Pensions: The Current Climate

An article by New York Institute of Finance pensions instructor Larry Morgan.

I live in Chicago, the principal city of a state which has become the poster-child for mismanagement of public pensions with almost $100 billion in unfunded obligations, but Illinois is not alone in its improvidence.

In fact, defined benefit pensions, both public and private, contain an almost inevitable conflict.  A pension plan is intrinsically a provident (“foreseeing”) allocation of resources to unavoidable old age and retirement from active work.  It consists, however, in promises which are easy to make today but which someone else has to make good on decades later.  The temptation is great for both public officials and corporate managers to promise workers a great deal, then make inadequate provisions to fulfill those promises.

In the last year or so this conflict has taken a new form.  The financial crisis of 2007-2008 and the subsequent recession hurt pension investments in many ways: first, diminished corporate receipts and public revenues made it harder to keep up with required contributions to pension funds; secondly, stock market valuations plunged; thirdly, bond yields fell to almost negligible levels.  The low bond yields improved the values of bonds already held in pension portfolios but also raised the discounted value of the funds’ liabilities. These long-term liabilities – the pension obligations themselves – have generally been discounted using a long-term corporate bond or swap rate. As such rates declined tremendously in the aftermath of the crisis, recession, and extreme low-interest-rate policies of the Federal Reserve and other central banks, the present value of the liabilities soared, driving pension funds in America and Europe into severely underfunded territory, to about a 25% underfunded status globally by 2011 (according to a Towers Watson study).

Reacting to this unpleasant turn of events, plan sponsors as well as regulators and legislators have chosen to change the method for discounting long-term pension liabilities, essentially increasing by fiat the discount rate used in measuring the liabilities. Two approaches have been employed:

In a number of European countries, laws have been changed to require the use  of what is called the “ultimate forward rate” (UFR), a hypothetical very-long-term rate (set at about 4.2% for government debt) imputed from economic estimates of expected long-term real interest rates (2.2%) and inflation (2.0%) – estimates, mind you, nothing like present actual yields. This is combined with an elaborate algorithm to interpolate discount rates for periods before the “ultimate.”

The other method, used in the United States, measures a “high quality market” (HQM) spot yield curve calculated econometrically out to 100 years based on yields of investment-grade corporate bonds.  Until recently this HQM rate was based on a 24-month average of yields.  Recently, however, this was changed to a 25-year average.  Since bond yields were much higher before the crises of the last couple of years, this change in methodology increased the discount rates for liabilities by 2 percentage points or more.

These alterations immediately improve the funded status of pension funds. One estimate for the Netherlands calculated that its public pensions’ overall funded status improved from 98.58% using a standard swap discount rate to 101.63% using the UFR, and the change in the U.S. can improve a 40-year obligation from 80% funded to 150% funded – with no change whatsoever in the actual composition or performance of the investments in the fund.

I don’t want to follow these details so intensely that I lose the main point.  The reality that pensions are publicly important, that promises are easy to make, and that promises so far in the future are difficult to keep means that authorities will go through intense contortions to appear to maintain those promises.  The contortions that would be necessary to maintain the promises in fact would require larger contributions by workers and the state or reduced benefits.  That would be more painful than mathematical prestidigitation. The conflict between appearance and reality is a persistent fact of life in the pension world.

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