FORUMTHE PENSION

published by the Pension Section of the Society of Actuaries

January 2005Volume 16, No. 1

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The Pension

ForumVolume 16, Number 1 January 2005

Table of Contents PAGE

A Reevaluation of ASOP 27, Post-Enron: Is It an Adequate Standard of Professionalism? 1by Frank Todisco

Discussions on A Reevaluation of ASOP 27, Post-EnronComments on Paper by Mr. Frank Todisco 19by Robert C. North Jr.

Commentary on Frank Todisco’s Paper 27by James Turpin

Author’s Response to Comments of Robert North and James Turpin 32by Frank Todisco

What’s Wrong with ASOP 27? Bad Measures, Bad Decisions 40by Lawrence N. Bader and Jeremy Gold

Letter to Actuarial Standards Board (ASB) 47

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A Reevaluation of ASOP 27, Post-Enron:Is It an Adequate Standard of Professionalism?1

by Frank Todisco, F.S.A., M.A.A.A., E.A.

Note: the following paper was originally written and published as part of the SOA’s “The GreatControversy: Current Pension Actuarial Practice in Light of Financial Economics Symposium,” held inVancouver, BC, Canada in 2003. Except for some minor edits, the paper is reprinted here as originallypublished. The two discussant papers and the author’s response which follow were written specifically for thisedition of the Pension Forum.

1. Introduction

U.S. pension actuarial practice is facing perhapsits most serious challenges in its existence as anidentifiable discipline. One of those challengescomes from advocates of financial economics.These critics charge that the standard actuarialmodel represents, quite simply, bad economics—and that this flawed model creates problems such

as inequitable cost allocations and inefficientinvestment policies. But another set of critics isdirectly attacking the profession’s ethics, ratherthan its economic model. Their charges are partof the broader criticism of various professions andgroups in the post-Enron environment, notably,accountants, investment bankers and analysts,lawyers, and corporate executives.

Abstract

This paper calls for a reconsideration of Actuarial Standard of Practice (ASOP) 27 in the wakeof the scandals that began with Enron and have rocked the world of finance. Financial pro-fessionals have been under scrutiny, and actuaries have not been spared. The profession isbeing questioned not just about its financial models, but also about its ethics.

ASOP 27 was the culmination of seven years’ effort over three exposure drafts—a difficultconsensus informed neither by financial economics nor, necessarily, by the financial scandalsstill to come. The paper critiques two aspects of ASOP 27: the actuary’s obligation withrespect to employer-selected Financial Accounting Standard (FAS) 87 assumptions, and theconcept of the “best-estimate range.”

ASOP 2 had required the actuary to disclose any disagreement with employer-selectedassumptions. ASOP 27 removed this requirement, relying instead on the weaker standard ofASOP 4. The paper examines the development of this change in thinking and argues for areturn to the ASOP 2 standard.

ASOP 27 also introduced the “best-estimate range.” Continued reliance on this constructioncould prove dangerous to the profession: it is a contradiction in terms, it is arbitrarily wide,and it permits the selection of aggressive assumptions. The paper argues for a tighter standard,perhaps based on the different approach taken in ASOP 35.

1 The opinions expressed in this paper are solely those of the author and do not necessarily reflect the views of his employer,Mercer Human Resources Consulting.

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The two critiques of actuarial practice are, in fact,related, because financial economics may offermeans to reduce or eliminate some ethical dilem-mas now faced by actuaries. However, anychanges to the regulatory landscape induced byfinancial economics will be slow in coming, andmay not come at all. The profession needs toaddress the direct ethical criticisms at the sametime that it debates an overhaul of its underlyingeconomic model. Debating financial economicsin isolation would leave the profession with anincomplete picture of alternative paths and theirimplications.

This paper looks at certain ethical problems with-in the context of the current pension actuarial model.While some individual firms and practitionershave already taken steps to review and more clear-ly delineate their own professional standards, theissues addressed herein go beyond the inevitableepisodes of malfeasance that afflict every profes-sion to some extent. Rather, the argument here isthat the profession’s practice standards themselvesmay lead to certain ethical dilemmas, increasingthe likelihood of individual behavior that may—after the fact—be challenged as questionable, andleaving the profession vulnerable to criticism.

The standards in question are Actuarial Standardof Practice (ASOP) 27, “Selection of EconomicAssumptions for Measuring Pension Obligations”(Actuarial Standards Board [ASB] 1996b) and itscounterpart for demographic assumptions, ASOP35 (ASB 1999). This paper offers the opinion thatthese standards should be strengthened; at thevery least, I hope that, in the new post-Enronenvironment, the continued appropriateness ofthese standards will be vigorously debated.

This paper will focus on ASOP 27, bringing inthe similarities and differences with ASOP 35 asneeded. It will scrutinize two aspects of ASOP27: (1) the actuary’s obligations with respect toprescribed assumptions, and (2) the concept of a“best-estimate range.” The remaining sections ofthis paper will present some of the recent cri-tiques of actuaries, examine in turn each of thetwo questioned aspects of ASOP 27, discuss

alternative approaches and possible solutions,and look briefly at the process of setting stan-dards. The paper draws heavily on publishedmaterial; the primary technique employed is totell a story and develop an argument by lettingthe public record speak for itself.

As is the case in many endeavors, the criticismwill prove to be easier than the solution. The cre-ation of ASOP 27 itself became an enormouslydifficult venture—a seven-year effort encompass-ing three exposure drafts. The first exposure draftitself consumed “more than three years of study,discussion, and drafting” by the PensionCommittee of the Actuarial Standards Board. Thecommittee lamented that

The field it [the first exposure draft] addressesis characterized by so many complex issues anddivergent actuarial approaches that obtainingconsensus has presented the committee withextraordinary difficulties. (ASB 1992, trans-mittal memo, p. 6)

The committee had the following to say about thecomments to that first exposure draft:

When the comments were assembled in a sec-tion-by-section format, there were nearly twohundred pages of material to be reviewed.

The diversity of opinion among the commentsis striking. There was a yes, no, or maybe onalmost every topic. The Pension Committeeinitially intended to revise the first exposuredraft on a minimal basis. However, in thecourse of the one and one-half years of attempt-ing to respond to the comments, at least tenprogressively different drafts were produced.Consequently, this second exposure draft is inlarge part a complete rewrite of the originalmaterial. (ASB 1994, app. 2, intro., p. 23)

The attacks on the profession, combined with theextreme difficulty in reaching consensus onASOP 27 in the first place, warrant a new look atthis standard.

