Mr. Findlay’s recent tirade (see Academic and Think Tank Hypocrisy In the Public Retirement Arena) against the academic and conservative think tank assault on public employee defined benefit (DB) pension plans displays a lack of understanding about the perils of using expected returns as a discount rate. Attacking expected returns as a discount rate is not an assault on public DB pensions, it is the most important step in putting them on a sustainable footing. Replacing expected returns with something more reasonable – I am fine with either a risk-free rate or a high grade taxable municipal bond rate – is absolutely necessary if public DB plans don’t want to go the way of the Dodo.
Expected rates of return as a discount rate have many problems. Let’s focus on just two of them: First, they create a huge “public” governance problem. Everybody at the negotiation table has an incentive to use the highest possible return assumption. If the financial crisis of 2008 should have taught us anything, it is that governance structures matter a lot. This governance problem lowers the probability that investment managers are able to achieve the expected returns.
Even more important is that higher expected returns push investment managers into riskier strategies. It may come as a surprise to Mr. Findlay that higher return volatility moves expected funding costs away from those implied under a no-volatility assumption. I have recently testified and then presented again to the Governmental Accounting Standards Board (GASB) that expected returns (of “typical well-diversified investment portfolios”) systematically underestimate future pension costs. I can only hope that GASB continues to question its previously stated preference of using expected returns as a discount rate and will finally discard it.
It is true that a risk-free rate may overestimate future pension expenses. Yet if expected returns systematically underestimate them, we have to ask ourselves on which side we rather want to err. Public pension officials worry that a risk-free discount rate would overcharge the current generation of taxpayers. Yet our ignorance of what pension promises really cost led to a situation in which the future generation of taxpayers will have to subsidize the pensions of the current generation without having access to DB pensions themselves.
How to turn good investment returns into bad funding outcomes
Why do we harbor the illusion that expected returns would be a good estimate of future pension expenses? Because we learn the wrong lessons from the past by looking at the wrong return measure! We focus on time-weighted rates of return whereas the correct funding cost measure is a money-weighted return. The National Association of State Retirement Administrators (NASRA), for instance, claims that taxpayer dollars were saved over the last 25 years since the realized return of 9.25% for most public plans exceeded the assumed rate of return of 8%. No such statement can be made from time-weighted average returns. Most likely, the opposite is true. DB pensions are an example where the differences between time- and money-weighted returns can be huge and systematically biased in one direction.
Money-weighted returns are path-dependent on the specific sequence with which a time-weighted return is achieved. Above average returns early on tend to increase the final money-weighted return while initial below-average returns decrease them. Note that NASRA has to go back 25 years to boast the impressive average return of 9.25%. But this is the good scenario! Public pensions should be healthily overfunded by now. Yet they are not because money-weighted rates of return are co-determined by average investment returns and stakeholder behaviors. Minimum funding policies, contribution holidays, deferring of necessary contributions through asset- and liability smoothing – all those actions shift the distribution of money-weighted returns downwards. And so do benefit increases when plans are temporarily overfunded. Expected returns know nothing about these behaviors and are thus too optimistic about future pension expenses.
Investment strategies that aim for higher expected returns require large funding cushions in good economic times. Temporary funding surpluses, however, are often converted into permanent benefit increases. When underfunded, ongoing liability payments subject DB plans to reverse dollar cost averaging, a well-known effect in individual retirement planning, yet largely ignored in the institutional DB world. We need to realize that profiting from an eventual risk premium is not an automatism. Most plan sponsors in the US – and public plan sponsors more so than their corporate peers – violate the requirements to convert an eventual risk premium into lower funding costs. To do so, they need to keep their plans, on average, fully funded.
Bad Asset Allocations – Or the Hypocrisy that Wasn’t
All these mechanisms require vastly different asset allocations for DB plans than for 401(k) plans. So the scolded academics and critics of DB plans may very well have asset allocations in their 401(k) that they rightly criticize as totally inappropriate for DB pension plans.
I also presented to GASB how the well-known risk-reward trade-off known from the Capital Asset Pricing Model (CAPM) can turn into a risk-penalty relationship for DB pension plans. When converting the single-period CAPM model into a multi-period model, much lower allocations to return seeking assets are the result.
Transparency and financial support
I want to stress that unlike Mr. Findlay, who may be retired by the time the public pension debacle enters its final stage, and unlike NASRA, which may find out that they are equally happy to represent state DC plans, my firm is dependent on the continued existence of DB plans. I therefore consider myself immune towards the accusation of having the sinister agenda of getting rid of DB pension plans. My opposition to expected returns as discount rates is born out of concern for the long-term viability of DB pension plans.
If we lack a good estimate of future pension expenses and systematically underestimate them, what is likely to happen to public DB plans? Employees will continue to overdemand, lawmakers will continue to overpromise, and investment managers will continue to underdeliver.
I believe that the biggest threat to public DB pensions does not come from academics, conservative think thanks and taxpayer organizations. The biggest threat comes from NASRA and all others who are interested in keeping the current status quo. Economic reality will catch up to public pension officials and their continued reluctance to material changes in pension accounting will eventually lead to a triumph of those who are determined to end public DB plans.
- Dr. Norman Ehrentreich, Ehrentreich LDI Consulting & Research
Dr. Ehrentreich specializes on providing consulting services on liability driven investment (LDI) strategies to DB plan sponsors, investment managers, and other consulting firms. He founded his consulting company in 2009 in an attempt to foster the adoption of LDI strategies among corporate and public pension plans.