Reasonable, Supportable, and Irresponsible

Recent Pension Commission hearings on plan assumptions demonstrate again that keeping contribution requirements in check takes priority over fiscal responsibility.

Behind the ongoing debate about public pensions is the black box of actuarial valuations – a mysterious container filled with the precision of sophisticated mathematics and the imprecision of assumptions about the future.  Occasionally, the lid on this box is lifted and lawmakers review and discuss the assumptions used to derive the funding requirements for the state’s pensions.  Such was the case this fall in hearings by the Legislative Commission on Pensions and Retirement.  These hearings again exposed one of the biggest unappreciated problems with public pensions.  Actuarial science is a discipline fundamentally devoted to the assessment of risk.  But in public pensions risk management doesn’t just take a back seat to funding policy, it’s locked away in the trunk.

One Step Forward, Another Step Back

Although the Commission has not yet formally adopted the actuaries’ recommendations, testimony revealed the impact on reported plan health is significant.  Reductions in wage and price inflation expectations would bring total liabilities down; working against them is a powerful demographic trend – increasing life expectancy.  But the 500 pound assumption gorilla remains the assumed return on investment which is used to calculate the present value of future benefit payments and determine contribution requirements.  For many years, plan actuaries recommended reducing the assumed return to 8%.  That recommendation was finally adopted in 2015 by two of three major state plans (MSRS and PERA), and all indications are TRA will join them this year.

These assumption changes, combined with lackluster returns over the last year, portend deterioration of reported pension fund health and more sustainability fixes.  According to pension plan estimates for forthcoming 2015 valuations, when including all these assumption changes, the total estimated unfunded liability (based on current market value) for just the three largest plans (MSRS General, PERA General, and TRA) is $14 billion.  Plan funded ratios for these plans would decline, ranging from 75.9% to 83.9% while contribution shortfalls would range from 1.6% to 4.2% of payroll.

As always, most of the Commission’s discussion and scrutiny was directed to the assumed investment return.  At 8% this assumption remains among the highest in the United States.  (The National Association of State Retirement Administrators reports the average assumed return is now 7.68%.)  Yet the inherent “blessing” of plan actuaries combined with the confident assurances of the State Board of Investment makes the 8% assumption easily justifiable.  Indeed, the state’s consulting actuary, who reviewed the work of each individual plan’s actuaries concluded, “the selected investment return assumption of 8.0% is reasonable and supportable.” What makes this conclusion a bit more interesting is that a part of the consulting actuaries’ testimony appeared to directly contradict it.

Heads or Tails? 

Two actuaries are duck hunting. They see a duck in the air and they both shoot. The first actuary’s shot is 20 feet wide to the left. The second actuary’s shot is 20 feet wide to the right. The actuaries give each other high fives, because on average they shot it.


There are an infinite number of ways the SBI can achieve an “average annual 8% return” over a defined period of time, but the sequencing of investment returns over time matters.  Unlike shooting fall mallards, investment “misses” from expectations compound and grow with time.  As a result, return projections that recognize sequencing and compounding effects (“geometric returns”) are preferable to modeling based on a simple arithmetic mean.  According to testimony by the state’s consulting actuary, “the industry trend is toward a preference of geometric returns.”  (The fact that this was described only as a “trend” and a “preference” in the industry should give pause – more on this later.)

So what does such a geometric return analysis suggest?  The table below was presented in testimony to the Commission by the state’s consulting actuary.  The median geometric return – which is by definition the return expected to be met half the time – is 6.97%.  The primary finding, however, lies at the bottom right of the table.  The probability of exceeding an 8% return over the next 20 years is only slightly better than 1 in 3.  The probability of exceeding a 7% return – a full 100 basis points below what our pension system is based on – is equal to a coin flip.

Practically, the odds are likely even worse because public pension contributions are notorious for “tardiness.”  The time when an economic downturn hits and investment markets decline is precisely when additional contributions are most needed.  But as Minnesota itself has demonstrated, budget circumstances that come with economic downturns make it very difficult for governments to divert additional money from their budgets and/or employee paychecks toward pension support.  At best, contribution increases are phased over a period of several years, missing out on a lot of market recovery in the process.

So why did the state’s consulting actuary still declare the 8% return “reasonable and supportable?”  The consulting actuary noted another geometric model with more optimistic findings.  Benchmarking against other states’ assumed returns also offered a sense of reassurance.  But the primary justification was simply the SBI’s own past investment performance and its own future projections.

“Hiding Risk is a Far Cry from Managing Risk"

“The use of the expected return assumption as the discount rate virtually guarantees the eventual failure of any plan using it.” 

Barton Waring, author of Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back Under Your Control, in testimony to the Government Accounting Standards Board

Policy makers are keenly attuned to the question of whether Minnesota can beat these odds and continue to meet or exceed these investment targets.  The more important question never gets asked: what is the logical justification for valuing future cash flows that the state absolutely has to pay based on hopes about what an investment portfolio can earn?

