CommentsECONOMY--On January 28, 2018, the Dow Jones stock index closed at a record high of 28,610. Nine days later, on February 6, the Dow index hit an intraday low of 24,198, a drop of over 15 percent. Since then the Dow index has recovered somewhat, along with other stock indexes and the underlying stocks around the world.
Nobody knows whether this sudden plunge is the beginning of a major downward correction, or even the beginning of a bear market, but it is a sobering reminder that permanently high returns on investment are not guaranteed. And it is a good opportunity to offer tools that local elected officials can use to assess the impact of a market correction on their agency’s required pension payments.
The tool presented here is a spreadsheet dubbed “CLEO Pension Calculator” (download here) that allows a layperson to evaluate various scenarios of pension finance. Before summarizing these tools, here’s how this spreadsheet predicts the impact of a 15% drop in the value of pension fund assets. This example shows the impact on all of California’s pension systems.
A recent CPC analysis “California Government Pension Contributions Required to Double by 2024 – Best Case,” using CalPERS official projections along with U.S. Census Bureau data, estimated California’s total pension assets for all of California’s state and local government agencies at $761 billion. Liabilities were estimated at $1.087 billion, meaning the total “unfunded” liability (assets minus liabilities) was estimated at $326 billion. Using that data as a starting point:
– If there is a 15% drop in pension fund assets, the unfunded liability rises from $326 billion to $440 billion.
– If there is a 15% drop in pension fund assets, the unfunded contribution, or “catch up” payment, rises from $30.8 billion to $41.5 billion.
– To summarize, for every sustained 10% drop in the value of pension fund assets, California’s state and local government pension funds will require another $7.0 billion per year. In reality, however, it could be worse, because a serious market correction could trigger another reassessment of the projected earnings. For example:
– If there is a 15% drop in pension fund assets, and the new projected earnings percentage is lowered from 7.0% to 6.0%, the normal contribution [1]will increase by $2.6 billion per year, and the unfunded contribution will increase by $19.9 billion. Total annual pension contributions will increase from the currently estimated $31.0 billion to $68.5 billion. [2]
These are mind-boggling numbers, but they are well-founded. The calculations used to arrive at these figures use formulas provided by Moody’s Investor Services in their current guidelines for municipal pension analysts, as reflected in their 2013 “Adjustments to US State and Local Government Reported Pension Data.”
This spreadsheet can be used by anyone, for any city, county, or agency.
INSTRUCTIONS TO USE THE SPREADSHEET
(1) To recalculate the unfunded pension debt, and to recalculate the unfunded pension payment:
On the tab “Unfunded Debt and Payment,” just enter the balances for your agency for your pension fund’s assets, liabilities, and assumed rate of return. Then change the rate of return from the official number to something lower, and see what happens. Change the value of the assets to something lower, and see what happens.
(2) To recalculate the normal pension payment:
This shortcut method, approved by Moody’s but discontinued in their final guidelines partly due to the difficulties in getting the data, requires the user to know the amount of their current normal contribution. CalPERS, to their credit, provides this information for each of their participating agencies in their “Public Agency Actuarial Valuation Reports.” If your agency is not part of CalPERS, you may be able to find this number in your pension system’s Consolidated Annual Financial Report, or you may have to contact the pension system and request the information. The fact that it is not easy for many participating agencies to know how their pension contribution breaks out between the normal contribution and the unfunded contribution is a scandal. If you know your normal contribution, just enter it on the “Normal Payment” tab on the spreadsheet, along with a revised rate-of-return projection, and see what happens.
(3) To perform sensitivity analysis to evaluate how various assumptions affect pension contributions:
This tab provides, using a hypothetical individual beneficiary as the example, an excellent way to see just how sensitive contribution rates are to various changes to benefits or other assumptions. To do this, go to the “Sensitivity Analysis” tab and enter any values you wish in the yellow highlighted cells. They include age of retirement, percent COLA growth per year during employment, the pension multiplier, the percent pension COLA growth during retirement, life expectancy, age when work commenced, percent of salary increase per year of employment, the percent of salary each year to the pension fund, the annual percentage return of the fund, and the final salary. Then the fun starts: The user must vary these inputs in order that the model displays a near-zero (within $10-$15K) value in the green highlighted cell “fund ending balance.” While this model is a simplification (for example it doesn’t account for the gap which sometimes occurs between a participant leaving the workforce and becoming eligible for retirement benefits) this model will help any user develop insights into what factors have the most impact on pension solvency.
(4) To determine the value of an individual pension:
A common and useful way to compare pension benefits to private sector 401K plans is to estimate what a pension benefit is worth at the time of retirement. Using this method is a valid attempt to provide an apples-to-apples comparison, by showing how much someone would have to have saved in a 401K plan to have an income stream in retirement equivalent to a pension. To do this, enter on the “Value of Individual Pension” tab a set of assumptions – age of retirement, years worked, pension “multiplier,” final year’s pension eligible compensation, pension COLA during retirement, and life-expectancy. There are also cells to enter various rate-of-return assumptions (discount rates). The green highlighted cells then display the present value of this pension benefit at various rates-of-return.
Any policymaker who is required to negotiate over pension benefits, explain pension benefits, consider changes to pensions, or understand the impact of pensions on current and future budgets, or for that matter, contemplate any sort of increase to local taxes and fees, needs to understand the basic financial concepts that govern pensions. They should understand the difference between the total pension liability and the unfunded pension liability. They should understand the difference between the normal payment and the unfunded payment. They should understand the difference between unfunded payment schedules that use the “percent of payroll” method vs. the “level payment” method. They should know what “smoothing” is. They should thoroughly understand these concepts and related concepts.
This spreadsheet is offered to reinforce understanding of these concepts, and to further better understand the impact of lower rates of return (and changes to other assumptions) on required contributions to the pension system.
Download CLEO Pension Calculator
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FOOTNOTES
[1] Unless the projected annual earnings percentage also drops from the 7.0% (which CalPERS is phasing in over the next few years, down from the current 7.5%), only the so-called “unfunded contribution” increases. This is because the “normal contribution,” is only required to fund the future pension benefits earned for work just performed in the current year. By definition, the normal contribution cannot change merely because the unfunded liability increases.
[2] The attentive reader will note the discrepancy between the currently estimated total employer pension contributions noted in the table “Employer Contribution 2017-18” of $31.0 billion in the report “California Government Pension Contributions Required to Double by 2024 – Best Case,” and the default values for total pension contributions in the spreadsheet of $15.2 billion (normal) and $30.8 billion (unfunded), totaling $46.0 billion.
This is because the spreadsheet calculates the unfunded contribution based on 100% of participating pension systems adopting the 20 year straight-line amortization, whereas the numbers in the report reflect the fact that many if not most pension systems have not yet required their participants to amortize their unfunded liability in 20 years.
This is validated by the report’s data for 2024-25, where the unfunded contribution rises dramatically, reflecting the determination of most pension systems to require their participants to begin adopting the more aggressive 20 year payback schedules.
It should also be noted that the spreadsheet’s default normal contribution amount of $14.0 billion only reflects the employer’s share of the normal contribution, and that typically (if not invariably), employee’s are never required to share via withholding in the burden of the unfunded contribution.
(Edward Ring has over 20 years experience in business and politics, primarily with start-up and early stage organizations. From 2010 through 2016, he was Executive Director, then President of the California Policy Center. This article was posted first at California Policy Center.)
