Pensions, actuaries, and stocks for the long run

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

Post by Verde »

Great discussion, good arguments on both sides.

I think this might be a case where micro (finance theory) and macro contradict each other.

Bobcat2 presents proof that standard finance theory and some big names in that discipline supports the use of a risk free discount rate to value guaranteed benefits.
I question whether the valuation of public db pension liabilities is a micro issue where standard finance theory applies, my gut feel is that this falls in the macro domain. (I’m not sure if this applies to S&L government, perhaps that is where I miss the point.)

We have seen many instances in the post crisis years where astute micro economists betrayed their ignorance of macro (eg. Eugene Fama on the treasury view as referenced by Jack).
This may be another such case.
I cannot accept bobcat2’s argument unless it is shown that there is no contradiction between finance theory applicable to individual agents, and macro-economic models; or that public pension financing should not be evaluated on a macro level.

I must add that if this is indeed a macro problem, disagreement on appropriate discount rates will remain.

I suspect the Austrian and New-classical schools would side with the risk-free rate, and New-Keynesians and Market-monetarists will support expected returns – each school will have some solid arguments supporting their view. I think this matter has not been resolved by academia.
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Re: Pensions, actuaries, and stocks for the long run

Post by Verde »

Oicuryy wrote:Taxpayers have some choices about how to raise the money to pay the debt.
I disagree, taxpayers don’t get to make any decisions, voters have that privilege.
I live in a country where voters make up 70% of the adult population, but taxpayers only 5%.
bobcat2 wrote: In any event none of this means S&L governments need only invest in safe assets. It means they have to discount the pension liability using a near risk-free rate. That does not mean they have to invest only in near risk-free assets.
BobK
Sorry to pick on you bobcat, it is only because your arguments are so persuasive, and as my interests won’t be served if you are right, my bias motivates me to frantically seek refutation.

I find it strange that you have no problem using risky investments to meet guaranteed liabilities.

Under this scheme:
1. Current taxpayers will have to double or triple their contributions, they are worse of no matter what.
2. The investments are not risk free, if the risk shows up future taxpayers will carry the can.
3. If the risk pays off, voters get to decide how the windfall is spent – will they throw taxpayers a bone?

How is this fair.

Another question raised by this discussion – if a future benefit depends on the uncertain ability of a future taxbase to fund it, is it really guaranteed?
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Re: Pensions, actuaries, and stocks for the long run

Post by bobcat2 »

The fact that a near guaranteed liability has to be discounted at a near risk-free rate doesn't mean that you have to fund it at a near risk-free rate. However, funding the liability using very risky assets would be reckless. I know of no school of economics that believes that the present value of a liability can be reduced by taking on more risk.

The only way I know to reduce the present value of a liability is thru a contingent contract. Examples of this in personal finance would be term life insurance and life annuities.

Twenty to thirty years ago it made sense to discount pension liabilities at 6% to 8% because the nominal interest rate on LT and IT US Treasuries was in that range and S&L pensions are typically nominal and not real. Currently the interest rates on LT and IT US Treasuries is in the 3% range or less. That requires a lowering of the discount rate on pension liabilities from what it was in the 1980s and much of the 1990s.

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

Post by Oicuryy »

In that NPR interview, Jeremy Gold discloses that he is pushing a political issue under the guise of an accounting change. He starts out by explaining discount rate. But at the end he calls for lower benefits from public pensions. At least he is honest enough to admit that he has a political agenda.

This thread should have been locked or deleted after the opening post. It links to another Jeremy Gold interview. Links advocating political views are not usually allowed here.

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

Post by LadyGeek »

Oicuryy wrote:This thread should have been locked or deleted after the opening post. It links to another Jeremy Gold interview. Links advocating political views are not usually allowed here.

Ron
I reviewed this thread with the moderators. The posting of a link which is directly political in nature is off-topic.

With the exception of some OT comments (which I've removed), the thread is relevant to both investors and government workers. Investors need to understand the underfunding, since it will have an effect on muni bonds and bond funds they may be invested in, or thinking about investing in, and employees have to understand that even cities, and possibly states, can and and do go bankrupt, so their pensions are not sacrosanct.

The OP's NY Times article link appears to be broken. I found it on the NY Times mobile site: Detroit Gap Reveals Industry Dispute on Pension Math
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Re: Pensions, actuaries, and stocks for the long run

Post by Malkielino »

http://users.erols.com/jeremygold/reinv ... cience.pdf

was disappointing to me. What I find interesting are the variety of ways in which pooled pension systems (as opposed to DC plans, where the pool is 1 until retirement, after which time there are 0 workers for every 1 or 2 retirees) reduce risk.

The obvious one is mortality risk... the average age at death of a pool of people has far lower variance than the average age at death of 1 or 2 people.

Another manner in which pooling reduces risk is the constant contributions of the younger people. The constant contributions reduce the risk of the fund going completely bankrupt... they naturally smooth out the volatility and extend the period for averaging stock market returns.

Using `risk free' discount rates seems to me to be an intellectual cop out, an esperanto-type extremism... one size fits all. We know the long, long term returns of the stock market are higher. The challenge is to use all the tools possible to reduce variance. Pooled pension systems have several tools that DC plans will never have.
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Re: Pensions, actuaries, and stocks for the long run

Post by nisiprius »

Oicuryy wrote:In that NPR interview, Jeremy Gold discloses that he is pushing a political issue under the guise of an accounting change. He starts out by explaining discount rate. But at the end he calls for lower benefits from public pensions. At least he is honest enough to admit that he has a political agenda.