Financial economists and practitioners, public finance and government scholars[1], the Nobel-winning “father” of the capital asset pricing model and the Nobel-winning “father of modern finance,”[2] business executives, even public sector defined benefit pension managers in other countries have all expressed considerable concern and a fair share of ridicule at how expected investment returns are used in U.S. public pension policy. [3]  They argue what a portfolio is expected to make is absolutely irrelevant; financing needs instead need to be based on the riskiness of the cash flows.  They point out engaging in this practice understates the cost of pension benefits and exposes future taxpayers to considerable risks and unknown costs.  They point out this practice cannot be found in any other area of public or private sector finance.  They point out the fact that states have failed to make adequate contributions to their pension funds shouldn’t be a surprise to anyone; this practice essentially guarantees pension underfunding. 

The practice persists in large part because of the recommendations and justification offered by pension actuaries backed by their actuarial standards of practice.  But not all actuaries are comfortable with what is going on and how their profession has acted.

Jeremy Gold is the Vice Chair of the Pension Practice Council of the American Academy of Actuaries and Chair of the Pension Risk Management Task Force of the Society of Actuaries.  In a September presentation to the annual conference of the MIT Center for Finance and Policy, he began with the statement, “I’m here to tell you a story about how a profession has failed to fulfill its duty to the public and thus enabled and abetted the very real crisis in public pension plans.”  From there he delivered a withering critique of his own profession and its role in contributing to the current state of public pensions around the country (available at for those who find MMA takedowns entertaining). 

  • On the big picture:  “What we have is a knowledge problem and a governance problem.  The knowledge problem: actuaries shamelessly, although often in good faith, understate the value of future pension payments by as much as 50%.  Their clients want them to.  The governance problem: actuarial standards of practice allow pension actuaries to cater to their clients while ignoring potential harm to third parties."
  • On Actuarial Standards of Practice (or ASOPs):  “Despite the Actuarial Standard Board’s assertion that ASOPs are principles-based they’re neither principle-based nor prescriptive.  They are driven by practice from the bottom-up, defer frequently to professional judgment, and assert “appropriate” practice not “best” practice….In many cases the only required action is for the practicing actuary to consider something….Don’t let an actuary fly your plane.”
  • On what pension actuaries are really accomplishing: “Actuaries keep contributions low.  Actuarial methods and assumptions continue to kick the can down the road and suppress true pension costs….Low current contributions cater to current taxpayers but burden future generations with great risks and unacknowledged costs.”
  • On the failure of the profession to deliver on its principal professional obligation – risk assessment: "(Actuaries) should have been risk managers, not risk camouflagers…Actuarial smoothing is a poor substitute for real risk management.  Hiding risk is a far cry from managing risk."
  • On the political failure of the profession: “What the profession has done is enable and abet those whose decisions and benefit levels and funding have brought us to a crisis point.  Actuaries should have been the cops.”
  • On what should be done about all this:  “Get angry."

Looking for a Cop

When the construction work picks up this spring following the shortened legislative session, the situation will likely be as it has been.  Thanks to our Lake Wobegon-like investment acumen (where all the investments are above average), Minnesota will continue to reduce the pressure on contribution policies by discounting its future pension cash flows at a rate roughly 50 basis points above what the average public pension plan in the United States thinks is prudent and hundreds of basis points above what Finance 101 demands.

Author Upton Sinclair once noted it’s difficult to get a person to understand something when that person’s self-interest depends upon not understanding it.  There’s probably no better or simpler explanation for the state’s unwillingness to address this issue.  Government administrators and public employees both benefit from lower contributions and shifting current government costs onto future taxpayers.  Pension plan trustees who are charged with proper plan governance are mostly comprised of current and future pension beneficiaries.  Pension actuaries are paid to provide the analytical justification for current practice and risk losing business if they move away from standard orthodoxy.  The self-interest of traditional money managers is well-served by the status quo.  And as the struggles of underfunded plans result in the chase for higher returns in the world of “alternative investments,” private equity managers and the like are only too happy to oblige and reap their large fees.

The group we should rely on to introduce financial reality and responsibility into this debate is our elected officials.  Because they are charged with balancing the private interests of those working in government with the public interest in a fair and fiscally responsible way, they offer the best hope.  But if a corollary to Sinclair’s observation is also true – that it’s difficult to get someone to understand something when an election certificate depends upon not understanding it – we should brace ourselves for a future of both higher taxes and reduced government services.  It’s not a matter of if, but of when.

[1] Donald Boyd and Peter Kiernan, Strengthening the Security of Public Sector Defined Benefit Plans, Rockefeller Institute of Government “

[2] William Sharpe and Eugene Fama, respectively

[3] Perhaps the most entertaining criticism came from financial industry executive and former New York City mayor Michael Bloomberg who said in response to a New York actuarial recommendation to reduce the expected return:  “The actuary is supposedly going to lower the assumed reinvestment rate from an absolutely hysterical, laughable 8 percent to a totally indefensible 7 or 7.5 percent.  If I can give you one piece of financial advice: If somebody offers you a guaranteed 7 percent on your money for the rest of your life, you take it and just make sure the guy’s name is not Madoff.”