Musings on Pension Plans, Social Security and Discount Rates

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Musings on Pension Plans, Social Security and Discount Rates

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

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.