Market-oriented actuaries need not apply

Pensions & Investments reports that the Montana Public Employees' Retirement Board and the Montana Teachers' Retirement System, both of Helena have issued RFPs for actuarial consulting services that threaten to disqualify bidders if they support market valuation of pension liabilities.

What's the big deal? Currently, Montana discounts its future benefit obligations at an interest rate of 8 percent, which is the expected rate of return on its investment assets. However, 8 percent is a risky rate of return, meaning we can't simply assume that the fund will return that amount. Market-oriented actuaries would use a lower risk return, on the order of 3-3.5 percent, says P&I. This risk neutral approach better captures the risk to the pension provider that their risky investment portfolio might be insufficient to fund full benefits in the future.

To illustrate the difference, imagine if the pension plan had benefit liabilities of $100 million beginning 20 years from now. At an 8 percent discount rate, the present value of that liability would be only $21 million. At a 3 percent discount rate, however, the present value of that $100 million future liability would be $55 million, over twice as much. You can see how big a difference market analysis makes in assessing the level of underfunding in a pension plan.

This also tells us something about the state pension providers in that they seem so eager not to hear what market analysis has to say.

Here's the substance from the RFPs:

3.   One (1) Market Value of Liabilities Report. Briefly state the position of the Primary Actuary and of the Actuarial Firm on this topic.  Please submit any written documentation in which the position of the Primary Actuary or the Actuarial Firm has been stated.  If the Primary Actuary or the Actuarial Firm supports MVL for public pension plans, their proposal may be disqualified from further consideration.  (Section 4.7)

4.7    Market Value OF Liabilities (MVL)

Much has been written and discussed regarding the pros and cons of using market value of liabilities in the actuarial valuations of public defined benefit plans.  Briefly state the position of the Primary Actuary and of the Actuarial Firm on this topic.  Please submit any written documentation in which the position of the Primary Actuary or the Actuarial Firm has been stated.  If the Primary Actuary or the Actuarial Firm supports MVL for public pension plans, their proposal may be disqualified from further consideration.

This paper, co-authored with Kent Smetters and Clark Burdick, applies market analysis to the cost of protecting Social Security personal accounts against stock market risk. While the context is different, the underlying difference between the "expected cost" approach and the "risk neutral" approach is the same.