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PENSIONS - The Next Financial Crisis?

Updated January 4, 2011 –

What’s Ahead for US Public Employee Pension Funds and Retirement Systems?

In 2010 the rumors and speculations of pension problems and shortfalls were reinforced by a series of studies focusing on the financial health of both public and private pension plans.  A recent report from the Kellogg School -- “The Crisis in Local Government Pensions in the United States,” prepared by Joshua Rauh of the Kellogg School and Robert Novy-Marx of the University of Rochester -- examined pension plans for  50 major U.S. cities and counties and found  $574 billion in unfunded liabilities

A new report issued by the think tank Manhattan Institute estimated that “New York State's public pension funds alone were underfunded by a staggering $120 billion -- and taxpayers will have to shell out an additional $8.5 billion a year by 2015 to keep them in the black.“  That was followed by a world review showing the US retirement income system’s ranking dropped from sixth place to tenth in one year in the Melbourne Mercer Global Pension Index, the world’s only global pension index. 

While news of the pension shortfalls persisted, those chosen to administer the funds came under fire for “pay to play,” a system that involved political operatives and  large fees.  Others in fund management admitted to a long standing policy of accepting trips and being entertained by fund managers.  The pension debacle that exists in many, but not all, states became part of the political rhetoric. Calls for change and transparency are being heard from governors, state legislators and members of the public.

Market upturns have helped many funds to regain some of their losses. But there are fundamental pension principles long accepted that are due for a change for future retirees.  The situation is in flux and that state will keep it in the Hot Topics focus for the coming year and beyond.


Pension Systems – millions of Americans now employed in the public and private sectors and millions more retired beneficiaries who once worked in these sectors are covered by pension systems to provide for payments in post-retirement.  Corporate America employed many millions at the height of the industrial age economy.  The “defined benefit” programs were provided to employees over the decades since General Motors, General Electric and other large firms introduced BD plans.  A good number of industrial companies with ranks of pensioners or current workers have disappeared or filed for bankruptcy protection – their plans’ payouts often taken on by the Pension Benefit Guarantee Corporation (PBGC) – especially in the airline industry, steel industry and other “old economy” industrial sectors.  The work formerly done by employees may have been outsourced to reduce costs but the promised pension payments remain in place at many employers.

A number of DB retirement plans have been converted to a “cash balance basis,” with employees assuming responsibility for managing their own post-retirement finances.  With rising healthcare costs DB plans are under assault with expenses rising.  Will DB plans be there for many of today’s private sector employees?  Hard to say.   And there then is the government (public) sector.

At one time, when industrial age salaries in the private sector outpaced the salaries of government workers, the “difference” for an employee entering the workforce was often the promise of payments and benefits in retirement.  Labor unions also negotiated for more generous plans for government employees.  As government salaries caught up to many similar positions in the private sector, retirement promises were not usually cut back.  Especially for government workersa promise is a promise. The larger states have a million or more public employees in their retirement systems while still working and millions more in post-retirement.  They vote and shape public opinion.  Who is brave enough to step up and cut back benefits, today’s and tomorrow’s? 

So then, how to pay for these benefits (current and promised)?  By directing tax dollars to the plans; generating returns on investments (assets) in the system; and, requiring a co-pay of some kind by current employees.  With the recent financial crisis, many public sector plans are under extreme pressure.  What to do?  Cut back retiree benefits?  Levy special taxes on local public employers in the plan?  Raise general taxes?  Increase return on investment?  All of the above?

As the Baby Boom Generation (born 1946-1964) nears or reaches retirement age by the millions, the pressure will be on employers in both public and private sectors.  This Hot Topic section is timely – the retirement age cohorts of workers are reaching a peak.

Above text is prepared by the editors of Accountability Central.


Introductory Commentary From Ryan ALM
The Pension Crisis is Here

If pension funds were to mark to market pension assets and liabilities, they would have a deficit over $2 trillion.  Given that the TARP stimulus package was less than a $1 trillion, such a deficit should rank high on our nation’s priorities. Cities and States have been hard hit by spiking pension contributions which have wrecked their fiscal budgets and have them fighting to stay solvent. Since pensions tend to hire the finest consultants, actuaries and asset managers, one has to question how this group of intelligence could create such a financial disaster. The answer can be found in inappropriate accounting rules and actuarial practices that misinform and mislead pensions into the wrong asset allocation for their plan.

Cities and States are under GASB accounting standards while corporations are under FASB accounting standards and PPA legislation. Current FASB/GASB accounting rules do not require valuing pension assets and liabilities to be marked to market.  Instead they allow for assets to be smoothed over some period of time (GASB = five years, PPA = two years) which currently overvalues assets; and they allow liabilities to be valued at higher than market interest rates (GASB = ROA, PPA = hypothetical corporate zeroes) which undervalues liabilities significantly. Such accounting rules distort economic reality (Funded Ratio) by not valuing assets and liabilities to accurate market valuations. As a result, many pensions were told they were fully funded when they had deep deficits. Perhaps, the biggest problem here is the use of the ROA (projected Return On Assets) as the hurdle rate for assets. Instead of focusing on the Funded Ratio (mv of assets/mv of liabilities) asset allocation models were focused on achieving the ROA. During the late 1990s when most pensions had a surplus, instead of shifting their asset allocation to more bonds to match liabilities and secure their surplus, they reduced their allocation to bonds since interest rates were well below the ROA. When the correction in equities hit in 2000 and continued, it was a time that pensions had the highest allocation to equities.

Given the tedious list of calculations, actuarial reports tend to be calculated annually, several months delinquent. Moreover, they tend to use actuarial valuations and not market valuations. As a result, the Board of Trustees and the asset side have little guidance and information on the size, shape and risk/reward behavior of liabilities. It would be hard, if not impossible, for an asset manager to manage assets vs. an index that comes out annually, months delinquent and is not marked to market. The Society of Actuaries recommended that pensions create a set of economic books that calculate the market value of assets and liabilities accurately and frequently. Until a Custom Liability Index is installed as the proper benchmark, all asset functions (Asset Allocation, Asset Management and Performance Measurement) are in jeopardy of a disconnect with the true liability objective.

The core asset portfolio of a pension should be high-quality bonds managed as a Liability Index Fund (Liability Beta Portfolio). The quest of a pension should be to reach full funding or greater with 100% in the liability Beta portfolio and the rest in a surplus portfolio. In this way, pensions achieve their true objective with low risk, low cost and low volatility of the Funded Ratio to the plan.


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Ronald J. Ryan, CFA

Ryan ALM, Inc.
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Ryan ALM Pension Scoreboard
The Ryan ALM  Pension Scoreboard is a tally of the growth in pension assets vs. the growth in pension liabilities using market values of generic market indexes for assets and the Ryan Treasury STRIPS indexes as well as the Ryan ALM FAS 158 index and the Ryan ALM PPA indexes (three segment and spot rates yield curve) for liability growth rates. Ronald J. Ryan, CFA is the designer of the Ryan indexes.  In 2006, he won the William F. Sharpe Index Lifetime Achievement award.

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