The subject of that heavily Wall Street joke is the incredibly arcane accounting rules that govern how corporate and public pension plans report their financial condition.
Ron Ryan ought to know. As chairman and founder of Ryan ALM, Inc., a pension-consulting firm, Mr. Ryan has been keeping a pension Asset/Liability Scoreboard for years. Corporate pensions were fully funded in1999 but his index shows that pension liabilities have outpaced pension assets by 50 percent over the last 5 years. Many readers will be surprised to see that two years of stock market recovery have done little to dig pension plans out of the hole they were in at the end of 2002. Indeed, Secretary of Labor Elaine L. Chao told the National Press Club in January that private pension funds were under-funded by an estimated $450 billion. A separate study by Morgan Stanley estimates the nations public pension funds are now under-funded by $1 trillion.
That's not, as they say, chopped liver.
|Ron Ryan's Pension Asset/Liability Scoreboard|
|This table shows the relative performance of pension assets (their investment portfolios) and pension liabilities (their cost of their commitments to deliver pension incomes) based on a model of typical pension assets and liabilities since the beginning of 2000. Note that while the assets have recovered, the growth of pension liabilities has outpaced asset growth in four of the last five years. All figures in percent.|
|Source: Ryan ALM, Inc.|
In a recent telephone interview I asked Mr. Ryan to explain the problem.
"Basically, it's because the rules are improper. They make us do the wrong things. Until we mark-to-market we won't get a real statement on the condition of our pension funds."
Some readers will recall the phrase "mark-to-market." It was used frequently during the $500 billion S&L crisis when auditors insisted that Savings and Loans value their low interest rate mortgage portfolios at what they could be sold for in a high interest rate market. The result was a bankrupt industry.
"The rules say that you can 'smooth' assets," Mr. Ryan continued. "They do this so corporations can reduce volatility--- five-year smoothing eliminates dramatic changes but it's also misleading. What would you think of a checking account statement that showed your average balance over the last five years? It wouldn't be too useful, would it?
"But the liability side is where this really comes unglued. Corporations are earnings led, not expense led. So under the accounting rules corporations can forecast asset returns for the coming year.
"Then, since pensions are an expense, they can figure out the return (on assets) needed to wash out the pension cost. But why stop there? Why not forecast a higher return on assets so you can create earnings?
"It's a major trend," he said. Mr. Ryan then explained that assumed asset returns for stocks, private equity, and other investments are based on historical figures--- but assumed asset returns on bonds are based on yield to maturity. As a result, as soon as bond yields fell below the 8 percent return on assets most pension funds need, the consultants reduced the amount pensions should invest in bonds. Basically, the accounting rules distorted investment decisions.
Few understand that pension liabilities--- the money pensions are committed to pay to current and future retirees--- are a major part of the problem, Mr. Ryan added. When interest rates go down, as they did during the bear market and in response to 9/11, it means that pension liabilities go up. So the same Federal Reserve actions that were meant to buoy the economy also caused a massive increase in pension liabilities. By his estimate, each 50 basis point change in interest rates (that's ½ of 1 percent) will cause pension liabilities to rise or fall by 6 to 7.5 percent.
The city of San Diego is a good example. Some time ago Mr. Ryan asked city officials what their funding ratio was--- over or under 100 percent. He was told the city pension was fully funded.
He asked how they did the calculation.
They said they assumed an asset return of 8.5 percent and, like all public pensions, that they assumed a matching discount rate of 8.5 percent for liabilities.
He pointed out that actual interest rates--- the rates that would be used to buy life annuities for retirees--- were about 300 basis points lower. As a result, San Diego's actual liabilities were 30 to 40 percent higher. The San Diego pension plan was under-funded in the real world, but doing fine in the rule world.
In fact, Mr. Ryan said, the situation was worse. Believing the pension was fully funded the city had increased benefits. As a consequence, Mr. Ryan says the plan could be as little as 40 to 50 percent funded--- if marked to market.
"Until you mark to market, you'll never know the financial truth," Mr. Ryan concluded.
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National Press Club Speech by Secretary of Labor Elaine L. Chao