Home > finance, math, modeling, statistics > Math fraud in pensions

## Math fraud in pensions

July 21, 2013

I wrote a post three months ago talking about how we don’t need better models but we need to stop lying with our models. My first example was municipal debt and how various towns and cities are in deep debt partly because their accounting for future pension obligations allows them to be overly optimistic about their investments and underfund their pension pots.

This has never been more true than it is right now, and as this New York Times Dealbook article explains, was a major factor in Detroit’s bankruptcy filing this past week. But don’t make any mistake: even in places where they don’t end up declaring bankruptcy, something is going to shake out because of these broken models, and it isn’t going to be extra money for retired civil servants.

It all comes down to wanting to avoid putting required money away and hiring quants (in this case actuaries) to make that seem like it’s mathematically acceptable. It’s a form of mathematical control fraud. From the article:

When a lender calculates the value of a mortgage, or a trader sets the price of a bond, each looks at the payments scheduled in the future and translates them into today’s dollars, using a commonplace calculation called discounting. By extension, it might seem that an actuary calculating a city’s pension obligations would look at the scheduled future payments to retirees and discount them to today’s dollars.

But that is not what happens. To calculate a city’s pension liabilities, an actuary instead projects all the contributions the city will probably have to make to the pension fund over time. Many assumptions go into this projection, including an assumption that returns on the investments made by the pension fund will cover most of the plan’s costs. The greater the average annual investment returns, the less the city will presumably have to contribute. Pension plan trustees set the rate of return, usually between 7 percent and 8 percent.

In addition, actuaries “smooth” the numbers, to keep big swings in the financial markets from making the pension contributions gyrate year to year. These methods, actuarial watchdogs say, build a strong bias into the numbers. Not only can they make unsustainable pension plans look fine, they say, but they distort the all-important instructions actuaries give their clients every year on how much money to set aside to pay all benefits in the future.

One caveat: if the pensions have actually been making between 7 percent and 8 percent on their investments every year then all is perhaps well. But considering that they typically invest in bonds, not stocks – which is a good thing – we’re likely seeing much smaller returns than that, which means their yearly contributions to the local pension plans are in dire straits.

What’s super interesting about this article is that it goes into the action on the ground inside the Actuary community, since their reputations are at stake in this battle:

A few years ago, with the debate still raging and cities staggering through the recession, one top professional body, the Society of Actuaries, gathered expert opinion and realized that public pension plans had come to pose the single largest reputational risk to the profession. A Public Plans Reputational Risk Task Force was convened. It held some meetings, but last year, the matter was shifted to a new body, something called the Blue Ribbon Panel, which was composed not of actuaries but public policy figures from a number of disciplines. Panelists include Richard Ravitch, a former lieutenant governor of New York; Bradley Belt, a former executive director of the Pension Benefit Guaranty Corporation; and Robert North, the actuary who shepherds New York City’s five big public pension plans.

I’m not sure what happened here, but it seems like a bunch of people in a profession, the actuaries, got worried that they were being used by politicians, and decided to investigate, but then that initiative got somehow replaced by a bunch of politicians. I’d love to talk to someone on the inside about this.

Categories: finance, math, modeling, statistics
1. July 21, 2013 at 11:35 am

It’s become more and more evident in recent times that the ground underneath the entire actuarial enterprise is subject to seismic shifts capable of tossing their models around like a Japanese tsunami in the first place. There must surely be enough actuaries aware of this for the PPRRTF to probably have been more of an attempt at retrofitting to send most of the blame flying off in the direction of the politicians, not them, when the quake hits. Note that it was a task force with PR to the second power: it was a “PPRR” task force.

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2. July 21, 2013 at 12:59 pm

Great post and the article brings out the roles the actuaries play in all of this, sounds just like Wall Street. I’m several steps down the ladder here with my levels of what I have done being a former developer with software but what happened with myself and I’m sure there are others out there too that have seen this too, but you look at how some of this runs and the end results and even without being a mathematician you “what the heck” at times..which is what I did with looking at the insurance side of healthcare and question how did they come up with that? That’s where I come from having been there and seen that if you will.

I have those that get mad at me too mostly because they don’t understand the impact of how we use verbiage whether it be new or old and how technology today models around it to stay legal and create an modern day IT infrastructure that doesn’t violate the verbiage if you will. I’m with you in wanting to know the inside story here. It is hard for the average consumer to get this with the connections with modern day technology with creating the infrastructure that runs it and I think this is where the ability to regulate lies as we don’t get all the pieces of the puzzle together and the media in many areas doesn’t even know how to report it at times, but some a good job like this article for sure.