This thread should have been locked or deleted after the opening post. It links to another Jeremy Gold interview. Links advocating political views are not usually allowed here.

Ron
I do see your point, Ron. I'm glad that the moderators judged the topic to be within bounds--I wasn't privy to their deliberations--but I wanted to acknowledge that I do see your point.

I was not being intentionally political. The New York Times article did not indicate clearly Jeremy Goldstein was not only criticizing the methodology but advocating a policy for dealing with the shortfall he anticipates. I personally am more interested in the question of how an actuary, or anyone else, determines whether retirement savings, any retirement savings, are adequate to meet the obligation. If the Society of Actuaries feels that "public pension plans had come to pose the single largest reputational risk to the profession," I'd say there's more here than politics.
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Re: Pensions, actuaries, and stocks for the long run

Post by Jack »

bobcat2 wrote:The fact that a near guaranteed liability has to be discounted at a near risk-free rate doesn't mean that you have to fund it at a near risk-free rate.
Huh, what?

First you claim that because the benefits are guaranteed, you must use the riskless discount rate. This means you must fund the pension assuming a return of no more than the riskless rate. If the pension is funded based on the riskless return, then according to your logic, adding equities must increase the risk and therefore you no longer have a guaranteed benefit. Either you believe that equities increase the return or it doesn't. You can't have it both ways.

By your logic, if you add equities to the portfolio, you increase the risk and therefore you must increase contributions at the same time in order to guarantee benefits. Of course this is nonsense but it is the logical consequence of your assumption of a riskless discount rate.

And of course this is contrary to everything that is taught on this forum. Most people believe that adding equities to a portfolio, for a long term investor, increases the probability of a safe retirement over a 100% bond portfolio, not reduces it. This is demonstrated empirically by the Trinity results which show a much greater risk of failure for a 100% bond portfolio.
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Re: Pensions, actuaries, and stocks for the long run

Post by bobcat2 »

Why is something so simple so hard for so many people. The PV of a liability is the COST of the liability.

The cost of something doesn't change because of the way you pay for it. :oops: :oops: :oops:

If the cost or price of a car (its PV) is $30,000 if I pay for with I-bonds, that $30,000 cost (PV) doesn't drop to $28,000 if I pay for it using shares of a small cap stock fund. Shockingly (at least to some), this is true despite the fact that the stock fund has the higher expected return. :wink:

If you are saying that the pension liability is guaranteed to be paid then it is nearly risk-free. That requires using a near risk-free rate to determine the cost (PV) of that liability, regardless of how you intend to pay for that cost.

The PV (cost) of a liability cannot be reduced by taking on more risk. If it could be reduced by taking on more risk, then all pensions should be funded 100% by higher expected return equities (assuming leverage is not allowed), because that would produce the lowest cost pension liability.

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

Post by Jack »

There are two uses for discount rates:

1. Generating a value for future benefit liabilities. This is just a number that goes on a balance sheet according to accounting rules.

2. Generating a rule for determining a proper funding level to pay the future benefits. This is used to indicate if the current investment assets plus current contributions are sufficient to cover projected payouts. The result is generally expressed as a percent of full funding with 100% representing fully funded. This need not be the same discount rate used for the first case.

If you are only talking about the first case, then, hey, knock yourself out. It's just a big scary number on a balance sheet so you can use the riskless rate or even 0% for all I care. It's just an accounting number.

But the original article is talking about the second use of a discount rate, determining whether pensions are fully funded or not. In that case a riskless discount rate does not make sense because a balanced portfolio of stocks and bonds returns more than the riskless rate.

You've been pedantically harping on number one but also dancing around number two so it is unclear where you stand. Most of us here are discussing number two as it is the only one that directly affects both taxpayers and pensioners.
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Re: Pensions, actuaries, and stocks for the long run

Post by bobcat2 »

Hi Jack,

The level of the "just the accounting number", as you put it, is the number that determines whether the pension is fully funded or not. The "just accounting number" is the present value of projected payouts. (Future benefit liabilities and projected payouts are two ways of saying the same thing.) A higher "just accounting number" might indicate that the pension is not adequately funded.

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

Post by Oicuryy »

nisiprius wrote:I do see your point, Ron. I'm glad that the moderators judged the topic to be within bounds--I wasn't privy to their deliberations--but I wanted to acknowledge that I do see your point.
Thank you. It's good to know someone sees my point. :wink:
nisiprius wrote:I personally am more interested in the question of how an actuary, or anyone else, determines whether retirement savings, any retirement savings, are adequate to meet the obligation.
I searched on the web for a good explanation of what actuaries do but didn't find one. I did find the diagram that goes with the explanation.

http://www.piperpension.com/?p=94

The diagram uses a plumbing analogy to illustrate the money flows of a pension plan. Contributions and investment earnings flow into the tank. Benefit payments flow out.

Each year the actuary calculates what next year's contribution flow should be. He does that by looking at the level in the tank and by making a guesstimate of the future inflow of investment returns and a guesstimate of the future outflow of benefit payments.

The tank is a reservoir. It can feed the benefit flow when the inflows are less than expected. And it can collect the excess when inflows are more than expected. The level in the tank can fluctuate. It does not have to stay at a fixed level. The actuary is supposed to adjust the contribution flow to keep the level from getting too low or too high.

