Pension Disclosure Can Curb the 'Giant Financial Tapeworm'

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"If something cannot go on forever, it will stop." — Herbert Stein's Law

The recently released "Report of the Blue Ribbon Panel on Public Pension Plan Funding," commissioned by the Society of Actuaries, explains why many state and local government pension funds are underfunded and makes excellent recommendations for improving pension funding and disclosure.

Adopting the panel's recommendations would increase the understanding of pension underfunding and go a long way toward better securing the retirement incomes of government employees.

We'd like to highlight and further explain one of the report's recommendations: "to avoid the undesirable accumulation of unamortized principal, amortization schedules should cover interest on unfunded amounts in full and amortize principal."

Scheduled negative amortization of pension liabilities is very common, can be perpetually increasing and is often unrecognized by many pension stakeholders and municipal market participants.

Under current actuarial and accounting rules, it is perfectly acceptable to create a repayment schedule for an Unfunded Actuarial Accrued Liability, or UAAL, using: (1.) a repayment period as long as 30 years, (2.) an implied rate of interest equal to an assumed earnings rate on fund investments, often around 8%, and (3.) a repayment pattern based on a constant percentage of assumed payroll which is often assumed to be increasing at 2% to 4% each year.

Amortizing an unfunded pension liability over 30 years at an 8% interest rate on a "level percentage of payroll basis" in which the payroll is assumed to increase 3% each year mathematically results in 10 years of negative amortization.

At the end of those 10 years the liability has grown by about 8.5% even if the government has been fully funding its Annual Required Contribution, or ARC, and all other actuarial assumptions are fully met. The unfunded liability is not reduced below the beginning amount until the 19th year.

Negative amortization of pension liabilities is analogous to the "NegAm" home mortgage structures, including graduated payment and deferred interest mortgages, which are often implicated as part of the financial engineering that helped fuel the housing price bubble leading up to the Great Recession.

The "open amortization" actuarial methodology permits the unfunded liability to be reamortized over a new 30-year period with each new actuarial study, resetting the clock to the beginning of the 10-year period of negative amortization each time.

So while each study, as a snapshot in time, can state the liability would ultimately be repaid if that year's repayment schedule is adhered to, really only the first year's payment, which may only partially cover accrued interest, is captured in the ARC.

Even for plans that do not use open amortization, periodic ad-hoc resetting of actuarial assumptions, which is very common, can also result in continuing negative amortization. Over a 30-year period, combining open amortization with a level percentage of pay methodology can result in the unfunded liability stealthily increasing by 50% even if the government has dutifully made its ARC payment each year and every other actuarial assumption is realized.

Open amortization is like annually refinancing into a new 30-year mortgage and increasing the loan balance in each refinancing to pay the first year's principal and part of the interest.

Contradicting the literal meaning of the word "Required," most governments are not required to fund their ARC. Governments' pension-funding requirements may be set by state law, by contract between the government and the pension fund, by union agreement or simply as a decision to be made each year in the budget process.

Governments that fully fund their ARC receive the golden seal of approval from the rating agencies and budgetary watch groups for meeting their fiscal obligations. It is assumed that with the passage of time, and a bit of investment and actuarial luck, everything will work out for both retirees and the sponsoring governments.

Few market participants seem to realize that funding of the ARC can result in a significant period of negative amortization and, if the liability is periodically reamortized, that negative amortization can continue indefinitely. It cannot, however, continue forever.

Under the new accounting rules for governmental pensions, Governmental Accounting Standards Board 67 and 68, there will no longer be a requirement to calculate an ARC. Those plans for which contributions from the sponsoring government are based on an actuarial-based methodology will be required to report an Actuarially Determined Contribution, or ADC, and the assumptions used in its calculation.

The plans that receive contributions based on statutory requirements will not be required to calculate an ARC or ADC. These new accounting rules will become fully effective for fiscal years beginning after June 15, 2014.

Official statements fully disclose the repayment schedule for bond indebtedness, often showing annual principal and interest requirements to the dollar. In stark contrast, the assumed repayment patterns of pension liabilities, which for many governments are larger than their bonded indebtedness, are very rarely disclosed in official statements beyond stating the assumptions used in creating a repayment schedule and the calculated amount for the first year as part of the ARC.

Amazingly, as you dig down deeper from bond disclosure to the government's annual report, to the pension fund's annual report, and then to the actuarial study, in most cases you will never find a pension- liability repayment schedule.

We would like to add the scheduled payment pattern of unfunded pension liabilities to the list of additional disclosures recommended by the Blue Ribbon Panel. Including the scheduled repayment plan, broken into implied principal and interest and with full disclosure of the effects of periodic reamortization, in pension fund reports and issuers' official statements, would give all stakeholders greater clarity as to whether the unfunded liability is being repaid or is literally compounding into an ever greater problem.

"The use of 29-year [Police and Firemen's Retirement System] (PFRS) and 30-year (GRS) amortization periods for funding UAAL — which is applied anew each year to the full amount of unfunded liability — that allows unfunded liabilities to continue to grow rapidly as a result of compounding."

The quote above is from page five of Detroit's Plan of Adjustment filed in bankruptcy court on Feb. 21, 2014. Pension amortization practices are listed as one of three reasons Detroit underreported its Retirement Systems liabilities, but those practices were also one of the reasons the city's pension liability ballooned over time.

Improved pension disclosure is not a panacea for the widespread problem of pension underfunding, but better disclosure would give stakeholders a better chance of understanding and controlling what Warren Buffet recently called the "giant financial tapeworm" on the balance sheets of many state and local governments.

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