The Panhellenic Conference on the Retirement Systems of Public Employees A report titled “Measuring the Public Health of Pensions: New Metrics, New Approaches” was recently released, which introduces new mechanisms for calculating and evaluating the sustainability of pension plans.
To create them, the report’s author, Tom Sgouros, a fellow and co-chair at The Policy Lab at Brown University, formed and hosted the Pension Accounting Task Force, a group of actuaries and public pension experts. The team came together to measure the health of plans and create new metrics to generate more knowledge about a pension’s sustainability so administrators and policymakers can make better, more informed decisions.
The task force came up with three new measurements. The first is the “scaled liability”, a measure of pension liabilities relative to the size of the underlying supporting economy. The second is the “unfunded actuarial liability (UAL) stabilization payment,” an objectively determined model of cash flow policy comparable to the funding ratio. And last is “risk-weighted asset values,” a method for assessing the value of a plan’s assets that represents a plan’s ability to withstand the downside risk it has taken on through its asset allocation.
The scaled measurement of liability uses financial strength as a proxy for tax capacity. This metric helps decision makers understand a plan’s viability by providing a comparison between a pension plan and its sponsor’s financial strength. The Federal Reserve includes a comparison of the net pension liability with measures of GDP and government revenue in the “Improved Financial Accounts” section of its “Financial Accounts of the United States” report.
However, instead of using state revenue or GDP, the liability scaling uses total taxable resources, published by the Treasury Department, at the state level, and cash income, published by the Census Bureau, at the county and city level.
The trajectory of raw liability growth in the plans looks dizzying, but compared to a percentage of personal income in an existing economy, liability growth looks much less dramatic, as income has grown as fast as liabilities.
The task force concluded that a standardized accounting of taxable capacity was a logical step for the future of plan reporting, but that using total taxable resources at the state level may not be appropriate for states that do not impose property or income taxes and use cash income as a metric for cities and counties may similarly be inaccurate as a standardized metric due to the lack of income taxes in some jurisdictions.
The UAL stabilization payment represents how large a payment must be to put a pension plan in the same funding position, or condition, at the end of the year as it was at the beginning. This metric focuses on a plan’s cash flow estimates rather than a ratio derived from a plan’s balance sheet.
The sponsor payment necessary to maintain a plan in its current financial position 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 “footprint” payment level metric used by Moody’s Investors Service and to a concept recently introduced by Standard & Poor’s to assess pension health called “minimum funding progress.”
Research using the UAL stabilization payment found that in plans where contributions were lower than the stabilization payment, the plan experienced a decline in funding ratio. In plans where contributions exceeded the stabilization payment, funding ratios increased. However, when both stabilization payment levels and contribution levels rose, the funding ratio fell.
In a webinar hosted by the National Institute for Retirement Security discussing the report, author Sgouros said, “No number means anything by itself — you have to compare it to something else to create meaning.” The UAL stabilization payment is an objectively determined cash flow ratio that can be easily compared to the funding ratio. “It’s a useful metric for measuring policy, but not for judging whether policy is good or bad,” Sgouros said.
The last proposed new accounting procedure, asset weighting, is used to measure the sustainability of a pension plan with more complete data. However, most pension funds measure their performance on a risk-free basis. The risk weighting method is not used for financing purposes, but rather as a mechanism for comparing a plan to other plans over the years.
Hedging assets may be more suitable for schemes than a stress test, which mainly measures the impact of short-term stressors, even though a pension fund’s liabilities are often very long-term. Risk-weighting a plan’s assets “may be a more direct and intuitive way to evaluate a plan than a simple stress test, although stress simulations are a very important part of modeling a plan’s viability,” Sgouros said.
Risk-weighted assets are not the norm in pension accounting, although they are commonplace in the banking sector and are mandated by the Basel Committee on Banking Supervision, where certain assets on bank balance sheets can be discounted up to 100%.
The NIRS report says that for pension plans, the ability to withstand and take on risk depends on a plan’s cash flow. “If you have a plan and are cash flow positive, you can afford to take risk on your investment. Therefore, one could use cash flow projections to gauge how much risk a project can take,” Sgouros said.
The method uses variables to discount the value of an asset with a weighting that is interpolated between a short-term standard deviation and a long-term one, according to the project’s cash flows. A positive cash flow schedule would use the long term discount and a negative cash flow schedule would use the short term.
The methodology behind the measurement is that a plan with positive cash flows can afford to wait out a temporary downturn or momentary loss in value of an asset, while a plan with significant negative cash flows can be forced to liquidate a declining asset.
Accounting for pension schemes is a complex endeavour. Money flows in through payments and investments and flows out through benefits and expenses. “What makes a pension fund is not the underlying assets or liabilities, but the strength of the plan from the plan sponsor,” Sgouros said.
Innovation in the reporting process and in plan evaluation methods and metrics is critical to better decision making for managers and policy makers. “The pensions themselves were an innovation – an actuarially funded sum of money for retirement was a life-changing innovation,” Sgouros said. “It is underrated how the democratization of finance in the 20th century improved the world. It improved the world as much as aviation, refrigeration, or railroads.”
Tags: National Pension Insurance Institute, pension liabilities, public pension funds, Tom Sgouros