After the stock market performance of the last decade the level in the tank is on the low side. Contribution rates are higher than plan sponsors would like. After the '80s and '90s the tank level should have been high. I suspect some plans did not contribute as much as the actuaries called for. Some even increased the benefit outflow.

Actuaries do not choose the benefits formula. They do not choose the asset allocation or the investments. They calculate what the contributions should be but they cannot force the plan sponsors to pay those contributions.

The debate in this thread is over the actuary's guesstimate of future investment returns. Remember that the purpose of that guesstimate is to calculate next year's contributions. Should that guesstimate be based on the plan's actual investment portfolio? Or should it be based on a hypothetical portfolio of default-risk-free bonds? Here is an opinion on that from an actuary who is not Jeremy Gold.

http://www.aei.org/files/2013/06/03/-un ... 092561.pdf

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

Post by Verde »

If you subscribed to the viewpoint below – what discount rate would you regard as appropriate to value and fund public db pension liabilities?

From a macro-economic perspective the payment of pension benefits always imposes a burden on the members of society who are economically active when the payment is made.
In aggregate it is irrelevant whether those benefits are transferred from the productive members of society to the retired population by taxing them or by withdrawing savings (interest/dividends/rent/capital redemptions) which derives its value from their productivity.

If a government levies a tax to fund future pension liabilities and transfers the proceeds to an investment like bonds or stocks this action is not a burden on the economically active population in aggregate – it is merely a transfer from one individual agent to another.
Only when benefits are paid to retirees by withdrawing funds from the retirement savings is a burden imposed on productive society.
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Re: Pensions, actuaries, and stocks for the long run

Post by bobcat2 »

Ron writes.
The debate in this thread is over the actuary's guesstimate of future investment returns.
No - that is not what the debate is about.

The debate in this thread is instead about how to calculate the cost of the future benefits that are to be paid. Using your terminology the cost of the "guesstimate of the future outflow of benefit payments". Suppose $1 million is to be paid out next year and $1 million is also to be paid out in the tenth year. What discount rate should we use to measure those two costs? This is a completely separate issue from the estimate of future investment return rates.

It is true that the estimate of future returns is also sometimes questioned, because critics believe the estimated investment returns in some cases are too high. That is a separate issue.

We have gone this far in the thread and people still don't understand what the criticism is. :oops:

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

Post by Levett »

This has been an invaluable thread.

Thank you for the last link, Ron.

Among many other things, I appreciated the author's note--namely,

"In fact, the term “risk-free” rate does not refer to investment
risk at all. Rather, it is the rate that the market would
use to price a cash flow that is sure to be paid, and thus free
of default risk."


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

Post by 555 »

The problem is having a defined benefit instead of defined contributions. There should only be defined contribution plans. People should accept what the market gives them on the contributions made.

Defined benefit plans never should have existed in the first place. It is a promise that can't be guaranteed to be kept, so it's a promise that should never have been made in the first place. [OT comment removed by admin LadyGeek]
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Re: Pensions, actuaries, and stocks for the long run

Post by Jack »

Thanks Ron. Your link http://www.aei.org/files/2013/06/03/-un ... 092561.pdf
provides more detail on the point I was making above about the two purposes of discount rates. There are two different accounting methods for evaluating pensions and they have two different purposes. The two methods use different discount rates. Both are appropriate when used for their designed purposes. Which one you use depends on which question you are trying to answer. The problem comes when some people confuse one with the other, deliberately or not.

First, the article above refers to the "market value of liabilities" or MVL. This method is used to answer the question of the buyout value of a pension if one wanted to terminate it. You would use it to evaluate an offer of a lump sum or a continuing pension. The accepted discount rate for this purpose is the riskless rate of bonds. This is the discount rate you should use when you are trying to answer the termination question. Most people don't really care about this number, but it is the one that bobcat2 has been pounding.

The second method is called the "acuarially accrued liability" or AAL. This method is used to answer a quite different question and the one most relevant to taxpayers and pensioners on this forum -- the amount of contributions required to adequately fund the projected benefits. In this case the discount rate used is the expected rate of return of the porfolio. This is the method used by most investors for their own retirment planning and the one supported by the Trinity study.

The problem comes when some people try to take the discount rate for MVL and apply it to AAL. The result is an exaggeration of pension liabilities that is often used to argue disingenuously for cuts in pension benefits. It leads to absurd conclusions such as adding equities to an all-bond portfolio requires a larger contribution/savings rate and reduces the success rate of the portfolio.

From the article above:
While discussions of appropriate long-term earnings assumptions and their associated risks should be encouraged, they should not be influenced by arguments based on liability measures that are unrelated to expected investment earnings.
In other words don't use the riskless rate where the expected return rate should be used.

There can be honest debate about the correct number to use for expected rate of return, but it is obvious that the riskless rate from MVL is wrong when used to evaluate pension health.

In this article http://www.cepr.net/documents/publicati ... 012-01.pdf, economist Dean Baker shows how a conditional expected rate of return based on PE values rather than a fixed rate of return provides a smoother, less volatile funding scenario than using the riskless rate. The riskless rate would have incorrectly told pension managers to stop contributions in 2000 when asset values were at their peak. The conditional expected rate of return would have provided the correct answer that expected rate of return had declined and therefore contributions should continue.

Likewise in 2009, the riskless rate of return would have incorrectly told pension managers that they needed to drastically increase contributions due to the market decline. The expected rate of return would have correctly told them that with a market decline, expected returns had increased and therefore contributions need only remain constant.

