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Old Mendocino County Courthouse Around 1915

California County Pension Debt

 

Pension Basics



This is Very Important to Understand

How Pensions are Funded



County Pension Basics


Choices -

The Benefit

Organization

Funding

Success or Failure

 

You need to understand how government Pension Funds were SUPPOSED to work to understand how badly many failed.

The next two pages are VERY IMPORTANT for you to understand.

The Basic Pension Funding Formula

Although pension funding can get very complex, if you boil it down there's a very simple funding formula.



  Employer and Employee Contributions
=
Pensions  
  + Investment Profits   + Pension Fund Expenses  

Compared to Pension payments Pension Fund Expenses are not very significant. (I'm not including fees paid to various investment professionals which can be quite substantial. But they are reported as deductions from Investment Profits rather than Pension Fund expenses.)

If everything works "according to plan" the contributions will provide 20% to 25% of pension payments and fund expenses. Investment profits earned by investing those contributions are supposed to provide 75% to 80%.

Actuarial Valuations - aka Pension Funding Plans

Actuaries Predict the Future
Actuaries Predict
the Future

Pension Fund Retirement Boards adopt an "Actuarial Valuation" prepared by its Actuary usually each year. These are "pension funding plans" that, among other things, quantify how much the governent and its employees must pay to the Pension Fund.

No one knows what the future will be. How long will retirees live? When will they retire? What will pension payments be in the future? Will the employee suffer a job-related disability? How much will the Pension Fund really earn? The unknowns go on and on.

The biggest thing most people don't understand about how today's massive unfunded pension debt is the "black box" of how actuaries figure this stuff out - or not. (See ACTUARIAL FAILURE.)

Actuarial Valuations are the Retirement Board's funding plan for its pension payments. If everything works out the way it's expressed in the Valuation, the pensions will be properly funded.

The Pension Fund's Funding Position

Does a Pension Fund have as much money as it should - or is it under or over-funded? Or - what is it's "Funding Position"?

As stated above there are huge uncertainties that compromise any attempt to answer this question - so many uncertainties that in fact it is impossible to be precise. All answers are estimates. Actuaries approach this question in several stages:

  1. Total Pension Liability - aka "Actuarially Accrued Liability" (AAL) - there are two steps in this calculation:
    1. Estimate Future Pension Payments that Have Already Been Earned: The first step Actuaries take is to estimate for each year in the future the total amount of pensions that will be paid that have already been earned in the past. These projections go out decades - as many as 70 years - until the point at which the Actuary estimates the last person receiving these pensions passes away.
    2. Calculate How Much Needs to be in the Fund today so ALL Those Future Payments will be paid: Then - for EACH of those future years the Actuary calculates how much money needs to be in the Pension Fund today so that if the Pension Fund earns its target rate of investment return each year in the future the pensions estimated to be paid in that future year will be paid. The total of all those years' calculation is the "Total Pension Liability" - known as "Actuarially Accrued (Pension) Liability". It would be more meaningful for most people if the term were "Actuarially ESTIMATED Liability".
  2. Value of Pension Fund Assets: How much money does the Pension Fund actually have? There are two main ways Actuaries calculate this.
    1. Market Value of Assets (MVA): Most of a Pension Fund's assets are investments of various types - stocks, bonds, real estate, hedge funds, etc. Most of these investments have an easily determined "market value" which is how much those investments could be sold for today. The total of all these investments plus cash held by the Fund less any liabilities that need to be paid in the immediate future (office supplies, rent, etc.) is the Market Value of the Pension Fund's Assets.
    2. Actuarial Value of Assets (AVA): Most of the time Actuaries modify the Market Value by a process called "smoothing". In the past Pension Funds mostly invested in very safe and stable bonds. But over time they were allowed to invest more heavily in much more volatile stocks. Usually the stock market loses a significant amount of its total value at the beginning of "Bear Markets" - a period of significant decline in stock prices. This can cause a sudden major decrease in the value of a Pension Fund's Assets which can create havoc in the pension funding plan (see unfunded pension amortization below). Actuaries prevent these chaotic shifts by "smoothing" the value of Pension Fund investments. Smoothing is a form of a "moving average" that spreads the volatily of investment values over several years. A very common form of smoothing is to spread the difference between expected and actual investment returns over 5 years.
  3. Funding Position: The difference between the value of Pension Fund Assets and the Total Pension Liability (AAL) is the Pension Fund's funding position. It is usually expressed in Actuarial Valuations both in "Market Value" and "Actuarial Value" (of assets) terms. But the payments that are expected to be made by governments and employees (see below) defined by the Actuary are almost always based on the Actuarial Value. If the Fund has more money based on the smoothed value of assets than the Total Pension Liability (AAL) it is said to be "over-funded". If it has less the amount it should have but doesn't is known as the "Unfunded Actuarially Accrued Liability" - or "UAAL".

There are variations of these calculations. One example - quite often Actuaries will deduct certain Pension Fund reserves that are set aside for purposes other than paying pensions to produce a "Valuation Value of Assets" (VVA) that is less than the "Actuarial Value of Assets" (AVA). This lower value will be used to estimate the Pension Fund's funding position. But the difference between the VVA and AVA is usually relatively small. For most purposes we don't need to be very concerned about this distinction - but these types of "wrinkles" exist.

Two Types of Payments (Contributions) to the Pension Fund

Each year the Actuary quantifies two types of payments to the Pension Fund that must be made in the next year.

  1. Normal Contribution: This is the Actuary's estimate of how much needs to be contributed in a specific year so that - with investment profits - there will be enough to pay the part of future pensions being earned by employees that year and the expenses of the Retirement Association. Both the government and its employees pay a portion of this payment.
Two Major Points!

The only payment into the Pension Fund that's supposed to be needed is the annual NORMAL CONTRIBUTION. The government and its employees each pay a share.

AND - a basic goal of pension funding is that when employees retire their pensions should be FULLY FUNDED - that is, no more contributions should have to be made for those retirees by either the government or the employees/retirees.
  1. Unfunded Pension Payments: However, if in a subsequent Valuation the Actuary estimates there isn't enough money in the Pension Fund to pay the part of future pensions that has already been earned in the past additional payments must be made to the Pension Fund to eliminate the unfunded amount.
Two Major Points!

Almost always only the government is obligated to make additional payments to eliminate unfunded pensions. Employees and retirees rarely have that obligation.

If a significant unfunded pension obligation develops it means the basic funding plan to require only Normal Contributions failed - no matter what the immediate cause.

If the government must make these extra payments it has two choices.

  1. Unfunded Pension Amortization Payments: The government can pay "amortization payments" to the Pension Fund - a series of payments over time. If all Valuation assumptions "come true" the government incurs "interest expense" at the Fund's assumed rate of return.
  2. Pension Obligation Bonds: Governments can borrow money by selling "Pension Obligation Bonds" hoping to get lower interest rates. The Pension Fund gets the money but the government (and its people) still has the debt.
Major Point

Pension Obligation Bonds are simply unfunded pension obligations "restructured" into Bonded Debt. From the People's point of view Pension Bonds are part of the government's unfunded pension debt and must be included in calculating the impact of unfunded pensions on the governments's finances.
Who Pays for Pensions?

A government's unfunded pension amortization payments to the Pension Fund and payments of Pension Obligation Bonds are BOTH payments of unfunded pension debt.

 
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