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1.1 Actuaries under Siege

Actuaries have been taken to task probably mostfamously by financier Warren Buffett. He wasquoted in Fortune magazine in December 2001,speaking about the expected return on assetassumption required under Statement ofFinancial Accounting Standard (SFAS) 87:

Heroic assumptions do wonders…for the bot-tom line. By embracing those expectation rates[shown in the article]…, these companiesreport much higher earnings—much higher—than if they were using lower rates. And that’scertainly not lost on the people who set therates. The actuaries who have roles in thisgame know nothing special about futureinvestment returns. What they do know, how-ever, is that their clients desire rates that arehigh. And a happy client is a continuingclient…I think that anyone choosing not tolower assumptions—CEOs, auditors, andactuaries all—is risking litigation for mislead-ing investors. (Loomis 2001, p. 94)

Here Buffett is accusing the profession not of badmodels but of bad ethics.

Pensions & Investments Europe reported in 2003that

Actuaries are under fire at the moment, withnewspapers calling for the profession to facethe same scrutiny as accountants did followingthe Enron collapse. For its part, the ActuarialProfession [the umbrella body for England’sInstitute of Actuaries and Scotland’s Faculty ofActuaries] says it has been “exploring the intro-duction” of compulsory peer reviews.(Brooksbank 2003, p. 5)

The U.S. profession is well aware of the attention.A report from the 2002 Enrolled Actuaries meetingobserved that “With Enron serving as everybody’s

worst-case scenario, much of the discussion atthe…meeting…revolved around ethics and profes-sionalism” (Actuarial Update 2002, p. 6). WhileAmerican Academy of Actuaries President DanMcCarthy stated that actuaries have “an extremelylow rate of (ethical) complaints compared to otherprofessional groups that practice before the IRS,”panelists “warned that actuaries and other pensionprofessionals should expect their actions to beclosely scrutinized in light of heightened publicawareness of pension issues” (ibid.). One sessionplanned for the November 2003 Annual Meetingof the Conference of Consulting Actuaries wasentitled “Am I My Client’s Keeper?—Precept 8Explored.”2

Meanwhile Pensions & Investments reportedthat

SEC officials in recent months have becomeincreasingly concerned that many companiesoverstated their pension assets using artificiallyhigh return assumptions. Now, they are alsoconcerned that companies are understatingtheir pension liabilities, using inappropriatelyhigh interest rates to calculate the presentvalue of their obligations.

If the impact is material, “we could ask compa-nies to re-present their information on a his-toric basis,” said Carol Stacey, chief accountantin the SEC’s division of corporation finance.(Anand 2003, p. 1)

Commission staffers have since indicated thatthey will audit any company assuming an expect-ed rate of return in excess of 9%, and require it torestate earnings if it can’t justify the rate (Walsh2003).

In these instances the SEC did not point its fingerat actuaries the way Warren Buffett did. But willthis blow back on actuaries? Will more peopleask, “Where were the actuaries?”

2 The Code of Professional Conduct (AAA 2003), Precept 8, states, “Control of Work Product: An Actuary who performsActuarial Services shall take reasonable steps to ensure that such services are not used to mislead other parties.”

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Other professions have already been forced byEnron-energized regulators to change the waythey do business: investment bankers and analystsvia a recent settlement agreement between themajor firms and the SEC (Labaton 2003), andaccountants and lawyers by the Sarbanes-OxleyAct. The latter’s restrictions on lawyers have beenattributed in part to “the American BarAssociation’s failure to adopt proposed changes toits own model ethical rules” (Glater 2002, p. 4).Will the actuarial profession be next, if we don’traise our own standards first?

2. Issue 1: Prescribed Assumptions

Much of the recent criticism of actuaries centerson the selection of economic assumptions inaccounting for employer-sponsored pensionplans, particularly the return on asset and dis-count rate assumptions. These assumptions affectcorporate earnings and balance sheet liabilities;often they affect executive compensation as well,to the extent such compensation is linked to netincome or related measures of performance. Whatshould be the actuary’s responsibility in theprocess of selecting these assumptions? What doour standards say?

Assumptions for SFAS 87 are chosen by theemployer,3 though for many of the assumptions,particularly the demographic ones, the employeris dependent on and will rely on the actuary’sadvice. The expected return on assets and the dis-count rate are the two assumptions where theemployer will most often exercise its power ofchoice.

Precept 8 of the Code of Professional Conduct,titled “Control of Work Product,” states that “AnActuary who performs Actuarial Services shalltake reasonable steps to ensure that such servicesare not used to mislead other parties” (AmericanAcademy of Actuaries [AAA] 2003, p. 85). Sinceunreasonable return on asset or discount rate

assumptions could arguably mislead investors andother parties, Precept 8, on its own, would suggestthat the actuary has some responsibility to avoidthe use of unreasonable assumptions. The actuarycould refuse to perform the calculations unlessreasonable assumptions are employed, or at leaststate an opinion about the assumptions in theactuarial communication.

Precept 3 of the Code, “Standards of Practice,”states that “An Actuary shall ensure that ActuarialServices performed by or under the direction ofthe Actuary satisfy applicable standards of prac-tice” (AAA 2003, p. 84). Therefore, we must turnto the ASOPs for further guidance on what,specifically, is expected of the actuary.

ASOP 2, “Recommendations for ActuarialCommunications Related to Statements ofFinancial Accounting Standards Nos. 87 and 88,”was released in 1987. It includes the following“disclosure of exceptions” requirement:

Disclosure of Exceptions—If the calculationsconflict significantly with the actuary’s under-standing of SFAS No. 87 and SFAS No. 88,including conflict with respect to the assumptionsutilized, that fact should be disclosed as part ofthe actuarial communication. (InterimActuarial Standards Board 1987, sec. 5, pp.1–2, emphasis added)

ASOP 2 explicates Precept 8 by defining what isa “reasonable step” to ensure that an SFAS 87communication is not used to mislead otherparties. That step, embodied in the disclosure ofexceptions requirement, is to disclose the actu-ary’s disagreement with the employer’s assump-tions as part of the actuarial communication.ASOP 2 did not go so far as to say that the actu-ary should turn down the assignment, even ifthe employer’s assumptions “conflict signifi-cantly with the actuary’s understanding of SFASNo. 87.”

3 Most of the discussion in this paper surrounding SFAS 87 applies to SFAS 88 and SFAS 106 as well, which will be left out forsimplicity.

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ASOP 27 was released at the end of 1996. Itintroduces the term “prescribed assumption,”defined as follows:

Prescribed Assumption—A specific assump-tion that is mandated or that is selected from aspecified range that is deemed to be acceptableby law, regulation, or other binding authority.(ASB 1996b, sec. 2.6, p. 3)

ASOP 27 views prescribed assumptions as ones forwhich “the actuary is precluded from exercisingindependent judgment”; consequently, ASOP 27“does not apply” to their selection (ASB 1996b,sec. 1.2, p. 2), “although it does apply to advicegiven to the party responsible for selecting the pre-scribed assumption” (ASB 1996b, sec. 3.11, p.15). The standard augments the definition of pre-scribed assumptions with some examples:

Examples of prescribed economic assumptionsinclude the required interest rate for determin-ing the present value of vested benefits forPension Benefit Guaranty Corporation(PBGC) variable rate premiums, the currentliability interest rate, and economic assump-tions selected by the plan sponsor for purposesof compliance with SFAS No. 87. (ibid.)

