Since the end of 2011, we’ve witnessed four out of the five largest municipal bankruptcies in US history, each in some measure caused by insurmountable pension obligations. Today, public plan deficits exceed US$4 trillion, and funding ratios linger around 40%. And while most states have taken steps towards reform, the changes have been incremental and the industry remains in crisis.
Ronald J. Ryan, CFA, has been beating the drum for US pension reform for some time now, and in his recently-published book, The U.S. Pension Crisis, he calls this crisis America’s “greatest challenge since the Great Depression.” Without immediate action, Ryan sees the solvency of states and cities, and the retirement security of millions, at risk.
Flawed accounting principles put in place by the Governmental Accounting Standards Board (GASB) are at the heart of the problem, according to Ryan. These rules understate the size of the pension funding gap, leading to inappropriate decisions when it comes to setting asset allocation, determining benefits, making contributions, and selecting benchmarks.
GASB calls for plans to discount their projected benefits at the expected return on plan (ROA) assets, an accounting convention which is unique to public pension funds. Standard financial theory dictates that cash flow streams should be discounted at an interest rate that is reflective of their risk. In the case of public plan benefits, which are essentially guaranteed, that rate should rightfully equal the risk-free rate. Instead, most plans discount their liabilities at an average rate of close to 8% and defend it by arguing that states and cities essentially exist in perpetuity, and deficits will be made up over time. But that isn’t always the case, as the recent bankruptcy filing in Detroit demonstrated.
Ryan recently shared his views at The US Public Pension Funding Crisis, an online forum held as part of the Future of Finance initiative at CFA institute. He referred to the pension crisis as a “cost crisis,” and explained that accounting rules distort economic reality by allowing pension plans to mismatch assets and liabilities. Ryan added, “Imagine a bank treating your account the way GASB treats pensions. Would you be comfortable writing a check with that information?” He called public plan’s focus on ROA a “$4 trillion error.”
Ryan’s solution is for plans to get off what he calls “the ROA roller coaster” and move to a liability-driven investment approach. The ROA, he noted, “has nothing to do with present value of liabilities. Liabilities are a separate and distinct portfolio. The intrinsic or present value of liabilities is what it costs to settle them. Pension liabilities are a term structure requiring a yield curve of discount rates.” Pension plans should want to know the financial truth, according to Ryan, and he is more than willing to be the messenger.
At the 67th CFA Institute Annual Conference, Ryan will discuss the myths, realities and courses of action that pension plans must face as they deal with the global pensions cliff. Follow this blog for additional news and conference updates.
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