Information on the Social Security Administration and Its Risks
In a recent blog we summarized the many risk management errors that are commonly found at defined benefit public pension funds and the amusing excuses given for perpetuating those errors.
van Deventer, Donald R. “Public Pension Plans: Reforming Disclosure and Risk Management to Protect Taxpayers and Beneficiaries,” Kamakura blog, www.kamakuraco.com, January 29, 2013. Redistributed on www.riskcenter.com, January 29, 2013.
A copy of the blog is available at this link:
In that blog, we contrast the way the U.S. Social Security Administration makes its disclosures and manages its risks. The U.S. Social Security program has plenty of problems, but we know what they are. In fact, on February 25, 2013, the Social Security Administration itself released this analysis of ten proposals to restore the solvency of the Social Security trust fund:
The Trustees of the Social Security trust funds in their 2012 annual report projected that the fund would be “exhausted” in 2033. At that point, since no funds would remain in the trust fund, the only money to pay promised benefits would be social security payments by younger taxpayers, and those payments would be sufficient to pay only 76% of the benefits promised to then-current Social Security recipients. The openness of the Social Security system allows constructive suggestions and critiques from researchers like Gary King (Harvard University) and Samir Soneji (Dartmouth). King and Soneji (2012, 2013), using more modern mortality modeling techniques, showed that an increase in longevity would actually lead the trust funds to be exhausted in 2031, not 2033. The problems of the Social Security trust fund stem from long-standing underfunding, in spite of a conservative investment strategy that puts 100% of trust fund assets into U.S. Treasury securities.
Public pension funds of states and municipalities, by contrast, offer a degree of disclosure that seems intended to mislead, even though the Government Accounting Standards Board has issued new statements (67 and 68) on public pension fund accounting. Private pension fund disclosure isn’t much better. On the public pension fund side, the true liability cash flows are not disclosed. Their net present value is mis-calculated, leading to an intentional understatement. Losses aren’t recognized immediately, like they would be if the same assets were held by a public firm or a fund manager; they’re amortized over a period of years. Worst of all, public pension funds use taxpayer and beneficiary money to invest like a hedge fund instead like a prudent individual investor trying to protect his or her retirement assets against losses.
The comprehensive annual financial reports of many public pension funds seem designed to obscure the true financial status of such funds. In the rest of this blog, we pose five simple questions that every pension fund beneficiary should demand be answered by pension fund administrators. If administrators cannot or will not answer these questions, then the fund is either in severe financial distress or more competent administrators are needed.
Question 1: Ignoring income from investments, looking only at individuals currently covered by the existing plan, what are the annual dollar amounts of cash in to the fund (from employee and employer contributions) and cash paid out of the fund (in the form of benefits to the beneficiaries) for the next 75 years?
The Social Security system makes exactly such disclosure for the 75 year time frame, a time frame which covers nearly the entire life span of even the youngest contributors to Social Security. Why do other public pension funds and private pension funds not make the same disclosure?
Question 2: Using the data from Question 1 and the current true market value (not actuarial value) of assets, what compound annual rate of return is necessary for the current assets of the fund to meet the net cash flows projected for the next 75 years?
The answer to this question will typically reveal that not even Warren Buffett could earn a high enough return to save the typical public pension fund without a dramatic increase in contributions from employees and employers (via the taxpayers) or a dramatic cut in benefits. The situation isn’t much better in the typical corporate pension fund.
Question 3: Assume that we think the current pension fund investment strategy is too risky and that we demand that the fund’s assets be shifted into U.S. Treasury securities on a matched maturity basis with the fund’s projected future cash flows. This mimics the Social Security Administration strategy. What amount of money is necessary to implement this strategy today? If this amount of money is $X, what is the actual current true market value of assets (not actuarial value) as a percent of $X?
The answer to this question will also reveal that almost every public pension fund is dramatically under-funded if the near-zero investment risk of the Social Security Administration is followed. Pension fund administrators hide this risk by using an “expected return” that is completely inconsistent with market realities. See the next question that proves even this expected return is often not good enough.
Question 4: Is the expected return on the pension fund’s assets less than the “break-even” return in the answer to question 2? If so, assuming that the fund earns exactly the expected return with no risk, in what year will the assets of the fund be reduced to zero?
As mentioned above, the Social Security administration makes this disclosure but next to no public or private pension funds do. The answer to this question makes it clear that even the diversion of attention to a fictional expected return is not enough to restore solvency to most public pension funds without an increase in contribution rates (i.e. taxes) or a reduction in benefits.
Question 5: Assume the fund continues to pursue its current highly risky investment strategy. Using the actual history of market returns in the U.S. and Japan, where equities remain still almost 80% below their peak in 1989, what is the probability that the fund’s assets will go to zero in each of the next 75 years?
This question, like the answers to questions 2, 3 and 4, re-emphasizes the fact that actual historical returns over a wide array of time periods and markets are not sufficient to bail out most public pension funds and many private pension funds. Many fund administrators use “selection bias” to understate the problems of the fund by choosing markets that have experienced an extended bull market as “typical,” ignoring two decades of malaise in Japan that stemmed from the collapse of real estate prices and low interest rates like we’ve experienced in the United States in the wake of the 2006-2011 credit crisis.
Many public and private pension funds are in severe financial difficulties. They’re pursuing a “double or nothing” high risk investment strategy in the hope that extraordinary market returns will bail them out. On October 9, 2012, Deborah Mills-Scofield wrote in a blog for the Harvard Business Review “We’ve all heard the phrase ‘hope is not a strategy,’ and it isn’t--especially when based on illusion, delusion, fiction or false assumptions.” The five questions above will reveal pension fund illusions, delusions, fictions and false assumptions. Only transparent disclosure of the current financial status and risk of public and private pension plans will lead to the least costly resolution of the current situation.
For more on pension fund risk issues, please contact us at Info@KamakuraCo.com.
Donald R. van Deventer
February 27, 2013
Copyright © 2013 by Donald R. van Deventer. All Rights Reserved.
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