Best practices for pension debt amortization

State and local public pensions in the U.S. in 2020 faced a total unfunded actuarial liability (UAL) of about $1.4 trillion, and the average pension plan was only 73% funded. Although preliminary data suggest that the current average funded status is closer to 85%, thanks to the substantial investment returns in 2021, the 2022 Public Pension Forecaster finds aggregate unfunded liabilities will jump back over $1 trillion if 2022 investment results end up at or below 0%.

However, despite funding developments from year to year, public pension plans remain subject to an uncertain economic climate, and the next downturn can quickly widen the unfunded gap.

While there are several answers for resolving the enormous debt accrued by pension plans, the standard solution employs a systematic plan to pay off the debt over many years. Usually, UAL is not paid off as a lump sum but is “amortized” over some time.

While the two most common amortization methods are level-dollar and level-percent, only the level-dollar method ensures predictable amortization contributions from year to year. It requires lower payment in the initial years of the schedule because it creates a predictable path to solvency by ensuring that specific amounts are paid each year.

When it comes to open and closed amortization schedules, this analysis graphically illustrates that closed amortization schedules ensure a timely repayment of UAL. Open amortization schedules, on the contrary, run the risk of keeping the amortization payment continually below the interest expense. This leads to perpetual negative amortization and makes it impossible for the pension plan to pay out UAL.

It is also important to keep the amortization period short. For longer amortization horizons, like 25 years, the interest exceeds amortization, leading to wasteful spending. Keeping an amortization schedule at 15 years ensures the intergenerational equity principle, that is, to pay off UAL within the average remaining working lifetime of active members of a pension plan.

The analysis that goes into calculating the amortization schedule relies on an assumption about the payroll growth rate and discount rate to be realized. Notably, the level-dollar amortization does not rely on an assumption about payroll growth, highlighting another advantage of the method. The discount rate, however, plays a critical role in the amortization of pension debt regardless of the method chosen. Setting the proper discount rate reduces the chance that the annual payments will not earn enough returns to pay off the debt eventually.

After thoroughly evaluating these policies, best practices for amortizing pension debt call for several recommendations, these include using level-dollar amortization, a closed schedule that does not exceed 15 years and setting appropriate discount rates. Plan sponsors should adhere to these principles to ensure the pension plan is equipped to fulfill its promises to existing retirees, as well as to assure the future robust functioning of the plan.

When adopting a particular amortization policy for a public pension, policymakers must consider a number of factors and tradeoffs. Time preference and budgetary constraints may prove influential forces in selecting from among the amortization method choices.

However, from the perspective of plan solvency and intergenerational equity, there are best practices that a pension plan can follow in adopting the best possible amortization policy.

(1) The level-dollar method is better than the level-percent method. Using level-dollar avoids actuarial assumption sensitivity, the potential for negative amortization, and requires lower total contributions over time compared to level-percent.

(2) Closed amortization schedules are better than open schedules. Using a closed schedule ensures the unfunded liability will actually be paid off. The open amortization approach violates the basic principles of intergenerational equity because the unfunded liability is never paid off.

(3) The length of an amortization schedule should not exceed the average remaining service years of the plan. This practice adheres the closest to the intergenerational equity principle. Today’s taxpayers, not future ones, should fund the pension benefits of today’s government employees. A good rule of thumb is to adopt schedules that are 15 years or less.

(4) The shorter the amortization schedule, the better. Shorter amortization periods may mean a higher level of contribution rate volatility, but they save costs in the long run and allow the pension plan to better recover from a significant near-term negative experience.

(5) Discount rates should appropriately reflect the risk of the plan’s liabilities. If the discount rate is too high, the recognized value of liabilities will be too low; thus, the value of unfunded liabilities that are amortized will be too low, and the plan will risk not having enough assets to pay promised pensions.

Plans that choose to adopt alternative policies to this gold standard can still make choices that aim for long-term solvency. Specifically:

(6) If using the level-percent method, adopt a closed design with a schedule of 15 years or less. Amortization schedules should always be closed, and the shorter the schedule, the better the policy.

(7) To avoid contribution rate volatility, use a layering method. Seeking to avoid spikes in amortization payments is an understandable budgetary goal, but it is best pursued by layering closed amortization schedules, rather than by using an open schedule.

Full Policy Brief: Best Practices for Pension Debt Amortization