Pensions, actuaries, and stocks for the long run

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.

Pensions, actuaries, and stocks for the long run

Postby nisiprius » Sat Jul 20, 2013 7:54 am

Detroit Gap Reveals Industry Dispute on Pension Math

This isn't just about pensions and Detroit, this is about funding retirement in general. Let me cut to the chase:
Much of the theoretical argument for retaining current methods is based on the belief that states and cities, unlike companies, cannot go out of business. That means public pension systems have an infinite investment horizon and can pull out of down markets if given enough time.
That's the connection with the concept of "stocks for the long run."
For several years, little noticed in the rest of the world, [actuaries have] been fighting over how to calculate the value, in today’s dollars, of pensions that will be paid in the future.... [There is a possibility] that a fundamental error has for decades been ingrained into actuarial standards of practice so that certain calculations are always done incorrectly....

When a lender calculates the value of a mortgage, or a trader sets the price of a bond, each looks at the payments scheduled in the future and translates them into today’s dollars, using a commonplace calculation called discounting. By extension, it might seem that an actuary calculating a city’s pension obligations would look at the scheduled future payments to retirees and discount them to today’s dollars.
"It might seem?" Good heavens. It would never have occurred to me that they would do anything else.
But that is not what happens. To calculate a city’s pension liabilities, an actuary instead projects all the contributions the city will probably have to make to the pension fund over time. Many assumptions go into this projection, including an assumption that returns on the investments made by the pension fund will cover most of the plan’s costs. The greater the average annual investment returns, the less the city will presumably have to contribute. Pension plan trustees set the rate of return, usually between 7 percent and 8 percent. In addition, actuaries “smooth” the numbers, to keep big swings in the financial markets from making the pension contributions gyrate year to year....

If the critics are right... even the cities that diligently follow their actuaries’ instructions, contributing the required amounts each year, are falling behind, and they don’t even know it.

These critics advocate discounting pension liabilities based on a low-risk rate of return, akin to one for a very safe bond.
The great divide. Plan on the basis of liability matching, or plan on the basis of guesses about future investment returns, meeting liabilities that will come due in finite time using a methodology based on an infinite planning horizon.

If you personally are planning on 7-8% returns in your portfolio, and a belief that you can always "pull out of down markets, given enough time," then you are planning the same way these pension funds have been planning. And I am confident that some will reply to this post by saying that this methodology is valid and that the pension funds doing it are sound.
A few years ago... the Society of Actuaries, gathered expert opinion and realized that public pension plans had come to pose the single largest reputational risk to the profession.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
User avatar
nisiprius
Advisory Board
 
Posts: 25288
Joined: Thu Jul 26, 2007 10:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Pensions, actuaries, and stocks for the long run

Postby George-J » Sat Jul 20, 2013 9:42 am

Thank you Nisiprius. An important topic. Most pension plans are a mess.

I am reminded of Warren Buffett 's 2001 article (12 years ago!) where he wrote -
“I'm a sporting type, and I would love to make a large bet with the chief financial officer of any one of those four companies, or with their actuaries or auditors, that over the next 15 years they will not average the rates they've postulated. … Heroic assumptions do wonders, however, for the bottom line. By embracing those expectation rates shown in the far right column, these companies report much higher earnings--much higher-- than if they were using lower rates. And that's certainly not lost on the people who set the rates. The actuaries who have roles in this game know nothing special about future investment returns. What they do know, however, is that their clients desire rates that are high. And a happy client is a continuing client.”
-- from December 10, 2001 issue of Fortune (vol 144, issue 12)

A recent memo by me at our institution adds more background about my own efforts on this issue.

I will try and add to this thread - time and energy permitting. :happy

George
George-J
 
Posts: 162
Joined: Sat Oct 06, 2007 3:28 pm

Re: Pensions, actuaries, and stocks for the long run

Postby richard » Sat Jul 20, 2013 9:54 am

For another view on pension liabilities, see http://www.cepr.net/index.php/blogs/bea ... n-benefits

"The discounted value of GDP over the next 30 years is roughly $447 trillion, which means that the estimated [pension] shortfall is a bit less than 0.9 percent of GDP. That's hardly trivial, but not obviously a crushing burden either. Furthermore, many state and local governments are already contributing at rates that are consistent with filling this gap, meaning that no additional committment of public funds will be needed to fill the shortfall, current levels of taxation are adequate."

BTW, corporations tend to predict returns as high or higher than used by states and cities. Public companies usually report funding assumptions in their financial statements. You can find 10-Ks (including financials) at http://www.sec.gov/edgar/searchedgar/companysearch.html
richard
 
Posts: 7420
Joined: Tue Feb 20, 2007 4:38 pm

Re: Pensions, actuaries, and stocks for the long run

Postby hicabob » Sat Jul 20, 2013 10:00 am

To be fair to the actuaries I'm sure they realize this and argue long and hard about "the assumptions". When I worked for an actuary many decades ago, the assumptions were always the point of contention - with the customer always wanting to assume what was most beneficial to them at the time.
hicabob
 
Posts: 1704
Joined: Fri May 27, 2011 6:35 pm
Location: cruz

Re: Pensions, actuaries, and stocks for the long run

Postby bdylan » Sat Jul 20, 2013 10:30 am

Some states don't even allow for a discussion of assumptions. Bit old, but Montana's RFP didn't allow for actuaries to use market valuation.

http://www.pionline.com/article/2009041 ... /904179979
bdylan
 
Posts: 43
Joined: Sun Feb 15, 2009 4:44 pm

Re: Pensions, actuaries, and stocks for the long run

Postby ofcmetz » Sat Jul 20, 2013 10:47 am

I first joined this site to ask questions about buying additional credit into my state pension, LASERS. It's 57% funded and expects an 8% investment return for calculations.

Needless to say I don't expect to receive all that is promised. How could I based on the numbers? Just like a lot of other things its going to be up to the individual to save and prepare for the future. Unfortunately most government employees are counting on pensions that are terribly underfunded.
Showing up at the donut shop at 5 am to get them hot out of the oil is an example of successful market timing.
User avatar
ofcmetz
 
Posts: 1738
Joined: Tue Feb 08, 2011 9:09 pm
Location: Louisiana

Re: Pensions, actuaries, and stocks for the long run

Postby Oicuryy » Sat Jul 20, 2013 12:39 pm

Anyone who has thought about taking withdrawals from a retirement portfolio knows that calculating the present value of retirement income is not as simple as calculating the present value of a bond or mortgage. You have to make a lot of assumptions. How long will you live? When will you retire? What fraction of your current income will you need in retirement? What will inflation be? What will your investment return be? How will you deal with portfolio volatility and the sequence of returns problem? Based on your assumptions you decide how much to save for retirement each year.

Actuaries for defined benefit pension plans have to make a lot of similar assumptions. They have to choose mortality tables, estimate how many people will retire each year, estimate how many will quit and withdraw their contributions, estimate how many will become disabled and estimate future promotions and pay increases.

No one should be shocked or surprised that a lot of assumptions go into calculating pension plan contributions.

Nor should anyone be too surprised that those assumptions do not always come true. Actuaries for public pension plans also assume that state and local governments will go on forever and that they have the power to tax. Future increases or decreases in contributions can make up for past assumption misses. But lately we have seen that some politicians would rather declare bankruptcy than raise taxes.

