Actuarial Inputs and the Valuation of Public Pension Liabilities and Contribution Requirements: A Simulation Approach

Abstract

This paper uses a simulated public pension system to examine the sensitivity of actuarial input changes on funding ratios and contribution requirements.  We examine instantaneous and lagged effects, marginal and interactive effects, and effects under different funding conditions and demographic profiles.  The findings emphasize the difficulty of conducting cross-sectional analyses of public pension systems and point to several important considerations for future research.

The paper found that:

• Discount rates, salary growth rates, cost methods, and mortality tables all influence funding ratios and contribution requirements. Without considering these effects, comparisons of funding ratios across pension systems will produce biased results.
• The discount rate assumption is the most influential actuarial input on funding ratios and contribution requirements. We show that a plan can postpone required contributions by raising its discount rate assumption, but its funding condition deteriorates in the long run.  In contrast, if a plan reduces its discount rate by 1 percentage point, and its investment returns continue at the level that was previously assumed, it will take approximately seven years for the funding ratio to return to its original level and an even longer time period for the ARC to return to its original level (though the exact length of time depends on investment returns and the baseline discount rate assumption).
• The effects of actuarial inputs greatly depend on plan characteristics such as demographic profiles and asset levels, and also interactions with other actuarial inputs. Because of the interactive effects, it is difficult to standardize funding ratios or pension obligations by only controlling for a single actuarial input.  With better data on plan characteristics (such as information on mortality tables and age distributions), simulations could be used to standardize pension liabilities.  In the absence of that information, improved consistency in financial reporting (such as requiring a single cost method) is an effective way to facilitate better comparisons of financial conditions across pension plans.

 
The policy implications of the findings are:

• The valuation (or measurement) of public pension liabilities and contribution requirements is highly sensitive to the choice of several actuarial assumptions, which should be considered when assessing the financial condition of public pension systems.
• The sensitivity of liability and contribution requirement valuations to actuarial assumptions and methods depends on the demographic profile of pension participants.
• Making more optimistic assumptions reduces the liability and contribution valuations in the short term, but, over time, more optimistic assumptions can have substantive and harmful effects on pension liabilities and contribution requirements.