Stanford Study’s Pension Math

Recently, there was a report published titled, Pensions Math: How California’s Retirement Spending is Squeezing the State Budget”. This report was prepared by the Stanford Institute for Economic Policy Research, which is headed up by ex-Assembly Member Joe Nation, and was aimed at the State Retirement System, PERS. There was an opinion piece in the Sacramento Bee which supported the conclusions of the study, and since the report’s conclusions could also apply to our 1937 Act Retirement System, the County Board of Supervisors was interested in the opinion of the SCERS administrator, Richard Stensrud.

The study suggested using a 4 percent rate of return in the actuarial assumptions and not adhering to the GASB (Governmental Accounting Standards Board) standards.  The study’s assumptions would treat public retirement systems the same as private retirement systems. Printed below is the response that Richard Stensrud sent to the Board of supervisors and he has given us permission to share it with SCREA members.

From: Stensrud. Richard
Sent: Tuesday, February 28, 2012 3:30 PM
To: Nottoli. Don; Serna. Phil; Yee. Jimmie; Peters. Susan; MacGlashan. Roberta
Cc: Villanueva. David
Subject: Follow-Up re Stanford Study


David Villanueva suggested that it would be helpful if I provided some follow-up information regarding some of the matters discussed in the recent article concerning the new study by the policy institute affiliated with Stanford. I am happy to do so.

I recognize that the principles and terminology of pension funding are not areas that you deal with on a daily basis, so I will try to avoid getting too technical. I also understand that you are not interested in a treatise on the subject, so I will focus my remarks on a few key subjects. However, I must apologize in advance because some of these subjects will take a little bit of explanation in order to make sense.

Basic Rule of Pension Funding:

The fundamental rule of pension funding is that Contributions plus Investment returns must equal Benefits plus Expenses (C + I = B = E). If investment returns go up, the required contributions go down. Conversely, if investment returns go down, the contributions must go up. This connection between investment returns and contributions will be important when we talk about the recent study.

SCERS’ Financial Health:

Here are some basic facts about SCERS’ financial health:

  • As of June 30, 2011 (the date of the last annual actuarial valuation) SCERS had an 87% funded ratio. Due to the very strong investment performance in the last two fiscal years (13.71% and 23.81%, respectively), SCERS’ assets are back at the level they were prior to the market collapse in 2007 and 2008. In addition, the level of investment losses from 2007 and 2008 that still need to be ‘smoothed’ into the plan has been substantially reduced. If SCERS continues to meet its investment return assumption of 7.75%, it is expected that the plan will switch from smoothing net losses to smoothing net gains as of the June 30, 2016 valuation. And because the over-hang of losses has been significantly reduced, the funded ratio is projected to remain above 84% during this period.
  • Since June of 1986, SCERS has produced an annualized investment return of 8.2%. As a result, 65 to 70 cents of every dollar of benefits SCERS has paid has been provided by investment returns.
  • The level of unfunded liability is not a fixed and certain amount. As suggested above, the investment experience can substantially reduce the amount of unfunded liability that is paid off by employer contributions (taxpayer dollars). Historically, investment earnings by the pension fund have paid off the vast majority of any unfunded liability that might have existed at any point in time at a ratio similar to what investment returns provide toward benefit payments (i.e., 65-70 cents of every dollar).
  • SCERS is one of the strongest pension plans in California: (1) SCERS’ funded status is the 9th highest out of the 24 plans reviewed in the recent study; (2) The employer contribution rate is the 8th lowest; (3) The portion of the employer contributions used to finance unfunded liability is the 5th lowest; (4) The pension plan’s cost as a share of total County expenditures is the 7th lowest; and (5) The average annual growth in pension expenditures is the 7th lowest.

Accounting Rules and Actuarial Standards:

As you will recall, SCERS performs an actuarial valuation as of June 30th every year. SCERS’ current actuary is The Segal Company, one of the largest and most respected actuarial firms in the country. SCERS also has a financial audit performed each year by an independent accounting firm. SCERS’ current auditor is Macias, Gini, which performed annual audits for the County for several years. SCERS’ actuary and auditor are required to adhere to professional standards in performing work for SCERS. They are also required to comply with the financial reporting standards established by the Governmental Accounting Standards Board (GASB). If SCERS did not comply with the GASB provisions, or if SCERS did not follow accepted actuarial standards, the auditor and actuary would refuse to issue their respective reports.

Determining the Liabilities of the Plan:

An important question about the pension plan that public officials and taxpayers want to know is what is the size of the financial obligation to employees and retirees and how much will it cost – today and into the future – to meet that obligation? As suggested by the comments above, SCERS and its professional service providers take this question seriously, and follow the established rules for determining the size of the plan’s liabilities. There are other parties, however, that advocate for a different approach to determining pension liabilities that is grounded in a subset of economic theory. The problem is that the two approaches are different at the most basic and conceptual levels, and answer fundamentally different questions.