Government Accounting Standards Board (GASB) statement 25 took effect around 1996. It requires public pension plans to value their assets at market value. Until then plans could value their assets at cost. Volatility was not a problem because unrealized gains and losses did not show up in investment returns. Some plans would use excess returns to reduce contributions. It was not politically palatable for the pension fund to hold much more money than the actuary said was necessary.

In the late 1990s the stock market volatility was all on the up side. Thanks to GASB 25 that volatility showed up as investment gains. I suspect some plans continued their practice of using unexpected gains to reduce contributions. They were not well prepared to deal with volatility that can swing in both directions. IMO, they still aren't.

The latest debate is centered on GASB statements 67 and 68. These statements will require state and local governments, but not their pension plans, to value their pension obligations using a lower discount rate. GASB argues that this will make it easier for bond buyers to compare government accounting statements with private sector accounting statements. Public pension plans would still be allowed to use their current methods to value obligations and calculate contributions.

Private sector pension plans are already required to use lower discount rates to value obligations. Actuaries for private plans and actuaries for public plans are arguing with each other over which method public plans should use. Take a side in this debate if you want to but IMO this is a tempest in a teapot.

Think back to all the threads you have seen on this site about how much to save for retirement and how to make retirement savings last a lifetime. It is not an easy question to answer; certainly not as easy as calculating the present value of a bond. And it is not any easier for actuaries trying to answer it for groups of people. It seems unlikely that pronouncements from GASB or the Society of Actuaries will make it any easier.

Ron
Money is fungible | Abbreviations and Acronyms
User avatar
Oicuryy
 
Posts: 857
Joined: Thu Feb 22, 2007 11:29 pm

Re: Pensions, actuaries, and stocks for the long run

Postby nedsaid » Sat Jul 20, 2013 12:58 pm

Risk is risk. It is there whether you assume it yourself or if the pension assumes it for you. As pensions run into trouble, the realization hits that the risk never really transferred but was mostly upon the individual all the time. The transfer of risk from employee to the company was an illusion. You also can't get around that if you want more reward, you have to be willing to take more risk. Pooling the investment risk helps and the actuarial benefit helps (some beneficiaries dying early), but there is no magic trick to make the risk of investing go away.

I am actually happy that only a small portion of my retirement is tied up in a traditional pension. I know what my investments are and the risks I am taking. With a pension, you don't 100% know what they are doing with your money and in any case have no control with what they are doing.

The other issue is that pension plans got away from liability matching with bonds. The pension plans are heavily invested in stocks which increases returns but makes future returns uncertain. What you gain in increased performance, you lose in certaintly. Our State Treasurer made this move many years ago, which was hailed as forward thinking and innovatinve (which it was). The problem was that we allowed employees to lock in pensions based on the increased investment returns, leaving the state in the hole when the rate of return on stocks dropped and dropped rather dramatically after the 2000 crash.

A pension with certain payouts and uncertain returns is a recipe for potential disaster. Perhaps we should get back to more liability matching. Lower returns and higher funding requirement but we then would not have to worry so much about bad markets running our state budgets in a hole. The ungoing costs would be more but bad markets wouldn't cause premiums to go up nearly as much. Another solution would be to guarantee the pension payout only upon retirement. You get what you get. Not promising a certain level of payouts beforehand seems less fair but it gets Governments out of the business of trying to keep unsustainable promises.
A fool and his money are good for business.
User avatar
nedsaid
 
Posts: 2407
Joined: Fri Nov 23, 2012 1:33 pm

Re: Pensions, actuaries, and stocks for the long run

Postby George-J » Sat Jul 20, 2013 2:50 pm

It seems to me there are two major sources for the pension problems.

First, there is the pension actuary and assumptions - like high future returns, etc - that nisiprius and the New York Times article raise.

Secondly, in addition, the active managers of pension funds are getting richer and richer. Rick Ferri highlights this in another thread, Active Managers Fail State Pensioners - he comments:
Truth be told, what is going on in the public pension market and endowment market provides a half-trillion dollar per year gift to Wall Street at the same cost to those institutions. When will it all end? I'm not holding my breath.
George-J
 
Posts: 162
Joined: Sat Oct 06, 2007 3:28 pm

Re: Pensions, actuaries, and stocks for the long run

Postby grok87 » Sun Jul 21, 2013 12:08 am

richard wrote:
BTW, corporations tend to predict returns as high or higher than used by states and cities. Public companies usually report funding assumptions in their financial statements. You can find 10-Ks (including financials) at http://www.sec.gov/edgar/searchedgar/companysearch.html


This may have been true in the past, but I think it is changing now. The big trend in corporate pension plan investing is de-risking and LDI, or liability-driven-investing. LDI basically means shifting into a matching strategy using bonds.

On the other hands public pension plans are increasing their risk in the hope of achieving those unrealistic ally high returns, into private equity and the like.
http://www.forbes.com/sites/baininsight ... mpetition/
It's not a pretty story and is likely to end very badly.
Last edited by grok87 on Mon Jul 22, 2013 1:33 pm, edited 1 time in total.
grok, CFA | Danon delenda est
grok87
 
Posts: 6452
Joined: Tue Feb 27, 2007 10:00 pm

Re: Pensions, actuaries, and stocks for the long run

Postby Artsdoctor » Sun Jul 21, 2013 10:10 am

Nisi,

Thank you for beating me to the punch. I was actually going to post this article this morning. The pension plan system is one of the biggest train wrecks around and I feel as if we're watching a crash in slow motion.

Detroit is a huge debacle to be sure, and I think most would say that it is the worst of the worst. But do you think that the municipal pension plans could ultimately affect the muni bond market as a whole? Are we going to see a war between muni bond holders and pension plan managers? Will cities decide that bankruptcy is an option that had previously been off the table? I'm watching the Stockton mess here in California and it's going on and on. I'll be curious about precedent since I think we're in unchartered territory here.

And no, I'm no friend of Meredith Whitney!

Artsdoctor
User avatar
Artsdoctor
 
Posts: 677
Joined: Thu Jun 28, 2012 4:09 pm
Location: Los Angeles, CA

Re: Pensions, actuaries, and stocks for the long run

Postby jeffyscott » Sun Jul 21, 2013 10:30 am

This "distinction" by the journalist seems to me to reveal the journalists ingnorance, the issue would be what rate to use, not whether obligations are discounted to "today's dollars" or "an actuary instead projects all the contributions the city will probably have to make to the pension fund over time". If a discount rate of 7-8% were used or future returns are estimated at 7-8%, both methods are going to have the same result.

Using 7-8% may not be ideal, but using something like the current 10 year bond rate of 2.5% would be even more foolish.

Some of the underfunding of public pensions is due to politicians choosing to not even put in the money that the actuaries calculated based on those 7-8% returns. I don't know about Detroit, but I know this is a major factor in Illinois.
press on, regardless - John C. Bogle
User avatar
jeffyscott
 
Posts: 5907
Joined: Tue Feb 27, 2007 10:12 am
Location: Wisconsin

Re: Pensions, actuaries, and stocks for the long run

Postby nedsaid » Sun Jul 21, 2013 10:48 am

I reread the original New York Times article posted by Nisiprius. Very interesting. You can see why corporate america is getting out of the business of running pensions.

