This post is a follow-up to our post of April 11, 2023 entitled, “Systematic Comparison of Assets and Liabilities—Its How We Actuaries Roll.” In this post we will describe the general process actuaries use to systematically compare assets and liabilities for many financial systems such as pension plans, Social Security and, as recommended in this website, personal financial retirement plans. We believe this general actuarial process is just as important, if not more important, in the management of a system’s finances than the models or assumptions actually used to project or calculate a system’s assets and liabilities.
After outlining the General Actuarial Process used for many financial systems, we discuss
- the Social Security Actuaries change menu for strengthening Social Security’s balance sheet,
- how you can create your own change menu for strengthening your own balance sheet, and
- two of our disappointments with the actuarial profession relative to application of the General Actuarial Process to specific systems
General Actuarial Process
The General Actuarial Process has six steps:
- Make reasonable assumptions about the future (generally deterministic, not stochastic),
- Calculate present values of system assets (including future sources of income) and system liabilities based on relevant demographic information, system provisions and assumptions made,
- Periodically (generally annually) compare calculated assets to liabilities (balance sheet) to determine the system’s funded status (snapshot comparison),
- Maintain a history of the system’s funded status over time and note trends,
- When warranted or required, make changes to assets or liabilities (or both) to restore desired funded status (and/or to address possible cash flow issues), and
- Periodically evaluate/stress test assumptions to see if they need to be changed or to assess risk
Note that this is an ongoing process. The process does not end when changes are made to restore a system’s funded status to its desired level as described in Step 5. Actuaries who employ this process for a financial system should take reasonable steps to make sure that system stakeholders understand that achieving actuarial balance of system liabilities and assets is a temporary (snapshot) measure of solvency based on assumptions about the future that in all likelihood will not be accurate. Therefore, it is quite likely that future system changes (in assets and or liabilities) to maintain actuarial balance will be necessary.
So, for example, if Congress adopts changes in Social Security’s tax rates or benefit levels (or both) to restore its actuarial balance (temporary solvency), this action should not be considered as “fixing” the system, and the package of changes should not be considered as a “solution” to Social Security’s funding problem. It should be considered as changes designed to strengthen the system’s financing based on best estimate assumptions used to measure the system’s funded status. The success of any system reform will depend on how well the assumptions made about the future compare with actual future experience, and there will be no guarantee that the reformed system will remain in actuarial balance for any specific number of future years following such action.
As noted above, pension plan actuaries generally use this same General Actuarial process for ongoing pension plan funding. Generally, changes required to strengthen a pension plan’s funded status involve increasing plan contributions based on statutory or other requirements, but plan sponsors may also adjust plan benefits. Pension plan actuaries should and generally do, inform their plan sponsor clients that future contributions may need to be increased if future experience is less favorable than assumed.
Social Security Administration Menu of System Changes
To facilitate Step 5 of the General Actuarial Process, the Office of the Actuary at the Social Security Administration periodically produces estimates of the effect of certain system changes on the system’s measure of its long-range funded status—the long-range actuarial balance. Their report is entitled “Summary of Provisions that Would Change the Social Security Program.” This report serves as a menu of changes that could be adopted to (generally) strengthen the system’s balance sheet by (generally) increasing taxes and/or decreasing system benefits. In the 1983 Amendments, changes adopted were designed to address short term cash flow needs and place the system back into long-range actuarial balance.
It should be noted that this menu of Social Security changes and their effects is based on the assumptions for the future adopted by the Social Security Trustees and reviewed by the Social Security actuaries. As discussed in our post of May 21, 2023, these assumptions include an implicit assumption that system outgo will equal system income after a period of 75-years. This implicit assumption has produced consistent actuarial losses since the system was last reformed in 1983 (as most recently documented in SSA’s Actuarial Note 2023.8) and, in our opinion, is not a reasonable assumption under current law. For this reason, the SSA menu of choices also includes the estimated shortfall in the 75th year in the hope? that policymakers will consider a package of changes that also reduces this shortfall. In any event, we believe the public and our policymakers should be made more aware of this issue and its potential implications for system reform packages.
Application of General Actuarial Process to Personal (Household) Financial Systems
If your household Funded Status is under 100% (or your desired funded status target if different) you can use the AFP to develop your own menu of changes to consider if necessary.
Changes that involve increasing your assets may include:
- Going back to work or working in part-time employment
- Selling an asset that was previously not considered a retirement asset
- Renting a vacation home, parking space, boat or room in your house
- Deferring commencement of Social Security
- Purchasing an immediate annuity
Changes that involve decreasing your spending liabilities may include:
- Decreasing discretionary spending
- Reclassifying recurring expenses as non-recurring
- Decreasing desired estate
- Assuming some expenses will decrease as you age
- Minimizing taxes
- Decreasing assumed expenses after first death within the couple
Disappointments with the Actuarial Profession
We are disappointed with the Actuarial Profession relative to application of the General Actuarial Process to two financial systems discussed in this post—Social Security and Personal Retirement.
Several organizations (including the American Academy of Actuaries) have recently released tools that quantify the expected impact on Social Security’s long-range actuarial balance associated with various possible system changes. These tools are based on the SSA change menu discussed above. The Academy’s tool is referred to as the Social Security Challenge. With this tool, users are encouraged to “fix” Social Security by selecting a package of reform options designed to eliminate the current (actually 2022) long-range actuarial deficit.
The previous version of this Academy tool (the Social Security Game) contained the following language, presumably provided in an effort to avoid misunderstanding of results by tool users:
“The following should be noted when interpreting results from the Social Security Game:
- The 75-year actuarial balance calculation used in the game does not consider significant revenue shortfalls expected to occur after the end of the 75-year projection period, and thus possible solutions illustrated in this game are generally not sufficient to achieve “sustainable solvency,” a concept discussed in the Trustees Report.
- The possible solutions assume immediate adoption of System changes, rather than gradual implementation. If changes to the System are gradually implemented, the required increases in tax revenue or benefit decreases will need to be larger than noted in the [challenge] to achieve actuarial balance.
- The success of reforms will depend on how well actual future experience compares with the assumptions made by the trustees and the Social Security actuaries. There is no mechanism in current Social Security law to maintain the program’s actuarial balance once it has been achieved. Thus, there can be no guarantee that the System’s long-term problem will be ‘solved’ for any specific length of time by enacting various system changes.”
The new tool (the Social Security Challenge) does not include such language. We are disappointed that the Academy has chosen to delete this language and believe that the above language represents a reasonable step to avoid misinterpretation of the tool results and that deletion of this language may be inconsistent with the profession’s Code of Conduct.
As discussed in our post of March 5, 2023, we are also disappointed with the profession’s reluctance to advance the use of the same basic actuarial principles and the General Actuarial Process described above for use in personal retirement financial planning. If you like these principles and processes for pension plans and Social Security, you will love them for personal financial retirement planning.
Summary
Actuaries employ a general process for determining a financial system’s funded status. The system’s funded status is used to manage the system finances and generally determines when changes should be made to system assets or liabilities to maintain a desired funded status. This is an ongoing process and system stakeholders should be made aware that system changes may be required in the future if assumptions about the future are less favorable than actual experience. We believe the same approach used for Social Security and pension plan funding can provide significant value for individual households and their financial advisors, and we encourage the actuarial profession to acknowledge this.
