This volume presents the current large underfunding of US pension plans as the result of accounting that failed to take into consideration either underlying pension liability risks or the risks inherent in the traditional diversified investment portfolio. It argues that the best method to discount pension liabilities is instead through the use of a customized liability index that takes into account both the risk-free (Treasury) yield curve and the mortality of the particular participant population. The book then goes on to argue for the creation and use of investment portfolios that are based on and benchmarked against the liability index.
Its author, Ronald J. Ryan, has long and distinguished experience working with fixed income indices and instruments. He was director of fixed income research at Lehman Brothers, managed fixed income investments and founded several investment advisory firms.
Ryan's current firm creates and sells the indices and advises on the creation of the portfolios recommended in the book. Readers should be aware of this in assessing the author's work.
Much of the book's analysis of the causes of underfunding is sound. The decision by the actuarial profession to discount liabilities based on a median-performance projection of asset portfolio returns, the ‘smoothing’ (amortization/recognition over many years) of portfolio gains and losses versus the projected rate, and the initial acquiescence by the accounting profession to those practices led to widespread lack of appreciation of the extent of pension liabilities and risks: not only were the risks greater than publicly reported, they were greater than even most professionals understood.
The book reports some estimates and some of the consequences of the resulting underfunding, although not systematically. For example, it describes the consequences of these unplanned burdens on taxpayers in cities and states and mentions service cuts in passing, but ignores the simultaneous efforts to reduce public employee pay and benefits, particularly for new employees. (The author also attributes other trends to the underfunding whose causes seem to be more complex. For example, Ryan notes the longstanding shift from defined benefit (DB) to defined contribution (DC) plans as a consequence of underfunding from 1985 to 2010, even though most DB plans were thought to be fully funded until after 2000.)
The book describes the processes by which private sector pension accounting under the financial accounting standards board (FASB) and public plan accounting under the governmental accounting standards board (GASB) were developed. The discussion points out that both accounting bodies accepted the discounting of liabilities based on projections of asset returns which leads to an under-estimate of those liabilities. The summary of the development of standards by both bodies is useful, but incomplete. A significant omission is that The U.S. Pension Crisis, published in 2014, does not even mention that GASB issued revised standards for accounting and reporting of public plans in 2012, much less discuss those standards. There are some inaccuracies as well. The author claims that FASB required the use of individual discount rates and individual liability determinations (the technique his firm uses to develop liability indices), whereas FASB 87 specifically allowed for use of approximations.
One area where more analysis would be beneficial is the relationship between accounting standards and actuarial practice. Ryan's assessment seems to be that the greater blame for underfunding falls on the accounting authorities rather than the actuarial profession. It is not clear that this is appropriate, since many of the original pension accounting standards seem to have codified actuarial practice.
This issue remains an important one. The author seems to believe that the accounting standards organizations should have abandoned the practices of the actuarial profession and developed new standards conforming to the views of financial economists. This is an entirely legitimate view – one shared by most economists – but the argument would benefit from a discussion of the merits and issues involved in doing so.
The book then goes on to describe, in some detail, both the theoretical rationale and the means by which asset-liability matching (ALM) can be achieved in pension portfolios. These sections would be useful for those plans that decide that reducing funding volatility is a priority. The author, whose firm assists plans that decide to undertake ALM, asserts both that this approach should be universally adopted and that doing so is the solution to the US pension crisis.
In fact, as the author recognizes, only a minority of plans have chosen to adopt ALM. The book is less successful in explaining why. In my view, most plans and their sponsors continue to accept the greater volatility of a traditional balanced portfolio in the hope that it will result in an adequately funded plan more quickly and at a lower cost in future contributions.
Although DB pension plans represent a declining percentage of retirement assets and cover a declining percentage of US workers, they continue to cover approximately 75 million Americans and involve more than US$8 trillion. Thus, these issues – how best to explain their risks and to fund their commitments – remain important and will remain so for decades.