It takes some noggin power to think through the issues involved and what this means to individuals. Most people are too lazy to do this.

It is a revealing picture of what happens on Wall Street. Look at numbers in the best light possible. The pressure to do so is intense in an aggressive management culture. Works great until you hit the brick wall of reality.

In the case of pensions, I don't think it is a case of dishonesty. It is the reluctance to take a really hard look at the numbers. No one wants to be the bearer of bad news to the beneficiaries. No one wants to be told that either pension funding has to go up or benefits cut or a combo of both. People got used to the high investment returns of the 1980s and the 1990s and think that is going to go on forever.

The actuaries aren't dishonest. They are under pressure to give good news to their clients.

We need a strong debate. These concepts are understandable but take some time to think through. Unfortunately, a lot of the public doesn't have a long enough attention span to think through these issues. They will just blame the banks, Wall Street, whatever. We might have to deliver the unpopular message of going back to liability matching and go to not promising so much to retirees. Everyone wants to be popular and the bearer of good news. Reality is often not what we have hoped for.
A fool and his money are good for business.
User avatar
nedsaid
 
Posts: 2407
Joined: Fri Nov 23, 2012 1:33 pm

Re: Pensions, actuaries, and stocks for the long run

Postby Oicuryy » Sun Jul 21, 2013 1:37 pm

It seems only fair to post the rebuttal from Gabriel, Roeder, Smith & Company, the actuaries for Detroit's pension systems.

http://www.gabrielroeder.com/news/pdf_p ... lliman.pdf

The [Milliman] study does, however imply that our calculations may be biased and it contains the following statement on page 2

“The following table contains our very rough preliminary guesstimates (“VRPG”) of the potential actual state of the [City of Detroit Retirement] systems. Please note that these VRPGs are based on a high level analysis using rules of thumb and knowledge from general experience are not based on any detailed calculations”

The study goes on to present figures that are remarkably different from the actuarial calculations that experienced public sector actuaries at GRS prepared using detailed data on the operation of the Systems and robust actuarial software. GRS work, which was not based on “VRPG”, complies with relevant pronouncements of the Governmental Accounting Standards Board (GASB) and actuarial standards of practice.


Ron
Money is fungible | Abbreviations and Acronyms
User avatar
Oicuryy
 
Posts: 857
Joined: Thu Feb 22, 2007 11:29 pm

Re: Pensions, actuaries, and stocks for the long run

Postby nedsaid » Sun Jul 21, 2013 4:32 pm

Another factor in all of this are the very low interest rates available now. Pension funds have the same problem that individuals do.

Investing was easier when bond yields were higher. I remember Bob Brinker recommending a strategy where an investor would split a portfolio into two. With one half of the portfolio, you could buy zero coupon bonds at 8% which would double your money in about nine years. The other half went into stocks. So if stocks went to zero, the portfolio would be back to its original value in nine years. I wish I could do that today. Today at 3%, it would take 24 years for the money to double.

For portfolio managers it was easier to "lock in" returns buying bonds and holding them to maturity. You can still do it, but "locking in" a return that is pretty much the rate of inflation doesn't look attractive.

The rates also determines the present value of a future amount of money needed to meet obligations. So dropping the assumed rate of return a notch or two can make a big difference. So if your assumed rate of return was 6% and then is recalculated to 5%, the dollars needed today to meet that future obligation goes up considerably. So a pension fund looks rock solid with an assumed 6% return looks like it is in a bit of trouble if that assumed rate goes to 5%.

In the days of higher interest rates you could buy the 5-6% yielding bonds to meet your future obligations. Today bonds yield maybe 3% and to get to the 5-6% you need to buy stocks to make up the difference. Take more risk.

Higher interest rates would go a long way to fix this problem.
A fool and his money are good for business.
User avatar
nedsaid
 
Posts: 2407
Joined: Fri Nov 23, 2012 1:33 pm

Re: Pensions, actuaries, and stocks for the long run

Postby ndchamp » Sun Jul 21, 2013 4:42 pm

[OT comments and link to article regarding proposed legislation removed by admin LadyGeek]
ndchamp
 
Posts: 256
Joined: Mon May 14, 2007 9:30 am

Re: Pensions, actuaries, and stocks for the long run

Postby Stonebr » Sun Jul 21, 2013 5:08 pm

Oicuryy wrote:Think back to all the threads you have seen on this site about how much to save for retirement and how to make retirement savings last a lifetime. It is not an easy question to answer; certainly not as easy as calculating the present value of a bond. And it is not any easier for actuaries trying to answer it for groups of people.


But it is in fact easier to do for groups of people. The larger the group the better the projection. For an individual you have to assume Murphy's Law will rule, but for a large group the Law of Averages.
"have more than thou showest, | speak less than thou knowest" -- The Fool in King Lear
Stonebr
 
Posts: 958
Joined: Wed Jan 21, 2009 12:19 pm
Location: Maine

Re: Pensions, actuaries, and stocks for the long run

Postby nisiprius » Sun Jul 21, 2013 8:49 pm

nedsaid wrote:The actuaries aren't dishonest. They are under pressure to give good news to their clients.
Dishonest? Dunno. Let's say unprofessional.

Professionals subscribe to a code of ethics and owe a duty to their profession, not merely to their employer. I didn't know until I checked five minutes ago, but just as I expected actuaries subscribe to a Code of Professional Conduct. I'm not a quasi-lawyer and don't know how the code is interpreted, but if actuaries yield to pressure to put optimistic distortion on their findings, it sure seems to me that this violates the parts of the code that say
An Actuary who performs Actuarial Services shall take reasonable steps to ensure that such services are not used to mislead other parties.
and
An Actuary shall act honestly, with integrity and competence, and in a manner to fulfill the profession's responsibility to the public and to uphold the reputation of the actuarial profession.
"Integrity" is exactly what is in question, and "the reputation of the actuarial profession" is exactly what is at stake.
Stonebr wrote:
Oicuryy wrote:Think back to all the threads you have seen on this site about how much to save for retirement and how to make retirement savings last a lifetime. It is not an easy question to answer; certainly not as easy as calculating the present value of a bond. And it is not any easier for actuaries trying to answer it for groups of people.
But it is in fact easier to do for groups of people. The larger the group the better the projection. For an individual you have to assume Murphy's Law will rule, but for a large group the Law of Averages.
That helps with the mortality part of the equation, because each person is a sample from (literally) a population. It doesn't help for savings-and-withdrawal part, because all people of the same age experience the same market returns in the same sequence. It doesn't matter whether it's one person or a million who had money in the stock market in 2007, it all dropped by 50%.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
User avatar
nisiprius
Advisory Board
 
Posts: 25288
Joined: Thu Jul 26, 2007 10:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Pensions, actuaries, and stocks for the long run

Postby grog » Sun Jul 21, 2013 9:19 pm

I remember reading a pretty interesting paper by Jeremy Gold (the actuary referenced in the article). He is a long-time critic of the U.S. pension system.

http://users.erols.com/jeremygold/reinventingpensionactuarialscience.pdf

He makes some interesting points about why it doesn't make theoretical sense to use expected return since it doesn't take risk into account. If a thousand dollars worth of bonds has an expected return of 5% and a thousand dollars of stocks has an expected return of 8%, it returns don't change the fact that they are both worth exactly $1000. If you have to match $1000 in liabilities, it's absurd to say that you would need $1000 worth of bonds but <1000 in stocks due to the higher expected return. Using expected return basically assumes the equity premium is a free lunch.

