News - Bill's Blog

Chicago police and fire pension plans: growing flush or going broke?

July 11, 2018

Different 'authoritative' sources say very different things.

Public-sector defined-benefit pension plans report “funded ratios,” a metric commonly used to assess their financial status. Calculating the ratio involves projecting future benefits promised to employees, discounting those promises to their current (present) value, and comparing the present value of promised benefits (in the denominator) to the invested assets in the plan (the numerator).

If a plan currently has less invested assets than the present value of discounted benefit promises, its funded ratio will be less than 100 percent (most are), and the plan will report a net pension liability in the annual financial report.

What constitutes an adequate funded ratio? This is a matter of some debate, with many industry participants willing to accept a conventional wisdom that something like 80 percent is “adequate.”  Other, more responsible observers are unwilling to accept anything less than 100 percent percent as adequate.

So, where are the Chicago police and fire pension funds today on their funded ratios?

The latest annual financial report for the City of Chicago’s firefighter pension fund (2017) showed a funded ratio (technically called the “plan fiduciary net position as a percentage of the total pension liability”) of 20 percent.  

Not 100 percent, not 80 percent.  Twenty percent.  

The City of Chicago’s police pension fund wasn’t much better, coming in at about 24 percent in 2017.

Things get very interesting—and progressively harder to understand—when you consider questions relating to how to discount those future benefit promises to their present value.  

A strong case can be made that these plans should use risk-free interest rates to discount the liabilities, but public-sector plans have traditionally used expected rates of investment return, which are significantly higher than risk-free rates. Some critics say this practice leads to inflated funded ratios, given that they use higher than appropriate discount rates (which lead to lower present values for the benefit promises). Some critics also decry how this choice of discount rate can lead to higher risk-taking in investment portfolios, with taxpayers facing the downside.

And speaking of complicated, the Governmental Accounting Standards Board in recent years has changed the way state and local governments calculate their discount rates. Expected rates of return on investment are still allowed, but only for periods in the future when invested assets are projected to exist. If plans expect to run out of assets, they are required to use a municipal bond yield to discount promised benefits after that.

Currently, municipal bond yields are well below expected investment returns, which yields higher present values for liabilities (and lower funded ratios) for plans if and when they have to adopt the new “blended” discount rates.

And that is what has happened to the Chicago police and fire pension plans in recent years. They both are using blended discount rates, given that they project themselves to be running out of assets a few decades into the future.

Trouble is, there is more than one way to skin a cat, and there is more than one way to project future financial conditions for pension plans.

State and local government pension plans also prepare and issue “actuarial valuation reports.” Longer story short, for both the police and fire pension plans in Chicago, these reports include tables projecting funded ratios rising from woeful levels today to 90 percent a few decades into the future.

For example, the latest actuarial report for the Chicago fire pension plan projected the funded ratio to rise from 20 percent in 2017 to 90 percent by 2055—a funded status goal also required, in theory, in current law. This projection shows the market value of the assets supporting the plan rising from $1 billion in 2017 to $8.6 billion by 2055.

Do you see where I’m going?

How can the Chicago fire pension plan expect assets to rise 8-fold over the next few decades, yet also be required to use a blended discount rate because it expects to run out of assets?

An important part of the answer lies in the fact that the actuarial projections allow for consideration of future contributions relating to current as well as future plan participants, while the GASB calculation is restricted to current participants.

So which perspective is “right?” They are measuring different concepts, but one way to check up on things is to look at the changes in the projections for contributions in the actuarial reports in recent years. Five years ago, the Chicago firefighter fund was projecting progressively sunnier skies.

But as current conditions began to arrive, the plan significantly cut back on near-term contribution expectations, and lifted the projections for contributions in the future—a sign that they may have been, and still are, too optimistic.

Back in 2013, the actuarial valuation report for the fire plan was projecting contributions to rise from $260 million in 2017 to $294 million by 2021. By 2017, however, the plan projections showed just $228 million for 2017, while the projection for 2021 rose from $294 million (as of 2013) to more than $360 million (as of 2017).

One can argue that the more restrictive GASB calculation is itself too liberal, given that it effectively capitalizes future tax revenue (supporting future contributions) as assets.  In the private sector, companies aren’t allowed to capitalize future sales revenue as assets.  

Granted, governments have some “sovereign” powers, like the power to tax. As coercive as this authority can be, it isn’t a sure thing.  And sovereignty isn’t owned and controlled by the government. In the United States of America, the government is not the only sovereign—if it is at all.

“We The People.” That’s how the Constitution starts.

 

 
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