this National Public Employees Pension Systems Conference recently published a report entitled “Measuring Public Retirement Health: New Metrics, New Approaches” that introduces new mechanisms to account for and judge the sustainability of pension plans.
To create these, report author Tom Sgouros, member and co-chair of the Brown University Policy Lab, founded and hosted the Pension Accounting Working Group, a group of actuaries and public pension experts. The group came together to create new metrics to measure the soundness of plans and create more insight into pension sustainability so trustees and policymakers can make better and more informed decisions.
The study group found three new metrics. The first is ‘scale liability’, which is a measure of pension obligations against the size of the underlying supporting economy. The second is the “unfunded actuarial obligation (UAL) stabilization payment,” an objectively defined cash flow policy standard comparable to the funding rate. And finally, “risk-weighted asset values” is a method of assessing the value of a plan’s assets, describing its capacity to withstand the downside risk that a plan receives through the allocation of its assets.
Scale debt measurement uses economic power as a proxy for tax capacity. This metric provides a comparison between a retirement plan and its sponsor’s economic strength, helping decision makers read about a plan’s sustainability. The Federal Reserve includes a comparison of the net retirement obligation with measures of GDP and government revenues in the “Enhanced Financial Accounts” component of its “Financial Accounts of the United States” report.
However, instead of using state revenues or GDP, scaled debt measurement uses total taxable resources published by the Treasury Department at the state level and money income issued by the Census Bureau at the county and city level.
The trajectory of raw growth of liabilities in plans looks dizzying, but compared to the percentage of personal income in an existing economy, the growth of liabilities looks much less dramatic as income grows as quickly as liabilities.
The working group concluded that standard accounting for taxable capacity is a logical step for the future of plan reporting, but using total taxable resources at the state level may not be appropriate for states that do not impose estate or income taxes and use money income. As a metric for cities and counties, it may be similarly flawed as a standard metric in some jurisdictions due to a lack of income tax.
The UAL stabilization payout represents how large a payout must be to put a retirement plan in the same funding position or condition as at the beginning of the year. This measurement focuses on the cash flow aspects of a plan, rather than a ratio derived from a plan’s balance sheet.
The sponsor payment required to maintain a plan in its current financial condition can be a leading indicator of changes in plan policy and underlying conditions, as well as a useful measure of risk exposure for a plan sponsor.
This metric is similar to the “tread water” payment level metric used by Moody’s Investors Service and the “minimum financing progress” concept recently introduced by Standard & Poor’s to assess retirement health.
Studies using the UAL stabilization payment have revealed a decrease in the funding rate for plans where the contributions are below the stabilization payment. Funding rates increased in schemes where contributions exceeded the stabilization payment. However, when there was an increase in both stabilization payments and contributions, the funding rate fell.
“No number stands for anything by itself — you have to compare it to something else to make sense,” said author Sgouros at a webinar held by the National Institute for Pension Security discussing the report. The UAL-stabilization payment is an objectively definable cash flow rate that is easily comparable to the funding rate. “It’s a useful standard of measurement for measuring policy, but not for judging whether policy is good or bad,” Sgouros said.
The most recently proposed new accounting procedure, risk-weighted asset values, is used to measure the sustainability of a pension plan with more complete data. However, most pension funds measure their returns risk-free. The risk-weighting method is not used for any funding purpose, but rather as a mechanism to compare a plan to other plans over the past few years.
Risk-weighted assets may be more appropriate for plans than a stress test, which often measures the impact of short-term stressors, even though a pension fund’s liabilities are often very long-term. “While stress tests are a crucial part of modeling the sustainability of a plan, risk-weighting a plan’s assets can be a more direct and intuitive way to evaluate a plan than a simple stress test,” said Sgouros.
Although risk-weighted assets are common in banking and mandated by the Basel Committee on Banking Supervision that some assets on bank balance sheets can be discounted up to 100%, they are not the norm in pension plan accounting.
The NIRS report says that for retirement plans, the ability to withstand and take risks depends on a plan’s cash flow. “If you’re a planner and your cash flow is positive, you can afford to take risks in your investment. Therefore, cash flow projections can be used to gauge how much risk a plan can take,” said Sgouros.
The method uses variables to discount the value of an asset relative to the plan’s cash flow by a weight that is interpolated between the short-term standard deviation and the long-term standard deviation. A positive cash flow plan uses the long term discount and a negative cash flow plan uses the short term one.
The methodology behind the metric is that a plan with positive cash flows can afford to anticipate a temporary setback or momentary depreciation of an asset, while a plan with significantly negative cash flows may be forced to liquidate an asset during a downturn.
Accounting for pension systems is a complex endeavor; money enters through payments and investments and leaves through benefits and expenses. “What makes up a pension fund is the strength of the plan sponsor’s plan, not the underlying assets or liabilities,” Sgouros said.
Refreshing the reporting process and plan evaluation methods and criteria is crucial for trustees and policy makers to make better decisions. “Pensions themselves were a novelty—a sum of actuarially funded money for retirement was an innovation that made lives better,” Sgouros said. “20. It is exaggerated how the democratization of finance in the 21st century has improved the world. It has improved the world as much as aviation, refrigeration, or railways.”
Tags: National Institute for Pension Security, pension obligations, public pension funds, Tom Sgouros