Inadequate Actuarial Work meets Underfunded Pensions and Poor Journalism – WP Guest

*Tia Goss Sawhney, DrPH, FSA, MAAA*

This article is in response to a recent article in the Forest Park Review, Police and fire pensions in the healthy zone, BGA report: Relative to neighbors, Forest Park funding above average [1] and the rebuttal article in WirePoints, Bad Pensions Meet Bad Journalism: An Example and a Lesson [2]. With one minor exception, discussed below, the WirePoints article presented a good analysis of the health of Forest Park’s pensions using the information readily available to the public. Unfortunately the information readily available to the public is limited with respect to both quantity and quality and actuaries, my professional organizations and peers, are responsible for a portion of the inadequacy. Unfortunately, the outlook for too many pensions only worsens with better actuarial work and more transparency.

The WirePoints article observes that, with respect to Forest Park, in spite of “pretty good returns” the “dollar total of its pensions’ unfunded liability has increased in each of the last two years.” Unfunded liability increases can occur under four circumstances:

1)     the total contributions made to the plan are less than the plans’ current year costs (actuaries call this amount the “normal cost”) and the interest on the unfunded liability (where the interest rate is the assumed asset return rate),

2)     the assumed asset return rate is not met,

3)     other assumptions (mortality, retirements, etc.) are not met, and/or

4)     the actuarial methods or assumptions change.

Circumstance #1 is just like your credit card: if you don’t pay your new charges and the interest on your balance, your balance grows. Likewise, think of the pension contribution that the actuary calculates as the pension “bill”, analogous to your credit card bill. Shouldn’t the bill calculated by the actuary always be at least adequate to cover the normal cost and the interest on the unfunded liability? And, if it is not, shouldn’t the actuary have to provide a BIG BOLD NOTICE that making a payment in full will still increase the liability? Shouldn’t the actuary also have to disclose when the unfunded liability amortization method and assumptions to be used for calculating future bills will contribute to liability increases – a situation know as negative amortization? Under current actuarial standards [3] the answer to all three questions is no. For a poignant example, please see the June 2013 Actuarial Valuation for Illinois’ Teacher’s Retirement System [4]. The recommended actuarial contributions is $1 billion less than the normal cost plus interest on the unfunded liability.

Unfortunately, sometimes municipalities don’t pay their bill in full. When that happens with your credit card, you get a notice of delinquency in big red letters and the delinquency haunts your credit report for years – available to anyone who is concerned about your reliability with respect to future bills. Shouldn’t pension plan underpayments be disclosed to stakeholders via some combination of prominent notice within the actuarial reports and the comprehensive annual financial report (CAFR)? Under the current actuarial standards the actuary has no obligation to disclose the impact of past underpayments and, as far as I know, there is no requirement for the municipality to make a disclosure within the CAFR.

Circumstances #2 and #3 might be construed as bad luck. And sometimes they are — we live in an uncertain world and any forward looking assumption is destined to be wrong. There are, however, assumptions that more closely resemble the best estimate of what will likely happen with conservatism for what might go wrong [6] and those that more closely resemble what we would like to happen. Pension assumptions often more closely resemble what we would like to happen because that reduces the apparent cost of the plans – there is political incentive to use favorably biased assumptions. Assumptions, however, are only future looking. Each year assumptions that are not met get rolled into the unfunded liability. Therefore, each year that actual plan experience is not as favorable as the assumptions, the unfunded plan liability grows. Biased assumptions simply shift the pension bill to the future; they don’t reduce the ultimate bill.

There is reason to believe that Illinois pension assumptions are biased. Let’s start with the Forest Park Police Plan. In order to calculate the tax levy (“bill”) for fiscal year 2013, Forest Park’s actuary assumed a 7.5% asset return and a mortality rate equal to the 1971 Group Mortality Table with no allowance for the mortality improvements observed since 1971 or the improvements likely for the future. Furthermore, he made no apparent assumptions for service related deaths or disabilities, even though there are distinct benefits associated with service related deaths and disabilities [5],[6]. In evaluating the 7.5% assumed asset return, consider that, by law, Forest Park can only invest 55% in non-cash and bond investments [7].

Would you feel comfortable assuming that you can pay yourself a guaranteed retirement benefit based on an assumed 7.5% return on your personal investment portfolio? Then why should Forest Park? What is Forest Park’s plan for “making up the difference” when they experience long-term rates of return less than 7.5%, mortality rates less than 1971 rates, and service-related deaths and disabilities and as a consequence the unfunded plan liability grows?