A while back a real study was done and written up in PLOS One about the fear of math and I have referenced it a few times, again with some satire just due to the nature of the study with using MRis to watch brains waives, etc. of how the “fear of math causes people physical pain”. Add this on to the politics and maybe we have a potential answer as to why this pot has taken so long to boil?

http://ducknetweb.blogspot.com/2012/10/algo-duping-plos-one-journal.html

Plos One also did another abstract about how scientists can “fiddle” with a P value and in that area look at all the scientists that have lied with their models and I figured there wouldn’t be an abstract about this if it wasn’t becoming a real issue either:) We get it over there too and mathematicians are busy calling foul over there too with their models and that is critical drug development and clinical trials if it’s not replicated.

http://ducknetweb.blogspot.com/2012/10/algo-duping-plos-one-journal.html

In my little humble opinion too we keep trying to apply what I call a “low tech” solution to “high tech fraud or problems” and it just wont work without model accountability, like Glass Steagall for an example…sure it will help but when the banks get 5 years to move money to a “boring bank”..well in the meantime they also get 5 more fun packed years of writing models as well with no accountability required:) I respect and admire Elizabeth Warren by all means but again with what we see it drills home the limits that current lawmakers have without understand models and how the current day models work with an IT infrastructure that runs everything. Maybe by a miracle the Detroit pension story might shake out some of this relative to the politics and who made money there.

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3. July 21, 2013 at 1:52 pm

Pensions are going to be in a rolling crisis for the foreseeable future.

This is obvious if you understand what is happening with respect to future projected returns.

Basically, a back of the envelope calculation shows that you will need 68% of the payroll to cover contributions (as opposed to the current assumption at of 19% of payroll) as set forth in the following Crestmont Research article (it’s extremely basic, so it’s nothing new to you at all.)

However, to admit the truth would be catastrophic (as in catastrophe theory), for human psychological reasons because the lie is *so* huge as to be unfathomable.

http://en.wikipedia.org/wiki/Catastrophe_theory

The current political leadership is incapable of addressing this.

The control fraud is there because the pension promises cannot actually be kept because we may to be transitioning from a growth model to a steady state model of the economy.

Which Jeremy Grantham calls the “Road to Zero Growth”:

http://www.marketfolly.com/2012/12/jeremy-granthams-latest-commentary-on.html

Welcome to the Future.

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4. July 21, 2013 at 10:00 pm

Where is the real mathbabe. How could you fall for this very right wing attack on defined benefit pensions.

The debate about assumptions behind pension funding are very political, which is why the response must be political. I see them as a right wing attack on defined benefit plans. If you can only assume low 3-4% returns the plans are not viable. It is difficult to believe that this is the best we can do. A well run plan with mix of long and short term investments has no trouble making long tetm gains of around 7%. Which from back of the envelope (along with a modern calculator) calculations only needs 15-17% of payroll to fund, including healthcare.

If you start from pension funding levels of 2011 or even better 2010 and assume 3-4% returns then the sky is indeed falling. This is the basis of the conservative argument for ending defined benefit plans and going to individual accounts.

The funding problems that exist come mostly from healthcare promises which tend to not be prefunded, not so much from the prefunded accounts that pay our other bills. The Detroit funds for example, which were reported in May to be essentially fully funded as of the end of 2011, are in good shape if you assume 6-8% returns (buying the market) but can be made to be in trouble if you can only assume long term treasury rates. Again a political Snyder/Orr republican decision. (Detroit has many other problems pensions are only a small part.)
If these low returns are all we are allowed much more than pensions are in trouble. Every form of life and casualty insurance uses the same types of assumptions. Do they have an actuarial problem?

The assumptions actuaries use must be given to them by professionals assigned the task of developing investment strategies. We can debate their competence. But we can’t make charges of mathfraud against people who use the assumptions given to them either by professionals, or as is being done with the Michigan teacher fund, by the state senate.

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5. July 21, 2013 at 10:06 pm

I have a different take on the NYT article. I view it as a prime example of the captured financial journalism profession abetting Wall Street’s preferred message, which is: “It’s too complicated for you.” Instead of presenting the simple story in the first line, namely that many actuaries believe assumptions of future return on investment are too high and therefore pensions will be much shorter on funds than current estimates reflect, the article goes through a long buildup involving the usual obligatory references to “math-and-statistics whizzes” and to various mysteries and complications that have little to do with the core issue.

In the late ’60s The New York Times started, at last, throwing in asides like “these numbers are probably exaggerated as usual” after quoting government statistics about how many Vietnamese had been killed in a battle. When financial journalists start throwing in such skeptical comments when they pass on, for example, industry statistics about average hedge fund performance, or about which mutual funds performed best (they could add “experience shows that such superior performance is unlikely to be repeated”) we’ll start to be getting somewhere.