ASOP 27 decrees that “When an assumption isprescribed, the actuary is obligated to use it”(ibid., emphasis added).

Not only is the actuary obligated to use the pre-scribed assumption, but the actuary is no longerbound to disclose conflict with the prescribedassumption—for ASOP 27 removes the disclo-sure of exceptions requirement of ASOP 2. ASOP27 merely requires that the “actuary’s communi-cation…state the source of any prescribed assump-tion” (ASB 1996b, sec. 4.2, p. 18, emphasisadded) and states that such disclosure “is deemedto fully satisfy the disclosure of exceptionsrequirement of ASOP No. 2” (ASB 1996b, sec.1.2, p. 1).

(That said, we’ll see shortly that ASOP 4,“Measuring Pension Obligations,” saves some ofthe substance of the ASOP 2 requirement, albeitmore weakly. To round out the picture, ASOP 35,the companion document covering demographicassumptions issued three years after ASOP 27 in1999, contains guidance identical to ASOP 27 onthis issue. ASOP 41, a more general standard on“Actuarial Communications” issued in 2002, didnot alter any requirements with respect to theissues at hand.)

The overturning of ASOP 2’s disclosure of excep-tions requirement was by no means a foregoneconclusion. The first exposure draft, in its sectionon communications and disclosure, states that,for an assumption not selected by the actuary, “Ifthe actuary considers that assumption to be out-side the range of reasonable assumptions . . . thisshould be indicated” (ASB 1992, sec. 6.2, p. 14).The effect is substantively similar to the ASOP 2requirement, and the exposure draft left ASOP 2itself untouched.

The second exposure draft contained the commit-tee’s summary of comments received on the firstexposure draft, which included the following:

Eight comments referred to section 6.2 [thesection in question]. Almost all respondentsobjected to the language in the first exposuredraft that required the actuary to indicatewhether assumptions chosen by others wereoutside the range of reasonable assump-tions…Although the language was somewhatmodified, the board felt that this added disclosurewas professionally appropriate. (ASB 1994, app.2, sec. 6.2, p. 40)

Thus, despite opposition, the second exposuredraft was unchanged on this matter, taking theposition that the required disclosure was “profes-sionally appropriate.” It is noteworthy too that, inthis instance, the response to the comments citesthe opinion of “the board”—that is, the Actuarial

Standards Board, which votes on whether toapprove exposure drafts and standards of practice;normally, responses to comments almost alwayscite the opinion of “the committee”—that is, thePension Committee of the ASB, which does thehard work to make exposure drafts and new stan-dards possible.

The third exposure draft was a different story.Summarizing reactions to the second exposuredraft:

Five comment letters requested deleting thelast sentence of section 6.2 (now 4.2…),which required the actuary to disclose when anassumption selected by someone else is incon-sistent with the standard. One comment letterurged that this requirement be retainedbecause it was the public plan actuary’s onlytool for dealing with unreasonable legislativemandates. The committee agreed with themajority of commentators on this issue, anddeleted the sentence. (ASB 1996a, app. 3, sec. 6,p. 37)

In addition to this turnaround, the third exposuredraft introduced the term “prescribed assump-tions” and stated the inapplicability of the stan-dard to such assumptions and the actuary’s obli-gation to use them. The final ASOP 27 “dottedthe i” by formally overturning the disclosure ofexceptions requirement of ASOP 2.

This reversal in the drafting of the standard coin-cided with significant change in the compositionof both the ASB and the Pension Committee.Between the first and second exposure drafts, thePension Committee experienced moderateturnover of 23%; but by the critical third expo-sure draft, cumulative turnover since the firstexposure draft was 77%. For the ASB, the corre-sponding turnover was 33% by the second expo-sure draft and a cumulative 56% by the third.

Both groups experienced no turnover between thethird exposure draft and the final standard.4

What one population of the Pension Committeeand ASB thought necessary to require because itwas “professionally appropriate,” another did not.In its responses to comments on the third exposuredraft, the committee offered instead the view thatASOP 4, not ASOP 2, had the appropriate guid-ance for dealing with unreasonable prescribedassumptions: “[T]he committee believes disclosingthe source of the assumption is adequate whenconsidered in conjunction with the existing disclo-sure requirement in section 6.3(g) of ASOP No. 4”(ASB 1996b, app. 3, sec. 4.2, p. 35).

That ASOP 4 requirement states that

If the actuary expects that the long-term trendof costs resulting from the continued use ofpresent assumptions and methods would resultin a significantly increased or decreased costbasis, this should also be communicated. (ASB1993, sec. 6.3g, p. 16)

The live exposure draft of a proposed revision ofASOP 4 would weaken this requirement, callingfor the following: “[I]f the actuary expects thelevel of pension costs to change abruptly from onemeasurement period to the next…[there must be]a disclosure to that effect” (ASB 2002c, sec.4.1.b9, p. 12, emphasis added).

Since unreasonable assumptions can be expectedto generate significant gains or losses, which willin turn affect costs, disclosure of these cost effectsis deemed sufficient under the ASOP 27/ASOP 4disclosure regime. The problem is that unreason-able assumptions can often sustain a misrepresen-tative level of costs for a long time. The proposedrevision to ASOP 4 would cover even fewer situ-ations. Moreover, disclosing an expected costtrend simply does not have the deterrent effect of

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4 Membership data are listed at the end of the transmittal memorandum in each of the exposure drafts and the final ASOP.

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stating directly that the assumptions are unrea-sonable or inconsistent with the requirements of,say, SFAS 87.

In summary, when an employer chooses unrea-sonable assumptions for SFAS 87, an actuary’sreaction (let’s say after unsuccessfully attemptingto persuade the employer to change the assump-tions) could range from among the following:

1. Strongest—Refusing to do the assignment,with a “noisy withdrawal.”

2. Next strongest—Refusing to do the assign-ment, without a “noisy withdrawal.”

3. Strong—Performing the assignment, butstating an opinion in the communicationthat the offending assumptions aren’t rea-sonable or don’t comply with the actuary’sunderstanding or interpretation of SFAS 87.

4. Moderate—Performing the assignment, butdisclosing that the assumptions will result ina long-term trend of increasing costs.

5. Weakest, obliging—Performing the assign-ment without qualification.

Under ASOP 2, the actuary had to at least do #3,and could do #1 or #2. Under ASOP 27/ASOP 4,the actuary almost appears to be prohibited fromdoing #1 or #2, and at least has support for rulingout such a response; is no longer obligated to do#3; will sometimes have to do #4, depending onthe facts and circumstances as well as the outcomeof the revision of ASOP 4; and will sometimes,perhaps often, be able to do #5.