Actuarial standards require actuaries to make a disclosure when the actuary feels that plan assumptions are unreasonable. “Reasonable” however covers a relatively wide range of possible assumptions, including assumptions that have less than 50% chance of favorably materializing. An actuary is not required to express any opinion or do any analysis relative to the ability of a plan or plan sponsor to absorb the risk of the assumptions not favorably materializing. Guaranteed benefits are being funded via risky investments without consideration of what will happen if the underlying assumptions are not met.

In all fairness, Forest Park is an extreme example of questionable actuarial work (though its reported unfunded liabilities on a percentage basis are pretty typical for Illinois municipal pensions). Based on a review of his work for seven Illinois police funds I filed an Actuarial Board of Counseling and Discipline (ABCD) report against their actuary, Mr. Timothy Sharpe [8]. My complaint is with respect to both assumptions and the overall quality of his actuarial communication. The complaint, filed in March, remains under investigation.

The general issue with assumptions, however, is common to many public pension plans and actuaries. Only in the last few months have Illinois’ biggest state plans TRS, SERS, and SURS reduced their assumed returns to 7.5%, and 7.25% respectively. Until then each plan was 0.5% higher [9]. I reviewed the work submitted by the SERS actuaries in making their recommendations for new assumptions. Based on future projections provided to them by unnamed sources, the actuaries calculated that the plan has a 42% chance of obtaining a 7.25% return over the next 30 years. Contrary to popular notion all things do not necessarily work out in the long term, even with respect to a large, diversified portfolio. The SERS actuaries also claimed that there was no need to incorporate both mortality improvements and margin into their recommended mortality assumptions [10].

The WirePoints article observes that nobody is really saying how much towns and cities will have to pay to hit their actuarially required contributions over the next five years. That’s true. The State of Illinois only requires actuaries to calculate fire and police pension tax levies (“bills”) for the current year [6].   Public plan actuaries are required to do only the work requested by the organization hiring them. Therefore a municipality that does not ask for more than the statutory minimum may well get only the minimum. Such is the case for Forest Park and many other municipalities.

Although plan trustees may ask to be educated and some actuaries volunteer to educate, actuaries also have no pro-active duty to educate beyond the disclosures required to be in compliance with actuarial standards. Therefore and actuary when asked to calculate an amortization schedule that gets a municipality to 90% funding over a period of decades, including a period of negative amortization, is not obligated to say “the Academy of Actuaries recommends 100% funding over a shorter term” and explain why. Likewise the actuary is not obligated to educate pension trustees about exacerbated challenges posed by the underfunding of “mature plans” (plans with a high proportion of retirees) as compared to less mature plans.

Changes in actuarial methods and assumptions are the #4 circumstance that can cause unfunded liabilities. Sometimes changes are necessary. What we estimated a number of years ago with respect to the next several decades is not necessarily what we now estimate with respect to the next several decades. The communication around change, however, may well be inadequate. Actuarial standards generally require actuaries to describe but not quantify the impact of changes in methods and assumptions. Under standards soon to be in effect, actuaries don’t even need to describe changes in methods if the change in method is statutorily required ([3] — ASOP 4).

Finally, as I said at the beginning and alluded to elsewhere in this discussion, I want to emphasize that actuaries are responsible for only a portion of the public plan information inadequacy. Municipalities and the state government bear responsible for another portion. The State mandates and recommends actuarial methods that delay the scheduled payment of unfunded liability, sometimes triggering negative amortization. Because of lack of financial sophistication or because they don’t want to hear the answers, the municipalities don’t ask enough of the actuaries. Neither the State nor the municipalities release all of the plan actuarial work — they inconsistently post actuarial work to their websites and inconsistently respond to Freedom of Information Act Requests. Finally, the State and municipalities very seldom release the detailed participant-level plan data necessary for a third party actuary to perform independent calculations even though the necessary information could be released without revealing the identity of individual participants.

I have prepared this article as part of an ongoing advocacy effort to encourage the actuarial profession to set and enforce higher standards for public pension plan actuarial work. I recently authored an article “Putting the ‘Public’ in Public Plan Actuarial Work” that discusses where I feel that actuarial standards and discipline fall short [11]. I believe that the public should have more and higher quality actuarially-produced information available in order to better understand the financial (ill-)health of many public pension plans.

The Actuarial Standards Board (ASB) is actively considering changes to actuarial standards. As such, they are offering an unprecedented opportunity for public comment. If any reader of this article, irrespective of whether the reader agrees with me with respect to a particular issue or not, has an opinion regarding actuarial standards, I urge you to submit your comments to the ASB by the November 15 deadline. See the citation below for instructions as to how to do so [12]. Especially if you are not an actuary, you are not expected to know the intricacies of the current actuarial standards of practice. It is sufficient for stakeholders to articulately describe their perspective regarding today’s actuarial work. The ASB can then figure out how the perspectives relate to the standards.

