STUMP » Articles » Much Ado About Discount Rates: Welcome to the Pension California » 20 September 2016, 05:06

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Much Ado About Discount Rates: Welcome to the Pension California  


20 September 2016, 05:06

Look at this one as a part two to my post Much Ado About Discount Rates: Illinois and the Actuaries .

In that one, we see one of the Illinois pensions decreasing its discount rate for valuation, with the thought that thereby they’ll automatically get higher contributions.

Oh, by the way, it wasn’t only the IMRF that reduced valuation rates in Illinois this year.

Again, that’s not necessarily going to get more money out of taxpayers.


Now, we have a story out of California, where NYTimes reporter Mary Williams Walsh notices a huge change in discount rate…but only if a town tries to leave Calpers:

When one of the tiniest pension funds imaginable — for Citrus Pest Control District No. 2, serving just six people in California — decided last year to convert itself to a 401(k) plan, it seemed like a no-brainer.

After all, the little fund held far more money than it needed, according to its official numbers from California’s renowned public pension system, Calpers.

Except it really didn’t.

In fact, it was significantly underfunded. Suddenly Calpers began demanding a payment of more than half a million dollars.

It turns out that Calpers, which managed the little pension plan, keeps two sets of books: the officially stated numbers, and another set that reflects the “market value” of the pensions that people have earned. The second number is not publicly disclosed. And it typically paints a much more troubling picture, according to people who follow the money.

The crisis at Citrus Pest Control District No. 2 illuminates a profound debate now sweeping the American public pension system. It is pitting specialist against specialist — this year in the rarefied confines of the American Academy of Actuaries, not far from the White House, the elite professionals who crunch pension numbers for a living came close to blows over this very issue.

There’s more to come from the article (on the actuarial brou-ha-ha, but I want to address this issue of much much higher valuations of pension liabilities when a Calpers-participating town wants to close up its Calpers plan. I mean, I want to address it again.

Oh, yes, I’ve mentioned this before.


From August 2015, we have this:


So we saw Hiltzik wasn’t too happy with the ballot proposal for being able to cut pensions, but he wasn’t done yet.

Did you know that closing pension plans magically makes pensions more expensive?

Hmmm, now why would unfunded liabilities rise sharply once a pension plan was closed?

“The main problem with closing defined benefit plans is that the demographics within the closed plans change quickly. Without new members coming in, the number of active workers making contributions shrinks. The loss of young members making contributions for years before retirement is especially damaging. California’s giant pension fund, CalPERS, made this point in a 2011 white paper; its findings are confirmed by the experiences of the three states.”

Now this highlights one of the big problems with public pensions: when they determine the plan costs, they can make them look cheaper by assuming later participants’ contributions can cover the costs of shortfalls that already exist.

This came up in the Detroit bankruptcy, by the way. By assuming that the payroll would continue to increase (as oppose to getting cut), the pension projections had that future contributions to the pensions would increase.

But they didn’t.

If your prior measurement of pension costs assume greater contributions in the future (and thus we don’t need to cover our current costs right now), obviously that cover goes away when that future base is obviously not increasing.

Here’s the other deal (though not in the NIRS report, I believe): in Calpers/Calstrs, if you want to leave, they switch the valuation rate from the “oh-so-reasonable” 7.something% down to a superlow “risk free” rate.

Unsurprisingly, that boosts the unfunded liability.

If Calpers/Calstrs had to use that low valuation rate all this time, they’d probably not be in the trouble they are in right now.

And it wouldn’t look so questionable that by stopping accruing more liabilities, the liabilities just-so-happen to cost more.

What a coincidence.

We’ll keep pretending the pensions cost less, as long as you stay part of the Ponzi pension scheme (as the UK actuaries like to say).

But if you leave, we’ll recognize the full cost. You know, the cost we should have been using to reflect how expensive these promises are.

Do they not realize that it doesn’t look good when you admit that you need younger members to keep the plan going along? To keep pretending you can pay less than what the promises are worth? Because there’s always a new sucker participant whose contributions will pay for the older ones… and as long as you keep having new people it never fails.

It can always keep going, right?


I’m going to let Yves Smith make the case that there’s nothing nefarious about what Calpers is doing:

New York Times Owes CalPERS a Retraction for Hatchet Job on Pension Fund Termination
Posted on September 18, 2016 by Yves Smith

I find myself in the peculiar position of having to defend CalPERS. But then again, it’s come out an accidental winner in a Godzilla-versus-Mothra contest with the New York Times’ Dealbook.