ASOP 27 appears to sanction much of the oblig-ing behavior decried by Warren Buffett. TheActuarial Board for Counseling and Discipline hasopined that, in interpreting Precept 8’s “reasonablesteps,” “to ensure that [actuarial] services are notused to mislead other parties,” “facts and circum-stances are always relevant” (Actuarial Board forCounseling and Discipline 2002, p. 7). But ASOP27 seems to provide a blanket answer: an “obliga-tion” (and, therefore, at least permission) to use

any prescribed assumption, no requirement to dis-close disagreement, and limited or no effective dis-closure of impact. All of this may not have beenthe intended meaning of some of those who wroteASOP 27, and, in practice, plenty of actuaries, totheir credit, have taken tougher stands with theirclients—but the standard does not read well. Andwith actuaries being blasted in the press, it’s timeto give it another look.

2.1 Unbundling Prescribed Assumptions

A useful way to start is by sorting out the varioustypes of prescribed assumptions. As noted earlier,ASOP 27 defines a prescribed assumption as onethat is “mandated or that is selected from a speci-fied range that is deemed to be acceptable by law,regulation, or other binding authority” (ASB1996b, sec. 2.6, p. 3). The examples given includethe current liability interest rate, the interest ratefor determining PBGC variable rate premiums,and economic assumptions selected by the plansponsor for SFAS 87 (ASB 1996b, sec. 3.11, p. 15).Other examples of mandated assumptions wouldbe those specified by certain state and local lawsregulating the funding of public employee plansand those chosen by state and local governmentsponsors for accounting under GASB 25 and 27.

ASOP 27 “gives equal deference to all prescribedeconomic assumptions regardless of their source”(ASB 1996b, app. 3, sec. 1, p. 24), and thereinlies a key philosophical underpinning of the stan-dard. If actuarial standards of practice were torequire disclosure of disagreement with employer-selected assumptions for SFAS 87, would they notalso need to require disclosure of disagreementwith all other assumptions not selected by theactuary, including those mandated by federal,state, and local law and regulation? Requiring theactuary to disclose disagreement with decisionsreached through legitimate political and judicialprocesses would put an unreasonable and unnec-essary burden on the actuary.

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The committee’s concern over interfering withpolitical outcomes is illustrated by one of thestandard’s requirements regarding consistencybetween prescribed assumptions and those select-ed by the actuary: “Selection of economicassumptions that do not satisfy this standard inorder to accommodate the prescribed assump-tion(s) is a deviation from the standard” (ASB1996b, sec. 3.11, p. 16).

The comments and responses to the second expo-sure draft explain the committee’s thinking:

Some respondents…[argued] that actuariesshould not be permitted to evade the intent oflaw or regulation by selecting assumptions thatoffset the effect of prescribed assumptions.Other respondents…[argued] that when a pre-scribed assumption is not individually reason-able, the actuary should be permitted to adjustother assumptions in order to reach a reason-able result. (ASB 1996a, app. 3, sec. 5, p. 34)

The committee agreed with the first argument:

The actuary may not agree that the result soachieved is reasonable or desirable…However,adjusting other economic assumptions to alterthe final result can only lead to further con-straints on actuarial practice. Therefore, thecommittee concluded that the actuarial standardof practice should require compliance with suchmandates. (ASB 1996a, app. 3, sec. 5, p. 35)

But can we make legitimate distinctions amongdifferent sources of prescribed assumptions? Infact, the profession has already done so withASOP 32, “Social Insurance,” released in 1998: itdoes require the actuary to “characterize the rea-sonableness of the assumptions,” including,apparently, those prescribed by someone otherthan the actuary (ASB 1998, sec. 4.1.8, p. 9).

The opinion here is that we should make the sameexception for SFAS 87 assumptions selected by

plan sponsors and reinstate the ASOP 2 disclosureof exceptions requirement. The basis for this con-clusion is the profession’s responsibility to act in thepublic interest. For any type of prescribed assump-tion, we should consider the practical effect of adisclosure of exceptions requirement. For example,it is pointless for an actuary to opine on the currentliability interest rate with every determination ofcurrent liability; such concerns are more usefullyexpressed through other channels.

Is it also pointless for the actuary to opine onSFAS 87 assumptions? One could argue that theASOP 2 disclosure of exceptions regime didn’tmake a significant difference while it lasted, thatsuch disclosure could not be meaningful sincethere is no forum for the actuary to communicatedirectly with investors, and that the professiondoesn’t have a regulatory basis for inserting itselfinto the auditor’s realm. However, the view here isthat, in this post-Enron world, requiring actuariesto opine on employer-selected SFAS 87 assump-tions is likely to have significant consequences forthe better. A mischievous plan sponsor would con-front a second gatekeeper besides the auditor, anda more diligent auditing profession would surelypay heed. It is true that the range of assumptionshas been tightening even without changes in for-mal actuarial standards; the SEC, rating agencies,the press, and individual auditing and actuarialfirms are cracking down. But our standards shouldcatch up, and the profession should lead.

3. Issue 2: The Best-Estimate Range

Both SFAS 87 and Section 412(c) of the InternalRevenue Code (IRC) require “best estimate”assumptions. SFAS 87 states that “Each signifi-cant assumption used shall reflect the best esti-mate solely with respect to that individualassumption” (FASB 1985, par. 43, p. 12). Section412(c) requires that

[A]ll costs, liabilities, rates of interest, and otherfactors under the plan shall be determined on

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the basis of actuarial assumptions and methods—(A) in the case of—

(i) a plan other than a multiemployer plan,each of which is reasonable (taking intoaccount the experience of the plan and rea-sonable expectations) or which, in theaggregate, result in a total contributionequivalent to that which would be deter-mined if each such assumption and methodwere reasonable, or(ii) a multiemployer plan, which, in theaggregate, are reasonable (taking intoaccount the experiences of the plan and rea-sonable expectations), and

(B) which, in combination, offer the actuary’sbest estimate of anticipated experience underthe plan. (IRC 2003, sec. 412(c)(3), p. 325)

ASOP 27 takes away the Section 412(c) option touse implicit assumptions,5 so that effectively wecan regard Section 412(c) as requiring that eachindividual assumption be a best estimate, just asunder SFAS 87.

