by Richard Dreyfuss
What is a defined benefit pension plan?
A defined-benefit (DB) pension plan provides formula-based monthly benefits to qualifying members at retirement.
The technical term for these benefit payments is an “annuity”.
Generally, members are required to contribute a fixed percentage of their pay to participate in the plan.
Annual employer (taxpayer) contributions are actuarially determined. Such calculations are based upon future assumptions including an expected return-on-assets, longevity, annual salary increases and dates of retirement.
To properly finance these expected future benefit payouts requires establishing a financial trust and accumulating sufficient plan assets to meet these expected obligations.
Of important note, the underlying investment risk of the plan’s assets is assumed by the plan.
In most public sector DB plans, the ultimate guarantor of the formula benefit payment is the taxpayer.
The actuarial funding process involves accumulating sufficient assets such that in the aggregate when a member retires, the expected benefit obligations are “fully-funded” or “paid-up”. For illustrative purposes, a plan needs a reserve of about 120 times the monthly pension to support a lifetime payout beginning at age 65.
What is an unfunded liability?
Annually an “actuarial valuation” takes place. This process measures the liabilities accrued by the plan as of a specific date in support of retired and yet-to-be retired members. These expected liabilities are measured in today’s dollars using the actuarial assumptions briefly described above. This “accrued liability” is measured against the “accrued” or accumulated assets. Any shortfall between these two numbers, in technical terms, is the “unfunded liability” (UL). Ideally asset growth should closely track the growth in liabilities.
Unfortunately, some incorrectly believe the unfunded liability is the shortfall which exists based upon the assumption of all members retiring today. From this premise, those same individuals conclude that the UL is some type of theoretical and abstract concept.
What does the debt clock actually represent?
The debt clock is an approximate real-time measurement of the combined ULs of Pennsylvania’s two largest defined benefit pension plans: The Public School Employees’ Retirement System (PSERS) and the State Employees’ Retirement System (SERS).
The debt clock adds interest to the last publicly reported UL from the respective plans. For PSERS and SERS, this annual interest rate is 7.25% and 7.5% respectively.
This debt clock excludes the ULs associated with the many defined-benefit municipal pension plans as well as the many retiree medical plans throughout Pennsylvania.
What are the approximate UL’s of PSERS and SERS?
PSERS last reported figures were based upon the actuarial valuation of 6/30/2016.
SERS last reported figures were based upon the actuarial valuation of 12/31/2015.
PSERS and SERS have assets under management of approximately $50B and $25B respectively. Based upon the market-value of assets as of the valuation dates above, these assets are approximately 50% to 55% of the amounts which should ideally exist in the respective trust accounts.
The UL of PSERS and SERS as of the above valuation dates are approximately $50B and $20B, respectively.
The debt clock adds interest to these figures to approximate the real-time metric of $74B+.
How did we get to this problem?
The unfunded liability is the cumulative result of sustained underfunding, subpar investment returns, retroactive benefit improvements and reduced future asset return expectations
Why is there so much debate over the UL?
The determination of the assumed rate-of-return is subjective at best. To lower this asset expectation, instantly increases the UL. In addition, the plans use asset averaging to determine the value of assets. PSERS and SERS use 10-year and 5-year periods, respectively. This averaging period is determined by respective state laws. Averaging periods are used to reduce volatility in asset values from year-to-year.
Some financial entities such as the Government Accounting Standards Board and credit rating agencies such as Moody’s use the market value of assets in their calculations.
Who determines and approves the assumed rate of return?
The annual assumed rate-of-return is under the purview of the Boards of the respective plans.
When will the ULs begin to decline?
Many are hopeful, this will take place over the next few years as a result of higher and sustained contribution levels coupled with favorable asset returns. Simply stated, the asset values need to increase at a greater rate than the accrued liability.
How can the number be reduced?
The number can only be reduced in three ways:
I. Modifying benefits to current members including retirees – Not being considered.
II. Exceeding asset return expectations – Not viewed as very likely.
III. Making incrementally higher than scheduled annual contributions – A politically problematic proposition.
Of significant note, modifying benefits for yet-to-be hired employees does not by itself increase or decrease the UL since only current members are included in the UL.
What does depletion date mean? When will this occur?
Depletion date occurs when the asset balances in the funds becomes zero. It is impossible to accurately predict if and when such a phenomenon might occur. This is due to the uncertainty regarding future plan experience including: actual employer contributions, benefit payments and investment performance on assets.
Clearly, negative cash flows and asset losses are unfavorable events, just as the prospects of higher contribution levels and superior investment returns are favorable to future fund balances within the plan.
What happens after depletion?
Benefit payments can and should continue as scheduled. However, the respective plan reverts to a pay-as-you-go system with annuities paid out as soon as funds are received. The concept of prefunding is fully-compromised. Given the ever-increasing challenges of the annual budget process at the state and local levels, such a scenario is extremely problematic.
What can I do?
One should request policymakers establish a plan design for new hires which precludes the existence of all politically-problematic UL. This would be a defined contribution plan. Equally important and concurrent to this action are funding reforms which eliminate the existing unfunded liabilities over periods of 20 years or less. This duration is consistent with the average remaining years of the active workforce. These actions would preclude transferring such ULs to the next generation of taxpayers.
What if I have other questions or comments?
Feel free to contact us.