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6. July 22, 2013 at 10:27 am

For a very good and sound analysis of Defined Benefit plans, please read this paper:
http://www.longfinance.net/index.php?option=com_content&view=article&id=718

It’s by Con Keating, a UK pensions specialist, and it shows very clearly how the question of the viabilty of a pension fund should be analysed. Spoiler alert: it is not by looking at current mark to market values….

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7. July 22, 2013 at 12:57 pm

@SWHSTTom:

Comment:

“If you can only assume low 3-4% returns the plans are not viable. It is difficult to believe that this is the best we can do. A well run plan with mix of long and short term investments has no trouble making long tetm gains of around 7%.”

Answer:

How do we do this in today’s magical world where the 10 year is yielding under 3% and the entire stock market has basically 0% in capital gains since 2000?

Current longer term stock market returns are projected about 4% nominal over the 7 to 10 year time frame because that’s where the valuation is right now.

There *are not going to be 7% (nominal) returns* until the price of the market is drastically reduced or a whole lot of time passes with limited gains.

You’re looking in the rear view mirror.

Comment:

“If these low returns are all we are allowed much more than pensions are in trouble”

Answer:

Yes. We are all, in fact, in trouble. Major trouble.

Comment:

“This is the basis of the conservative argument for ending defined benefit plans and going to individual accounts.”

Answer:

Nobody in their right mind (who understands that Wall Street is basically an economic rent seeker) wants to go to individual accounts so that Wall Street can get their 3% cut off the top.

That would be worse that the current pension mess.

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• July 23, 2013 at 1:14 pm

A minor point, maybe, but I agree that one cannot say “no trouble making” [prospectively] long term gains of 8% or so. It may have been true but that doesn’t mean that it must be going forward, even on a nominal basis.

That’s not to say it is necessarily irresponsible to assume 8%, but one should be prepared for potential shortfalls and it doesn’t seem fair to stick other taxpayers with, in effect, guaranteeing the assumed actuarial rate. To me, that’s an asymmetric moral hazard. In that case, why not dial up more “justifiable” risk and assume 9%. If you end up short and underfunded over time, citizen taxes to the rescue.

If you want the parties to negotiate with their own money and not “other people’s,” then there should be a reduction in benefits if the investment targets are not reached. I doubt in that situation that many pension negotiators would be as comfortable with current investment allocations and assumptions.

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8. July 22, 2013 at 8:08 pm

Hi, Cathy. Thanks for the balanced treatment. Good to see your passion for numerical accuracy trumping ideology. I do want to quibble with one point. You say:

“One caveat: if the pensions have actually been making between 7 percent and 8 percent on their investments every year then all is perhaps well. But considering that they typically invest in bonds, not stocks – which is a good thing – we’re likely seeing much smaller returns than that, which means their yearly contributions to the local pension plans are in dire straits.”

I didn’t think the point about public employee pension funds typically investing in bonds was true, so I checked CalPERS Investment Report at http://www.calpers.ca.gov/eip-docs/about/pubs/annual-investment-report-2012.pdf. Over 50% of CalPERS funds are invested in equities and equity options. About 9% is invested in Real Estate and REITs. So cash and fixed income only account for about 40% of their portfolio.

In my study of Illinois credit risk published by the Mercatus Center at http://mercatus.org/publication/modeling-state-credit-risks-illinois-and-indiana, I report that one state pension fund has an average annual return of over 10% for the period 1970-2012.

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• July 23, 2013 at 1:14 am

The historical return from 1970-2012 is not a good guide to future return. From 1970 to 1982 the 30-year Treasury bond yield averaged ~10%, which would have been a good forecast of expected safe fixed income return from 1970-2012 since it could be locked in (except for reinvestment of interest). Expected equity return would have been the same plus an equity risk premium. Now, 30-year Treasuries are yielding only about 3.6%. That suggests future expected returns more than 6% lower than from 1970-2012. This does not bode well for pensions.

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• July 23, 2013 at 12:24 pm

This is an interesting approach, but the 30-year Treasury yield is a dubious benchmark because it is subject to Fed manipulation. High bond yields in the 1970s were due to inflation – which may return given the long term imbalance between future federal revenues and expenditures.

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9. July 23, 2013 at 12:10 pm

“Expected equity return would have been the same plus an equity risk premium. Now, 30-year Treasuries are yielding only about 3.6%. That suggests future expected returns more than 6% lower than from 1970-2012. This does not bode well for pensions.”

Exactly.

Everyone’s looking in the rear view mirror.

Equities are essentially priced for 0% real return going forward.

4% nominal seems to be quite reasonable at the median.

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• July 23, 2013 at 1:15 pm

And no matter how they are currently “priced,” the market can be wrong. They do call is “expected” equity return, after all. And even that is probably a, even is accurate, slanted use of vocabulary.

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10. July 23, 2013 at 2:11 pm

@George

“And no matter how they are currently “priced,” the market can be wrong. They do call is “expected” equity return, after all. And even that is probably a, even is accurate, slanted use of vocabulary.”

