Actuarial Failure to Recognize Asset Depletion Risk of Baby Boomer Retirements Led to Death Spiral in Chicago Teachers’ Pension Fund
In a recently released research report, former actuary Theodore Konshak reviewed the effects of Baby Boomer retirements on the Chicago Teachers’ Pension Fund.
When George W. Bush was elected President of the United States, privatization of the Social Security system was hotly debated. At that time some advocates of privatization would claim that the future retirements of the Baby Boom generation would bankrupt the Social Security system.
‘Death spiral’ is a term that the Pension Benefit Guaranty Corporation, the federal insurer of private sector pension plans, has used to describe the situation where the contribution requirements spiral upwards to a point where the employer can no longer afford to fund the pension plan. The skyrocketing costs of the Chicago Teachers’ Pension Fund are an underlying cause of a potential strike action by the Chicago Teachers’ Union against the Chicago Public Schools.
The death spiral in the Chicago Teachers’ Pension Fund results from the retirements of the Baby Boom generation. There is a substantial and continuing increase in the disbursements from the fund due to these retirements. With these Baby Boomer retirements, the Chicago Teachers’ Pension Fund ceased to be in an accumulation phase and entered into a disbursement phase.
Individuals saving for their retirement are in an accumulation phase. Individuals managing their assets after their retirement are in a disbursement phase. Individuals who accumulate too small of a retirement fund may experience financial difficulties in the later years of their retirements. The current problems of the Chicago Teachers’ Pension Fund are no different from the financial difficulties of those individuals. The fund accumulated by the Chicago Teachers’ Pension Fund prior to these Baby Boomer retirements was too small.
The cash necessary to pay the pension benefits of the Chicago Teachers’ Pension Fund ultimately comes from either the contributions into the trust fund or the investment income on those contributions. The actuarial interest rate is traditionally defined as the expected rate of future investment return. It determines the portion expected to come from future investment income. Higher actuarial interest rates assume a larger portion of this cash will come from future investment income.
The Chicago Teachers’ Pension Fund has been underfunded through the use of an actuarial interest rate assumption that has historically been set at too high of a level. Too much of the cash necessary to pay these pension benefits was expected to come from future investment income. Not enough of the cash was expected to come from future contributions.
Initially this actuarial interest rate caused the plan to receive no contributions from the Chicago Public Schools for a period of ten years. No contributions were necessary since the superior investment returns of those days were expected to continue far into the distant future. No contributions being made in insurance terms is known as a ‘premium holiday’.
After ten years of this ‘premium holiday’, the contributions calculated thereafter by the actuaries would prove to be insufficient. At that time, in spite of lower investment returns, the actuaries still expected the superior investment returns of the old days to continue far into the distant future. After the Baby Boomer retirements commenced, these superior investment returns had still not returned. The trust fund was too small and would deplete during this period of lower investment returns.
In the early stages of this death spiral, the Chicago Public Schools would obtain a partial ‘premium holiday’ from 2011-2013 from the State of Illinois. This would further compounded the depletion. The appetite of the death spiral for more contributions from the Chicago Public Schools would not be abated by legislative action. Favorable investment return may provide a brief respite here and there but the death spiral will demand more and more contributions from the Chicago Public Schools (CPS). The CPS contributions have to spiral upwards to compensate for the absence of the expected investment dollars.
In selecting the actuarial interest rate assumption for the Chicago Teachers’ Pension Fund, the actuaries failed to consider the asset depletion risk of the upcoming Baby Boomer retirements. They only considered Baby Boomer retirements as a demographic risk affecting the calculation of their actuarial liabilities.
The actuarial interest rate is also traditionally defined as the average rate of future investment return. As an average rate of investment return, the actuarial interest rate assumption might be achieved in the long term but there would still be a depletion risk where the investment return in actual dollar amounts can be less than expected. For example, for the Chicago Teachers’ Pension Fund, the annual investment return on the Actuarial Value of Assets for the five year period from July 1, 2007 to June 30, 2012 was 1.62%. With an annual investment return of 14.38% in the following five years, the investment rate would average to the then existing 8% assumed rate of return. Sustaining such a high rate of investment return is improbable but the actual investment return in dollars won’t average anyway. There will be a shortfall in those actual dollar returns.
This shortfall is the investment income that would have been earned on the assets that went out the door from June 1, 2007 to June 30, 2012 in the form of benefit payments. Because of the Baby Boomer retirements, those benefit payments were one third of the plan’s assets ($5.132 billion). An annual investment return of 14.38% would not be earned on that third in the subsequent five year period.
The depletion risk of these Baby Boomer retirements should have been considered by the actuaries long before those retirements actually occurred. It wasn’t an unanticipated event beyond the control of the actuary.
Only members of the American Academy of Actuaries meeting its Qualification Standards can perform and certify the actuarial valuation results of public sector pension plans. In selecting the actuarial interest rate, the actuaries for the Chicago Teachers’ Pension Fund performed their task as specified by the American Academy of Actuaries and its Actuarial Standard of Practice No. 27 (ASOP No. 27). The risk of asset depletion associated with these Baby Boomer retirements was not considered by the actuaries under this ASOP No. 27.
The American Academy of Actuaries has always engaged in an aggressive campaign to intimidate any member of the actuarial profession that might publicly express ideas contrary to its official positions. According to their authoritarian beliefs, any difference in opinion should remain within the profession itself and not be discussed in the press. The views of the actuarial profession should be expressed only by its designated spokespersons. Inept and unsavory actuarial practices will persist when limits are placed on the public expression of views in the press.
The American Academy of Actuaries and the state governments that installed the Academy’s single-party rule over their pension plans should be held partially responsible for the demise of the Chicago Teachers’ Pension Fund and other similarly situated pension plans. The relationship between this Soviet-style American Academy of Actuaries and state governments has been a mutually advantageous one. State governments were the ones that gave exclusive certification rights to the American Academy of Actuaries.
The unreasonable cost method enacted by the State of Illinois was given credibility by Academy members who failed to prominently mention its unreasonableness in their actuarial valuation reports. Vigorously criticize its unreasonableness and the Academy may lose that exclusive certification right. The same identical Qualification Standards could be created within the larger and more politically powerful accounting profession.
Independence from this rival has always been one of the hallmarks of the actuarial profession. According to this actuarial doctrine, if actuaries operated within the accounting profession, the higher salaries of senior account managers would be paid to accountants rather than to actuaries.
For further information, review the attached copy of this research report. Columnist Jane Bryant Quinn of AARP, Ellen E. Schultz of the Wall Street Journal and freelance journalist Bruce Shutan are mentioned in this research report.
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