Note that the expected rate of return provides the same slow and steady advice advocated on this forum while the riskless rate leads to wild gyrations of optimism and panic.
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Re: Pensions, actuaries, and stocks for the long run

Post by bobcat2 »

The article cited by Ron makes two points.

The first point concerns what the disagreement is about. The disagreement is about what the appropriate rate of discount should be on the pension payouts - not the rate on investment returns.

Secondly, the actuary writing the piece is arguing the case for using the current methods for discounting the pension payouts. The critics argue that the discount rate for the pension payouts should be closer to the risk-free rate. Using the risk free rate is consistent with economic and finance principles. The current method, which the actuary writing the article believes is correct, is inconsistent with economic and financial principles.

What a great idea - we should fund pensions by market timing the contributions based on PE ratios. I hope Dean Baker ex-post picked the 'right' PE ratios. :wink:

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

Post by bobcat2 »

The AEI article Ron cites was apparently in response to this AEI article in favor of using market valuation for public pension liabilities.

http://www.aei.org/files/2013/05/29/-un ... 782445.pdf

Now, as it turns out, this second article in an earlier thread was cited by Jack for being a politically biased article from the conservative and biased AEI think tank. It turns out, though, that AEI articles are only politically biased in those cases where Jack disagrees with the findings. :D In AEA articles where Jack agrees with the findings the AEI is a font of truth and scholarship. :D

I suggest people read both AEA articles and give both sets of authors the benefit of the doubt that what they write is what they truly believe is the correct way to value pension liabilities. Then make a decision about which method is more reasonable.

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

Post by Verde »

Individuals can sacrifice (save) current consumption to fund future consumption.
If they want this future consumption to be guaranteed they should use a liability matching strategy.
In simple terms the discount rate used to calculate the amount to be saved should be the real yield on long term treasuries.
Most of us opt to forego the guarantee due to the high cost – which is perfectly rational. We discount our at-risk future consumption at a risky rate to calculate how much to save.

On the macro level this is not possible – future public guaranteed db pensions can only be funded out of future gdp. We cannot set aside a portion of current gdp to fund these future liabilities – see my previous post.

Gdp is created by the economically active. A pension payment is a transfer of gdp from the economically active to non-productive pensioners at the time the payments are made.

The correct discount rate for valuing the real cost of future public db pension liabilities is the expected real per capita gdp growth rate.

This is the number public policy makers should consider when they offer future guaranteed pensions.
They do not burden current gdp with these promises, they burden future gdp.

If they pledge to pay a real amount of $X to retirees in 2043, the burden is not $X/current gdp, it is $X/real 2043 gdp.
If current gdp =X*100 and real gdp stagnates for the next 30 years the cost will be 1% of 2043 gdp.
If real gdp doubles by 2043 the cost will be .5% of 2043 gdp, if it halves the cost will be 2% of 2043 gdp.

Public policy makers should frame the problem in terms of the burden their decisions place on future gdp. The best estimate of this burden is to express the real value of benefits promised as a % of real expected gdp when they come due.
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Re: Pensions, actuaries, and stocks for the long run

Post by bobcat2 »

Here's Jack in the earlier thread talking about an article from AEI which discusses discounting as it applies to public pensions.
You might want to be wary of quoting papers from the American Enterprise Institute (AEI), which has a long history of -- how do I put this politely -- dishonesty and questionable mathematics.


But now Jack sees no problem at all at quoting at length a paper from AEI on the discounting of pensions. You would think from his earlier statement that Jack would never quote from an AEI paper on public pensions, given the AEI's "long history of ... dishonesty and questionable mathematics" according to Jack, particularly in regard to AEI papers on public pensions. You would be wrong. :D

Here is the link to the earlier post.
http://www.bogleheads.org/forum/viewtop ... s#p1711986

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

Post by Lauren Vignec »

Verde wrote:
Another question raised by this discussion – if a future benefit depends on the uncertain ability of a future taxbase to fund it, is it really guaranteed?
Hello Verde,

Detroit's bankruptcy claim is a big deal, and will set a precedent. Right now, it looks like the answer to your question is going to be answered negatively. No, the future benefit is not really guaranteed.

I believe this is a financial planning question, not a political question. I don't know whether such benefits should be guaranteed. But at present, the most likely outcome is that the courts will decide they are not guaranteed.

Every retiree relying on a state, city or county pension should consider how secure their pension really is.
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Re: Pensions, actuaries, and stocks for the long run

Post by Jack »

bobcat2 wrote:But now Jack sees no problem at all at quoting at length a paper from AEI on the discounting of pensions. You would think from his earlier statement that Jack would never quote from an AEI paper on public pensions, given the AEI's "long history of ... dishonesty and questionable mathematics" according to Jack, particularly in regard to AEI papers on public pensions
The earlier paper was produced by paid staff at the AEI. The second paper was not produced by the AEI -- it is a reprint of a paper created and published outside of the AEI previously -- see here: http://www.segalco.com/publications/pub ... ne2011.pdf

I do have to give the AEI credit for republishing outside research. I still would not trust anything produced inside their walls. It's important to pay attention to distinctions.
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Re: Pensions, actuaries, and stocks for the long run

Post by bobcat2 »

Hi Jack,

I see. When the AEI publishes papers on public pensions done by well respected researchers such as Smetters and Biggs it is undoubtedly part and parcel of their "long history of ... dishonesty and questionable mathematics". When OTOH the AEI republishes an article on public pensions by a California actuary originally writing a piece that is part of his own firm's newsletter, then that article should be regarded as highly reputable research.