A major innovation of ASOP 27 was the conceptof “best-estimate range”:

Because no one knows what the future holdswith respect to economic and other contin-gencies, the best an actuary can do is to useprofessional judgment to estimate possiblefuture economic outcomes based on pastexperience and future expectations, and toselect assumptions based upon that applica-tion of professional judgment. Therefore, anactuary’s best-estimate assumption is gen-erally represented by a range rather thanone specific assumption. The actuaryshould determine the best-estimate rangefor each economic assumption, and select aspecific point within that range. In some

instances, the actuary may present alternativeresults by selecting different points within thebest-estimate range. (ASB 1996b, sec. 3.1, p.3, boldface emphasis added)

The best-estimate range is defined as “the narrow-est range within which the actuary reasonablyanticipates that the actual results, compoundedover the measurement period, are more likelythan not to fall” (ASB 1996b, sec. 2.1, p. 2).

The standard outlines the process in which thebest-estimate range is used:

The general process for selecting economicassumptions for a specific measurementshould include the following steps:

a. identify components, if any, of eachassumption and evaluate relevant data;

b. develop a best-estimate range for each eco-nomic assumption required for the meas-urement, reflecting appropriate measure-ment-specific factors; and

c. further evaluate measurement-specific factorsand select a specific point within the best-estimate range. (ASB 1996b, sec. 3.4, p. 5)

The “measurement-specific factors” referred toabove “should be considered in constructing thebest-estimate range…and/or in selectingan…assumption within the range” (ASB 1996b,sec. 3.6.3, p. 8). In the case of the investmentreturn assumption, 10 examples of potentially rel-evant measurement-specific factors are cited: pur-pose of the measurement, investment policy, rein-vestment risk, investment volatility, investmentmanager performance, investment expenses, cashflow timing, benefit volatility, expected plan ter-mination, and tax status of the funding vehicle.

5 ASOP 27, Section 3.9 states, “Each economic assumption selected by the actuary should individually satisfy this standard” (ASB1996bb, p. 14)

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This whole approach is dangerous to the profes-sion and disserves the public. Both SFAS 87 andIRC Section 412(c) (the latter as bolstered bythe explicit assumption practice standard)require an assumption to be a “best estimate.” Tothe layperson and the nonpension financial pro-fessional alike, that suggests a single number.Financial reporting must deliver a single pensionexpense number, and Section 412(c) defines asingle minimum required contribution. Theactuarial profession has redefined “best estimate”to mean a range, a redefinition that, frankly,could appear Orwellian to some.

The danger is that the ASOP 27 approach couldbe used by some practitioners as license to selector agree to aggressive assumptions desired byclients seeking pecuniary advantage. The client oractuary might feel free to pick any point in therange without constraint—at least not from actu-arial standards. Some published statements of thecommittee and other actuaries seem to justify thisinterpretation.

First, let’s look at the propriety of selecting con-servative funding assumptions to enhance benefitsecurity. Here is the guidance given in the firstexposure draft:

If the purpose of the measurement is to deter-mine the periodic cash funding requirementunder ERISA with a margin for safety, a moreconservative funding method should be usedrather than conservative economic assump-tions. (ASB 1992, sec 5.12.2, p. 12)

By the time of the third exposure draft, the term“best-estimate range” had already been coined, andthe general selection process—evaluate data; devel-op range, reflecting measurement-specific factors;further evaluate measurement-specific factors andselect point within range—was in place.6 In the

third exposure draft and final standard, committeeresponses on the issue of conservative fundingassumptions clarify a reversal of course:

[M]easurement-specific factors enable theactuary to select conservative economicassumptions as appropriate to the plan’s cir-cumstances, including the need to enhancebenefit security (ASB 1996a, app. 3, sec. 5, p.28)

and

The purpose of the measurement—a primarymeasurement-specific factor—encompassesbenefit security. (ASB 1996b, app. 3, sec.3.6.3, p. 29)

How can conservative assumptions be justified inlight of Section 412(c)’s requirement for best esti-mates? If the best estimate is defined to be arange, there is no longer a violation. In this casethe outcome—enhanced benefit security—isprobably a good one, but it is achieved by neutral-izing the intent of the law, about which the pro-fession has indicated concern. If the law allowsvery little margin for conservative funding, is thisthe proper way to attempt to change it?

Unfortunately, what’s good for the goose is goodfor the gander. If the best estimate is a range, itcan be used to justify aggressive as well as conser-vative assumptions. Consider this committeeresponse that appeared in the second exposuredraft:

Another commentator questioned whether anactuary could act on the plan sponsor’s desireto maximize deductions or minimize costs byselecting assumptions from an appropriate endof the best-estimate range. The committeebelieves that the plan sponsor’s objectives are

6 Second draft of ASOP 27 (ASB 1994, sec. 2.2, p. 2) for best-estimate range; third draft of ASOP 27 (ASB 1996a, sec. 3.4, p5)for general process.

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among the many factors that might be consideredfor selection of assumptions within the best-esti-mate range. (ASB 1994, app. 2, sec. 5.3, pp.28–29, emphasis added)

This is a clear statement that an aggressiveassumption may be chosen, limited only by theupper end of the range, for no other reason thanthat the plan sponsor wishes to minimize costs.

Consider, too, this statement from the transmittalmemorandum to the third exposure draft:

Like the first exposure draft, the second expo-sure draft recommended that each assumptionshould be individually reasonable (i.e., shouldbe within the actuary’s best-estimate range).(ASB 1996a, p. vii, emphasis added)

The statement equates reasonability with theentire breadth of the best-estimate range.

In 2001 the Academy’s Pension Practice Councilpublished a Practice Note to assist actuaries incomplying with ASOP 27. While the documentis not binding and was not promulgated by theASB, it does provide more evidence of how actu-aries have been thinking about ASOP 27. Here iscommentary on a case study that was presented:

Note that by selecting a point within the bestestimate range other than the mid-point, theactuary did not deviate from the requirementto select the best estimate assumption. Rather,the actuary acknowledged that the selection ofthe range itself is by no means an exact processand that the actual average return on planassets over the measurement period might rea-sonably fall anywhere within the selectedrange. (AAA 2001, p. 15, emphasis added)

The fact that assumption setting is not an exact,predictive science does not mean that an entirerange constitutes a best estimate.

Even if we accept the concept of a best-estimaterange, another problem is that its width is arbi-trary. As already noted, the best-estimate range isdefined as “the narrowest range within which theactuary reasonably anticipates that the actualresults…are more likely than not to fall.”Simplistically, such a range would be a 50% con-fidence interval covering the 25th through 75thpercentiles. The definition was not so stated bothfor technical reasons and because of the commit-tee’s desire “to craft a definition that is meaning-ful to both actuaries and nonactuaries and whichalso reflects the fact that the selection of assump-tions is not a precise mathematical process” (ASB1996b, app. 3, sec. 2.1, p. 26).

Somehow, a 50% confidence interval is equatedto “best estimate”—but why not 75%, or 25%?There is no basis for the conclusion, effectively,that a 50% confidence interval is “the best anactuary can do,” to use ASOP 27’s phrase. Forinvestment return assumptions where the assetsinclude a significant equity component, a 50%confidence interval can be quite wide.