He also makes some interesting points about ERISA (passed in 1974) and how it prevented the pension field from incorporating the many advances in financial theory (portfolio theory, CAPM, Black-Scholes, Sharpe Ratios, etc.) and turned it all into a compliance game.

I don't know much about public pensions, but I always assumed the states and cities did pretty much whatever they wanted. I didn't think there was even a pretense that contributions would fully fund the benefits. I was just reading about a public executive in my city who will be retiring with a ridiculously generous pension (better than a five-star admiral) and yet the employee contribution was only 4%.

Finally, I think people in the pension field are probably a lot sharper than they are portrayed in the press. For instance, it might seem really stupid that during the 90s bull market, a lot of pension funds had contribution holidays and/or benefit increases instead of holding a surplus for lean years. But there are tax laws and the IRS will not allow the deduction of pension contributions once the plan becomes overfunded. This means you will probably have to increase benefits or cut contributions. There's not really a great option in that situation, but most articles make it sound like they were breaking out the champagne and caviar 'cause they didn't know any better.
grog
 
Posts: 136
Joined: Sat Jul 20, 2013 2:09 pm

Re: Pensions, actuaries, and stocks for the long run

Postby Valuethinker » Mon Jul 22, 2013 9:23 am

nedsaid wrote:Another factor in all of this are the very low interest rates available now. Pension funds have the same problem that individuals do.

Investing was easier when bond yields were higher. I remember Bob Brinker recommending a strategy where an investor would split a portfolio into two. With one half of the portfolio, you could buy zero coupon bonds at 8% which would double your money in about nine years. The other half went into stocks. So if stocks went to zero, the portfolio would be back to its original value in nine years. I wish I could do that today. Today at 3%, it would take 24 years for the money to double.

For portfolio managers it was easier to "lock in" returns buying bonds and holding them to maturity. You can still do it, but "locking in" a return that is pretty much the rate of inflation doesn't look attractive.

The rates also determines the present value of a future amount of money needed to meet obligations. So dropping the assumed rate of return a notch or two can make a big difference. So if your assumed rate of return was 6% and then is recalculated to 5%, the dollars needed today to meet that future obligation goes up considerably. So a pension fund looks rock solid with an assumed 6% return looks like it is in a bit of trouble if that assumed rate goes to 5%.

In the days of higher interest rates you could buy the 5-6% yielding bonds to meet your future obligations. Today bonds yield maybe 3% and to get to the 5-6% you need to buy stocks to make up the difference. Take more risk.

Higher interest rates would go a long way to fix this problem.


Not quite.

High *real* interest rates make things easier.

Higher nominal rates, with inflation concommitantly higher as well, doesn't have much of an impact (except it increases the 'tax drag' of investing, ie tax is paid on nominal returns, not real returns).
Valuethinker
 
Posts: 24765
Joined: Fri May 11, 2007 12:07 pm

Re: Pensions, actuaries, and stocks for the long run

Postby George-J » Mon Jul 22, 2013 9:28 am

grog wrote: ... Finally, I think people in the pension field are probably a lot sharper than they are portrayed in the press. For instance, it might seem really stupid that during the 90s bull market, a lot of pension funds had contribution holidays and/or benefit increases instead of holding a surplus for lean years. But there are tax laws and the IRS will not allow the deduction of pension contributions once the plan becomes overfunded. This means you will probably have to increase benefits or cut contributions. There's not really a great option in that situation, but most articles make it sound like they were breaking out the champagne and caviar 'cause they didn't know any better.


Tax laws? Overfunded? -- what happened in our DB plan is that when the market return was higher than the assumed return (in the 1985 to 2000 period) - they simply assumed this meant the they could increase the return going forward. A 1% increase in the assumed investment return (going forward forever) reduced going forward liability by about 20%. Reducing the liability made it look like the fund was overfunded - and so the contribution holiday was "required" by tax law. In my view this was silly and truly irresponsible.

A hot market period does not continue forever. Instead it usually means there will be lower return period at some point in the future. And reducing the assumed investment return can add hugely to the deficit. Or to repeat - one has a seeming free lunch while increasing the return assumption - but the opposite when reducing the same assumption. The earlier "free lunch" must be paid. As Warren has said - "when the tide goes out, one sees who is not wearing a swim suit".

And in his recent book, "The Clash of the Cultures", page 215, Jack Bogle writes:
Today our nation’s system of retirement security is imperiled, headed for a serious train wreck. That wreck is not merely waiting to happen; we are running on a dangerous track that is leading directly to a serious crash that will disable major parts of our retirement system.
George-J
 
Posts: 162
Joined: Sat Oct 06, 2007 3:28 pm

Re: Pensions, actuaries, and stocks for the long run

Postby Chan_va » Mon Jul 22, 2013 9:55 am

George-J wrote:A hot market period does not continue forever. Instead it usually means there will be lower return period at some point in the future.


It's not so cut and dry. You have to remember that there is an economic cost to assuming a low rate of return as well. That would lead to the conclusion that the pension was underfunded, which means either higher taxes, or reduced benefits. Both those lead to lowered customer spending, and the economy takes a hit.

If you over estimate returns, then you either get lucky, or bond holders and retirees take a haircut.

In fact, an argument could be made that the economic cost of over estimating rate of return is less than the cost of under estimating it.
User avatar
Chan_va
 
Posts: 409
Joined: Wed Dec 05, 2012 8:15 pm

Re: Pensions, actuaries, and stocks for the long run

Postby George-J » Mon Jul 22, 2013 10:14 am

Chan_va wrote: ... In fact, an argument could be made that the economic cost of over estimating rate of return is less than the cost of under estimating it.

I sure don't understand this and so cannot believe it. As James Montier recently pointed out in his CFA lecture on "The Flaws of Finance" - there are bad models, bad policies, bad incentives and bad bahaviour.
George-J
 
Posts: 162
Joined: Sat Oct 06, 2007 3:28 pm

Re: Pensions, actuaries, and stocks for the long run

Postby nisiprius » Mon Jul 22, 2013 11:02 am

Chan_va wrote:In fact, an argument could be made that the economic cost of over estimating rate of return is less than the cost of under estimating it.
As the Church Lady used to say, "very convenient."

An argument can be made for the Irish to fund their retirement by marketing their babies as food, and for many other propositions. But one first has to ask what the purpose of pensions is supposed to be.

"Economic cost" would be a good argument if the participants in a pension plan had voted favorably on the proposition: "Resolved: we're good sports and happy to roll the dice and take a chance of getting half of our planned pension, provided we're sure that luckier workers who retire in a more favorable year will get triple their planned pension."

