Assessing the Impact of Investment Shortfalls on Unfunded Pension Liabilities: The Allure of Neat, but Faulty Counterfactuals

In this paper I provide a methodological critique of the conventional method for assessing the impact of investment shortfalls and other contributors to unfunded pension liabilities, and offer a methodologically sound replacement with substantive policy implications. The conventional method – simply summing the annual actuarial gain/loss figures over time – provides a neat, additive decomposition of the sources of the rise in the Unfunded Accrued Liability (UAL). In doing so, however, it implicitly assumes that in the counterfactual exercise, amortization would adjust dollar-for-dollar with the interest on additional UAL. That is, even if the total (and average) shortfall from covering interest is substantial, the marginal shortfall is assumed to be zero. This is not how contribution shortfalls arise under funding formulas typically used by public plans in the United States. Using the actual funding formula in the counterfactual – with contribution shortfalls on the margin -- leads to much higher estimates of the UAL impact of investment shortfalls than the conventional method. The reason is that there are large interactions over time between investment shortfalls and marginal contribution shortfalls. The conventional counterfactual implicitly assumes away these interactions. The resulting additivity is alluring, but illusory. The conventional method also leads to untenable results on other UAL-drivers. Most striking is the implication that the cumulative UAL impact of pension obligation bonds (POB’s) is no different from the initial impact of receiving the proceeds, independent of the return (actual or assumed) on those proceeds. The underlying problem with the conventional framework is that it has emerged without careful attention to the counterfactual scenarios it is meant to address. This paper provides explicit and internally consistent counterfactuals to better understand the conventional method and its flaws, as well as the reasons for using instead the actual amortization formula in the counterfactual. Mathematical methods are used to illuminate the theoretical issues that lie behind any simulations. The analytical results are illustrated empirically with an adapted version of the actuarial history of the Connecticut State Teachers’ Retirement System (CSTRS), FY00-FY14. The example is instructive because it is a highly underfunded system, notable for its high (and unreduced) assumed rate of return (8.5 percent), as well as its use of $2 billion in POB proceeds to reduce the UAL in FY08, just before the market crash.