If you were an actuary working for a Defined Benefit pension plan, or Social Security, you would develop an estimate of the stream of cash flows that you expect the plan to pay. The expected cash flows are ultimately what matters. Estimates of what the cash flows are worth in the present are a sideshow, because the estimates of what the assets of the plan will earn are far less stable than the estimates of what will get paid, even over the long term.
Unless we get significant and prolonged inflation, the discount rates applied to the liabilities are unrealistic, even in Indiana, which has the lowest rates that I have heard of for major plans at 6.75%. Discount rates should be in the 3.5-5.0% area. It is very difficult to earn more than 1-2% over the long Treasury, or more than can be earned from long Baa/BBB bonds.
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Thus, in my opinion,virtually every underfunded pension plan is behind the curve, and their underfunded status is underestimated.
So here’s the scandal. As funds don’t earn enough to pay the benefits, their funded status worsens. As their asset levels drop to Puerto Rican levels, they become forced to raise taxes to keep pace with the rising payments as Baby Boomers retire. That’s the curve that they are behind: the curve of increasing retirement benefits.
Now, there are other strategies. Reduce benefits to active employees. Eliminate COLAs. New hires only get a DC plan. Play hardball with retirees, and get them to reduce vested benefits in exchange for greater certainty of payment.
I’m not optimistic here. There will be cuts. The only question is on whom the cuts will fall.
By David Merkel, CFA of Aleph Blog