How to Discount Pension Funds

The NYTimes has a good piece on the Dutch pension system which is characterized by sober calculation.

The Dutch central bank also imposed a rigorous method for measuring the current value of all pensions due in the future. Pensions are not supposed to be risky, Governors_of_the_Wine_Merchant's_Guildso the Dutch measure them the same way the market prices very safe bonds, like Treasuries — that is, by discounting the future payments to today’s dollars with a very low interest rate. This method shows that a stable lifelong benefit is very valuable, and therefore very expensive to fund.

Notably, the Dutch central bank prohibited the measurement method that virtually all American states and cities use, which is based on the hope that strong market gains on pension investments will make the benefits cheaper. A significant downside to this method is that it lets pension systems take advantage of market gains today, but pushes the risk of losses into the future, for others to cope with. “We had lengthy discussions about this in the Netherlands,” said Theo Kocken, an economist who teaches at the Free University in Amsterdam and is the founder of Cardano, a risk analysis firm. “But all economists now agree. The expected-return approach is a huge economic offense, hurting younger generations.”

Economists agree, the Dutch are correct. We know with high certainty the payments that pension funds will have to make in the future so they should be discounted at a relatively low, risk-free rate. Discounting at a risky rate implies that we can fund these pensions with risky assets but as I pointed out in Average Returns Aren’t Average most investors won’t achieve the average return (see also John Cochrane on this point) so the American system practically guarantees that lots of pension funds will run into severe problems.


The Dutch don't allow the following attempt by a company to use bankruptcy to get out of pension obligations either -

'AMR, the parent company of American Airlines, filed for bankruptcy on November 29, 2011. American sponsors four defined benefit pension plans covering nearly 130,000 workers and retirees. Although the plans are insured by PBGC, American is solely responsible to pay benefits owed under its four pension plans. These plans are ongoing and PBGC is doing its utmost to ensure that American maintains responsibility for the plans and keeps the pension promises it has made. That way, people who count on those plans can receive their full plan benefits, without regard to the limits in the pension law – and PBGC will not be forced to pick up obligations that AMR really can afford.'

Which, as it turns out, did not turn into a taxpayer bail out of a company declaring bankruptcy because its management was too incompetent to properly fund its contractual obligations - 'On March 7, 2012, AMR announced it would freeze, not terminate, the pensions of its non-pilot employees. That means going forward workers won’t earn additional benefits, but they won’t lose a dime they’ve already earned. PBGC Director Josh Gotbaum had this to say: "It is great progress and good news that American recognizes it can reorganize successfully and preserve its employees’ pension plans. We’re also glad the company is willing to work with us to preserve their pilot plan too."'

The Dutch also don't allow the fiollowing either, and do not need a judge to decide that a company needs to honor its commitments - 'U.S. Bankruptcy Judge Sean Lane on Friday denied part of American Airlines’ request for summary judgment on the issue of retiree health benefits and approved part of the request.

However, it looks like pretty much a win for most of the tens of thousands retirees who would have faced paying their own insurance premiums.

His order doesn’t settle the issues raised, only that he didn’t find sufficient reason to rule in American’s favor. American could request a full trial.

A representative of the retirees’ committee said “the retirees prevailed almost across the board. The groups where the court granted AMR summary judgment are very small and many, if not most of the individuals in those groups, are in other groups where the court refused to grant summary judgment.”

American had sought a ruling that it was free to change the health plans in which it helps pay the premiums for retirees. If allowed, American said it would require retirees who wanted to keep the benefits to pay all of the premiums.

“We thank Judge Lane for his thoughtful consideration of the issues,” American spokesman Casey Norton said. “American will review his ruling and consider next steps related to the retiree health and life insurance benefits. We always remain open to productive discussions to finally resolve this matter.”

American’s attorney had told the judge at a March hearing that it intended to make retirees begin paying 100 percent of their premiums soon. In the face of Friday’s ruling, ““We’ll review our legal options and make sure we conduct ourselves according to the judge’s ruling,” Norton said.

The judge wrote that the question was whether promises made to provide the benefits had been promised in way that they were vested and couldn’t be unilaterally changed.

“The Plaintiffs [American, parent AMR and other relative companies] contend that none of the operative documents can be read as a promise to provide benefits for life and that the documents reserve the right to modify the benefits,” Lane wrote.

