Bad Rules Have Led to Big Pension Problems

Published March 1, 2006

Ron Ryan is founder and chairman of Ryan ALM, Inc., an asset/liability management company in New York City that is nationally known for its pension fund consulting. Before founding the company in 2004, Ryan ran Ryan Labs, which specialized in solving financial problems through low-risk solutions. Before then, Ryan served as director of research at Lehman Bros., where he designed many of the popular Lehman bond indices that have become the key fixed-income benchmarks for asset management today.
Ryan recently spoke with Steve Stanek, managing editor of Budget & Tax News, about the nation’s public employee pensions.

Stanek: How do you size up the government pension situation?

Ryan: It’s almost criminal. We’re going to have cities going bankrupt, a lot of it due to bad rules, which give bad results. That’s the theme: Bad rules lead to bad things. We have bad accounting and reporting rules, and pensions have behaved accordingly.

Stanek: Can you give some examples?

Ryan: Take the corporate side first. They’re under FASB, the Financial Accounting Standards Board. Corporations want to do anything that enhances earnings. Pensions hurt earnings. The offset is returns on pension assets. FASB allows corporations to forecast the return a year in advance. So they try to forecast a return that minimizes or wipes out the pension expense.

When they forecast a return on assets–say 9 percent–that return must be validated by the auditors. The way companies do that is to tell pension consultants they must come up with an asset allocation that suggests they can earn that 9 percent. They are allowed to use historical averages for everything except bonds, where they must use current returns. As a result, since the late 1980s allocations have been going less and less to bonds. When the stock market correction hit in 2000 and 2002, there was one of the highest allocations to equities in modern history.

But there is more. The asset side is not marked to market. It is smoothed over five years. This distorts the true economic value of assets. Imagine a bank not telling you your current balance, but your average balance over five years. Could you write a check on that? Smoothing overstated assets by 27 percent at the end of 2004, by 44 percent by the end of 2003, and by 63 percent at the end of 2002. Fortunately, for 2005 smoothing overstates assets by only 7 percent.

Now to the liability side. This is not marked to market either. What they do there is price liabilities at one interest rate. Not only is it a flat yield curve, it is a yield much higher than market. The higher the interest rate they use, the lower the present value of liabilities. For corporations, we’ve calculated a 10 to 15 percent error. When you add assets that are overstated and liabilities that are understated, the funded ratio naturally is way off.

Stanek: What about public plans?

Ryan: Here we’ll find the worst pension situation of them all. Why? Because we’re going to price liabilities at a return-on-assets assumption. If you think the asset side is going to grow at 8 percent, you’re going to use that same rate to price liabilities. Corporations are using a rate of 6 percent; public pensions are in the neighborhood of 8 percent.

To show the error, take the discount rate on liabilities and compare that to the market. The market is the Treasury bond yield curve, which is about 4.5 percent. Calculate the difference, multiply that by 10 to 15 years, and you get 30 to 45 percent understated liabilities. The funding ratio for public plans is 30 to 45 percent off. If they thought they were fully funded, they’re really maybe 70 percent funded. Most of them admit a deficit. Subtract another 30 to 45 percent off whatever deficit they admit.

Stanek: So what does this mean for the plans?

Ryan: If you thought your plan was fully funded, you might increase benefits, right? That’s what every public plan did. We need a rule that public pension funds cannot increase benefits if they are underfunded on a true economic basis. In the late 1990s they thought they had a surplus, so they increased benefits at a time when they really didn’t have a surplus, but according to the rules they did.

It’s the rules that led them to this. I’ve never heard anybody talk about this. It’s because of smoothing, the discount rate being wrong, and increasing benefits when they can’t afford it.

Stanek: So what’s the solution?

Ryan: Until you mark to market, you will never know the truth. Financial lies should not be tolerated in America any more. Fortunately, the rules have changed in Europe. FASB looks like it’s going to get rid of smoothing [in the United States], so corporations will begin marking to market.

GASB [Governmental Accounting Standards Board, which sets accounting and reporting rules for government entities] is going to be slow to do this. We’re going to have cities going bankrupt. San Diego, one of the nation’s largest cities, is on the verge because of its pensions.

Some places, like Illinois, have issued pension obligation bonds and put the proceeds into equities hoping for fast gains. This might work, but they made a bet that equities will grow faster than liabilities.

Stanek: Can’t actuaries figure out how much liabilities will be and how much money they need to put away to cover them?

Ryan: They can, but it doesn’t happen. You never hear of lotteries having a problem. They match assets and liabilities to market and go to bed. Pensions don’t focus on the objective, which is to meet the liabilities. It’s not to beat the S&P 500 or some other index. It’s to meet the liabilities, but too many pension funds tell their asset managers to outperform the market.

Las Vegas has built an empire on the principle that people play till they lose. If you beat your liabilities, you should take your chips off the table. In the late 1990s equities won big. Instead of taking their chips off the table, the pension funds kept betting. When the correction came, they lost everything they gained, and they had increased liabilities because of their pension sweeteners.

It’s so sad that we have corporations going bankrupt, and cities and states borrowing money, and budgets that are being crushed by pension obligations. Most people don’t have any idea how these things compound over time.

There is some good news. Interest rates are at the lowest levels in 40 years on the long end. That would suggest non-bond assets have a good chance to win the game, if given time. Many people believe interest rates will go up. If that happens, then liabilities will go down in present value. If interest rates go up in the next three years, and the present value of liabilities goes down, and the non-bond assets do well, they might catch up a lot. But these are all ifs.

Steve Stanek ([email protected]) is managing editor of Budget & Tax News.