The Public Sector Approach:

The approach used by SCERS and its professional service providers is intended to provide information to plan stakeholders about how much money it will cost and over what period of time to satisfy the financial obligation to plan participants. The approach does this by calculating what is called the actuarial accrued liability (AAL), which utilizes both current information and reasonable expectations about future events over the long term, including the future service and pay earned by employees which will increase the plan’s obligations. The approach then incorporates information about past and future investment earnings attributable to the plan’s assets to determine a ‘discount rate’ for calculating the present value of the future benefit payments. Under GASB rules and actuarial standards, the discount rate used to calculate public sector pension liabilities is the long term expected return on the plan’s investment portfolio. In the end, the AAL approach provides information about actual costs to the employer (and ultimately, to the taxpayer) based on the way SCERS actually invests. Or put another way, it provides information about what the C (contributions) will be based on the I (investment returns).

The Private Sector Approach:

The approach advocated by some parties is not focused on the question of pension funding. It is designed to estimate the theoretical market price of a plan’s obligations if all the plan’s participants wanted to replicate their accrued pension benefits by purchasing securities that would provide the same stream of income, or if the employer were to terminate the plan and transfer all benefit obligations to a third party. From this perspective the liabilities should be valued independently of the long term expected return on assets since the question being asked is what is the market’s ‘going price’ today if the benefits are to be provided by fixed income investments and not from long term, diversified invested assets. As a result, this approach uses current returns on fixed income instruments to establish the appropriate discount rate. This approach – often referred to as market value liability (MVL) – was developed to address specific financial and policy concerns faced by private sector companies sponsoring pension plans, in particular, the fact that a private sector employer has the ability to terminate a pension plan and freeze all benefit accruals. In such a case, it is important to have a ‘termination liability’ or ‘settlement value’ that approximates what it would cost to have a third party take over the liabilities. In the end, the MVL approach only provides helpful information about the current market price of a theoretical set of liabilities, and not on what the C (contributions) will need to be given actual and projected I (investment returns).


Why the Private Sector Approach is not Appropriate for Public Sector Plans;

The MVL approach is not appropriate for public sector plans because: (1) It provides little helpful information about what the plan will likely cost, or the financial health of the plan; (2) It is not relevant to public sector plans because public plans are governed by statutes that do not contemplate plan termination (while an employer could decide to switch from a pension plan to a defined contribution plan for new employees, all the employees in the pension plan would continue to accrue more service and their benefits would be based on their compensation at the point of retirement); (3) It does not take into account the ongoing growth in the liabilities due to future service accruals; and (4) With respect to what the plan will actually cost, MVL estimates will be inaccurate at best and misleading at worst because they do not take into account how the assets of the plan will be invested.

Accordingly, since funding costs are the overriding practical concern facing stakeholders, it is clear that the AAL approach provides more qualitative and quantitative information about current and future costs, and a greater understanding of how the plan fits into the employer’s overall financial position.

For these reasons, after more than 3 years of study of whether the MVL approach or the AAL approach should be utilized, GASB and the Actuarial Standards Board (ASB) recently re-affirmed that the discount rate for calculating public sector pension liabilities should be the rate at which plan assets are expected to grow as a result of investment earnings over the long term horizon of the plan – in other words, the AAL approach should be maintained.

Recent Report:

The recent report chose to disregard these legal and operational considerations. It suggested that a 5% discount rate should be used to determine the liabilities rather than the 7.75% long term investment return assumption/discount rate SCERS is required to use. The 5% discount rate was based on the interest rate currently paid on State of California general obligation bonds, and did not take into account the investment returns projected by SCERS’ broadly diversified investment model. By using the lower discount rate, the report suggests that SCERS’ unfunded liability is larger and its funded status lower than the levels produced by the correct methodology. The report then suggests that the risk to taxpayers is being understated and implies that the ‘true’ costs will swamp the County budget.

As illustrated by the discussion above, the report’s findings are flawed, inaccurate and misleading.

It is also worth noting that despite the report’s assertion that the calculation of a plan’s liabilities should be considered separately from what the plan expects to earn, in the end, the implicit premise of the report is that retirement systems will not be able meet their investment return assumptions and therefore higher contributions will be necessary. Yet the report provides no explanation or analysis to support this view. In contrast, SCERS’ actuary and investment consultants review SCERS’ investment return assumption on a regular basis, incorporating a wide range of financial, economic and market factors. It is their view that based on SCERS’ broadly diversified investment program, the 7.75% return assumption is reasonable over the 20-30 year time horizon the assumption is meant to cover.

Finally, I think it is important to put the recent report in the proper context. Normally, one tends to think of something coming out of Stanford as being highly credible. In this case, however, I believe there are certain considerations that should cause a reader to take the findings with a grain of salt. First, the authors are not pension professionals – i.e., they are not pension fund actuaries or accountants, and they have not managed a pension fund. Rather, the authors are economists and their key premise is founded in economic theory. This is not intended to disparage the authors, only to make the point that they are looking at the issues from a theoretical perspective and not from the operational perspective of how and why pension funds work the way they do in real life. The second consideration is related to the first – i.e., the authors do not have the same professional standards, duties and potential liability that falls on the professionals who provide actuarial, accounting and pension fund management services to pension funds. Accordingly, while the authors are free to suggest that something is being done incorrectly, pension professionals have the legal responsibility to carry out their duties in accordance with the law and codes of professional conduct.

In sum, the methodology SCERS uses to determine SCERS’ funded status is consistent with actuarial standards, accounting rules, and fiduciary responsibilities, and reflects the correct assessment of the plan’s funded status under the law.

I apologize again for the length, but I hope this is helpful. Please let me know if you have any questions.



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