“But for reasons set forth below, with limited exceptions, the Court denies the Motion because the relevant documents contain language reasonably susceptible to interpretation as a promise to vest benefits and lack language categorically reserving the Plaintiffs’ right to terminate their contributions to the retiree benefits,” the opinion stated.'

I think this is a good illustration of what is wrong with the US system. When your pension depends on future cash flows it will be by definition unreliable. The Dutch seem to understand that savings returning a modest return is the best assurance of future benefits.

How many people have gained or maintained positions of influence and power in the US by promising benefits based on future cash flows? Maybe their assets should be seized.

PA's understanding of the issue is pretty lousy based on the comment he/she wrote. I doubt he even grasped the meaning of yours, or the initial blog post.

Assume r > g*.

*See Piketty.

It's this kind of BS that leads me to reluctantly support unions. My dad was a pilot who quit the union because of its excesses, but they helped in the pension issue when Eastern went bankrupt.

Imagine a place where regulators existed to make sure everyone followed the rules.

Imagine a federal republic of sovereign states, who get to make their own laws and regulation. Snideness aside, to what extend to could an American federal agency impose an accounting rule on the states. The question has three levels (1) what existing agencies might have such power, (2) whether the constitution would allow a federal law to set such rules and (3) whether there would be any political will to do so.

Imagine your employer incorporates in Delaware with all employees in other States because the home office is mailbox forwarding service. Delaware sets the accounting standards for the corporation. Right?

Better yet, the corporation incorporates in the Antilles.

Or do you believe States should be able to regulate trade between States and states?

He's talking about the pension funds of the states themselves.

Yes I was. But reading my own post, I realise that was not explicit. Mea Culpa.

No need for explicitness. Delaware is an anomaly among states.
The Antilles is of an entirely different geography.

This is an MR post:

This is a hoax. Just not true.

Those thrifty Dutch, they bought Manhattan for $25 worth of trinkets too. But if the Indians had invested that $25 in long-term bonds, compounded, they'd have enough money to buy the Emperor's Palace in Tokyo. As Albert Einstein observed, compounded interest is a modern marvel.

Well, Piketty would certainly agree.

Yes, correct. This game has been going on for a while. Essentially a pension fund should be immunizing it's liabilities, not trying to outperform them. Since the liabilities are well understood and not risky (ie they have to be paid off), they should be immunized with government bonds and TIPS. The high expense of funding them this way is related to the certainty of having to pay them off. To attempt to fund them less expensively with riskier assets is to implicitly take the risk of not being able to meet the obligations or the risk of passing on the burden of an unfunded shortfall to a broader group of taxpayers. Since public funds invest in a lot of the same types of assets there is also the correlation risk of underperformance causing systemic shortfall problems.

"the American system practically guarantees that lots of pension funds will run into severe problems": they're doing what they are designed to do - deferring the problem rather than solving it.

Yep. It really is by design. Everybody really wants to be J. Wellington Wimpy- deep down inside at least.

Very interesting post, Alex. Thank you.

Sooner or later, public employees will have to accept the same rate of return individual 401K holders experience. The real question is: when?

This is also about private company pensions. In the Netherlands, for example, 90% of workers are covered by a real pension.

But the great thing about 401k plans is that they are portable and your employer has limited ability to mess them up. No vesting. No accumulation of little pieces of pension here and there that don't add up to much (my 6 years at company X, for example, which had 10 year cliff vesting).

It's a lot easier to imagine a US with only 401k (403b, etc) plans for pensions than it is for US pension trustees to follow the Dutch model. But since I live in Illinois, I come by this cynicism honestly.

Yeah, that formal and informal job training and employee development was a real burden on employees because they were enticed into employer loyalty be the pension terms.

Far better to require workers to first work for the competitors who are old style to get the job training, so that they can be hired away to crush the employer who trained them. Today there is no loyalty to employers.

Which also means no loyalty to employees. Which means nothing invested in employees. You either come valuable, or you are worthless and get discarded. No matter what you could offer, the risk of putting anything into you will be rewarded with you stabbing your employer in the back by taking what you were given to a competitor.

Employers could deal with this problem by offering employment contracts -- and they do, to executives.

Pensions aren't an effective way to keep younger workers (who get most of the training you describe) because younger workers don't properly value the pension. The idea in employee benefits is to have benefits that cost the company less than what the employee values them as. Pensions for younger people are the reverse.