For demographic assumptions, ASOP 35’s coun-terpart to the best-estimate range is the “assump-tion universe,” defined as “the possible optionsthat the actuary might reasonably use for the spe-cific assumption” (ASB 1999, sec. 2.2, p. 3,emphasis added). Section 3.3.4 of ASOP 35 con-tinues that “The actuary should select each demo-graphic assumption from the appropriate assump-tion universe” (p. 6). The definition of “reason-able” is given as

A reasonable assumption is one that is…notanticipated to produce significant cumulativeactuarial gains or losses over the measurementperiod. For any given measurement, the actuarymay be able to identify two or more reasonableassumptions for the same contingency. In someinstances, the actuary may present several resultsto illustrate the effect of alternative reasonableassumptions. (ASB 1999, sec. 3.1, p. 3)

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An “assumption universe” that satisfied this defi-nition of “reasonable” would have to be verytight, for every assumption in this universe wouldbe anticipated not to produce significant cumula-tive actuarial gains or losses. While “the actuarymay present several results to illustrate the effectof alternative reasonable assumptions,” such arange of results might not be worth the cost ofproduction.

If this test of reasonableness is applied to ASOP 27,the best-estimate range fails. For both the top endand bottom end of an investment return best-esti-mate range to be reasonable, neither rate could beexpected to produce significant cumulative gains orlosses. A fixed, 50% confidence interval cannotguarantee this outcome. For typical confidenceintervals for equity returns, it’s not even close.

4. Solutions

On Issue 2, is the solution just to jettison thebest-estimate range? On the funding side we haveseen that IRC Section 412(c) calls for a best esti-mate, and ASOP 27 says that the best estimate isa range. Well, maybe it is; sometimes the law canbe interpreted by how it is enforced. Many anindividual practitioner signs the Schedule B forseveral plans using a variety of funding interestrates that could not be explained by plan-specificcharacteristics. The IRS has not, to my knowl-edge, made a practice of asking such practitionersto explain how each of those rates could simulta-neously be their best estimates. Through years ofenforcement policy, the IRS has effectively inter-preted 412(c) to mean that a best estimate isindeed a range; and by cracking down on extremeassumptions once in a while, it indicates that the

width of the range has to be “reasonable” in somesense.

In fact, in the 1980s the IRS introduced internalguidelines for audits of funding assumptions thattolerated a wide range—an effective spread ofover 8%!7 By comparison, for a portfolio invested70% in equities in the present economic environ-ment, a not atypical 25th–75th percentile rangeover a 20-year time horizon would have a widthof about 4%. In this sense one could view theASOP 27 best-estimate range as an evolutionaryadvance in practice standards: arbitrary like theIRS standard, but tighter. If so, it’s time for thenext evolutionary advance.

Should that advance eliminate the notion that abest estimate is a range? Stripping ASOP 27 of thebest-estimate range could put consulting actuariesin untenable positions—squeezed between clientdesires and impractical standards that the IRSitself has effectively deemed unnecessary. This is avalid argument. Nonetheless, the proposal here isto raise the bar. ASOP 27 is too much of anaccommodation to loose practice; better to prom-ulgate no definition at all of “best estimate.” Ifanything, ASOP 35 is a better model, essentiallylimiting the “best estimate” moniker to a group orrange of assumptions tight enough so that anyone choice wouldn’t generate significant gains orlosses relative to any other.

On the accounting side, suppose the professionwere to both discard the best-estimate range andrequire the actuary to state an opinion onemployer-selected SFAS 87 assumptions. Notevery practitioner or client will have the same bestestimate. If the best estimate meant a point, the

7 The comparison of SOP 2 is imperfect. The audit guidelnes looked at the aggregate effect of all assumptions and tested theassumption not against the best estimates but against actual experience over the prior three to five years, with or without inclu-sion of the current year’s experience. The tolerance was plus or minus 4% of accrued liability, for an 8% spread. With six choicesof period (three, four or five years, with or without the current year), the tolerance range expands beyond 8%. This tolerancecould all be applied to justifying the interest rate assumption; the midpoint of the effective range might be odd, but the width ofthe range would be 8% plus. See IRS (1984, sec. 430 adn 450) and IRS (1983, worksheet III): for technical criticism of theguidelines, see Anderson (1985).

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client’s best estimate would match the actuary’sonly by coincidence, rounding, or consensus. Asensible disclosure might be not whether the actu-ary had the same best estimate, but whether theactuary agreed that the client’s best estimate was areasonable best estimate. How far should the actu-ary go in recognizing the reasonability of therange of others’ best-estimate points? Perhaps itshould be beyond the tight range implied by theASOP 35 “no significant gain/loss” criterion.While this is a very difficult question to answer,the present answer—the ASOP 27 “more likelythan not” range—is a poor choice for the profes-sion and should be replaced.

My proposal is as follows:

• Reinstate the ASOP 2 disclosure of excep-tions requirement and require the actuary toopine on employer-selected SFAS assump-tions.

• Repeal the ASOP 27 best-estimate range,either without replacement or replaced by amuch tighter range based on the ASOP 35“no significant gain/loss” criterion.

This proposal would not be without difficulty,and I welcome vigorous debate and better sugges-tions.

5. Epilogue

5.1 Intersection with FinancialEconomics

If lawmakers, regulators, and actuaries were all toadopt the proposals for change put forward byadvocates of financial economics (see Bader andGold 2003), the scale of the problems discussedin this paper would be reduced. If the fundinginterest rate and SFAS 87 return on asset assump-tion were not to anticipate earning a risk premi-um, two of the most debated assumptions would

be much less malleable. Conservatism for benefitsecurity would be automatic. Other assumptionswould still, of course, be “in play.”

Arguably, the economic model underlying currentpension actuarial practice has generated tempta-tions, some of which a corrected model wouldremove. In the meantime, however, actuarial stan-dards of practice must promote high ethical stan-dards within the current economic model.

5.2 Post-Enron Regulation and StandardSetting

If we are to contemplate raising our standards inthe post-Enron environment, it is worthwhile toconsider what other professions and groups aredoing and experiencing. Here are a few tidbitsfrom the news and elsewhere:

• PricewaterhouseCoopers announced that itwould take a tougher stance on its audits,even saying that it would resign from anaccount if it couldn’t resolve its concerns(Glater 2003a). Should more pressure beput on actuaries, through Precept 8 as inter-preted by standards of practice, to do thesame?

• The SEC adopted rules requiring lawyers totake concerns about securities law violationsto top executives at the companies theyadvise and, if necessary, to corporate boards(Glater 2003b). The SEC had also pro-posed, but in the face of fierce oppositiondid not adopt, a “noisy withdrawal” rulethat would have required lawyers to taketheir concerns directly to the SEC if thecompany failed to respond appropriately.Could a scandal still to come lead to a “noisywithdrawal” regulation for actuaries?

