Wednesday, August 30, 2006


Pension Valuation Tower of Babel



In my June 22, 2006 post entitled "Will the Real Pension Deficit Please Stand Up?", I made the case that measurement ambiguity is dangerous. It prevents anyone from addressing a financial funding problem in any meaningful way. While ERISA plan metrics have often been the focus, it turns out that municipal plan analysis may be similarly difficult to interpret. New York Times journalists Mary Williams Walsh and Michael Cooper report that the use of multiple valuation methods can result in completely different assessments. (See "On Tracking of Pensions, No Consensus", August 27, 2006.) Their interviews with several rating agency professionals suggest concern and the need to supplement reported numbers with additional metrics.

Actuarial methods are called into question as well, especially if they result in overly optimistic investment return projections and artificially smoothed expenses over time. Though clarification would be a welcome relief, the reporters write that "The Governmental Accounting Standards Board, which sets the rules, is in the initial stages of reviewing the 12-year-old standard governments use when reporting pension values. Any changes are likely to take years."

In contrast, note what an anonymous blog reader has to say (with some minor edits).

The NYT article talks about valuing the pension liability using the appropriate municipal bond yield. Because this rate is lower than the current GASB-mandated rate, the liability balloons.

But municipal bond yields are low because they are tax exempt. I'd make the case for the same-risk corporate bond yield. (If NYC has Aa credit, use the Aa corporate bond yield.) This approach would reflect the risk of the pension liability, but not the tax shield. Since pension distributions are subject to taxation, the tax-exempt municipal yield is inappropriate from the pensioner's perspective.

Some might argue that public pension obligations are close to guaranteed since municipalities can raise taxes to pay bills. This suggests they should be valued at a risk free rate. If so, I'd argue that it should be a Treasury rate, not a Aaa muni rate.

As an Accredited Valuation Analyst, I think it's safe to say that reasonable people can disagree about assumptions as long as each appraiser employs logic and can defend, and document, the basis of his or her assumptions. Competing methodologies are a different story altogether when they produce outrageously divergent outcomes that are hard to support.

Perhaps this is the beginning of a new specialist career - pension valuation translator.
posted by Susan Mangiero at 8/30/2006 12:30:00 AM