As it is, I think the vast majority of workers want their pensions to be secure and predictable, as opposed to having the highest mathematical expectation when averaged over all age cohorts.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.
User avatar
nisiprius
Advisory Board
 
Posts: 25288
Joined: Thu Jul 26, 2007 10:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Pensions, actuaries, and stocks for the long run

Postby bobcat2 » Mon Jul 22, 2013 11:09 am

Standard financial theory indicates that future streams of payment should be discounted at a rate that reflects the risk of the payment. In the case of state and local pension plans, the risk is the uncertainty about whether payments will need to be made. Since these benefits are protected under most state laws, the payments are, as a practical matter, guaranteed. Consequently, to assess accurately the status of a plan warrants discounting its stream of future benefits by the risk-free interest rate. *

* The analysis of choice under uncertainty in economics and finance identifies the discount rate for riskless payoffs with the riskless rate of interest. See Gollier (2001) and Luenberger (1997). This correspondence underlies much of the current theory and practice for the pricing of risky assets and the setting of risk premiums. See Sharpe, Alexander, and Bailey (2003); Bodie, Merton, and Cheeton (2008); and Benninga (2008).

Gollier, Christian. 2001. The Economics of Risk and Time. Cambridge, MA: MIT Press.

Luenberger, David G. 1997. Investment Science. Oxford: Oxford University Press.

Sharpe, William, Gordon J. Alexander, and Jeffrey W. Bailey. 2003. Investments. Upper Saddle River, NJ: Prentice Hall, Inc.

Bodie, Zvi, Robert Merton, and David Cheeton. 2008. Financial Economics. Upper Saddle River, NJ: Prentice Hall, Inc.

Benninga, Simon. 2008. Financial Modeling. Cambridge, MA: MIT Press.

As events have unfolded in the wake of the economic crisis of 2008-09, though, benefits have proved themselves not to be riskless; the benefits for current workers and retirees have been reduced in several states by suspending the cost-of-living adjustment. Nevertheless, core benefits will almost certainly be paid, so benefits – for reporting purposes – should be discounted by something closer to the risk-free interest rate.

Link to article - http://crr.bc.edu/wp-content/uploads/2013/07/slp_32.pdf



From the NYTimes article.
When state and local governments go looking for a new pension actuary, they sometimes post ads saying that candidates who favor new ways of calculating liabilities need not apply.


BTW, the Governmental Accounting Standards Board’s (GASB) has new actuarial standards going into effect next year. The new standards move somewhat in the direction of standard financial theory, but will still be closer to the old methods than financial theory. Even these reasonable but modest changes to the accounting standards is being met with howls of pain by state and local governments.

BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). | | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.
User avatar
bobcat2
 
Posts: 4191
Joined: Tue Feb 20, 2007 4:27 pm
Location: just barely Outside the Beltway

Re: Pensions, actuaries, and stocks for the long run

Postby Oicuryy » Mon Jul 22, 2013 2:20 pm

bobcat2 wrote:Standard financial theory indicates that future streams of payment should be discounted at a rate that reflects the risk of the payment. In the case of state and local pension plans, the risk is the uncertainty about whether payments will need to be made. Since these benefits are protected under most state laws, the payments are, as a practical matter, guaranteed. Consequently, to assess accurately the status of a plan warrants discounting its stream of future benefits by the risk-free interest rate. *

Are you saying that pension plan actuaries should assume that a portfolio of stocks and bonds will earn no more than the risk-free rate of return?

Ron
Money is fungible | Abbreviations and Acronyms
User avatar
Oicuryy
 
Posts: 857
Joined: Thu Feb 22, 2007 11:29 pm

Re: Pensions, actuaries, and stocks for the long run

Postby bobcat2 » Mon Jul 22, 2013 4:20 pm

Oicuryy wrote:
bobcat2 wrote:Standard financial theory indicates that future streams of payment should be discounted at a rate that reflects the risk of the payment. In the case of state and local pension plans, the risk is the uncertainty about whether payments will need to be made. Since these benefits are protected under most state laws, the payments are, as a practical matter, guaranteed. Consequently, to assess accurately the status of a plan warrants discounting its stream of future benefits by the risk-free interest rate. *

Are you saying that pension plan actuaries should assume that a portfolio of stocks and bonds will earn no more than the risk-free rate of return?

Ron

No. If the liability (retiree benefit) is essentially guaranteed (close to riskless), then the discounting must be close to riskless. If there is money you must have at a future date, you don't invest in an emerging market stock fund to meet that liability. If S&L governments want to invest in risky assets to fund their pension liabilities, then the pension beneficiaries should be subject to variable retirement benefits, depending on how well or poorly the highly variable returns of those risky assets perform. If, OTOH, the benefits are essentially fixed (practically guaranteed by statute) then the discounting and investing needs to be low risk.

It makes little sense to guarantee future benefits, but meet that funding level only by the high "expected" return of risky assets. The guarantee stays, but the risk may show up.

Nisi's intuition on this is very good. :wink:

BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). | | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.
User avatar
bobcat2
 
Posts: 4191
Joined: Tue Feb 20, 2007 4:27 pm
Location: just barely Outside the Beltway

Re: Pensions, actuaries, and stocks for the long run

Postby Oicuryy » Mon Jul 22, 2013 6:45 pm

bobcat2 wrote:If S&L governments want to invest in risky assets to fund their pension liabilities, then the pension beneficiaries should be subject to variable retirement benefits, depending on how well or poorly the highly variable returns of those risky assets perform. If, OTOH, the benefits are essentially fixed (practically guaranteed by statute) then the discounting and investing needs to be low risk.

It makes little sense to guarantee future benefits, but meet that funding level only by the high "expected" return of risky assets. The guarantee stays, but the risk may show up.

The high expected return of risky assets is not the "only" way to meet that funding level. Employer contributions are also available.

It is the local taxpayers, not the retirees, who have chosen to take market risk. Taxpayers need not make any investments at all. They could wait until a benefit payment is due and then pay it out of current taxes. That is basically how social security works.

But taxpayers, through their elected representatives, have chosen to begin making contributions for an employee's retirement as soon as the employee starts work. They invest those contributions in the hope that investment returns will pay part of the benefit so that they will not have to pay it all with taxes. If the taxpayers do not get the investment returns they expected, they are the ones who are obligated to cover the shortfall.

The actuary's job is to tell the taxpayers how much they need to contribute each year. His calculations are based on a number of assumptions about the future including an assumption about future investment returns. But the future never matches the assumptions exactly. The actuary re-does his calculations every year taking actual experience into account. Contributions are adjusted each year as needed to keep the plan on track to meet its obligations to retirees. It is these variable contributions rather than variable retirement benefits that adjust "depending on how well or poorly the highly variable returns of those risky assets perform".

Ron
Money is fungible | Abbreviations and Acronyms
User avatar
Oicuryy
 
Posts: 857
Joined: Thu Feb 22, 2007 11:29 pm

Re: Pensions, actuaries, and stocks for the long run

Postby Prudent Saver » Mon Jul 22, 2013 7:23 pm

richard wrote:
BTW, corporations tend to predict returns as high or higher than used by states and cities. Public companies usually report funding assumptions in their financial statements. You can find 10-Ks (including financials) at http://www.sec.gov/edgar/searchedgar/companysearch.html


Richard, corporations do not value the liability at rates similar to public pensions. They may assume a rate of return in line with public pensions, but that does not impact the liability valuation. The explicitly stated discount rate does that. You're comparing apples and oranges.
Be greedy when others are fearful, and fearful when others are greedy.
Prudent Saver
 
Posts: 102
Joined: Mon Jul 11, 2011 1:19 am
Location: Illinois

Re: Pensions, actuaries, and stocks for the long run

Postby Prudent Saver » Mon Jul 22, 2013 7:27 pm

Frankly, the bottom line in all of this is what could you settle the liability for today? That settlement rate will be based on like-risk bonds currently trading in the market. That's the rate at which you must discount the liability. Use anything else, and you're obfuscating and being dishonest about the value of the liability.
Be greedy when others are fearful, and fearful when others are greedy.
Prudent Saver
 
Posts: 102
Joined: Mon Jul 11, 2011 1:19 am
Location: Illinois

Re: Pensions, actuaries, and stocks for the long run

Postby George-J » Tue Jul 23, 2013 7:02 am

Prudent Saver wrote:Frankly, the bottom line in all of this is what could you settle the liability for today? That settlement rate will be based on like-risk bonds currently trading in the market. That's the rate at which you must discount the liability. Use anything else, and you're obfuscating and being dishonest about the value of the liability.

