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An actuarial balancing act

Debates over public pensions can quickly plunge into the pool of minutiae and tediousness.

May 1, 2006


Ron Wirtz Editor, fedgazette
An actuarial balancing act

Debates over public pensions can quickly plunge into the pool of minutiae and tediousness. Unfortunately, some important distinctions often get overlooked in the process. So put on that swimsuit for a quick dip.

One critical distinction has to do with funding ratios and actuarial soundness. For instance, a pension might have a funding ratio well under 100 percent, but still be actuarially sound. A pension can also be fully funded, but not be actuarially sound (though unlikely), or it could face other hidden problems.

Basically, actuarial soundness checks the pension formula to determine if projected revenues (contributions, plus investment return minus expenses) will grow enough to meet future benefit obligations. It then checks to see that actual revenues—particularly government contributions—are coming in as planned.

There's more than a little guesswork involved, because there are a lot of underlying assumptions—predictions, really—to consider: investment returns, changes in retirement age and longevity, and myriad other matters. Actuarial assumptions and formulas are based on the best information available at the time—investment history, economic forecasts, actuarial tables and the like, which get revisited and updated periodically. Still, they can and do turn out to be wrong, usually by matters of degree.

Which assumptions miss most often? "Longevity would be top of the list," said Keith Brainard of the National Association of State Retirement Administrators. That is, workers who live longer than anticipated after retirement throw off the funding formula.

There are other actuarial pitfalls. In the case of the Minnesota Public Employees Retirement Association, which covers local government employees, turnover was lower than projected because many members entered the plan for the first time in their late 30s, and more workers were staying on the job longer than expected—both of which added to the liability numbers, according to Executive Director Mary Most Vanek.

States also throw an occasional monkey wrench into actuarial tables, usually as a result of short-term fiscal problems. Faced with a significant state budget deficit in 2002, Michigan then-Gov. John Engler offered early retirement to qualified state employees, which included a bump in the average pension multiplier. Over the course of the next two years, some 8,000 workers accepted the deal, several times the annual number of retirees. Such a maneuver helps a state's annual budget because it replaces higher-salaried older workers with lower-paid younger ones, or none at all. But it doesn't do the pension fund any favors because it overrides important actuarial assumptions—including length of retirement—that are baked into a pension's funding recipe.

The funding ratio, on the other hand, is a simple-math snapshot of whether projected assets are on course to cover future liabilities. It is, in part, a function of the actuarial formula. But the funding ratio highlights the fact that every formula has moving parts with a fair amount of wiggle room.

For example, pensions use long-term benchmarks for investment return, usually around 8 percent. That means it has to average 8 percent over time; 4 percent one year and 12 percent in another is perfectly acceptable. Investment fluctuations—like those seen earlier this decade—can push a pension's fund ratio below fully funded, yet a plan remains actuarially sound so long as its investment benchmark is realistic over the long term.

Timing is also important to consider when assessing funding ratios, because pensions typically smooth investment results over a five-year period in an effort to take out some of the actuarial volatility. That means the full effect of any negative investment returns from 2000 to 2002 didn't immediately show up in funding ratios, nor have recent strong returns been fully weighted.

A + B = C (we hope)

Because actuarial formulas are based on innumerable assumptions, none of which might be accurate, pensions periodically conduct "experience" studies—how a plan actually performs in the real world. The North Dakota Teachers' Fund for Retirement did one last year. According to Fay Kopp, with the state Retirement and Investment Office, the experience study showed that "teachers are retiring earlier and living longer" than the fund's projections, and benefits increased faster than expected, in part to "to pump up teacher salaries," which are on the low end compared to most states. "They were wise, prudent decisions at the time. Hindsight's a wonderful thing."

When it comes to actuarial assumptions, the trick is balance: Misses on the low side in one year, or with one assumption, have to be made up in future years. Estimates on longevity, retirement age, investment returns—"all of these are assumptions, and you have to match them up," said Kopp. "It's a guessing game."

One can't be too knee-jerk either, as permutations in factors such as retirement age and longevity only reveal their true pattern over time. "The trick is trying to identify whether (a shift) is a long-term trend or a short-term blip," Kopp said. "You don't want to be ginning these (assumptions) up and down every year."

Ron Wirtz
Editor, fedgazette

Ron Wirtz is a Minneapolis Fed regional outreach director. Ron tracks current business conditions, with a focus on employment and wages, construction, real estate, consumer spending, and tourism. In this role, he networks with businesses in the Bank’s six-state region and gives frequent speeches on economic conditions. Follow him on Twitter @RonWirtz.