Food for Thought: Inspecting Public Pension Plans

Just over a century ago, Upton Sinclair wrote The Jungle. While the novel was intended to highlight the horrible conditions of many immigrant workers, it gained traction with the public by way of its "exposure of health violations and unsanitary practices in the American meatpacking industry". Combined with the prevailing winds of Progressive Era politics, Sinclair's muckraking efforts led to the creation of the Meat Inspection Act and ultimately to the Food and Drug Administration (FDA). The fact that we normally take food safety for granted is a testament to the great success of these measures.

Despite having a robust system of programs and regulations that ensures the safety of the food we consume, the same cannot be said of our public retirement plans. Many are chock full of high risk investments in a desperate attempt to boost returns and many give a false sense of security that promised benefits will be delivered without significant new funding. Worse, these inadequacies threaten the financial health of us all.

Fortunately we aren't starting from ground zero in these matters. An important precedent was set in 1974 when the Employee Retirement Income Security Act became law in response to widespread mismanagement of private pensions in the 1950s and 1960s. In a similar vein to some of the food laws in the early twentieth century, ERISA was intended to protect the interests of employees by way of "establishing standards of conduct for plan fiduciaries".

What ERISA did not do, however, is apply these quality assurance standards to public pension plans - and this is an important distinction. Public pension plans, in contrast to private ones, generally provide much stronger guarantees. As a result, when private plans go bust retirees lose their benefits, but when public plans go bust they normally have to tap taxpayers to make up the difference. That makes the underfunded status of public plans an investment problem for everyone who lives in their jurisdictions.

Given this debt-like burden that must be borne by society, one might assume that an industry effort to facilitate greater transparency and more efficient management with the goal of better serving public interests would be uncontroversial. One would be wrong.

Indeed just this past summer, the working paper, Financial Economics Principles Applied to Public Pension Plans ("pension report"), was due to be published by the American Academy of Actuaries and the Society of Actuaries (SOA). Shortly before its expected publication, however, both organizations aborted these plans stating that "producing a final paper could not be achieved to the satisfaction of the Academy and the SOA," and the group tasked with producing the paper was disbanded. A few weeks later the SOA changed course again deciding to "make the draft paper available at this time."

The pension report comes across as a fresh application of ideas and principles from the realms of economics, financial economics, public finance, investments, and financial reporting that conjures up a sense of thoughtfulness much more than controversy. The logical and lucid conclusions are intended to guide better reporting and better decision making among public pension plans and are characterized by some key tenets that address important issues:

  1. The cost of benefits and the value of liabilities depend on the benefits offered, not upon the assets expected to finance those benefits.
  2. Satisfying intergenerational equity, an economic term of art, requires each generation of taxpayers to pay contemporaneously the costs (including compensation and benefits) of the services it receives.
  3. Public financial reporting must take into account the market value of costs and liabilities in order to hold officials accountable, to be decision useful, and to assess interperiod equity.

The most important implications of the pension report were illustrated nicely by Andrew G. Biggs. One serious issue is that the value of liabilities in public pension plans is severely understated. Biggs explains that "Under current practice, a state or local government employee retirement plan 'discounts' its benefit liabilities using the assumed return on the investments held by the plan." He continues by describing that, "Most state and local pensions hold about 75 percent of their investments in risky assets such as stocks, private equity or hedge funds and they assume annual investment returns of about 7.6 percent." As a result, "Based on this method, state and local plans today are about 74 percent funded and have unfunded liabilities of about $1.4 trillion."