Who Wants to See Their State Go Broke?

Few people would raise their hands when asked that question. But actually putting a state’s financing on sound footing is difficult in practice. That makes Rhode ‘s Island’s pension reform not only unique, but also a good example for other states to consider.  Rhode Island got not only the policy, but also the politics right, according to Drew University political science professor Patrick McGuinn in a new Brookings Institution study.

In other words, how pension reform is accomplished is as important as what the reforms entail. In his study, McGuinn offers some sound principles on the politics — the “how” — of pension reform. Another new study, commissioned by the Society of Actuaries (SOA), offers some basic principles on the policy — the “what”.

First, the policy.

The Society of Actuaries’ study outlines three basic principles for funding pensions and measuring the risks pension funds face:

1) Adequacy, which the study’s authors define “as being achieved when future annual contributions, together with existing assets, are sufficient to pay promised benefits over a wide range of future economic outcomes and employee salary and service experience.”

In practice, this means that funding should at a minimum provide for benefits if the median expected future investment conditions occur. By focusing on the median expected outcomes, the adequacy concept considers both return volatility and those scenarios in which investment return assumptions are not realized. …

Adequacy also means that the sponsor should have the resilience and flexibility to respond to conditions significantly more or less favorable than expected.

2) Maintenance of intergenerational equity, or in other words, not passing the bill to future generations.

In practice, the goal of intergenerational equity may be furthered by paying the costs of pension benefits over the employees’ working lifetime.

That’s easier said than done, as long as pension funds remain vulnerable to politicians’ temptation to promise generous benefits to their union supporters while passing the bill to someone else.

3) Cost stability and predictability, a lower priority than adequacy and intergenerational equity, essentially boils down to avoiding overly risky assets that, while they can boost returns, can also lead to unusually large losses.

The report offers some detail on how to enact reforms along these principles, which would take to long to outline here, but two, regarding discount rates and asset smoothing, merit special attention.

Discount rates: A major factor in pension shortfalls are discount rates based on overly optimistic investment return projections, often in the 7 to 8 percent range. While such returns are achievable, discount rates should reflect returns that are achievable year-on-year, as liabilities — pension payout obligations — continue growing without interruption.

In the end, the [Blue Ribbbon] Panel reached a consensus that while ”adjusted past returns” offer a common and useful reference point, the rate-of-return assumption should be more heavily based on use of the current risk-free rate plus explicit risk premia, or other forward-looking methods.

Such a risk-free rate should be closer to the rate of return of 10- to 20-year Treasury bonds, in the 3 to 4 percent range.

Smoothing: Smoothing is supposed to help investment managers manage risk volatility by “smoothing” out large short-term gains or losses over a longer period. However, overly long smoothing periods can lead to huge distortions.

Therefore, the SOA study recommends that smoothing periods not exceed five years, and that pension actuaries adopt a direct rate smoothing method that allows pension managers to better budget contributions (see pp. 29-30).

In the next post, the politics.