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As liability-driven investing (LDI) has taken over as US corporate pension plans’ dominant strategy, heads naturally have turned to public pensions. Could they—or would they—get on board with a similar approach to address their serious underfunding issues?
Less than 10% of US state plans are fully funded—according to themselves. The first step onto the LDI track would be to standardize the measurement of liabilities. Yet, the Governmental Accounting Standards Board decided last year not to transition into a mark-to-market valuation of liabilities, as some had predicted it might.
However, Moody’s Investors Services moved in to pick up the slack and overhaul its valuation methodology.
Moody’s now holds public plans to an almost-corporate standard for funding—a much higher bar than the industry had become used to. The ratings agency measures public liabilities on a market-based discount rate, using a “high-grade, long-term taxable bond index rate”—Citibank’s Pension Liability Index—and a common duration of 13 years. Rather than allow pensions to rely on long-term return assumptions, which are typically 7% to 8%, Moody’s will use current market interest rates to value future cash flows. For 2010 and 2011, the formula turned out an average discount rate of 5.5%.
The mark-to-market approach to measuring liabilities will result in much larger total liabilities than those reported using governments’ approaches, according to a Moody’s report from April of this year. More volatility will also be taken into account in this new measurement, and unfunded liabilities will be treated as “debt-like obligations that can create a significant burden on government operating budgets.”
Marcia van Wagner, Moody’s vice president and senior analyst, says it’s premature to predict how much this methodology will affect investment strategies: “We’re looking at pensions from a credit perspective. I wouldn’t necessarily say that what we’re doing is going to have an impact on investment strategies. That’s up to the pension plans.”
Proponents of the mark-to-market valuation disagree. “I think the impact of Moody’s methodology change is really important to understand,” says Dave Wilson, managing director and head of the customized strategies group at Cutwater Asset Management. “Their ratings have a big impact on municipal financing levels, and they will punish you if your pension plan is too underfunded—this could affect the financial statements of many municipalities.” Six state pensions have already been downgraded under the new methodology, due to consistent and serious underfunding. Illinois had the heaviest pension burden in the country, as of Moody’s June report, with net pension liabilities totaling 241% of the state government’s annual revenue.
The shift by Moody’s could be the nudge public pension plans need to implement LDI-like hedging and de-risking strategies. American economist Jeremy Gold believes changes like these will help public pensions face up to the gratuitous risks they undertook during 30 years of declining interest rates and to finally accurately measure liabilities. “It’s a step in the right direction,” Gold says. “It’s making people more aware that interest is a risk, and as with almost any other risk, if you don’t measure it, you’re not likely to manage it. Mis-measurement is a very poor form of risk management.”
But these developments warrant an unavoidable question: How realistic is an en masse move by public pensions into LDI? “In theory, these plans will pay much more attention to interest-rate exposure and do more to take that risk off the table, especially now that Moody’s is paying attention,” Gold says. “But it’s very difficult for the federal government to regulate the behavior of public pension plans. We end up with states’ rights and 10th Amendment issues very quickly.” And he’s right—the Pension Protection Act of 2006 monitors corporate pensions, but public plans are allowed to fend for themselves.
Economists also argue that underlying social and political forces work against meaningful public pension de-risking. “Everybody is so afraid of telling the truth about how big the public plan pension liabilities are in reality, and about how big the contributions would need to be in order to bring them back to a fully secure funding status,” says Barton Waring, an economist and former Barclays Global Investors CIO for investment strategy. “Hedging to protect benefits from funding-level volatility is difficult but quite doable. You can’t do a perfect job, but you can do a pretty damn good job.”