Muddled Thinking About Defined Benefit Pensions – Part 2
Public Sector Pensions: a Model for Solving State and Local Government Budget Shortfalls
An open letter to state and local government officials describing how to apply actuarial pension finance principles to pay for all governmental expenditures without taxes
Dear state and local government officials:
The $350 billion of Coronavirus state and local fiscal recovery funds from the American Rescue Plan Act of 2021 are spent. You must now pay for the services you provide to your constituents without pandemic windfalls.
Luckily, like Dorothy in The Wizard of Oz, you’ve always had the power to generate funds without taxes. The magic lies within the actuarial finance you use to fund your pension plans.
Here’s a step-by-step iterative process using a simple, scalable example:
Step 1: Issue a general obligation zero-coupon bond that pays $20 million in 20 years.
Based on the going rate for high-quality general obligation bonds of roughly 3.5%, the proceeds should be around $10 million.
Step 2: Observe that based on your pension plan portfolio’s “expected return” of 7% per year, you would only need to fund about $5.2 million to pay off the $20 million in 20 years. Call $5.2 million your “liability” based on the 7% expected-return discount rate and, in a dedicated trust, invest $5.2 million of the $10 million proceeds identically to how your pension portfolio is invested.
Your debt is now “100% funded.” The $5.2 million in the dedicated trust is equal to your liability. If you don’t believe me, ask your actuary and accountant.
You now have $4.8 million of free money to spend on providing services!
Step 3: Go back to Step 1 and repeat the process, varying amounts and maturity dates as you like, until you have generated enough free money to pay for your entire annual budget (and maybe pick up something nice for yourself). Your resulting outstanding debt here is just like your pension plan, except that you owe bondholders instead of plan members. Another difference is that this obligation is “100% funded!”
Wait - there’s one more requirement. You must incant the word “pension” while executing the three-step process. Uttering the word “pension” results in the glazing of eyes and the magical suspension of the fundamental finance principles that apply to every other financial endeavor and would otherwise make this wonderful wizardry impossible.
Think of each step in the process as a click of magic-slipper heels and the word “pension” as “there’s no place like home.”
Your accountant will sign off on your reporting of “full funding.” As the Governmental Accounting Standards Board (GASB) explained in Statement 68 (paragraphs 227-228) for pensions:
The Board [GASB] concluded that this approach [for setting the discount rate], which first considers the long term expected rate of return on pension plan investments [the crucial 7% above], appropriately reflects the environment in which governmental employers incur an obligation …, accumulate assets in a dedicated trust to satisfy that obligation, and ultimately discharge that obligation… from accumulated, dedicated assets…[G]overnmental employers and the pension plans through which they accumulate and manage assets and provide pensions are long-lived entities. The Board believes that discounting using the long-term expected rate of return on pension plan investments, when pension plan assets are expected to be invested using a strategy to achieve that return, reflects the long-term nature of the employer’s pension liability. [emphasis added]
The amounts that are projected to be provided by … investment earnings represent a reduction in the employer’s expected sacrifice of resources to satisfy the obligation… Therefore, if the potentially significant effect of pension plan investment earnings is not considered in the measurement of the… liability, the Board believes that amounts recognized by the employer…potentially would be misstated
(See - didn’t your eyes glaze over when you read that?)
It’s not your fault that GASB and, apparently, most public pension actuaries failed, or failed to take, introductory finance. For pensions, they’ve handed you an arbitrage between real-world finance and accounting that you happily use to your advantage. But why stop at pensions when there is so much more free money for the taking? When it all comes crashing down, that will be your successors’ problem, so party on.
You’re welcome.
Very truly yours,
Larry