Is that your story and your sticking to it? :D :D :D :D :D :D :D

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

Post by Levett »

Great thread, but let's get a reality check with respect to the specific case of Detroit pensions.

I'm talking legality, not politics.

The Attorney General of Michigan has made a decision in light of his understanding of the state of Michigan constitution.

And this is his decision:

http://www.mlive.com/news/detroit/index ... tte_1.html

Now it goes to the courts.

Stay tuned.

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

Post by Oicuryy »

bobcat2 wrote:The AEI article Ron cites was apparently in response to this AEI article in favor of using market valuation for public pension liabilities.

http://www.aei.org/files/2013/05/29/-un ... 782445.pdf
Biggs and Smetters are doing the same thing that Bader and Gold are doing. They are trying to change public policy through the back door. Biggs and Smetters state their desired public policy up front:
each generation of taxpayers should fully fund the benefits accruing to public employees at that time, rather than shifting those costs to future generations. [snip] Interperiod equity requires that future taxpayers be insulated or, in economists’ terms, “immunized” against the risk of being forced to pay for pension benefits accrued in the past.
They spend the rest of the paper demonstrating that current public policy does not provide that immunization. No one said it did. Angelo did not take a side in the public policy debate. He just asks that actuaries be allowed to use the discount rate that is appropriate for the public policy they have been given by policymakers.

The moderators were kind enough to let this thread continue. But I doubt they want us to debate whether or not future taxpayers should face the risk of increased pension contributions. Let's just recognize that the folks pushing for this change in actuarial practice are really pushing a public policy change.

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

Post by LadyGeek »

Oicuryy wrote:The moderators were kind enough to let this thread continue. But I doubt they want us to debate whether or not future taxpayers should face the risk of increased pension contributions. Let's just recognize that the folks pushing for this change in actuarial practice are really pushing a public policy change.

Ron
I agree, thanks for the summary.
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Re: Pensions, actuaries, and stocks for the long run

Post by patrick »

Oicuryy wrote:They spend the rest of the paper demonstrating that current public policy does not provide that immunization. No one said it did. Angelo did not take a side in the public policy debate. He just asks that actuaries be allowed to use the discount rate that is appropriate for the public policy they have been given by policymakers.

The moderators were kind enough to let this thread continue. But I doubt they want us to debate whether or not future taxpayers should face the risk of increased pension contributions. Let's just recognize that the folks pushing for this change in actuarial practice are really pushing a public policy change.
Is anyone pushing a public change always wrong? If I criticize deferred annuities with guaranteed minimum income benefits in order to push a public policy change, does that mean my criticism must be wrong?
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Re: Pensions, actuaries, and stocks for the long run

Post by Epsilon Delta »

Verde wrote: On the macro level this is not possible – future public guaranteed db pensions can only be funded out of future gdp. We cannot set aside a portion of current gdp to fund these future liabilities – see my previous post.
A government anticipating a demographic bulge of retirees (and they are easy to anticipate) could do a lot worse than ensuring that infrastructure is in tip-top condition. This is just one way to set aside a portion of current production for future consumption.
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Re: Pensions, actuaries, and stocks for the long run

Post by patrick »

Jack wrote:Thanks Ron. Your link http://www.aei.org/files/2013/06/03/-un ... 092561.pdf
provides more detail on the point I was making above about the two purposes of discount rates. There are two different accounting methods for evaluating pensions and they have two different purposes. The two methods use different discount rates. Both are appropriate when used for their designed purposes. Which one you use depends on which question you are trying to answer. The problem comes when some people confuse one with the other, deliberately or not.

First, the article above refers to the "market value of liabilities" or MVL. This method is used to answer the question of the buyout value of a pension if one wanted to terminate it. You would use it to evaluate an offer of a lump sum or a continuing pension. The accepted discount rate for this purpose is the riskless rate of bonds. This is the discount rate you should use when you are trying to answer the termination question. Most people don't really care about this number, but it is the one that bobcat2 has been pounding.

The second method is called the "acuarially accrued liability" or AAL. This method is used to answer a quite different question and the one most relevant to taxpayers and pensioners on this forum -- the amount of contributions required to adequately fund the projected benefits. In this case the discount rate used is the expected rate of return of the porfolio. This is the method used by most investors for their own retirment planning and the one supported by the Trinity study.
The Trinity study did not say an investor is safe if the plan would work in the event of expected returns. It looked at past data to see what would survive in almost all past periods, including those with below expected returns.

I don't think an individual investor should claim to have a fully funded retirement that covers a specific spending level if the investor can only meet that level if the market at least matches the expected return. Expected returns are not guaranteed returns.

The individual investor can always deal with below expected returns by working longer, spending less in retirement, or leaving a smaller bequest. The pension fund does not have these options but must pay the same benefit.

A public pension does, of course, have another option in case of a shortfall. It can use taxes to cover the difference. But is it really a fully funded pension if it must plan for recourse to tax funds in the future? Should we consider possible future tax payments to be part of the pension fund today?

Note also that the AAL rule is not applied to private annuities. An insurance company selling SPIAs would not be permitted to invest the money in stocks and then claim to have legally sufficient reserves because the stocks would return enough to make the guaranteed payout if the stock market matches its expected return.
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Re: Pensions, actuaries, and stocks for the long run

Post by bobcat2 »

About the Author
Paul Angelo is a senior vice president and actuary for the Segal Company and currently serves as the valuation actuary for 16 major California county and city retirement systems and associations, as well as for the University of California Retirement System.