From the above - my impression is that you are informed and honest. I'm also trying to be the same. Thus can you confirm or correct my understanding of the following?

Your statement above refers to "settle the liability today" - meaning the liability for active (not yet retired) members of DB pension. It consists of the commuted settlement if you leave the pension today. The commuted value calculation uses the bond returns - currently and as prescribed by the government rules. The liability for those already retired and collecting a pension is similar - and uses bonds.

The other liability is for a continuing or the "going concern" pension plan liability. The key assumption here is what is a reasonable and sustainable investment return assumption going forward (forever). Using an unrealistic and optimist high investment return number results in reduced liability projection - and so allows for dishonest shortchanging in the annual DB pension contribution.
George-J
 
Posts: 162
Joined: Sat Oct 06, 2007 3:28 pm

Re: Pensions, actuaries, and stocks for the long run

Postby Oicuryy » Tue Jul 23, 2013 9:49 am

If anyone is interested, here is a summary of the actuarial assumptions used by the Detroit General Retirement System for their 2011 actuarial report.

http://www.rscd.org/actuarial%20annual% ... 11_F-6.pdf

Notice that the 7.9% return assumption is made up of a 3.9%-4.9% real return assumption and a 3%-4% inflation assumption. Which of those assumptions is "dishonest"? For comparison, here is Rick Ferri's forecast for 30-year real and nominal returns.

http://www.portfoliosolutions.com/2013marketforecast/

Ron
Money is fungible | Abbreviations and Acronyms
User avatar
Oicuryy
 
Posts: 857
Joined: Thu Feb 22, 2007 11:29 pm

Re: Pensions, actuaries, and stocks for the long run

Postby johnep » Tue Jul 23, 2013 2:31 pm

Oicuryy wrote:If anyone is interested, here is a summary of the actuarial assumptions used by the Detroit General Retirement System for their 2011 actuarial report.

http://www.rscd.org/actuarial%20annual% ... 11_F-6.pdf

Notice that the 7.9% return assumption is made up of a 3.9%-4.9% real return assumption and a 3%-4% inflation assumption. Which of those assumptions is "dishonest"? For comparison, here is Rick Ferri's forecast for 30-year real and nominal returns.

http://www.portfoliosolutions.com/2013marketforecast/

Ron


Detroit's pension assumed rate of return is within the range of most govt pension systems, which is between 7 and 8%. They are consistent with their peers on that point. I do not know enough about Detroit's situation to comment beyond that, but generally speaking, many people, myself included, believe achieving a nominal return of 7 to 8% long term is not realistic considering the AA most pensions use. NC has a mix of equity, bonds, REITS and alternative investments. Using Ferri's return projections (which seem reasonable to me), they should yield an average return of about 5.5%, but they assume 7.25%. Over time that becomes a significant shortfall. Thankfully NC's pension system is one of the best funded govt systems. However, it is still quite vulnerable to bear markets like the one in 2008, but many other pension systems will fare worse.
johnep
 
Posts: 1083
Joined: Wed Dec 28, 2011 10:56 am
Location: North Carolina

Re: Pensions, actuaries, and stocks for the long run

Postby jeffyscott » Tue Jul 23, 2013 5:43 pm

What is unreasonable about 3.9-4.9% real return?

60/40 with 5.8% real from stocks and 2% real from bonds, gives 4.3% real and is in line with Ferri's numbers. Ferris nominal figures are lower only due to his lower inflation assumption of 2% vs. Detroit's 3-4%.

The problem with underfunded public pension systems is not, I think, primarily a result of the actuarial assumptions, it is a result of the politicians choosing to not put the money in that the actuaries have told them to put in. They are underfunded primarily due to underfunding, not due to poor calculations of what was needed for full funding.

For example:
The city (Detroit) has struggled to meet its pension obligations since the 1950s. Post-war Detroit invested heavily in infrastructure, shortchanging the pension funds to pay for those improvements...For elected officials, frequent defaults on pension obligations to save operating cash became something close to standard operating procedure.
http://www.freep.com/article/20130714/O ... s-retirees
press on, regardless - John C. Bogle
User avatar
jeffyscott
 
Posts: 5907
Joined: Tue Feb 27, 2007 10:12 am
Location: Wisconsin

Re: Pensions, actuaries, and stocks for the long run

Postby bdylan » Tue Jul 23, 2013 8:36 pm

First, the assumption is 4.4 to 4.9 percent (the 3.9 percent is over wage growth, which is typically higher than inflation).

Second, the issue isn't the reasonableness of the assumption, it's how do you fund certain liabilities. As Bobk said, you want to match liabilities with your risk. For pensions with state constitutional guarantees, you should be using the risk free rate of return. Think about it in the context of building a floor for your retirement. You place income needs that have to be funded in risk or near risk free assets; or, alternatively you accept some level of risk that you won't have enough retirement income if you choose riskier assets.

There's also the fact that they used an entry age normal actuarial method, which is important in not really covering the full pension costs. There are other methods that would have a higher cost, though with additional uncertainties.

An alternative point of view would be that taxpayers explicitly took on this additional risk themselves, though if your familiar with the literature used to sell pension increases in the late nineties, this is a bit tough to believe.

Funny (well, not really funny, more sad) enough, if the courts allow municipalities to shed some of their liabilities, then the higher discount rate is more appropriate, as the pensions are no longer risk free.
bdylan
 
Posts: 43
Joined: Sun Feb 15, 2009 4:44 pm

Re: Pensions, actuaries, and stocks for the long run

Postby ofcmetz » Tue Jul 23, 2013 8:49 pm

bdylan wrote:There's also the fact that they used an entry age normal actuarial method, which is important in not really covering the full pension costs. There are other methods that would have a higher cost, though with additional uncertainties.


What does "entry age normal" mean?
Showing up at the donut shop at 5 am to get them hot out of the oil is an example of successful market timing.
User avatar
ofcmetz
 
Posts: 1738
Joined: Tue Feb 08, 2011 9:09 pm
Location: Louisiana

Re: Pensions, actuaries, and stocks for the long run

Postby bdylan » Tue Jul 23, 2013 9:52 pm

It's an accounting method where an employees pension costs accrue as a constant percent of their salary. It only sort of takes into account future salary increases and doesn't include additional service years. That can be reasonable, but it can also skew costs downward. For example most pensions provide an annuity based on years of service times final X years average salary (x is typically 5 or so.) If the normal cost of your pension is 12 percent of that years pay, you need the contribution to grow at the discount rate used to value the liabilities.

