Andrew D. Wozniak, CFA, ASA, Director of Research and Analysis with BNY Mellon Pension Services, and Peter S. Austin, Executive Director of BNY Mellon Pension Services, explained in a report issued by BNY Mellon that “many financial economists believe that public pension plan liabilities should be valued the same way financial markets value the debt of governments.” These critics of the current actuarial methods of public pension funds believe the use of a discount rate, asset smoothing, and varied cost methods – actuarial methods eliminated in the valuation of private pension plans by recent regulations  – understates public funds’ liabilities, distort real asset and liability values, and make comparisons with other plans challenging.

However, advocates of the current system point out that unlike corporations, governments exist permanently, do not have the threat of bankruptcy, and have an unlimited ability to tax or print money to fund obligations, according to the report. These advocates claim market-based valuations are irrelevant and would be challenging or misleading because:

• Certain actuarial cost methods do not define and accrued liability,
• Estimated future benefit payments are not known with certainty due to uncertainty of actuarial assumptions (e.g. mortality, future salary increases, future cost of living increases, and withdrawal and retirement assumptions), and
• A lack of matching assets for a pension commitment, such as a 50-year inflation-indexed bond.

Advocates of the current public pension valuation methods warn that the disclosure of a market-based liability could result in unfavorable changes in the public plan landscape as has been experienced in the private defined benefit plan world. Stakeholders could notice a 20% – 40% increase in liability values, leading to reports of serious funding deficiencies, leading policy-makers to freeze benefits or switch to defined contribution plans, and ultimately leading to a less secure retirement for public employees, the report said.

Wozniak and Austin suggest a compromise between the old valuation methods and those similar to what private pension plans are moving to. In their scenario, assets would be reflected at market value as of a valuation date, a uniform actuarial cost method would be used for every public pension plan, and two liability measures would be used: market liability and ongoing liability.

The report authors say that the traditional valuations based on an actuary’s best guess should be replaced with an annual probabilistic valuation looking at a range of possibilities and their likelihood. In the authors’ suggested scenario policy-makers would specify in advance what ongoing and market funding ratio thresholds would be required to increase benefits, and governments would reflect the market values of assets and liabilities on their balance sheet.

Finally, Wozniak and Austin warn that a change in valuation methods would require governments to educate the media and stakeholders that lower funded status ratios do not necessarily indicate a plan is in trouble and to emphasize a plan’s ongoing funding.

The report, U.S. Public Pensions At a Crossroad: Which Way Forward?, is here .