The boards should turn to actuaries for
advice on risk management—not only of
investments but also of the governance
process. Risk is one of the areas in
which we work best: measuring risk,
mitigating risk, and managing risk.
NOR TH: I think Jim is dead-on in terms of what actuaries can do.
We have a great controversy underway in the actuarial profession over how to measure things—discounting the obligations
using expected returns on assets or discounting obligations
based on the characteristics of the obligations themselves, often called market value liabilities.
Most retirement boards explicitly take a mismatch risk
between assets and liabilities. It’s because one of the highest
goals of most funds is to deliver benefits at the lowest expected
cost. But the lowest expected cost comes with higher risk. That
sometimes gets lost in traditional actuarial practice because we
show the expected number. But if you provide some of these alternative measures and you talk about their implications, some
of that information jumps out.
There’s controversy at the moment over what information
to report to public plan sponsors. Economists will usually say
that if you have a series of payments that are guaranteed, that
the value of that stream of payments should be discounted at
a Treasury yield rate because that’s a similar guaranteed asset. Actuarial work generally takes that stream of payment and
discounts it by the expected return on the related assets. You
get different numbers and benefit values if the interest rates
for Treasuries are different than the expected return on assets.
Some say providing this information would cause more
harm than good by causing confusion and giving the impression that plans are not as well-off as they really are. I believe
this information is valuable, and it indicates that we understand
completely what is going on with our systems. We understand
how much liability there is and that a point-in-time measurement when interest rates are low and the stock market is low
isn’t the whole story.
KEN T: I agree that actuaries should take into account not only
actuarial science but the science of economics. This measurement of market value of liability is an important concept to
benchmark in a discussion around the amount of risks within
these systems. The confusion arises when those numbers are
then purported to represent the amount that needs to be budgeted and funded. These are large systems that have the ability
to invest in a diversified portfolio of assets generating higher
returns than individuals typically can get. They pool various
individual risks—most significantly, longevity. By taking on some
risk and through pooling of risk, public retirement systems can
offer an efficient means of providing financial security.
The Market Value of Pension Liabilities
RIZZO: The market value of liabilities is what the government
would have to pay to settle its liability of what has accrued so
far. But governments don’t go bankrupt, seldom merge and discharge their pension liabilities. It’s a curiosity number more
than anything else. My problem with making its disclosure
mandatory is that for the very few governments that would ever
settle their liability, we would be forcing governments all across
the country to publish this number that is not relevant to the
operation of these pension funds.
KEN T: When we advise our clients on how much they should
contribute, we’re asked to produce a single number at a single
moment in time. That number is based on a series of expectations in the present and in the future. It’s almost as if there is
a cloud of rational and reasonable numbers and we’re asked to
pull one of the numbers out at any point in time.
This market value of liability is a moment-in-time valuation
based on a very specific assumption. The reality is that these
pension systems are expected to go on for a long time and nobody will know exactly how much they will cost until the last
participant receives the last check.
RIZZO: The market value approach doesn’t care how the pension fund is invested for the future. It doesn’t care if you’re
60/40 stocks/bonds or if you’re entirely in 90-day Treasuries or
you put all the money on Lady B in the eighth race. All it wants
to know is what’s the yield curve look like on the measurement
date. And that’s what the market would demand for that security—if the pension fund were a security.
The conventional approach is the expected fulfillment cost.
This is because the pension fund fulfills its obligation or settles
its obligation—not all at once, but a little at a time over a long
period of time.
What is the cost to taxpayers to settle the pension fund’s
obligation in that fashion? Really good performance in the pension fund, or even expected performance in the pension fund,