Pension Vocabulary: What does "smoothing" mean?

Pension Vocabulary:  What Does “Smoothing” Mean?

One of the elements of the addition of a Tier III in the new law for latest hires in Illinois is a change in how state government calculates the amount of money TRS and other programs will receive from the state government in Illinois for the years going forward: 2018, etc. 

Making common sense of how one might determine what would constitute a required annual contribution is a bit complicated, because that contribution by the State of Illinois to TRS is dependent upon the fluctuating rates of investment returns in the reserves into which we (teachers) all pay. 

Confused?  Believe me, as a retired Language Arts teacher, me too.   But think of it this way:

If the investments in TRS do better than the funds assume (predict) in a current year, the state and local governments can fund pensions with much less tax money, which could be in turn used for services, infrastructure, or citizen benefits. 

However, if the investment returns do poorly, the required annual contributions  by the state will need to increase to meet the needs; and that will crowd out the same programs – the services, infrastructure programs, and citizen benefits mentioned above.

With me so far?

So…if TRS is down 5% this year in investment returns, the state picks up the additional 5% of contribution.  Or if the investment returns are up 3% this year, then the state is able to lessen its payment by the corresponding amount.  Right?

Yes, that is, until a little actuarial gimmick called smoothing is applied to the mathematical reality. 

According to one economist, smoothing is a “actuarial camouflage,” a method to dampen on-book asset volatility.”  The practice is meant to protect the payer from the shocks of sudden changes in market returns (or volatility) in gains and losses during a single year.  So, why not spread the damages or gains over five, or ten, or twenty years to artificially reduce asset volatility? 

Analogy:  I’ll meet with my Doctor later next month.  He’ll be checking my weight carefully again as he does every six months.  Let’s just say that I have a deep and abiding love for good food and paired wines.  And my weight has fluctuated during those times we have met.

 Doctor:  Well, I must tell you that I see you have gained about five pounds despite the last serious talk we had in April.  And you had done so well the time before with a drop of nearly eight pounds.

Me: Yes, you know, Doctor, I think we should smooth the last five years of our appointments.  I calculate an overall average loss of a single pound over our ten meetings.  That’s a hopeful indicator, don’t you think?

Doctor: Does that make you feel better?

When the smoothing is done, it is more likely that the underfunding of pensions will continue as it artificially reduces asset volatility and reduces funding pressures in the short run.  In my case, my assets may look better than they are (pun intended), and the same is true of this engineered value of pension assets and returns.

According to the Rockefeller Institute study on Public Pension Funding Practices, “Funding policies and practices that take a long time to repay shortfalls protect current taxpayers and beneficiaries of government services from sharp and possibly unaffordable changes.  But they create risk that the pension plan will become deeply underfunded and that future taxpayers who never benefitted from past services will have to pay for them.  This is particularly true of the plan suffers a series of shortfalls over several years.” 

Welcome to Illinois.

According to TRS, the original state contribution for TRS expected in fiscal year 2018 – $4.65 billion – will be recalculated.

“TRS must retroactively “smooth” the fiscal effect of any changes made in the TRS assumed rate of investment return over a period of five years.  The “smoothing” applies to assumption changes from 2012 on.  Up until now, the fiscal impact change in the assumed was totally absorbed at one time.  For example, in 2016 TRS reduced its rate of investment return from 7.5% and the result was a $402 million increase in the fiscal year 2018 state contribution to TRS.  Under this new law, that $402 million increase would be phased in over a five-year period.“

The only way it could get any more slippery or worse is if Illinois found a way to short the funding even more.

They did:

According to Mr. Richard Ingram, the executive director of Illinois’ TRS,  “Over the last several years state government has taken its responsibilities to TRS very seriously and has paid its legal obligation in full. Still, the legal state contribution for the last several years has been insufficient to improve the System’s long–term finances. State government’s annual contribution is set artificially by law. It is not an actuarial calculation.

As it does every year, for FY 2017 the TRS Board asked its actuaries to calculate two state contributions — the payment calculated under state law and the payment calculated under actuarial practices. Under standard actuarial practices, the state’s annual contribution for FY 2017 should be $6.07 billion.

The calculations set in state law artificially lower the state’s annual funding level. For instance, state law:

•   Requires pension costs to be calculated on a 50–year timetable instead of the standard 30 years

•   Establishes a 90 percent funding target instead of the standard 100 percent goal

•   Requires the debt payments on state pension bonds to be deducted from the total contribution. 

Illinois teachers have always paid their required share and are counting on their pensions to sustain them in retirement. The state has never paid its full share.

The annual contribution is the amount of money required by state law to fund TRS pensions during the coming year, as well as a payment on the System’s unfunded liability, which currently stands at $71.4 billion.”

The inclusion of another Tier by the General Assembly as a laurel to Republicans and Rauner does not fix the hole nearly 80 years of underfunding has excavated.  It provides some relief (like SB7 did) to borrow to pay off debts, once again on the backs of those who paid into their pensions as demanded each and every paycheck. 

Does that make you feel better?

Nope.