It seems that there is consensus between the Left and the Right (in economics) on this isue, but (roughly) only those on the Right want governments to one up to these funding shortfalls. The irony is that (roughly) only those on the Left believe that the size of public debt (roughly) does not matter. We would live in a more intelectually honest (though not less fiscally screwed) world if the Left called their own bluff on this issue.

This is relevant to both public and private pensions.

Good luck using those accounting methods at a private pension. You may find yourself in prison.

Private pensions aren't underfunded? What discount rate do you think these companies were using? Is it different than the public pensions?

They are not nearly as underfunded as the public pensions, Jan. One of the reasons private pensions are on the decline in the US is precisely because they were forced, starting in the 1970s, to more accurately account for and fund the promises made, though I still don't think it is done properly. If private companies in the US had to do what the Dutch seem to do, I think all of the plans would be frozen and replaced with defined contribution plans.

At the limits, defined contribution and defined benefit plans should converge in benefits and costs, and when and where they don't, you end up with either higher costs or a shortfall in funding. It sounds to me like the Dutch, through proper accounting, have managed that convergence about as well as it can be. Call them Dutch pensions if you want, but I just call them employee funded retirement accounts no different from a fully contributed and conservatively funded IRA.

I agree with most of what you say about US pensions. Sure public pensions are more underfunded (of course there are many more of them), but I don't actually know how much less-funded public pensions are versus private. Do you? I am not sure there is a good reason for a business to make a decision to accept the funding requirement and risk of a defined benefit pension these days.

The Dutch system simply doesn't accept overly optimistic investment performance projections. However, employers and employees both pay into them (all employees pay a fixed % of salary, while employers put in more than 50% of the total contributions) and > 90% are defined benefit schemes. This is different from what you describe.

One of the reasons that public pensions are underfunded is because states do not fund the plans when times are tough.

Imagine that. A pension fund that doesn't grow if the employer doesn't contribute to it.

Yes, Bill, and in good times some pensions pay out extra. Imagine that.

Ted, Do you run your own pension that way, that is, do not contribute to your 401k when the market is good.

@Jan, in the US, private sector pension assets are about $2.5 trillion and liabilities (measured using a high quality yield curve) are maybe $3.0 trillion. Many plans are frozen, so this is largely a "legacy" liability.

Aggregate public sector pension liabilities, measured in the same way, might by $12 trillion, with assets of maybe $6 trillion. And most benefits are not frozen- in lots of cases, they are unfreezable for current employees.

That's pension. Then there's medical...


No and I also don't take out money when times are good.

Bear in mind that in the US there are 5 private workers to every public worker and that public pensions have a net liability (according to BD's post) that is 12x greater. There really is no comparison. The public pension system in the US is a long term mini-disaster. The private sector has transitioned to defined contribution plans and is in much better shape.

This is an interesting intersection of economics, politics and reality. Piketty decries the accumulation of wealth, libertarians would expect due diligence by those placing their hope in someone deciding their future. The right points out the union power or the political clot of public sector unions extracting unsustainable benefits, the left depends on them. Keynesians bemoan the savings not generating consumption, Sunstein wants to nudge more of it. The low returns threaten bankruptcy of state and municipal governments making one wonder if the asset price inflation said by some to be caused by the Fed policy is working as designed.

Those that think return assumptions are the problem are mostly misguided. In fact, over 90% of public pension plans have achieved the 7.75% discount rates over time long term periods. Most plans have begun to reduce return assumptions to reflect for what is likely to be a lower return period over the next decade. Even if a plan fails to meets that return hurdle, self-correcting mechanisms include higher contribution rates to correct for the shortfall. So why do we have underfunded pensions if returns have not been the problem? Because inadequate contributions are by and large the problem. (But this also plagues defined contribution--401k type--plans. What is the average account size for those approaching retirement? For a more sober stat, look at the median account size...) Pension plans have some great features--mortality pooling, professional management, reduced costs, and forced saving in some cases. Deficits and surpluses SHOULD exist if we are truly concerned about inter-generational equity. Where plans most often fail is granting new benefits funded from a surplus. The pendulum ultimately swings, and it becomes evident to sponsors that they are not as wealthy as they thought they were. (Sound familiar?) But that is a governance problem, and one that will continue to exist as a problem if we continue to ignore it with red herring arguments suggesting the discount rate as the problem. Also, any actuary or consultant worth their salt knows that you don't achieve the "average" return.

