans get to decide what assumptions to use.

And they don’t all pick the same assumptions – nor should they, necessarily. I have no problem thinking that the mortality for West Virginia teachers may differ from Illinois police. But some of the mortality assumptions I’ve seen are so different from the overall population, one wonders.

But no worries, the SOA is looking into doing an experience study with public plans.

The Data Review Team:
….
Agreed with RPEC that the exclusion of public/federal plan3 data from the final RP-2014 dataset was appropriate and that the SOA should undertake a separate mortality study for these plans.

…….
RPEC ultimately received and processed mortality data from three sponsors of extremely large public plans. [4] Multivariate analysis indicated that (1) the overall mortality experience for the combined public plans was significantly different from that of the combined private plans, and (2) the mortality experience for each of the three individual public plan sponsors was significantly different from that of the other two. Based on those statistical discrepancies and the original intent to produce mortality tables for private pension plans, RPEC concluded that it would be preferable to focus solely on the private plan datasets.

I really hope they do the public plan experience study. I think it would be really interesting.

Even pretending that the valuation assumptions were the same (and they’re not), there are different approaches to valuing the liabilities. I am not a pension actuary, so I don’t know the differences in approaches well enough to explain how they differ, but needless to say it involves how one decides what pension benefit has been accrued thus far.

Some approaches include salary increases into the future (based on a specific scale), as most public pensions benefits are dependent on final salaries. Some approaches take a seriatim approach (so liability is determined member-by-member) and some take an aggregate approach. These can make for different ARCs for the same DB plan benefit.

Then there is the aspect of whether certain “optional” benefits are included, like the notorious thirteenth checks.

PLAYING WITH NUMBERS

Then there’s the notorious Campbell’s Law.

“The more any quantitative social indicator (or even some qualitative indicator) is used for social decision-making, the more subject it will be to corruption pressures and the more apt it will be to distort and corrupt the social processes it is intended to monitor.”

No, not me.

Now, it can be difficult to do too much playing with the funded ratios, but I’ve already seen this happen once with Illinois plans:

The bit I’m talking about is the change in actuarial methods in the 1990s — they went from asset-smoothing (which reduces the effect of year-to-year investment volatility) to market value of assets…. because the returns had been so good in the 90s. While this reduced the unfunded liability, it didn’t reduce it by much, and it only “helped” when the market returns were good.

The big assumption one can play with, of course, is the discount rate.

Discounting at 4% is very different from discounting at 8%. That sort of thing adds up over time.

I will look at how discount rates have changed over time in a later post, but let me show the ranking table with that info added:

Well look at that. Kentucky ERS discounts at 7.75% and is 24% funded on that basis. But look down the list a little ways — Connecticut SERS is 41.5% funded, but it uses a higher discount rate of 8%. What would that funded ratio be if CT had to use the lower discount rate?

Go down the list further, and you see Indiana Teachers using a discount rate of 6.75% has a 48% funded ratio.

How bad would KY ERS and CT SERS look if they had to use 6.75%?

But more to the point, the funded ratio is merely a snapshot in time. What is often the case is that the trend shows you how well the pension fund is doing, not merely a snapshot.

This kind of analysis is done with insurance companies — sure we look at their capital position and their RBC (risk-based capital) ratios, but actuaries also know the RBC trend is important, as well as what risks go into that RBC calculation. It’s very different if it’s based on a portfolio of poorly-hedge variable annuities that just happened to be doing well versus a basket of 10-year fixed annuities.

So no, I’m not going to be doing a ranking table of the worst public pensions, because I just plain can’t.

But Kentucky ERS is in a really bad position, whether or not it’s the worst.

RELATED: Public Pensions Watch: How Important is the Mortality Assumption? Other Assumptions?

Public Pensions Followup: The Effect of Assumptions and Materiality

Compilation of Kentucky posts


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