The Times’ remarkably fact-challenged article, A Sour Surprise for Public Pensions: Two Sets of Books, is false in its major contentions, as documents readily available on CalPERS’ website show. It looks like reporter Mary Williams Walsh was taking dictation from public pension fund opponents and didn’t bother with rudimentary fact checking. Note that the errors were ferreted out in less than 24 hours, with no input from CalPERS’ staff. What is the Grey Lady’s excuse for this shoddy performance?

We’ll get into the details shortly, but let’s debunk the two Big Lies at the heart of this article. First, CalPERS does not keep different sets of records. The pension fund has a very conservative, arguably punitive, methodology, which is enshrined in law for how to determine how much government entities that contract with CalPERS owe when they exit the pension system. As we’ll discuss, there are good reasons for discouraging exit. Second, the termination amount has been disclosed for every plan on CalPERS site since 2011, and prior to that, CalPERS would provide that information if an employer asked for it.
Let us reiterate: all this means is that CalPERS uses a take-no-prisoners valuation methodology for departing employers. In general, parties exiting a service agreement early routinely face penalties. Intuitively, it makes sense that the punishment should be more severe if the agreement is long-term or the cancellation is disruptive. In the case of CalPERS, the concerns include having employers game the system or panicking in a severe down market when there isn’t much liquidity. CalPERS’ selling to cash out departing employers could result in losses on distressed sales, hurting the remaining members.

False claim 5: The row with CPCD shows CalPERS and other public pension funds are pulling a fast one on their members and taxpayers. From the article:

“The two competing ways of valuing a pension fund are often called the actuarial approach (which is geared toward helping employers plan stable annual budgets, as opposed to measuring assets and liabilities), and the market approach, which reflects more hard-nosed math.

“The market value of a pension reflects the full cost today of providing a steady, guaranteed income for life — and it’s large. Alarmingly large, in fact. This is one reason most states and cities don’t let the market numbers see the light of day.

If Sharpe and the New York Times want to object to CalPERS’ approach, they could contend that the giant pension system is using unduly risk-averse approaches to screw departing employers to the benefit remaining CalPERS beneficiaries. But that isn’t the case being made here.

The insinuations are that CalPERS (and other pensions) are trying to pull a fast one on all their members. The Times has no evidence for its explicit claim that public pension funds routinely calculate “market value numbers” but hide them.. Indeed, as we pointed out in “False claim 3” above, CalPERS does not make this computation for 2/3 of the members in its system. You can’t hide what you haven’t done.

And this section makes clear that it regards the “hard nosed math” of providing for the “full cost” today, when as we explained above, that’s clearly conservative by virtue of assuming no future contributions by workers who still are likely to continue to work and pay into the system, as well as assuming what any investment professional would regard as a very risk-averse approach.

Tellingly, even actuarial publications don’t agree with how the New York Times presents the “market based method”.5 For instance, consider a 2013 article from the American Association of Actuaries, Measuring Pension Obligations Discount Rates Serve Various Purposes. The Times seems to think it should get a pass for providing a link to the article in the online version and then ignoring what it says.

There’s more. You can read Yves’s points here.


Here’s my terse reply:


The NYT owes apologies to nobody (in this case. I will not address any other issues the NYT may have.)

Here’s my longer reply.

I am familiar with “make whole” provisions for all sorts of liabilities. Let’s consider commercial mortgages that often have such provisions.

Suppose you get a 10-year balloon mortgage on your office building for 8%, but 5 years into the mortgage you want to pay off the mortgage as the interest rates you can now get are 5%. A make-whole provision would make you pay the difference of present value in 5% and 8% loans for the remainder of the mortgage’s terms at the time you settle in order that the mortgage issuer isn’t harmed by you paying off early. After all, the mortgage issuer can only issue the new liabilities at 5%, which obviously don’t yield as much as 8% loans.

Here’s the thing, though: these make-wholes are based on differences in how market value evolves over time.

Make-whole provisions might be expensive if there’s a huge drop in interest rates in a short amount of time, but in general it takes a long while for such a drop to develop. (Interest rates spiking up, though….) And obviously, the less time left in the mortgage, the less expensive the make-whole is, because there is less amount of present value left on the loan.

With regards to pensions, they are treating the liabilities as accruing at the discount rate at all times. If you had a commercial mortgage issued at 8% and wanted to settle up a year later and they said that they’re valuing the mortgage at 2%, so you’re going to have to pay a lot more to make them whole…. you would already be getting your lawyer out of your holster to prepare your lawsuit.

The issue here isn’t that the exit value is “secret”. It’s that the “make whole” shows a huge disparity even if you accrued the liability just last month.