It seems to me that Mr. Angelo has ample political motivation to keep current discount rules in place.

As chief actuary for 16 pension funds using the current methods of discounting benefits, how would things work out for Mr. Angelo if one or more of those pension funds goes bust, and it is shown that he was using the wrong discount procedure? I would think that in that eventuality, Mr. Angelo would have his fanny sued from here to Timbuktu. :( At this point that is not an error he could afford to admit, even if he thought it was true. He is about as far from being a non-political disinterested observer in this controversy as one could find.

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

Post by Verde »

Epsilon Delta wrote: A government anticipating a demographic bulge of retirees (and they are easy to anticipate) could do a lot worse than ensuring that infrastructure is in tip-top condition. This is just one way to set aside a portion of current production for future consumption.
What about the 'crowding out' effect?
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Re: Pensions, actuaries, and stocks for the long run

Post by Epsilon Delta »

Verde wrote:
Epsilon Delta wrote: A government anticipating a demographic bulge of retirees (and they are easy to anticipate) could do a lot worse than ensuring that infrastructure is in tip-top condition. This is just one way to set aside a portion of current production for future consumption.
What about the 'crowding out' effect?
We want the crowding out effect in this case. Spending on infrastructure reduces consumption before the retirement bulge hits and reducing infrastructure spending increases consumption during the retirement bulge. In any case infrastructure does not have to be private, on a personal level you could reroof your house with a 30 year roof just before retirement.
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Re: Pensions, actuaries, and stocks for the long run

Post by Verde »

Epsilon Delta wrote:
Verde wrote:
Epsilon Delta wrote: A government anticipating a demographic bulge of retirees (and they are easy to anticipate) could do a lot worse than ensuring that infrastructure is in tip-top condition. This is just one way to set aside a portion of current production for future consumption.
What about the 'crowding out' effect?
We want the crowding out effect in this case. Spending on infrastructure reduces consumption before the retirement bulge hits and reducing infrastructure spending increases consumption during the retirement bulge. In any case infrastructure does not have to be private, on a personal level you could reroof your house with a 30 year roof just before retirement.
Raising additional taxes to spend on infrastructure crowds out investments which the market would have preferred. Reducing consumption reduces income which would otherwise have been available to tax. It hinges on whether governments are better at allocating resources than markets.

Back to the topic - do you agree that the payment of pension benefits involves a transfer of economic benefits derived from gdp produced at that time from the economically active to pensioners, or is there a funding system which can transfer those benefits from previous generations, leaving the full economic benefits of gdp produced at the time when the pensions are paid in the hands of the then economically active.
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Re: Pensions, actuaries, and stocks for the long run

Post by carolinaman »

Harvard's Kennedy School of Government produced a report on this issue in 2012 entitled: "Underfunded Public Pensions in the United States". It is a worthwhile read (the executive summary is only 3 pges) for those interested in this problem as it talks about not only the public pension problem but some potential solutions.

http://www.hks.harvard.edu/var/ezp_site ... funded.pdf
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Re: Pensions, actuaries, and stocks for the long run

Post by Epsilon Delta »

Verde wrote:
Raising additional taxes to spend on infrastructure crowds out investments which the market would have preferred. Reducing consumption reduces income which would otherwise have been available to tax. It hinges on whether governments are better at allocating resources than markets.

Back to the topic - do you agree that the payment of pension benefits involves a transfer of economic benefits derived from gdp produced at that time from the economically active to pensioners, or is there a funding system which can transfer those benefits from previous generations, leaving the full economic benefits of gdp produced at the time when the pensions are paid in the hands of the then economically active.

There is certainly a way to fund retirement which does not involve transfers from the economically active to pensioners: store goods. This method can, in theory, work even if there is no next generation. This has been done in the past, some homesteaders would build an enormous wood pile while they were able so that they did not need to cut wood later in life.

Having the "economically active" having full benefit of gdp produced at the time the pension is paid is not the same as "no transfers". Your condition is equivalent to the next generation confiscating the capital of the prior generation.
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Re: Pensions, actuaries, and stocks for the long run

Post by Verde »

Epsilon Delta wrote: There is certainly a way to fund retirement which does not involve transfers from the economically active to pensioners: store goods. This method can, in theory, work even if there is no next generation. This has been done in the past, some homesteaders would build an enormous wood pile while they were able so that they did not need to cut wood later in life.

Having the "economically active" having full benefit of gdp produced at the time the pension is paid is not the same as "no transfers". Your condition is equivalent to the next generation confiscating the capital of the prior generation.
Ok, but if we store goods to fund retirement there is no point arguing about appropriate discount rates for valuing future benefit payments.

How is it equivalent to confiscation - I do not question the legitimacy of the claims held by pensioners, I would hope for my own sake that such claims are inviolable.

I am arguing that the societal cost of providing these benefits has nothing do with historic investment returns earned on various asset classes or a risk free rate.

