Valuations of assets and liabilities of public pension plans serve several important purposes. These measurements help stakeholders to assess the degree to which pension systems are achieving the goals of benefit security for employees and fiscal responsibility for taxpayers. Adopting so-called “market value of liabilities” measurements would make it harder for pension systems to achieve these goals.
As I have written in the Journal of Policy Reform, and as I have explained in congressional testimony, the policy goals of benefit security and fiscal responsibility are best served by pension accounting and funding rules which promote predictable, regular contributions. A movement to so-called “market value of liabilities” measurements would undercut this objective by increasing the volatility of measured liabilities, thus creating a more volatile funding burden for taxpayers and employees. Even more problematic, this funding burden would move in a countercyclical fashion—that is, funding requirements would grow at exactly the same time that taxpayers (and employees) could least afford them, during cyclical downturns, and they would ease during periods of economic strength, when the ability to fund is greatest.
Although there may be methods available to limit the impact of this countercyclical volatility by changing investment practices, these would involve significant insurance costs, undermining the goal of fiscal responsibility. An equally undesirable method to limit the countercyclical funding burdens caused by “marking-to-market” would be to close pension plans or reduce benefits in them, undermining the goal of benefit security. Thus, the proposed changes to valuation methods do not advance public policy goals.
Defining policy efficiency
As a basic policy rule, pension valuation changes should only be adopted if they are more efficient—that is, if they better accomplish the key policy goals of making benefits secure and ensuring demands on taxpayers are kept manageable, or if they advance one of these goals without undermining the other goal.
The primary goal of asset and liability valuations is to gauge the security of promised benefits. A close second goal is to keep demands on taxpayers manageable. Both goals are intertwined with the predictability of contributions. Regular contributions enhance benefit security. Such contributions are more likely to be forthcoming from employers when they are predictable. Similarly, the twin goals of benefit security and fiscal responsibility are enhanced by investment practices that create economic efficiencies by enabling plans to manage long-term risks that are inherent in any pension plan.
Assessing policy efficiency of moving to “marking-to-market”
Moving from current actuarial practices toward marking asset and liability valuations to market is an inefficient policy move, largely because doing so automatically increases the volatility of plan valuations, undermining the goals outlined above. A number of factors contribute to this result.
First, interest rates can be relatively volatile in the short run as new information—information that is often incompletely processed in the market—becomes available. Short-term movements in interest rates can send misleading signals not just to market participants, but to employers, legislators, and other decision makers. For instance, the cost of a pension benefit improvement would look less expensive in a high interest rate environment than in one with low interest rates. This is misleading, though, since the benefits would actually be paid out over a period of decades. Thus, short-term movements in interest rates could undermine a sensible approach to benefits policy.
Second, this volatility exhibits a specific cyclical pattern. During an economic downturn, asset values fall and interest rates also fall because demand for loans weakens and because monetary policy typically becomes more accommodating. Because asset values tend to fall at the same time that measured liabilities spike, funding burdens grow at exactly the point in the business cycle that they are least affordable for employers and employees. Pension funding burdens become countercyclical in a mark-to-market approach, undermining a sensible funding policy.
Third, the volatility of the countercyclical funding burdens created by “marking-to-market” will have differential effects on plans, based on the maturity of their workforces, because of the introduction of a yield curve of interest rates. Assuming that such rates can be properly calculated, benefits owed to more mature workers will be discounted at rates that reflect shorter-term maturities. Economists observe that short-term rates have a tendency to fall further than long-term rates in an economic downturn. The shape of the yield curve itself is not stable and is volatile over the business cycle. In particular, liabilities for employers with more mature labor forces will experience larger cyclical swings in their liability valuations than employers with less mature labor forces. It is not clear that such highly volatile measures impart useful information to either employees or taxpayers.
So-called “market value of liability” measurements would undoubtedly reduce the predictability of employer contributions, not just in the short term, but in the long term as well. In effect, contribution rules and practices will follow funding level valuations in the future. Keeping two sets of measurements—one for “disclosure” and one for funding—will be perceived as internally inconsistent and difficult to sustain politically. To illustrate, one of the stated goals of the Bush administration’s support for moving private sector pension regulations toward a strict “mark-to-market” approach during negotiations over the Pension Protection Act of 2006 was to create pressure from employees on employers to increase contributions to pension plans when valuations showed “underfunding.” There is no reason to believe that a similar political link would not be made with respect to public pension plans. Consequently, employer contributions will become more volatile as funding valuations do.
Strategies to handle volatile funding burdens created by marking-to-market
If employers do not take steps to address the volatility of their contributions, demands on the taxpayer could become unmanageable. Employers may address the volatility of their contributions by terminating plans, which would severely hamper benefit security. The experience in the private sector from greater “marking-to-market” has already shown that many plan sponsors will reduce their exposure to contribution volatility by terminating or freezing their pension plans.
An alternative approach discussed by both advocates and opponents of marking-to-market is to move a plan’s investments toward an all-bond portfolio or a bond-like portfolio that depends on synthetic instruments like swaps or other derivatives. Such a move would forsake an equity premium that is as yet not fully explained, but all too real. This would be a highly questionable move: From an employer and taxpayer perspective, the same level of benefit promises would require larger employer and employee contributions. In the interest of balancing benefit security and taxpayer interests, it is likely that at least some part of addressing these higher and unnecessary costs would be borne by employees through lower benefits.
Adopting new valuation methods would move public policy further away from its intended goals. Mark-to-market approaches do not reflect the nature of a pension plan, which exists primarily as a mechanism for groups to share risks (principally longevity and investment risks) across individuals and over time. To accomplish this objective, a pension plan, especially one in the public sector, manages risks and invests over very long-time horizons. Thus, the valuation of assets and liabilities in such plans needs to account for the inevitable deviations of financial market prices from their long-term equilibrium values. After all, a financial entity with a decades-long (if not infinite) time horizon—such as a pension plan for state and local government employees—is better able to manage risks than an individual planning to retire next year, or a private sector pension plan that is about to be terminated. Indeed, economists have shown that pension plans create economic value for risk-averse individuals.
Applying valuation standards that implicitly assume an impending termination of a public sector plan not only ignores the relevant economics of these plans; it takes away the ability of these plans to create economic value for employees and taxpayers by managing risks. Economic value would be lost by artificially forcing plans to hedge all risks and incur the costs of doing so.
Based on the available economic evidence, the change under consideration does not appear to improve the intended policy outcomes—benefit security, fiscal responsibility, and the predictable pension contributions which support these. A more productive policy discussion would consider policy alternatives that better achieve these goals than marking assets and liabilities to market. Such a discussion might include a consideration of the factors that enhance (or impede) employers’ ability to make predictable pension contributions and the types of benefit policies and funding policies that work best to promote sustainable, secure benefits at a reasonable cost to taxpayers.