In a New Pension Plan Actuarial Standard, a Subtle Warning of Possible ‘Fire!’

State and municipal pensions have understated their pension liabilities for decades. Newly revised ASOP 4 addresses that, but in a fashion that is far too subtle

Paper tag written with 'Pension Plan' inscription. Yunus Malik/ShutterStock

Commentary

Valentine’s Day, Feb. 14, closed out a state and municipal pension plan accounting regime that allowed plan managers—who are overwhelmingly politicians—to obfuscate the funding levels of their pension plans by making actuarial assumptions about anticipated rates of returns that are  largely illusory. A revision to the Actuarial Standards of Practice (ASOP) No. 4 at least calls foul on the practice.

New York City’s Grievous Example

Here in New York City, for example, our current and prior comptrollers, going as far back as at least 2008,  assumed an 8 percent, and then a  7 percent, compounded annual growth (or CAGR) even as the Federal Reserve drove the rates on AAA-rated bonds down to near zero in the aftermath of the financial crisis of 2008–09.  Even former New York City mayor Mike Bloomberg, a seasoned pro from Wall Street, said of the city’s sanguine CAGR: “It’s overstating it a little bit to say the only one who’s done that well is Bernie Madoff, but 8 percent  [the city’s CAGR in 2010] for a long period of time is not something that very many pension funds have ever achieved.” By comparison, private pensions  sponsored by corporations for their emploees were required to use a CAGR of around 3 percent, and even that was only for plan participants with a long timeline to retirement. The CAGR for the older pool of workers was even less.

But as of  Feb. 15, 2023, state and municipal pension plans (SMPPs) valuation reports issued on or after that date will require an assessment of the  plan’s portfolio investment risk measured against a low default risk obligation measure (LDROM), like the returns offered by U.S. Treasurys, among the lowest rates of return in the financial markets, but the most secure.

The new actuarial standard is prudent and, in my view, both long overdue and troublingly oblique.

A Broad Look at US Pensions

The Employee Retirement Income Security Act, commonly known as ERISA, is a 1974 federal statute that  imposed certain requirements on companies offering pension plans. Those requirements included segregating plan participants into pools based on their anticipated years to retirement. It also required plan administrators to use a CAGR derived from among the financial market’s lowest-yielding instruments to actuarially estimate the funding level of a company’s pension plan, the very highest quality investment-grade bonds.

These actuarial strictures were required because ERISA also provides limited insurance coverage of pensions via the Pension Benefit Guarantee Corporation (PBGC).  If an ERISA-covered plan becomes insolvent, the PBGC steps in to ameliorate the loss. Since the PBGC has “skin in the game” to make good on pensions that become insolvent, it  requires actuarial estimates of the pension value to be calculated using very conservative estimates of what the plan can earn. If a higher CAGR were to be used, the pension plan would appear to be the better funded  in annual actuarial reports because the higher rate anticipates more money can be earned on the pension assets over time. That would allow the sponsoring company to make a lower amount of pension contributions to the plan. Of course, the opposite is true: a lower CAGR requires the company sponsor of the plan to make a greater pension contribution to the plan. Because the PBGC has to pay if pensions become insolvent, the PBGC sets very high standards for estimating percentage of a pension plan’s liabilities are funded.

Standards, I like to say, are the  codification of collective experience borne of past errors and tragedies. That is certainly the case with ERISA and its insurance component. Growing up in a small mill town in upstate New York, before ERISA, I saw firsthand the experiences of my childhood friends’ parents, hard-working mill workers, whose pensions had been both grievously underfunded all along and then, ultimately, misappropriated to maintain the failing business of the mill, the town’s biggest employer. ERISA’s standards are protective as necessary a defense against reckless fiscal conduct as drunk driving laws are against traffic accidents.

But SMPPs are not covered by ERISA and they are not insured by the PBGC. So they are allowed to use whatever CAGR the state and local government plan sponsors choose. Not surprisingly, the political figures usually responsible for funding the plans use a very high CAGR we discussed to minimize the amount they have to contribute to the pensions. That’s because they would prefer to use the government funds that should be contributed to SMPPs to fund popular pet political projects, like parks, schools, and union pay raises.

Moreover, politicians like those here in New York City who have, in my view, underfunded  the city workers’ pension plans, have the added advantage of likely being retired themselves or moved on to some other office if the plan goes insolvent. The blame will be ascribed to some future official if and when the city’s pension plan actually becomes insolvent. It’s like a crowd of fools tossing around a lit firecracker: the person who holds it when it finally explodes pays the price; they will be blamed foe the explosion, not the people who set the fuse or ignored it as it burned down to ultimate disaster.

The vastly disparate CAGRs of ERISA pensions and SMPPs is also attributable to what economists call “moral hazard”—that is, the notion that “somebody else” will  step in to cover the costs of  fiscal recklessness should it ultimately become necessary.

There’s reason to believe that could happen with the New York City pension plans I believe to be underfunded. Just last year, for example, Senate Majority Chuck Schumer (D-N.Y.) bailed out the New York State Teamsters Pension Plan to the tune of almost $1 billion using funds from the American Rescue Plan. But those of us of a certain age still have vivid memories of a New York Daily News headline reading “Ford to City: Drop Dead!” when city officials approached the White House for a bailout in 1975.

In New York, as in other states, our state constitution prohibits pensions from being “diminished or impaired.” While courts in other states have held such provisions to be inoperable in a Chapter 9 (municipal) bankruptcy, there is no federal guideline or Supreme Court ruling that does so. At best, the purported “guarantee” is nebulous, and possibly unenforceable, in a Chapter 9 bankruptcy. But while cities can go bankrupt, states, of course, cannot. So if a municipality in a state goes bankrupt, it would seem the state—by virtue of the “guarantee”—becomes, effectively,  the guarantors of its bankrupt city’s pension plans. Thus, it would appear that the state’s taxpayers are liable for the pensions of their fellow state citizens who are participants in a bankrupt city’s pension plan.

 ‘Warning Light’ to Cities and States

The new LDROM risk disclosure that came into being last week is what public relations professionals call a “limited hangout,“ a tactic borrowed from espionage tradecraft when an undercover operation is accidentally discovered. Spy masters use a release of a small portion of the operation that was accidentally discovered in the hope the wider covert operation would not be discovered. In public relations, it is a technique to manage perceptions to ameliorate public outrage at bad behavior by corporations, celebrities, or politicians. An example would be the seemingly happily politician and parent publicly apologizing when his mistress is exposed, while continuing to keep secret that he has maintained her apartment and lavish lifestyle with funds he has diverted from public funds.

The new actuarial disclosures, as a limited hangout, will give a clear hint of what I believe to be the enormous risk of state and municipal pension shortfalls, but will not be so fully transparent as to make them fully obvious to any other than pension experts.

I would have obviously preferred to see SMPPs covered by the same rules as ERISA pensions. That would prevent any obfuscation as to the actual funded status of those pensions or their ability to meet pension obligations as they come due. But that would also tend to upset the municipal finance market by creating now huge liabilities where there had previously been none. At least, however, it would be honest. It quietly urges SMPP managers, participants, and trustees, as well as state and municipal bond holders and credit ratings agencies, to look closely at the risk to the pensions workers rely on for their retirement and, thus, the fiscal health of the state and municipality.

In that sense, the new required pension disclosure is a bit like the warning light on your car dashboard, telling you your car is low on oil. Ignore it, and keep driving, without taking action, and you will find your car’s engine is totally destroyed, possibly even catch fire.

Leaders in government, Wall Street, and industry should all  abide the warning to stop municipal finance from, one day, catching fire.