Also, many pensions are back loaded (ie how much should you value a non vested employees valuation vs a vested employees, and when should you value them?). The EAN method actually isn't that bad, but there are wrinkles in it that can matter.
bdylan
 
Posts: 43
Joined: Sun Feb 15, 2009 4:44 pm

Re: Pensions, actuaries, and stocks for the long run

Postby ofcmetz » Tue Jul 23, 2013 10:46 pm

bdylan wrote:It's an accounting method where an employees pension costs accrue as a constant percent of their salary. It only sort of takes into account future salary increases and doesn't include additional service years. That can be reasonable, but it can also skew costs downward. For example most pensions provide an annuity based on years of service times final X years average salary (x is typically 5 or so.) If the normal cost of your pension is 12 percent of that years pay, you need the contribution to grow at the discount rate used to value the liabilities.

Also, many pensions are back loaded (ie how much should you value a non vested employees valuation vs a vested employees, and when should you value them?). The EAN method actually isn't that bad, but there are wrinkles in it that can matter.



Thanks. This is a nice explanation.
Showing up at the donut shop at 5 am to get them hot out of the oil is an example of successful market timing.
User avatar
ofcmetz
 
Posts: 1738
Joined: Tue Feb 08, 2011 9:09 pm
Location: Louisiana

Re: Pensions, actuaries, and stocks for the long run

Postby Prudent Saver » Tue Jul 23, 2013 11:48 pm

Oicuryy wrote:If anyone is interested, here is a summary of the actuarial assumptions used by the Detroit General Retirement System for their 2011 actuarial report.

http://www.rscd.org/actuarial%20annual% ... 11_F-6.pdf

Notice that the 7.9% return assumption is made up of a 3.9%-4.9% real return assumption and a 3%-4% inflation assumption. Which of those assumptions is "dishonest"? For comparison, here is Rick Ferri's forecast for 30-year real and nominal returns.

http://www.portfoliosolutions.com/2013marketforecast/

Ron


What's dishonest about it? The fact that it is being used as the discount rate. When public companies project expected returns, they DO NOT use it as the discount rate to value the liability. It impacts the income statement through investment income recognition and the balance sheet through equity via OCI, but it DOES NOT impact the liability valuation AT ALL. It also DOES NOT impact the calculation of service cost, which also must be discounted and displayed in the notes to the financial statements.

Stop comparing expected returns assumed by corporate plans and public plans. They use those returns for different components of pension accounting. Using expected returns of your portfolio to discount the liability is unequivocally dishonest. It does not correctly value the liability. Stop making that argument It's tired, flawed, and frankly, ignorant.
Be greedy when others are fearful, and fearful when others are greedy.
Prudent Saver
 
Posts: 102
Joined: Mon Jul 11, 2011 1:19 am
Location: Illinois

Re: Pensions, actuaries, and stocks for the long run

Postby saurabhec » Wed Jul 24, 2013 12:10 am

[OT comments removed by admin LadyGeek]
saurabhec
 
Posts: 1816
Joined: Wed Oct 01, 2008 4:52 pm

Re: Pensions, actuaries, and stocks for the long run

Postby nedsaid » Wed Jul 24, 2013 12:52 am

Nisiprius,

All professions have codes of ethics. All professions suffer from client pressure. All practitioners in these professions have to battle the temptations and pressures.

I did read the rebuttal by the Detroit Pension Fund actuaries as well. I am willing to cut a little slack before calling people thieves and liars. We should not base our opinions on one article.

I think a lot of people believe that the assumptions about the assumed rates of returns in pension funds are too high. Mr. Bogle has stated this many times.
A fool and his money are good for business.
User avatar
nedsaid
 
Posts: 2407
Joined: Fri Nov 23, 2012 1:33 pm

Re: Pensions, actuaries, and stocks for the long run

Postby johnep » Wed Jul 24, 2013 10:04 am

Prudent Saver wrote:
Oicuryy wrote:If anyone is interested, here is a summary of the actuarial assumptions used by the Detroit General Retirement System for their 2011 actuarial report.

http://www.rscd.org/actuarial%20annual% ... 11_F-6.pdf

Notice that the 7.9% return assumption is made up of a 3.9%-4.9% real return assumption and a 3%-4% inflation assumption. Which of those assumptions is "dishonest"? For comparison, here is Rick Ferri's forecast for 30-year real and nominal returns.

http://www.portfoliosolutions.com/2013marketforecast/

Ron


What's dishonest about it? The fact that it is being used as the discount rate. When public companies project expected returns, they DO NOT use it as the discount rate to value the liability. It impacts the income statement through investment income recognition and the balance sheet through equity via OCI, but it DOES NOT impact the liability valuation AT ALL. It also DOES NOT impact the calculation of service cost, which also must be discounted and displayed in the notes to the financial statements.

Stop comparing expected returns assumed by corporate plans and public plans. They use those returns for different components of pension accounting. Using expected returns of your portfolio to discount the liability is unequivocally dishonest. It does not correctly value the liability. Stop making that argument It's tired, flawed, and frankly, ignorant.


I am a little confused by your post. My focus on this pension issue is trying to understand whether or not a pension fund is adequately funded, not what appears in the financial statements which may not be reflective of the true status of pension liabilities. My understanding is that the formula for determining Net Pension Liability is:

Total Pension Liability – Plan Net Position (plan assets) = Net Pension Liability

A positive result reflects underfunded and a negative result reflects surplus.

The Total Pension Liability is derived by calculating a Present Value of all future pension obligations using a Discount Rate which is the expected rate of investment return of pension assets. The calculation is very complex with other variables and beyond my pay grade to understand and explain but I believe that I have described the essence of it. If the Discount Rate is too high, it will result in projecting too low of a Total Pension Liability and vice versa. Therefore, IMO, responsible pension administrators should use a Discount Rate (i.e. expected rate of return of investments) that is reasonable, and if anything, erring on the conservative side.

The following describes the process of determining Net Pension Liability:

http://www.gabrielroeder.com/news/pdf_r ... NPL-PE.pdf

I welcome feedback so that I can better understand this matter. Thanks.
johnep
 
Posts: 1083
Joined: Wed Dec 28, 2011 10:56 am
Location: North Carolina

Re: Pensions, actuaries, and stocks for the long run

Postby Ketawa » Wed Jul 24, 2013 10:11 am

johnep wrote:I am a little confused by your post.


The crux of the disagreement is the discount rate. This is the reason that the discount rate should be much lower, stated eloquently earlier in the thread.

bobcat2 wrote:
Oicuryy wrote:
bobcat2 wrote:Standard financial theory indicates that future streams of payment should be discounted at a rate that reflects the risk of the payment. In the case of state and local pension plans, the risk is the uncertainty about whether payments will need to be made. Since these benefits are protected under most state laws, the payments are, as a practical matter, guaranteed. Consequently, to assess accurately the status of a plan warrants discounting its stream of future benefits by the risk-free interest rate. *

Are you saying that pension plan actuaries should assume that a portfolio of stocks and bonds will earn no more than the risk-free rate of return?

Ron

No. If the liability (retiree benefit) is essentially guaranteed (close to riskless), then the discounting must be close to riskless. If there is money you must have at a future date, you don't invest in an emerging market stock fund to meet that liability. If S&L governments want to invest in risky assets to fund their pension liabilities, then the pension beneficiaries should be subject to variable retirement benefits, depending on how well or poorly the highly variable returns of those risky assets perform. If, OTOH, the benefits are essentially fixed (practically guaranteed by statute) then the discounting and investing needs to be low risk.