The market isn’t even “wrong”. It’s currently being increased in price through QE Infinite. The stock market isn’t going up because it’s pricing in anything. It’s being flooded with all of the QE that’s being poofed into existence, so it’s going up. Stop the liquidity? Market goes down.

@Joffemd

“This is an interesting approach, but the 30-year Treasury yield is a dubious benchmark because it is subject to Fed manipulation. High bond yields in the 1970s were due to inflation – which may return given the long term imbalance between future federal revenues and expenditures”

The *stock market* is subject to “Fed manipulation.” It’s a major destination for the QE cash.

We already have inflation. It’s called asset inflation and it’s currently driving the stock market and the housing market higher.

You might as well say that “high bond yields in the 1970’s were due to lack of QE”.

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• July 23, 2013 at 2:18 pm

Jon: Your points support my belief that high nominal pension fund returns of 8% or more are still quite possible, since pension funds can take advantage of this Fed-inspired inflation. In Illinois, at least, retiree cost of living adjustments are limited to 3%, so the funds gain from asset inflation would not be fully offset by additional benefit expenses.

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• July 23, 2013 at 2:22 pm

Agreed that pension funds “could” achieve the 8% due to inflation, but is that any way to run a railroad?

I doubt the reason some pensions are in the fix their in is because they anticipated this years ago. Further, as much as I am tempted to agree we’ll head that way (and the 3% cap will have beneficiaries screaming) , it doesn’t have to happen. Nothing needs to be airtight but still…

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• July 23, 2013 at 2:33 pm

Taking the discussion back to math for a moment (one reason we’re all here!): I advocate using a simulation to analyzing government credit. One of the things you can simulate is the pension fund return. I have built an open source government budget simulation/rating tool and posted it on my web site at http://www.publicsectorcredit.org/pscf.html.

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11. July 23, 2013 at 2:16 pm

Agreed. Probably a little inarticulate to use “wrong.” I merely meant that however some say the market is pricing itself and what one can conclude about what is “expected,” it will be what it will be and that may not even nominally be 7%. Anyone’s guess.

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12. July 25, 2013 at 3:51 pm

The Blue Ribbon Panel reminds me of the Roberts Commission investigating the Challenger Disaster. Richard Feynman focused attention on the O-Rings, although he later realized that he had been led down a primrose path by NASA personnel and contractors in an effort to anonymously provide the evidence which would support the conclusions on which he would later report. People “in the trenches” knew what was going on, but it took someone with a high profile to override the culture of NASA management and call attention to the facts. Feynman famously said, “For a successful technology, reality must take precedence over public relations, for nature cannot be fooled.”

I mention the Feynman story because we have a similar situation with how actuarial calculations are used/misused here. I don’t think the problems are mathematical. *I think they are cultural*. People have difficulty doing things that are hard, whether it’s funding obligations up front or facing inconvenient truths, like underfunded obligations. It’s easier to “kick the can down the road”.

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• July 25, 2013 at 4:50 pm

@John. Right. Math is just cover. Just as nature cannot be fooled, markets cannot be tamed or known, thus erring on the side of caution would appear to be the better path. But, as you say, higher actuarial rates lessen the current pain.

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13. July 26, 2013 at 11:04 am

Some further thoughts…

If I were a large organization, I would want to reduce uncertainty.
Instead of defined benefit pensions, I would want to have defined contribution pensions.

As an individual, I want to reduce uncertainty.
Instead of defined contributions, I lean toward defined benefits.

I took an early retirement in 2004 from a company (AT&T-formerly one of the bluest of the blue chips) that mostly transitioned from defined benefits to defined contributions over the course of my career. I took a lump sum severance payment because I doubted the future longevity of the company. I thought that I would decrease my exposure to the risk of the company going under in exchange for increasing my exposure to the risk that I would earn a low return or outlive my money. My thinking at the time was that I could either purchase an annuity or roll my own, using laddered Treasuries. This assumes the company I purchase my annuity from will be around for the long haul and that the U.S. Government will remain solvent and won’t “inflate away” my purchasing power.
Right now, I feel stuck and very frustrated.

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• July 26, 2013 at 11:09 am

Well, a laddered portfolio of TIPS for significantly reducing default and inflation risks. and/or a single premium immediate annuity to address longevity risk — but that does add, as you point out, business risk. Perhaps use a combination of the two vehicles to create an acceptable annuity amount (a livable income floor), then the remainder, if any, at risk. For me, it would be owning the market portfolio in index funds. 3-4 vanguard funds or ETS ought do the trick.

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1. July 21, 2013 at 2:26 pm
2. July 22, 2013 at 9:44 am
3. July 22, 2013 at 9:55 am
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