• Standard & Poor’s has called for “placingtighter limits on the leeway companies haveto set assumptions regarding the discount

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rate, future compensation increases, andexpected investment returns” (2003, p. 7).Similarly, during the development of SFAS87, the FASB (1985, par. 192, p. 58) haddebates about mandating assumptions. Willtoo many loose assumptions lead to a con-striction of the actuary’s role?

• In the United Kingdom the accountingstandard itself makes the actuary at leastpartly responsible for employer-selectedassumptions. FRS 17 states that “Theexpected rate of return should be set by thedirectors (or equivalent) having taken advicefrom an actuary” (U.K. AccountingStandards Board 2000, par. 54, p. 26).

What should we expect from our own standardsof practice? Lawrence Bader and Jeremy Goldhave been prominent critics of the profession’sstandard-setting process. Some of their recentstatements include the following (in the lastcomment they are joined by six other namedactuaries and three actuaries who choseanonymity):

• The current process for setting actuarial stan-dards of practice (ASOPs) is dominated bypractitioners and protects existing mainstreampractice. (Bader and Gold 2003, p. 10)

• This standard-setting process is unlikely toproduce changes adequate to the challengeswe face. The profession should organize aseparate effort to reconstruct an actuarialpension model that is informed by theteachings of financial economics. (ibid.)

• The current standard-setting process is runby active practitioners whose everyday workenmeshes them in existing practice. (In con-trast, the Financial Accounting StandardsBoard is part of a structure that is independ-ent of other business and professional organ-izations). The actuarial standards structure is

a recipe for incrementalism, focused on nar-rowing the permitted range of current prac-tice. (Bader and Gold 2003, p. 11)

• It is not uncommon, particularly in the pub-lic plan sector with plans subject to GASB,for actuaries to be whipsawed betweenrequests to raise investment return assump-tions when interest rates rise (and marketvalue is likely to be below the actuarial assetvalue) and requests to restart the actuarialasset value at market when market valueexceeds the actuarial value (and interest ratesare likely to have fallen). Because ASOPs giveboth latitude and protection to practicingactuaries, we must recognize that excessive lat-itude may limit the actuary’s ability to resistthis kind of double bind. (Bader et al. 2003,p. 37, emphasis added)

These criticisms are motivated first by the chal-lenge from financial economics, but they areclearly imbued with and linked to ethical con-cerns as well. The commentators questionwhether the standard-setting process is adequateto meet the conceptual challenge created by theascendancy of financial economics; the samequestion can be asked about the ethical challengesof a post-Enron environment.

Statements by Academy and ASB members lendsome support to the idea that the standards of prac-tice merely support existing practice. The live expo-sure draft of a proposed update of ASOP 21, “TheActuary’s Responsibility to the Auditor,” states that

The ASB’s intent in revising ASOP No. 21 isto clarify and update the standard without“raising the bar” (i.e., requiring a higher levelof practice than is generally accepted as appro-priate practice by members of the professionpracticing in this area). Does the proposedrevised standard appropriately reflect generallyaccepted actuarial practice? (ASB 2002b,transmittal memo, p. v)

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In 2002 the ASB withdrew an exposure draft ofa proposed standard of practice on “ProjectedBenefit Illustrations in Connection withRetirement Plan Amendments.” In writingabout that case, an ASB member observed that“standards typically codify generally acceptedactuarial practice—and if no practice has gainedbroad acceptance within the profession, then inmost [but not all] instances it’s probably too earlyto begin drafting a proposed standard” (Rackley2002, p. 6, emphasis added). In this case “therewas no generally accepted actuarial practice thatcould be codified into a standard. Setting ameaningful standard likely would either putactuaries out of the benefit illustration businessor lead to widespread noncompliance” (ibid.).

The Academy expressed a somewhat similar viewof the function of actuarial standards of practicein a recent amicus curiae brief:

Standards of practice typically reflect theefforts of the Actuarial Standards Board todescribe “generally accepted” actuarial practiceand, therefore, can provide some evidence ofwhat “generally accepted” practice was prior totheir development. However, in some situa-tions actuarial practice has not evolved to thepoint where a particular practice or practiceshave become “generally accepted” and, there-fore, the Actuarial Standards Board is calledupon to define what practice(s) will be accept-ed within the profession. In such situations,standards should not be deemed to reflect gen-erally accepted practice prior to the date oftheir adoption. (Bloom 2003, pp. 6–7)

Within these statements is the implication thatstandards of practice must and sometimes do leadand change standard practice, rather than justcodify existing practice. This should be one ofthose moments. The transmittal memo to ASOP41, “Actuarial Communications,” states that “It isvery important that any standard of practice notconflict with the Code of Professional Conduct”

(ASB 2002a, transmittal memo, p. iv). ASOP 27,if it doesn’t directly conflict with Precept 8, at thevery least weakly interprets it.

In the post-Enron environment, as outside criti-cism of, and pressure on, actuaries and other pro-fessionals has intensified, the actuarial professionhas already started to change its practices. Firmshave clarified and tightened their internal stan-dards regarding the acceptability of assumptions.To the extent actuarial standards of practice codi-fy existing or emerging practice, a change in prac-tice is under way that should be observed andultimately formalized.

But just as changes in practice influence the devel-opment of new ASOPs, existing ASOPs influencethe course of practice—sometimes leadingchange, sometimes constraining it. The danger atpresent is that the protection afforded by ASOP27 will be a ceiling on the extent to which con-sulting actuaries strengthen their own practicestandards. This is a time for the profession tolead—to both remove that ceiling and raise thefloor of pension actuarial practice.

Acknowledgments

The author would like to thank Paul Zeisler,Heidi Rackley, Ethan Kra, and Pierre Couture fortheir review and commentary on an earlier draftof this paper. The views expressed are my own,and any errors are my sole responsibility.

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References

Actuarial Update. 2002. 2002 Enrolled ActuariesMeeting: Pension Professionalism, May: 6.

Actuarial Board for Counseling and Discipline.2002. Enrolled Actuaries Report: ABCD CashBalance Letter: Rephrasing the Question, fall, 1, pp.4–8. Washington, DC: Actuarial Board forCounseling and Discipline.

Actuarial Standards Board (ASB). 1992. ProposedActuarial Standard of Practice: Selection ofEconomic Assumptions for Measuring PensionObligations. First exposure draft. July.Washington, DC: Actuarial Standards Board.

________1993. Actuarial Standard of Practice no.4: Measuring Pension Obligations. October.Washington, DC: Actuarial Standards Board.

________1994. Proposed Actuarial Standard ofPractice: Selection of Economic Assumptions forMeasuring Pension Obligations. Second exposuredraft. July. Washington, DC: Actuarial StandardsBoard.

