In recent months two interesting research papers were issued. The first, published by the Fraser Institute and authored by Malcolm Hamilton and Phillip Cross is Risk and Reward in Public Sector Pension Plans – A Taxpayer’s Perspective. The second, published by the CD Howe Institute and authored by Stuart Landon and Constance Smith is Managing Uncertainty: The Search for a Golden Discount-Rate Rule for Defined-Benefit Pensions. Both papers focus on discount rates and reveal how the assumptions that actuaries make about future interest rates impacts the recognition of the cost of pension promises over time.
The Hamilton-Cross paper presents a clever way of thinking about the difference between the ‘value’ of a pension promise and the ‘cost’ to fund the promise and the paper delivers to readers the truth that the difference between these two amounts is the reward for taking investment risk. Just a warning, after all the math is done the authors expose an estimated $22 billion annual subsidy that taxpayers are providing to government workers in the form of valuable pensions – the cost of which is under-estimated by pretending that investing in equities over the long-term has no risks. This can be upsetting to readers that worry our governments are spending beyond their means.
Where the Hamilton-Cross paper uses pure math to demonstrate its conclusions, the Landon-Smith paper focuses on the question of funding pensions using a different approach. Landon-Smith use Monte Carlo simulations to examine six different approaches to setting a discount rate. These approaches range between the conservative approach of 3% per annum and the aggressive approach of 9% per annum. In between are ‘discount-rate rules’ such as ‘inflation + 3%’. To be honest, I have never been the type of mathematician that sees the elegant answer that Hamilton and Cross have spotted. I have always been partial to the ‘brute force’ method of mathematics employed by Landon and Smith.
So, after 50,000 simulations and the application of a ‘quadratic loss function’ the Landon-Smith paper concludes several findings:
The authors conclude by choosing the discount-rate method that they find best balances the risks of too many assets with too few.
But wait, is that what we should be taking from this paper? Should we stop sponsors of pension plans from systematically encouraging actuaries to choose discount rates at the high end of the range and as a result perpetuate a system that is tilted towards underfunded plans?
To me this is not the conclusion at all. The real learning is:
In the private sector, sponsors looked at the conclusions above and decided that bond-like investments defeated the investment advantage of pooling pension assets for employees and the lose-lose surplus/deficit proposition made chasing a moving target foolish. Thus commenced the exodus of private sector plan sponsors willing to play the DB game.
It is on the final point that I think we have work to do. This is not work for the actuaries. If governments want DB plans in the private sector – the funding regime needs to reflect two truths. First, accumulating pension savings over decades requires prudent risk-taking and this risk taking shouldn’t be discouraged. Second, everyone should be clear on how the risks and the rewards are shared among stakeholders. DC plans became popular in the private sector because they aligned the party taking the investment risk with the party benefiting from doing so – the plan member.
If you go back to the Hamilton-Cross paper, the beauty of their work is that they expose the fact that while targeting public sector pension contributions at a reasonably ‘expected’ level, there is no accounting for who will pay in the 50% of scenarios where the assets fall short. Governments can resolve this challenge easily by clarifying to public sector workers that they have one of two choices:
In option 2 above, the government should probably also get out of the business of investing in equities and go back to investing in federal and provincial bonds. But that is a discussion for another day.