After Detroit's bankruptcy, a nasty surprise surfaced from the wreckage: not just the city itself, but its retirees and would-be pensioners – from police officers to city clerks – would suffer, thanks to an unexpected pension fund shortage of some $3.5 billion.
A firm hired by the emergency manager of the city used a different method to calculate pension values than the one Detroit had used for years, turning what everyone believed was a surplus into a shocking deficit.
Now, a dispute is raging over which way is right, leaving school districts, municipalities, states and public employee groups to wonder whether they, too, are at risk. Trillions of dollars are at stake nationwide.
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For once, corruption or neglect have nothing to do with the unexpected shortfall. Instead, accepted actuarial practices used for decades are being questioned, with one side defending them and the other saying they fail to protect benefits – to say nothing of threatening the credit ratings of municipalities that have relied on the method.
The issue is a thorny one. Actuaries themselves do not agree, as a group, on which way value should be determined, but actuaries are not the only ones arguing over the best method. The battle has escalated as pension trustees and unions of public workers have waded into the dispute; each group has its own concerns and fears.
Typically, an actuary projects how much a municipality will need to contribute to a pension fund over time. One factor in this projection is the return on the investments in the fund; the higher the returns, of course, the lower contributions will need to be.
That's also one part of the problem, since assumptions are usually made in the neighborhood of 7-8 percent – which was perfectly fine 30-40 years ago, but not in today's economy.
Another factor, also part of the problem, is that actuaries traditionally "smooth" market volatility to even it out, so that pension plan contributions don't fluctuate wildly from one year to the next.
That's based on the assumption that municipalities don't "go out of business" the way a failed corporation would, so they have an infinite investment horizon, allowing them to use some of that time to exit down markets and protect plan assets. But Detroit proved that's not necessarily the case.
Actuary and economist Jeremy Gold, who has been campaigning for a change to the old method for a number of years, explained it this way:
"Actuarial methods and assumptions were designed to develop a stream of contributions (dollars into the plan from the plan sponsor/employer) that are expected to be sufficient to meet the benefit payments (dollars out of the plan to the retirees/beneficiaries).
"The expectation is that there is a 50-percent chance that the money will be sufficient or more than sufficient and a 50-percent chance that there will not be enough money to meet all the benefits. As time goes by, contributions are adjusted to maintain this 50-50 chance."
This approach is problematic, in Gold's view, for several reasons.
First, "pension benefits are understood to be guaranteed. Those who guarantee cash flows do not set aside merely enough money to have a 50-percent chance of making good on the guarantees. Insurance company actuaries aim to have enough on hand to assure a 99-percent chance of making good."
Second, he said, "pension actuaries have used discount rates in the neighborhood of 8 percent since the 1990s. Insurance company discount rates have dropped steadily as environmental interest rates (e.g., Treasury and corporate bonds) have dropped pretty steadily since the early 1980s. Eight percent (or even 7 percent or less) no longer even gives us a 50-50 chance of sufficient funding."
The third problem is that "(i)t is not merely a question of estimating future returns – these benefits are not supposed to be risky."
"Financial economists … understand that the discounted value of non-risky cash flows must be higher than the discounted value of risky cash flows. The expected return on risky assets held by a pension plan is not the proper rate to use for discounting (non-risky) benefit cash flows. … Today the solvency discount rate is approximately 3% (up from maybe 2.5% a few months ago)."
Last but not least, he concluded, "when benefits are negotiated it is inappropriate to discount those benefits at risky rates since this undervalues the benefits, resulting in benefits that are often too large for the wage concessions that together comprise the compensation package … Too low a price invites generous benefits that are then underfunded … the situation today is upside down from the situation in the 1980s, when actuarial discount rates were too low, benefits were overpriced and contributions were too high."
Plan trustees, unions and many actuarial firms, unconvinced that the problem lies in the way funding is calculated, have protested any advocacy of a switch to the "new" method that revealed Detroit's problem.
Trustees claim that such a move would cause confusion and volatility. Unions fear that the new method will make their hard-won benefits appear too expensive and contribute to an attack on benefits. They also question the way some of the assumptions will affect the results.
Actuaries are divided, with the Society of Actuaries forming a panel that Patrick Gould, managing director of marketing and communications at SOA, said would "consider the causes of underfunding in many U.S. public pension plans and make recommendations as to how governments can more securely fund plans going forward."
"Pension plan sponsors and, of course, policymakers are ultimately responsible for these plans," he added, "but the Society of Actuaries also believes it's important to study the issue, understand the potential risks and provide advice as to the best way of assuring future funding for public workers."
Consulting firm Segal has challenged the right of the SOA to do anything at all, saying such an action is not within its purview but rather belongs to the American Academy of Actuaries; it also criticized SOA for "lack(ing) balance" and "design(ing) a survey wrought with bias" for its information-gathering. Other groups, including unions and trustees, also have attacked the SOA's panel, its questionnaires and its mission.
However, Donald Fuerst, senior pension fellow for the American Academy of Actuaries, said that in forming its panel "the SOA has brought together a number of very intelligent and qualified people that know a lot about pension plans, and it's our understanding that they're interviewing a wide diversity of people with divergent opinions. We look forward to reading that report, and hope that it's helpful to the entire situation."
He added that the Detroit situation "goes far beyond that controversy (over which method to use)."
"Their real problem is a declining tax base, a declining payroll of city workers and not making enough contributions to the plan," he said. "It doesn't make any difference how you measure the liabilities of a plan if the sponsor doesn't fund those liabilities."
No doubt, but until just a few weeks ago, Detroit public employees and their pension trustees were working under the assumption that all was fine and good with their fund.
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