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By David Larrabee, CFA

At the recent Global Investment Risk Symposium, Ron Ryan, CFA, of Ryan ALM, appealed for greater transparency and the application of commonsense principles in pension accounting. He warned that without such changes, the solvency of corporations, cities, and states is at stake. Ryan estimated that mark-to-market accounting would put the U.S. private pension deficit today at $538 billion, and the public plan deficit at $4.3 trillion - together roughly a third of U.S. GDP. If the $700 million Troubled Asset Relief Program (TARP) was considered a national emergency, Ryan asked, "What do you call this rascal?" As to what led to the pension crisis we now face, Ryan said that a fundamental misunderstanding of risk and inappropriate accounting rules as the primary culprits.

Ryan long ago saw the need for risk to be redefined. In 1966 Nobel laureate William Sharpe equated risk to the volatility of returns and asserted that the risk-free asset was that asset with the lowest volatility, the three-month T-bill. The Sharpe ratio was introduced as a measure of risk-adjusted returns, with the excess return per unit of risk being the "risk premium."

This notion of risk went largely unchallenged until 1994, when Sharpe published "The Sharpe Ratio," which recast risk as the uncertainty of meeting an objective, and the risk-free rate as the certainty of matching an objective. As Ryan illustrated the concept, for a mutual fund with the stated objective of beating the S&P 500 Index, the three-month T-bill would be a risky asset, while the S&P 500 Index fund or ETF would represent the risk-free asset. "You can't measure or manage risk without knowing the objective," Ryan said. The "new" Sharpe ratio, known today as the information ratio, has become a popular measure of risk-adjusted performance relative to an objective.

Turning to the pension crisis, Ryan compared pension liabilities to snowflakes, saying, "You'll never find two alike." And because they have different labor forces, different salaries, different mortality rates, and different plan amendments, using a generic market index as the liability objective is, in Ryan's view, inappropriate. Instead, a custom liability index (CLI) is required, he argued. A CLI redefines beta as the portfolio that matches the objective, in this case the liabilities. As a result, beta equals a liability index fund, which is the risk-free portfolio. Likewise, a CLI redefines alpha as the excess return above the objective, also the liabilities. And alpha becomes the excess return above the CLI. When portfolio managers focus on outperforming a generic market index, they are doing a disservice to their clients, Ryan said.

Because of its far-reaching impact, Ryan likened the current pension crisis to the Great Depression. He cited Illinois, with its five main pension funds reportedly only 40% funded, as a prime example of the financial problems facing state and municipal governments. Compounding the state's troubles, the Securities and Exchange Commission recently charged Illinois with fraud, alleging that it did not adequately disclose risks to investors. Meanwhile, New York City's largest pension fund, NYCERS, has seen its contributions spike over the past decade to more than 20% of payroll and 100% of the budget deficit. "Fix the pension system, and you solve the budget crisis," Ryan said.

A lack of mark-to-market accounting and accounting rules that generally favor obfuscation over truth-telling, enabled by weak oversight from the Government Accounting Standards Board (GASB) and Financial Accounting Standards Board (FASB), have led to a grossly distorted picture of the health of pension plans and, by extension, municipalities and corporations. However, Ryan sees positive change in the offing, spurred in part by the International Accounting Standards Board (IASB) and its former chairman Sir David Tweedie, who has repeatedly called for more simplified, principles-based pension accounting that one could "explain to your granny." IAS 19, in place since 2012, requires non-US corporations to mark-to-market, and Ryan expects the US to see a similar shift in two to three years. He noted that AT&T (NYSE:T) Honeywell (NYSE:HON), International Business Machines (NYSE:IBM), Verizon (NYSE:VZ), and UPS (NYSE:UPS) have already adopted mark-to-market pension accounting.

In the current low-rate environment, Ryan thinks other firms would be wise to follow suit and make the switch to mark-to-market accounting. As interest rates go higher, liabilities should be easy to beat, and pension plans could recover quickly.

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Source: Avoiding The Pension Cliff With Common Sense Accounting Practices