No doubt there are ways to improve the public (and private) pension system. Becoming overly short-term focused under the guise of "transparency" is not one of those ways. I'm all for transparency, but arguing for transparency is not the same as arguing for simplicity. Assumptions must be made about ever-changing liabilities in the future--this is complex stuff. Harping on the discount rate is simple, but it is not the problem in isolation. Keep in mind too that if a plan assumes too low a rate of return, the younger generations of taxpayers are also hurt. Think of lost efficiency, lost investment in capital and higher contributions over a lifetime. This doesn't mean there is no room for additional conservatism in pension accounting, just make sure you hit the real problem and not the perceived problem.

Even if a plan fails to meets that return hurdle, self-correcting mechanisms include higher contribution rates to correct for the shortfall

Amazing. That's all?

"Even if a plan fails to meets that return hurdle, self-correcting mechanisms include higher contribution rates to correct for the shortfall "

So, assume a can opener?

I say that, because you are assuming a "self-correcting mechanisms" of higher contribution rates that often fails to appear. Generally, in the various reforms, there is often a higher contribution rate, but in most cases, it's not high enough for a long enough period of time to make up the short fall.

Yes, this is the actuarial industry's argument for obfuscating the issues for decades. It's bullshit, and leads to to attempts to immunize essentially fixed or CPI adjusted liabilities with riskay assets.

The economics profession misses the mark here. There are two mistakes made:

1. That there is real "present value of liabilities" to be measured, and
2. That there "present value of liabilities" calculated by actuaries for funding purposes should correspond to it.

The purpose of an actuarial present value of liabilities is purely instrumental: it is an input to a funding scheme. Using a much lower discount rate makes it a *worse input*. The consequences of this requirement are recognized by commenter Mesa above (although he sees them as a positive feature): a pension fund required to use a discount rate tied to a particular class of assets is given a strong incentive to invest in that class of assets lest the plan become systematically over- or under-funded.

Public DB plans have a bit over $5tn in assets and private DB plans add a little over half that again. That's a huge amount of money to vacuum out of equity markets and shove into debt markets (even with those assets already around 60/40). You are just shoving the risk elsewhere in the system and demanding the creation of more "safe" assets which, as we have seen, may not be quite as safe as we hope.

Interesting point. And at some point that extra demand drives the discount rate down even further.

Excellent comment. As a matter of fact, these assets will not be shoved into debt markets, thankfully.

In the public sector, where the real issue lies, funded ratios and contributions look bad enough with the 7% or so discount rate used for funding purposes. The math will not allow these liabilities to be "settled" insurer-style at 3%-4%.

In the private sector, many employers are winding plans down- there is a certain (expensive) logic to employers "de-risking" pension liabilities with matching bond portfolios. Only a minority of employers have done this so far, however.

From a systemic standpoint, investing (30+ year horizon) retirement assets in bonds seems extremely shortsighted, particularly due to the certainty of mediocre bond returns over the next 20 years.

Yeah, it would be incredibly stupid for someone to invest on a 30 year time horizon in bonds. You get better average and worst case returns over that horizon in equities for any starting point over the past 200 years. If pension accounting doesn't allow any risk pooling at all and this also forces the investment structure into bonds, pensions will be a much worse form of compensation for employees. Except that most employees would do an even worse job on their own. Such is life. That's why we have social security. Biggest pool possible, no investment concept, just pay out of future tax revenue, target floor on annual income with a weak correlation to how much is paid in.

It's not just about (cash) pensions, but also about retiree health plans.

Here's a wild idea. Why not link health plans to the state of healthcare available at the time of retirement? If you retired in 1994, you don't get access to the last twenty years of new & expensive treatments. Would this save much money? Or is most of the cost of healthcare incurred in doctor & nurse time, rather than drugs & tech?

It good that this news [about how to value pension funds] has reached the NYT. Perhaps that means it will someday reach the people who structure pension funds and the auditors who certify them. As Keynes said, it takes a long time for what economists know to get reflected in policy.

Finally some sense on this topic. Market risk is taken on by someone. Your choices are would you rather see the effect of market movement as your balance accumulates or would you rather pretend everything is fine because you can't see the fluctuation?

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