What Public Pensions and Geology Have in Common

In 1915, German scientist Alfred Wegener published a paper that first proposed the theory of continental drift. His radical idea was based the striking similarities in rock and fossil records on the opposite sides of the Atlantic Ocean. For 50 years this transformational theory was met with tremendous resistance from the scientific community. It received considerable scorn, jeers, and derision – especially from those who were invested heavily in the geologic theories of the period. But those stubborn rock and fossil records still demanded some explanation. Over time other scientific evidence accumulated supporting his idea, and the well-established science of plate tectonics was born.

Watching Pension Commission hearings and observing members struggle with the arcane world and terms of actuarial science, I was reminded of this history. For a very long time something rather radical and fundamental has been gnawing at the edges of actuarial practice – and has been met with resistance by many actuaries and especially by those who employ them in the public pension world.  Most of the calls for new thinking have come from the outside by financial economists and analysts.

However in 2001 a seminal article appeared in the Society of Actuaries’ Pension Section News with the provocative title “The Model Has No Clothes.” For the first time a rock was being thrown at the stained glass window from inside the church. Two years later a no-less controversial paper appeared entitled, “Reinventing Pension Actuarial Science.” The debate accelerated. Several years after that an article entitled “The Actuary’s New Clothes” appeared in Contingencies, the magazine of the American Academy of Actuaries. It concluded with this:

The weaknesses in the traditional pension actuarial model must therefore be addressed. The principles of financial economics offer an important tool in addressing some of the weaknesses and developing a more robust actuarial model for the valuation of pension plans. The new model, to survive the next few decades, must shift the focus from calculating expected values to assessing the risk of underfunding and must strive to be more transparent (emphasis ours).

All this could be dismissed as an incomprehensible, wonky math fight if so much wasn’t on the line. Everyone – current employees, retirees, government officials and taxpayers (present and future) – have a mammoth stake in getting this right. And as this debate shows, the standard refrain used to justify the status quo -- that governments are measuring their pension liabilities using assumptions that are consistent with the actuarial profession’s standards of practice –conveys far less uniformity of opinion and confidence than it once did.

Despite the epithets thrown in Wegener’s direction for so many years, the mystery of those rock and fossil records required an explanation. Similarly, as easy as it is to dismiss critics of current pension policy as nothing more than alarmist, anti-public sector zealots, the mystery of how average annual investment returns exceeding 10% for over 30 years can result in an $11-plus billion pension hole begs scrutiny.