Society can shift the responsibility for bearing these claims from one individual agent to another by funding a pension scheme, but the cost of these benefits should be expressed in terms of the expected future income (gdp) which will be burdened to pay it.
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Re: Pensions, actuaries, and stocks for the long run

Post by Epsilon Delta »

Verde wrote:
Epsilon Delta wrote: Having the "economically active" having full benefit of gdp produced at the time the pension is paid is not the same as "no transfers". Your condition is equivalent to the next generation confiscating the capital of the prior generation.
How is it equivalent to confiscation - I do not question the legitimacy of the claims held by pensioners, I would hope for my own sake that such claims are inviolable.
Because some of the gdp is return on capital (profits or interest) and some of that capital is owned by retired people. If you allocate the entire gdp the active workers then retired workers are not getting any.
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Re: Pensions, actuaries, and stocks for the long run

Post by Verde »

Epsilon Delta wrote:Because some of the gdp is return on capital (profits or interest) and some of that capital is owned by retired people. If you allocate the entire gdp the active workers then retired workers are not getting any.
It would indeed be theft if the entire gdp is allocated to active workers, thereby flouting the property rights of others– that’s a recipe for anarchy.
Implicit in this discussion is the assumption that pension benefit claims are legitimate, and it is in the interests of society to fully meet these claims.
Gdp should obviously be allocated to the legitimate owners thereof – the rightful claims of pensioners entitle them to a portion of gdp. It can however only be paid out of income produced by the efforts of the then active economic participants – either by taxing that income or by selling assets to the recipients of that income.
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Re: Pensions, actuaries, and stocks for the long run

Post by Verde »

The fact is public db pensions are guaranteed.
Government has the power to raise taxes in future to pay these benefits.
If we expect that these future payments will make up an unsustainable % of future income(gdp) then we must conclude that pensions are underfunded.
If these liabilities are sustainable in terms of future expected gdp then it is irrelevant if a risk free discount rate shows them to be underfunded.
If they are not sustainable then no level of returns from investing in risky assets can salvage the situation.
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Re: Pensions, actuaries, and stocks for the long run

Post by Jack »

Verde wrote:If these liabilities are sustainable in terms of future expected gdp then it is irrelevant if a risk free discount rate shows them to be underfunded.
But the whole debate is how to determine sustainability.

In a pay-as-you-go pension system like Social Security, it is fairly easy to determine sustainability. The projected payouts are easy to estimate and the payroll tax income is reasonably easy to estimate. The only unknown is the rate of increase in GDP, but it can be bounded.

That contrasts with municipal and corporate pensions which are partly pay-as-you-go and partly pre-funded. The pre-funded part is invested in a stock and bond portfolio and in order to determine sustainability, you must apply a discount rate to those assets -- in other words, you need to estimate the return you expect on those assets. The rest needs to be made up by current contributions. The selection of the discount rate, the estimate of investment returns, is a big deal because it can halve or double the amount of current contributions and taxes needed for sustainability, just as an individual's investment return determines how much they need to save for retirement.

The selection of the discount rate to use in formulas for estimating contributions required for sustainability is a legitimate subject for debate. You will see lots of arguments on both sides for either a higher or lower discount rate.

But in the midst of this debate you need to be wary of arguments that are not made in good faith and apply a filter to what you hear. This is because there are certain people who are philosophically opposed to the idea of pensions in general and will use arguments of unsustainability to promote an agenda of pension benefit cuts. It should not be surprising that some of these same people used an argument for high investment returns during the 1990s to stop contributions to pension funds in order to underfund them, and now argue for a low investment returns to say that the pensions are unstable and benefits must be cut.

So this is why "discount rate" is such an important debate. Keep in mind that we are really just talking about expected returns on investment for retirement portfolios, a common subject of debate on this forum.
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Re: Pensions, actuaries, and stocks for the long run

Post by Epsilon Delta »

Verde wrote: Gdp should obviously be allocated to the legitimate owners thereof – the rightful claims of pensioners entitle them to a portion of gdp. It can however only be paid out of income produced by the efforts of the then active economic participants – either by taxing that income or by selling assets to the recipients of that income.
It can also come from consuming assets. Not just selling them to current workers, but using them up. Any account should have both a balance sheet and a cash flow statement. GDP is a purely cash flow item.
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Re: Pensions, actuaries, and stocks for the long run

Post by Verde »

Jack wrote:The selection of the discount rate, the estimate of investment returns, is a big deal because it can halve or double the amount of current contributions and taxes needed for sustainability, just as an individual's investment return determines how much they need to save for retirement.
Individuals can sacrifice (save) current consumption to fund future consumption.

On the macro level this is not possible – future pensions can only be paid out of future gdp. We cannot set aside a portion of current gdp to pay these future liabilities.
Pensions can only be paid out of income produced by the then active economic participants – either by taxing that income or by selling pension fund assets in exchange for income earned by the economically active.

In aggregate it is irrelevant whether the system is pay-as-you-go or pre-funded. The same amount of income has to be transferred from the productive members of society to the retired population either way.

By funding a pension scheme we only shift responsibility for bearing these claims from future taxpayers to future investors.
If the scheme is fully funded when benefits fall due, investors will bear the full burden, if not taxpayers will be on the hook for the difference (in the case of a guaranteed db pension).
It is only in this sense that investment returns are important – they determine who is liable to pay the pensioner’s claims (investors if returns were adequate, taxpayers if they were not).

The sustainability of the plan does not depend on investment returns, it depends on the level of future income (gdp) produced by the economy relative to the size of the pension payments that have to be settled then.

