Public Pension Finance Symposium May 2009 Session 1: Measuring Public Pension Liabilities The Contrasting Views Discounting State and Local Pension Liabilities David Wilcox
Discounting State and Local Government Pension Liabilities Jeffrey R. Brown, University of Illinois David W. Wilcox, Federal Reserve Board May 18, 2009 1 Outline* I. The basic economics of discounting future cash flows II. Eight key questions about discounting state and local government pension liabilities III. Summary IV. An audience survey *The views expressed here are those of the authors and may not be shared by the Federal Reserve Board or the other members of its staff. 2
One preliminary How to discount and how to invest are distinct questions Some disagreement among economists about how to invest Virtually none about how to discount This talk only addresses how to discount 3 I. The basics of discounting 4
Definition of present value The present value of a future cash flow is the amount that must be invested now to produce the future cash flow for sure, in all future circumstances If it doesn t meet this definition, it s not a PV N.B.: For sure does not necessarily mean that a risk-free discount factor is the right answer 5 Implementing the definition The key is to match the characteristics of the discount rate as closely as possible to those of the cash flow For example, if the future cash flow is meant to fluctuate with the return on stocks, then the discount factor should be derived from stocks be free of default risk then the discount factor should be derived from securities having the same characteristic In many contexts, difficult or impossible to match. Here, however, easy to match because public pension benefits are effectively free of default risk 6
Benefits are safe in theory Seven state constitutions guarantee benefits: Membership in any pension or retirement system of the State shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired. Illinois Constitution Article XIII, Section 5 Benefits in many other states are protected by case law regarding contracts 7 Benefits have been safe in practice New York City in the mid-1970s City cut 61,000 jobs from its payroll and froze wages Inflicted losses on bondholders But has thus far paid accrued vested DB benefits in full Orange County County cut 1,600 jobs Defaulted on $1.1 billion of bonds But has thus far paid accrued vested DB benefits in full 8
What you do and don t need to know to calculate the PV of riskless cash flows Do need to know: The term structure of riskless interest rates Don t need to know: The permanence of the pension sponsor The purpose of the pension sponsor The asset allocation of the pension trust fund The equity premium 9 II. Eight key questions 10
1. Are basic principles of finance applicable to public-sector pensions? Yes. Even states and locals need to recognize that resources come at a price appreciate that risk matters understand that their own permanence makes the benefits they promise more likely to be paid, and hence more valuable to workers and costly to provide, not less 11 2. Does MVL increase volatility? No. The volatility of the liability is what it is MVL simply recognizes that volatility whereas traditional methods understate it If the volatility of the liability is a problem, use the portfolio of assets to hedge it 12
3. Does MVL increase cost? No. The value of the liability is what it is MVL simply recognizes that value whereas traditional methods understate it Why? Because they ignore the price of risk Having a thermometer stuck at 70 o wouldn t make August in Phoenix any cooler Do we really want governments to value resources more cheaply than constituents do? 13 4. Why do Brown and Wilcox favor overcharging current generations? We don t. We favor not pretending that the price of risk is zero benefits cost less than they really do Even if a government wishes to redistribute from one generation to another, the proper method of discounting remains the same Planning based on expected values amounts to assuming that the price of risk is zero 14
5. How can liabilities be assigned a market value when they are not traded in markets? The pension promises of state and local governments are (nearly) riskless cash flows The economics of how to value riskless cash flows are extremely simple There is an active market in cash flows that are (nearly) riskless 15 6. What s wrong with using the expected return on assets to discount liabilities? Nothing provided the liabilities are intended to have the same risk characteristics as the portfolio of assets Public pension benefits are riskless despite the assets being invested in risky instruments For extra credit: Name the asset that is missing from conventional presentations of a pension trust balance sheet 16
7. Doesn t investing in equities make the provision of benefits cheaper? No. The value of the liability is what it is. Investing in equities does not change it A famous equation: Contributions + Investment earnings = Benefits + Expenses While famous, not very useful Often interpreted to mean: If you boost your investment in equities, you ll be able to cut your contributions But there are plenty of times (like right now!) when a larger investment in equities means more contributions 17 7. Doesn t investing in equities make the provision of benefits cheaper? (ctd.) If you promise riskless benefits but invest in equities, there must be a hidden put option A less-famous but more-useful equation: Equities + Put Call = Risk-free asset The more you invest in equities, the costlier the put that protects against the downside
8. Why do Brown and Wilcox (among others) focus on the ABO? This is fundamentally a non-issue Other concepts of liability are broader. Let s agree on how the ABO should be valued and then we can discuss the rest The ABO puts pension expense on the same footing as wage and salary expense 19 III. Summary 20
Summary, part I Markets put risk in the hands of those best able to take it. In that sense, markets generate the lowest possible price of risk Do you want governments assigning a yet lower? Permanence of the sponsor does not justify attaching a lower price to risk Implicitly, investing in equities places taxpayers in the position of writing put options 21 Summary, part II Making good on those puts can be costly Does anybody really need to be reminded of that today? Risk is important Kinda, probably is not the same as for certain Public pension plans are in the for certain business Planning on the basis of expected values amounts to assuming that financial markets charge a zero price for risk 22
IV. Audience survey 23 How many would be willing to A. take $925.93 in cash today, invest it any way you want, and promise at all costs to return $1,000 one year from now? Note: $925.93 = $1,000 / 1.08 B. take $146.02 in cash today, invest it any way you want, and promise at all costs to return $1,000 twenty-five years from now? Note: $146.02 = $1,000 / (1.08^25) C. How many are more comfortable with B than A? 24