Woody at work
Woody is the villain of the new book The US Pension Crisis – What We Need to Do Now to Save America’s Pensions, by Ronald Ryan. According to Ryan, Woody is the “pension pencil” or “the weapon of mass destruction in financial America”, used since the 1990s for accounting gimmicks that conceal the real financial situation of pension funds.
“What we need now is financial truth,” says Ryan, a recipient of the prestigious William F Sharpe Index Lifetime Achievement Award, and CEO and founder of Ryan ALM, an asset-liability management firm based in Florida. The truth, according to Ryan’s book, is that public and private plan deficits exceed $4trn (€3trn) today and their funded ratios linger around 40%.
Ryan agrees strong equity markets since 2009 have helped improve pension fund assets. “But it has not solved the crisis,” he says. “Cities and states have the worst deficits regarding their retirement systems. The causes are the misleading rules issued by the Governmental Accounting Standards Board (GASB). Instead of marking to market, GASB allows public pension plans to smooth assets over a moving five-year average, as a way to remove volatility from budgets and contribution costs. On the other hand, GASB calls for plans to discount their liabilities at the expected return on assets [ROA], which has been typically 8% for a long period.”
The combination of smoothing, which overvalued assets in the 2000s, and using the ROA as the discount rate, which undervalued liabilities, means the reported funded ratio of public plans is exaggerated by 19-41%, according to Ryan.
“During the 1990s, when Wall Street was ebullient, most pension funds were OK,” recalls Ryan. “At that time they should have secured the victory and de-risked – buying bonds and using only the surplus for risky investments. They didn’t and, since then, interest rates have been going down while Wall Street has been through a few major corrections. On top of that, public pension funds have reduced contributions and increased benefits, hence the recent municipal bankruptcies in Detroit and other cities”.
The New York City Employees Retirement System is another example of the huge cost of this approach, Ryan says. The city’s contributions were $68m in 2000 but $3bn now.
In contrast, the Financial Accounting Standards Board (FASB) has not adopted ROA as the discount rate and the Pension Protection Act of 2006 introduced new funding rules. But a law signed last August by President Barack Obama is another example of Woody at work, according to Ryan. The Moving Ahead for Progress in the 21st Century Act (MAP-21) concerns road repairs costing $10.8bn, with knock-on implications for pension funding.
Ryan notes the federal government wanted to avoid raising fuel taxes to pay for it, given the proximity of mid-term elections, and instead applied an accounting trick to finance the provisions of the legislation. “They allowed corporations to smooth their liabilities, making them look smaller, so they can delay contributions, their profits go up, and the government gets more corporate taxes,” notes Ryan.
To save pensions, Ryan urges a move to liability-driven investing – an approach familiar to many European funds. They must fund liabilities on a less costly and risky basis, he says, pointing to the benefits of cashflow-matching and liability-beta portfolios made up of bonds.
Ryan recommends first creating a custom-liability index (CLI) as the proper benchmark for each specific plan. To create a CLI, Ryan ALM uses zero-coupon STRIPS, given their secure future value, a point FASB also emphasises. An alpha portfolio should be applied to create a surplus versus liabilities.
The trouble is that few US pension funds are following this advice, Ryan admits. The American Academy of Actuaries has published a white paper that agrees with this view and the International Accounting Standards Board (IASB) has already decided that corporations should use mark-to-market financial reporting for their pension funds.
“IASB is the model and America will follow, sooner or later,” concludes Ryan.