Therefore:

The correct discount rate for valuing the real cost of future public db pension liabilities is the expected real per capita gdp growth rate.
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Re: Pensions, actuaries, and stocks for the long run

Post by Verde »

Epsilon Delta wrote:
Verde wrote: Gdp should obviously be allocated to the legitimate owners thereof – the rightful claims of pensioners entitle them to a portion of gdp. It can however only be paid out of income produced by the efforts of the then active economic participants – either by taxing that income or by selling assets to the recipients of that income.
It can also come from consuming assets. Not just selling them to current workers, but using them up. Any account should have both a balance sheet and a cash flow statement. GDP is a purely cash flow item.
Paper assets derive their value from future gdp - if everyone retires gdp goes to zero - stocks, bonds cash even property (no income = no rent) goes to zero. We revert to a barter economy, where a different set of rules apply which is beyond the scope of this discussion.
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Re: Pensions, actuaries, and stocks for the long run

Post by Epsilon Delta »

Verde wrote:
Epsilon Delta wrote:
Verde wrote: Gdp should obviously be allocated to the legitimate owners thereof – the rightful claims of pensioners entitle them to a portion of gdp. It can however only be paid out of income produced by the efforts of the then active economic participants – either by taxing that income or by selling assets to the recipients of that income.
It can also come from consuming assets. Not just selling them to current workers, but using them up. Any account should have both a balance sheet and a cash flow statement. GDP is a purely cash flow item.
Paper assets derive their value from future gdp - if everyone retires gdp goes to zero - stocks, bonds cash even property (no income = no rent) goes to zero. We revert to a barter economy, where a different set of rules apply which is beyond the scope of this discussion.
I am not talking about paper assets. I am talking about physical assets: Roads, railways, airports, sewer systems, buildings, pipelines, telecommunications systems, power plants. satellites, ... . These assets wear out (are consumed) on a time scale of decades, similar to the duration of a retirement bulge. Build or refit them before a retirement bulge hits so that they have a maximum useful life, do not replacing them till after the bulge is over.
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Re: Pensions, actuaries, and stocks for the long run

Post by Jack »

Verde wrote:The correct discount rate for valuing the real cost of future public db pension liabilities is the expected real per capita gdp growth rate.
So what if GDP growth is zero? Assets held can still return dividends forever to pay benefits. Are you saying this infinite income should have a zero discount rate? No matter what the dividend yield, the discount rate is zero? That dividend yield is completely irrelevant to sustainability of pension benefits? That a low dividend yield is just as good as a high dividend yield because in both cases the discount rate is zero?
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Re: Pensions, actuaries, and stocks for the long run

Post by Verde »

Jack wrote: So what if GDP growth is zero? Assets held can still return dividends forever to pay benefits. Are you saying this infinite income should have a zero discount rate? No matter what the dividend yield, the discount rate is zero? That dividend yield is completely irrelevant to sustainability of pension benefits? That a low dividend yield is just as good as a high dividend yield because in both cases the discount rate is zero?
What if the assets held by the pension fund are worthless after 30 years when benefits fall due, (perhaps they invested in infrastructure per Epsilon's suggestion and realized too late that what they were doing was equivalent to digging holes and filling them back up. :happy ) but gdp grew at 10% real for 30 years. Would the payment of publicly guaranteed db pensions be unsustainable because the fund's investment returns were -100%?
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Re: Pensions, actuaries, and stocks for the long run

Post by Verde »

If a pension fund has sufficient assets to pay its liabilities when they fall due because of good historic returns this is proof that the gdp at that time is capable of bearing the burden placed on it by these payments. It shows that there are investors who are willing and able to exchange their income for the pension fund’s assets. Correlation does not imply causation.
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Re: Pensions, actuaries, and stocks for the long run

Post by Valuethinker »

Epsilon Delta wrote:
Verde wrote: On the macro level this is not possible – future public guaranteed db pensions can only be funded out of future gdp. We cannot set aside a portion of current gdp to fund these future liabilities – see my previous post.
A government anticipating a demographic bulge of retirees (and they are easy to anticipate) could do a lot worse than ensuring that infrastructure is in tip-top condition. This is just one way to set aside a portion of current production for future consumption.
Would that it were that simple in practice.

Infrastructure, world over, is an area where politics (and its dark brothers: corruption and kickbacks in the construction industry and the political system) is the major force determining what gets built, and where, and when. Notoriously in Japan (the Yakuza are very powerful in the construction industry) where they ran up to 10% of GDP on physical construction, with little apparent good effect. Or in China (High Speed trains that fall off the rails, architect designed city halls for cities of half a million people, etc.).

The US is fairly dysfunctional in this: as I understand it US legislation does not recognize, nor mandate, explicit cost-benefit calculations?

Now the UK does, and HM Treasury requires a minimum of £2.50 of benefit for every £1.00 of direct public expenditure (it doesn't matter whether you do it that way, or via an infrastructure company, all that matters is how you pay for it ie user tolls or general taxation). So our largest piece of upcoming expenditure is High Speed 2 (London to Glasgow via Manchester and Leeds)-- £40bn. Cost to benefit? £1.30 to 1-- 'high speed train envy' has infected our political system. (they've also used completely dodgy benefit calculations: they assume that modern businesspeople do not use train time to check emails or make calls, but that such time is completely dead time-- this for a train that will start running post 2030!).

So I'm all for infrastructure, and especially for *maintenance* of existing infrastructure. But don't think it is easy to get the right level of such spend, nor to do it efficiently, picking the highest return projects.
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Re: Pensions, actuaries, and stocks for the long run

Post by Epsilon Delta »

Verde wrote:(perhaps they invested in infrastructure per Epsilon's suggestion and realized too late that what they were doing was equivalent to digging holes and filling them back up. :happy ) but gdp grew at 10% real for 30 years.
You can do anything stupidly, But insisting that anything you don't like must be done stupidly is a straw man argument.
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