Comments on: Actuarial Measures of DB Pension Plans

1. Comments on:Actuarial Measures of DB Pension Plans Barry Bosworth

2. Current Treatment • All employer-sponsored pension funds are included in household sector • Receive contributions from employer –part of labor compensation • Capital income of pension fund is included with household capital income (dividends and interest) • Contributions, and income reported on a cash flow basis. • Pension benefits available only as an addenda and only for DB plans. • NIPA adopted the SNA93 system with the 1999 revisions.

3. SNA 2008 • Adopt a accrual system of accounting for defined benefit plans • Cash accounting gives an incomplete picture of the financial condition of DB plans • Benefits are actually based on a formula, not cash on hand. • Construct a value of the pension liabilities based on the present value of the accrued pension benefits • Compare with market value of plan assets to determine degree of over or underfunding.

4. Receipts & Expenditures for Private Plans

5. Impact on Saving • Depending on the degree of underfunding, the reform will alter the flows of income between economic sectors • National saving is unaffected, but the accounting changes will drastically alter its distribution • The adjustment for under-funded plans will add to household income flows and increased the costs to pension sponsors (governments and business) • Increase imputed employer contributions and imputed property income on unfunded liabilities • More realistic valuation of DB Plans

6. Valuation Issues • Accrual method • ABO - accumulated benefit obligation – accrued service * current salary (value if plan were terminated) • PBO-- projected benefit obligation – accrued service * projected termination salary. • takes account of likely future career benefit obligations (wage increases and additional years of employment). • Initial valuation is higher but they are equal at retirement. • ABO seems closest to current national accounts practice, but Lucas&Zeldes prefer PBO • The time patterns of the two are similar, suggesting it is not a major macro issue. • BEA prefers PBO for government. Why? Standardization seems preferable where possible • Valuation of Liabilities • Discounted value of future benefits. • Choice of discount rate.

7. Discount Rate • Actuaries • Historically, actuaries suggested the use of a relatively high discount rate that derived from the belief that the employer could take a long-term view that averaged out the vicissitudes of the market. • Financial economics • Payment streams (liabilities) should be discounted at a rate that reflects their risk (Modigliani and Miller (1958)), independent of the rate of return of assets. • The higher return on equity-centric portfolios is simply a return for risk, but pensions must be paid in any case. Thus, they advocate for a discount rate closer to that for riskless bonds. • This argument gains increased force in the public sector where constitutional mandates often require the payment of pensions even in a situation of general default. • In addition, many public pensions are indexed for inflation suggesting the use of a discount rate based on inflation-indexed bonds.

8. Discount Rate • Choice of discount rate is politically sensitive • BEA Proposal – recent experience with asset returns (does not seem consistent with risk standard of financial economics) • Private sector – 6% or 1% + %CPI • State and Local – 5½-6% (should be less than private) • Federal Government - ? • For much of its history, the federal plan was PAYGO. • Two options to create a funded alternative. • Constant cost rate • Model simulation that reflects some of the changes in the plans and the underlying demographics- Option B seems more time consistent. • There are major risk differences among the public and private plans that ought to be reflected in the discount rate. • The discount rate should be derived from a fully taxable bond with risk characteristics (including inflation risk) as close as possible to those of the benefit liability.

9. Further Thoughts • Choice of a discount rate for the valuation of future liabilities is separable from the choice of investment assets. • Discounting with a riskless asset does not imply that the fund must invest in riskless assets. • The use of a discount rate that matches the risks of the liability would yield a more realistic measure of the costs and prevent games with computed excess assets and the use of gimmicks such as “pension obligation bonds.” • However, fund managers should understand that decisions to invest in higher return assets do involve the assumption of risk.

10. Further Thoughts(2) • Location of the pension sector • Under the SNA methodology, the pension sector will normally have a negative saving balance (income minus expenses) because households are credited with the interest income on the unfunded liabilities, but no matching receipt is recorded from employers. • If the pension fund is within the business sector, it will be recorded as reducing the saving of business, but • the NIPA leaves all pensions in the household sector. • It seems most logical that that any imbalance of the DB pension accounts should be offset with an entry for the relevant employer (for both under and overfunded plans), assigning the residual to the employer.

11. Further Thoughts(3) • Source data • BEA has put together a large amount of new data on pension accounts • Reduces reliance on 5500 reports • Many report do not distinguish between interest & dividends and investment income (inclusive of valuation changes). • National accounts needs to exclude valuation changes. • Use of assumed interest rate will reduce reliance on 5500 reports and the volatility of pension income. • Integration with national balance sheet and flow of funds accounts • Will an aggregate measure of unfunded liabilities appear in integrated macroeconomic accounts?

12. Questions • Should the methodology be extended to social insurance programs (OASDI, Medicare, unemployment insurance)? • The Federal government has the power to change benefits, implying a higher discount rate, but would it exercise it. • Other countries have enacted major changes in their programs. • Will the computations be done across countries in ways that increase or reduce the validity of international comparisons? • Are the SNA accounts becoming too complex for less developed countries to implement?