Think of all the cows had by dropping discount rates by 50 basis points, that is 0.5 percentage points.

What about dropping the valuation rate 500 basis points (i.e., 5 percentage points)?

I can believe wanting some risk premium paid for a make-whole, as downturns can’t be made up by the town in the future, but 500 basis-points-worth?

What’s really in that difference?

And by the way:

- why should it be considered that take-no-prisoners approach a la Goldman Sachs is appropriate for a state entity?

- why should it be considered a-okay that government agencies don’t bother to make calculations of what the liabilities are really worth if they had to assume that the promises are risk-free? Ignorance is a good thing, mmm?


Back to the NYTimes piece:

Much of the debate surrounded the routine practice of translating future pension payments into today’s dollars, which is called discounting. The tiny pension plan at Citrus Pest Control District No. 2 shows clearly what the problem is.

“Every economist who has looked at this has said, ‘It’s crazy to use what you expect to earn on assets to discount a guaranteed promise you have made. That’s nuts!’” Professor Sharpe said.

But what he calls crazy is enshrined in the actuarial standards. And since adhering to the standards makes public pensions look affordable, there is a powerful incentive to preserve those standards.

“Actuaries shamelessly, although often in good faith, understate pension obligations by as much as 50 percent,” said Jeremy Gold, an actuary and economist, in a speech last year at the M.I.T. Center for Finance and Policy. “Their clients want them to.”

Mr. Gold was also a ringleader of that stormy professional meeting in 2003. Since then, there have been more conferences, monographs, speeches, blue-ribbon panels and recommendations — to say nothing of an unusual spate of municipal bankruptcies and insolvencies in which ailing pension plans have played starring roles. And yet little has changed.

Even as Citrus Pest Control District No. 2 was scrambling to find the cash to pay its unexpected bill this year, another fight broke out within the American Academy of Actuaries, which represents the profession in Washington, over the same issues.

An academy task force had commissioned a paper on how financial economists would measure public pensions. But during the peer review process, the opus was spiked, the task force disbanded and the four authors — Mr. Gold among them — barred from publishing the work elsewhere.

Accusations of censorship flew. The four authors said the academy’s copyright claims were false. The academy’s president, Thomas F. Wildsmith IV, said in a statement to members on the academy’s website that the paper “could not meet the academy’s publication standards.”

In a separate email message to The New York Times he said the academy was committed to helping the public understand the different measurements, and provided a position paper concluding that both measures are useful, but for different purposes.

Then the Society of Actuaries, which handles the education and testing of actuaries, joined the fray. It posted the suppressed paper on its own website, albeit with the authors’ names removed. It claimed to hold the copyright jointly with the academy. It also added a statement that the paper did not reflect the position “of any group that speaks for the profession” but called the authors “knowledgeable.”

The society’s president, Craig W. Reynolds, sent an email message citingother efforts “to develop strong funding programs that are responsive to a rapidly changing environment.”

The four authors then issued a revised version of their paper, with their names on the front — and a claim that they held the copyright. The paper, which runs 19 pages, says in brief: Use market values for public pensions.
Professor Sharpe noted that Calpers’s market-based method was “virtually the precise approach advocated in this paper.”

This is another one of the shoes I was waiting for (ooooh, a closetful of shoes!) I expected the NY Times was going to pull in the latest actuarial brou-ha-ha, because it is closely tied to the various plans decreasing their discount rates.

Prior posts on discount rates and the recent actuarial brou-ha-ha:

By the way, while the Citrus Pest Control District No. 2 probably hoped this would be a nice shaming of Calpers, and would have liked a much higher discount rate on the exit valuation [they did pay the bill to get out, btw. At least they’re not accumulating continuing expensive benefits], what people like Sharpe and Gold (and me) are arguing is that this exit value should have been what was used for valuation of liabilities all along.

And then….

….well, that will have to wait for later this week.

UPDATE: I like John Bury’s take:

So I propose more appropriate names for low-ball and high-ball estimates of pension liabilities…..
Political: as in politicians who always want lower liability values that generate lower contributions so they can promise phantom benefits without fully funding them and divert that tax money for purposes more in line with their immediate objectives.

Fewl: A new word combining the principal uses of this approach – Financial Economics and Withdrawal Liability – though there may be a more memorable mnemonic device* for this acronym.

The real liability value falls between the Political and Fewl numbers, as experience will bear out, depending on the funded status of the particular plan. But these days there is not much of a constituency for accuracy when your client has their mind made up about what number they expect to see and it is the actuary’s job to provide it.

Go to John’s post for why the acronym should be memorable.

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