Involved stakeholders can effect change! (Silent ones don’t.)

*Dr. Sawhney is a qualified health insurance actuary employed by the Illinois Department of Healthcare and Family Services. As such, she is an active participant in the State Employees’ Retirement System (SERS), another highly underfunded Illinois plan.

The opinions expressed are solely her own. She has produced them on personal time and equipment. While she is an actuary and Illinois public pension stakeholder, she is not a pension actuary. She may be reached at tiasawhney@yahoo.com.

[1] “Police and fire pensions in the healthy zone / BGA report: Relative to neighbors, Forest Park funding above average”, Forest Park Review, August 12, 2014, Jean Lotus, http://www.forestparkreview.com/News/Articles/8-12-2014/Police-and-fire-pensions-in-the-healthy-zone/.

[2] “Bad Pensions Meet Bad Journalism: An Example and a Lesson – WP Original”, WirePoints Illinois News, August 14, 2014, Mark Glennon, https://wirepoints.org/bad-pensions-meet-bad-journalism-an-example-and-a-lesson-wp-original/.

[3] “Actuarial Standards of Practice (ASOPs)”, Actuarial Standards Board, promulgated various dates, http://www.actuarialstandardsboard.org/asops.asp. The standards relevant to this discussion are:

ASOP 4: currently “Measuring Pension Obligations” with a new standard “Measuring Pension Obligations and Determining Pension Plan Costs or Contributions” soon to be in effect.

ASOP 6: currently “Measuring Retiree Group Benefit Obligations” with a new standard “Measuring Retiree Group Benefits Obligations and Determining Retiree Group benefits Program Periodic Costs or Actuarially Determined Contributions” soon to be in effect.

ASOP 23: “Data Quality”

ASOP 27: “Selection of Economic Assumptions for Measuring Pension Obligations” with a new standard of the same name soon to be in effect.

ASOP 35: “Selection of Demographic and Other Noneconomic Assumptions for Measuring Pension Obligations”

ASOP 41: “Actuarial Communications”

ASOP 44: “Selection and Use of Asset Valuation Methods for Pension Valuations”

[4] “Teacher’s Retirement System (TRS) of the State of Illinois / Revised June 30, 2013 Actuarial Valuation of Pension Benefits”, Buck Consultants, January 2014, Larry Langer and Paul Wilkinson, http://trs.illinois.gov/pubs/actuarial/2013ValuationRept.pdf.

[5] “Village of Forest Park / Forest Park Police Pension Fund / Actuarial Valuation for the Year Beginning May 1, 2012 and Ending April 30, 2013”, TWS Actuary, signed September 26, 2013, Timothy W. Sharpe, obtainable by Freedom of Information Request or ask Tia Goss Sawhney for a copy.

[6] With respect to the assumed rate of return on assets a school of thought called “financial economics” recommends the rate associated with risk-free or near risk-free bonds and investing fund assets accordingly.

[6] “Public Act 096-1495 / Illinois Pension Code / An ACT concerning public employee benefits”, State of Illinois, http://www.ilga.gov/legislation/publicacts/96/PDF/096-1495.pdf.

[7] “Complaint again Timothy W. Sharpe, EA / For work done with respect to the Illinois Municipal Police Pension Funds”, March 23, 2014, Tia Goss Sawhney, ask Tia Goss Sawhney for a copy.

[8] “Teachers’ Retirement System Changes Will Affect Pension Savings”, Institute for Illinois’ Fiscal Sustainability at the Civic Federation, June 26, 2014, http://www.civicfed.org/civic-federation/blog/teachers%E2%80%99-retirement-system-changes-will-affect-pension-savings.

[9] “State Employees’ Retirement System of Illinois / 2014 Experience Review for the Years July 1, 2009 to June 30, 2013”, Gabriel Roeder Smith & Company (GRS) Consultants and Actuaries, April 8, 2014, Alex Rivera, David Kausch, and Paul T. Wood, not posted on plan website but available at https://burypensions.files.wordpress.com/2014/05/sers-experience-review.pdf.

[10] “Putting the ‘Public’ in Public Plan Actuarial Work”, In the Public Interest, newsletter of the Social Insurance and Public Finance Section of the Society of Actuaries, July 2014, Tia Goss Sawhney, https://www.soa.org/Library/Newsletters/In-Public-Interest/2014/july/ipi-2014-iss-10.pdf.

[11] “Request for Comments – ASOPS and Public Pension Plan Funding and Account”, Actuarial Standards Board (ASB), July 2014, http://www.actuarialstandardsboard.org/pdf/exposure/Public_Pension_Funding_RFC_July2014.pdf.