It makes little sense to guarantee future benefits, but meet that funding level only by the high "expected" return of risky assets. The guarantee stays, but the risk may show up.

Nisi's intuition on this is very good. :wink:

BobK
User avatar
Ketawa
 
Posts: 1009
Joined: Mon Aug 22, 2011 2:11 am
Location: Norfolk

Re: Pensions, actuaries, and stocks for the long run

Postby George-J » Wed Jul 24, 2013 12:03 pm

saurabhec wrote:[OT comments removed by admin LadyGeek]

Yes and no. The blame game reminds me of a recent article by Charles Ellis in Financial Analysts Journal (July/August 2012) - "Murder on the Orient Express: the Mystery of Underperformance" - he starts with
Evidence increasingly shows that a 'crime' of extensive underperformance has been committed in mutual funds, pension funds, and endowments. In a pattern reminiscent of Agatha Christie's famous novel 'Murder on the Orient Express', an investigation leads to a surprising, if inevitable conclusion: The usual suspects - investment managers, fund executives, investment consultants, and investment committees - are all guilty. (my emphasis)

I would include others, including politicians, lawyers and actuaries.
George-J
 
Posts: 162
Joined: Sat Oct 06, 2007 3:28 pm

Re: Pensions, actuaries, and stocks for the long run

Postby Valuethinker » Wed Jul 24, 2013 12:09 pm

saurabhec wrote:[OT comments removed by admin LadyGeek]


It's not reasonable to fault unions for trying to do the best for their members. The AMA and the ABA are no different in that respect-- trade unions for professionals. And they all spend lots of money and effort lobbying (AARP anyone?).

If politicians were overly weak spined in response, then that is aided and abetted by an incorrect (under) statement of pension liabilities due to overly aggressive assumptions about expected returns and/or incorrect choice of discount rate. It appears also there is a lack of an appropriate legislative framework regarding the reporting of local authority (ie municipality) pension liabilities.

*that* is where actuaries may be in violation of their professional duty of care. Like auditors, the defence that 'the client expected us to do this and nudge nudge wink wink we all know we do this', just won't wash.
Valuethinker
 
Posts: 24765
Joined: Fri May 11, 2007 12:07 pm

Re: Pensions, actuaries, and stocks for the long run

Postby Valuethinker » Wed Jul 24, 2013 12:12 pm

johnep wrote: Thankfully NC's pension system is one of the best funded govt systems. However, it is still quite vulnerable to bear markets like the one in 2008, but many other pension systems will fare worse.


As I understand actuarial valuations, the impact of a stock market crash, even like 2008, should not have a big impact on surplus or deficit, because they use long term smoothing.

That is at least how it is done in the UK to the extent I understand such things.
Valuethinker
 
Posts: 24765
Joined: Fri May 11, 2007 12:07 pm

Re: Pensions, actuaries, and stocks for the long run

Postby johnep » Wed Jul 24, 2013 12:38 pm

Valuethinker wrote:
johnep wrote: Thankfully NC's pension system is one of the best funded govt systems. However, it is still quite vulnerable to bear markets like the one in 2008, but many other pension systems will fare worse.


As I understand actuarial valuations, the impact of a stock market crash, even like 2008, should not have a big impact on surplus or deficit, because they use long term smoothing.

That is at least how it is done in the UK to the extent I understand such things.


NC uses a 5 year smoothing method for its plan annual gains and losses. Apparently this works better in theory than practice. It took NC 5 years to recover from 2008 losses and they had to substantially increase employer contributions to do that. Plus there have been no COLAs since 2008.
johnep
 
Posts: 1083
Joined: Wed Dec 28, 2011 10:56 am
Location: North Carolina

Re: Pensions, actuaries, and stocks for the long run

Postby bobcat2 » Wed Jul 24, 2013 12:48 pm

johnep writes.
The Total Pension Liability is derived by calculating a Present Value of all future pension obligations using a Discount Rate which is the expected rate of investment return of pension assets.

Standard financial theory considers the above to be an inappropriate discount rate.

Instead, standard financial theory indicates that future streams of payment should be discounted at a rate that reflects the risk of the payment.
In other words, the appropriate discount rate has nothing to do with the expected return on the assets.

In the case of state and local government pensions those benefits are essentially guaranteed, i.e. they are close to being risk-free. Therefore, the appropriate discount rate should be close to risk-free, regardless of the expected return on the fund's assets.

See any of the following books for more on this.

Gollier, Christian. 2001. The Economics of Risk and Time. Cambridge, MA: MIT Press.

Luenberger, David G. 1997. Investment Science. Oxford: Oxford University Press.

Sharpe, William, Gordon J. Alexander, and Jeffrey W. Bailey. 2003. Investments. Upper Saddle River, NJ: Prentice Hall, Inc.

Bodie, Zvi, Robert Merton, and David Cheeton. 2008. Financial Economics. Upper Saddle River, NJ: Prentice Hall, Inc.

Benninga, Simon. 2008. Financial Modeling. Cambridge, MA: MIT Press.



BobK
In finance risk is defined as uncertainty that is consequential (nontrivial). | | The two main methods of dealing with financial risk are the matching of assets to goals & diversifying.
User avatar
bobcat2
 
Posts: 4191
Joined: Tue Feb 20, 2007 4:27 pm
Location: just barely Outside the Beltway

Re: Pensions, actuaries, and stocks for the long run

Postby George-J » Wed Jul 24, 2013 1:27 pm

bobcat2 wrote:johnep writes.
The Total Pension Liability is derived by calculating a Present Value of all future pension obligations using a Discount Rate which is the expected rate of investment return of pension assets.

Standard financial theory considers the above to be an inappropriate discount rate.

Instead, standard financial theory indicates that future streams of payment should be discounted at a rate that reflects the risk of the payment.
In other words, the appropriate discount rate has nothing to do with the expected return on the assets.
....
BobK

Sorry Bob. I don't understand the statement - "appropriate discount rate has nothing to do with the expected return on the assets". Why so? I'm not in financial theory but it seems that for the long term the actual rate of return is what counts. If possible, could you explain why you say the above? Or refer to a short article that explains it? Thanks Bob.
George-J
 
Posts: 162
Joined: Sat Oct 06, 2007 3:28 pm

Re: Pensions, actuaries, and stocks for the long run

Postby Oicuryy » Wed Jul 24, 2013 2:51 pm

bobcat2 wrote:johnep writes.
The Total Pension Liability is derived by calculating a Present Value of all future pension obligations using a Discount Rate which is the expected rate of investment return of pension assets.

Standard financial theory considers the above to be an inappropriate discount rate.

The key question for pension plan sponsors and for individuals is how much to save each year for retirement. Please explain why it is inappropriate to consider the expected return on those savings when answering that question. "Because standard financial theory says so" is not a convincing explanation.

Ron
Money is fungible | Abbreviations and Acronyms
User avatar
Oicuryy
 
Posts: 857
Joined: Thu Feb 22, 2007 11:29 pm

Next

Return to Investing - Theory, News & General

Who is online

Users browsing this forum: meowcat, packer16, pop77, Steelersfan, walker and 26 guests