________1996a. Proposed Actuarial Standard ofPractice: Selection of Economic Assumptions forMeasuring Pension Obligations. Third exposuredraft. July. Washington, DC: Actuarial StandardsBoard.

________1996b. Actuarial Standard of Practiceno. 27: Selection of Economic Assumptions forMeasuring Pension Obligations. December.Washington, DC: Actuarial Standards Board.

________1998. Actuarial Standard of Practice no.32: Social Insurance. January. Washington, DC:Actuarial Standards Board.

________1999. Actuarial Standard of Practice no.35: Selection of Demographic and OtherNoneconomic Assumptions for Measuring PensionObligations. December. Washington, DC:Actuarial Standards Board.

________2002a. Actuarial Standard of Practiceno. 41: Actuarial Communications. March.Washington, DC: Actuarial Standards Board.

________2002b. Proposed Actuarial Standard ofPractice: The Actuary’s Responsibility to Auditorsand Examiners in Connection with FinancialStatements. Exposure draft. September.Washington, DC: Actuarial Standards Board.

________2002c. Proposed Actuarial Standard ofPractice: Measuring Pension Obligations andDetermining Pension Plan Costs. Exposure draft.December. Washington, DC: Actuarial StandardsBoard.

American Academy of Actuaries (AAA). 2001.Pension Practice Council Practice Note: Selectingand Documenting Investment Return Assumptions.May. Washington, DC: American Academy ofActuaries.

________2003. Code of Professional Conduct.In 2003 Yearbook, 82–6. Washington, DC:American Academy of Actuaries.

Anand, Vineeta. 2003. “SEC Warns CompaniesMight Have to Restate Financial Data.” Pensions& Investments (March 31): 1-30.

Anderson, Arthur W. 1985. “The UnworkableWorksheet III.” Pension Journal (March).

Bader, Lawrence N., and Jeremy Gold. 2003.“Reinventing Pension Actuarial Science.” PensionForum 14(2): 1–13.

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Bader, Lawrence N., Jeremy Gold, H. J.Brownlee, Richard Daskais, Arshil Jamal, DavidKass, Sven Sinclair, and Margaret M. Warner.2003. “Selection of Asset Valuation MethodsLetter.” Pension Forum 14(2): 1-13.

Bloom, Lauren M. 2003. Brief of amicus curiae,American Academy of Actuaries. In Cohen v. J.Huell Briscoe & Associates Inc., Court of Appeals,State of Arizona. January 17.

Brooksbank, Daniel. 2003. “Actuaries Say BondsBest for Meeting Liabilities.” Investment &Pensions Europe (March): 5.

Financial Accounting Standards Board (FASB).1985. Statement of Financial Accounting Standardsno. 87: Employers’ Accounting for Pensions.December. Norwalk, CT: Financial AccountingStandards Board.

Glater, Jonathan D. 2002. “Round Up the UsualSuspects. Lawyers, Too?” New York Times (August4/Bus. Sect.): 4.

________2003a. “Pricewaterhouse Taking aStand, and a Big Risk.” New York Times (January1): C1, C9.

________2003b. 2003. “SEC Adopts New Rulesfor Lawyers and Funds.” New York Times (January24): C1, C18.

Interim Actuarial Standards Board. 1987.Actuarial Standard of Practice no. 2:Recommendations for Actuarial CommunicationsRelated to Statements of Financial AccountingStandards nos. 87 and 88. April. Washington, DC:Actuarial Standards Board.

Internal Revenue Code (IRC). 2003. Section 412:Minimum Funding Standards. In Pension &Benefits Law. New York: Research Institute ofAmerica.

Internal Revenue Service (IRS). 1983. ActuarialAssumptions Worksheet. Document 6904.November. Washington, DC: GovernmentPrinting Office. Reprinted in RIA PensionCoordinator, vol. 2, pp. 19,551–19,565. NewYork: Research Institute of America, 2004.

________1984. Actuarial Guidelines Handbook.Washington, DC: Government Printing Office.Reprinted in RIA Pension Coordinator, vol. 2, pp.19,501–19,536. New York: Research Institute ofAmerica, 1988.

Labaton, Stephen. 2003. “10 Wall St. FirmsReach Settlement in Analyst Inquiry.” New YorkTimes (April 29): A1, C4.

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Rackley, Heidi. 2002. “ASB Withdraws ProposedPension Standard.” Actuarial Update (November):1, 6.

Standard & Poor’s. 2003. “Pitfalls of U.S. PensionAccounting and Disclosure.” March 3. New York:McGraw-Hill.

U.K. Accounting Standards Board. 2000.Financial Reporting Standard no. 17: RetirementBenefits. November. London: AccountingStandards Board.

Walsh, Mary Williams. 2003. “A Study ofCorporate Pension Funds Shows Many AssumedOutsize Gains.” New York Times (April 17): C1, C4.

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Introduction

In his paper “A Reevaluation of ASOP 27, Post-Enron: Is It an Adequate Standard ofProfessionalism?” Mr. Frank Todisco has done theactuarial profession a favor by setting forth con-cerns about the professional framework underwhich Actuarial Standards of Practice (ASOPs)are established and the rules under which pensionactuaries practice their craft.

In a strong expression of concern, Mr. Todiscostates that the actuarial profession is being “ques-tioned not just about its financial models, but alsoabout its ethics.” The prime illustration of Mr.Todisco’s concerns is Actuarial Standard ofPractice Number 27 (ASOP 27), “Selection ofEconomic Assumptions for Measuring PensionObligations,” which is the governing authority onthe subject for pension actuaries.

Mr. Todisco observes that ASOP 27 was

• The culmination of seven years’ effortincluding three exposure drafts;

• Developed before the emerging debate onfinancial economics; and

• Developed before the recent string of finan-cial scandals, including the Enron case.

In particular, Mr. Todisco expresses concerns withand proposes changes to the way ASOP 27 handles

• Prescribed assumptions (e.g., the actuary’sobligation with respect to employer-selectedassumptions used to develop information inaccordance with Statement of Financial

Accounting Standards No. 87 [FAS 87]) and• The “best-estimate range.”

In the following discussion I shall comment onseveral of the observations made by Mr. Todiscoand present some additional ideas for considera-tion. The comments herein are mine alone. Iwould, however, like to acknowledge the staff ofthe New York City Office of the Actuary, whoassisted in the preparation of this discussion.

Background

I began writing with the intention of being bal-anced. When asked to be a discussant on Mr.Todisco’s paper, preferably with a somewhat neu-tral viewpoint, I explained that I was already onrecord expressing concerns about ASOP 27 andthe development of ASOPs in general.Nevertheless, I began drafting this discussion inan attempt to present ideas that would both sup-port and challenge the principles of the currentASOP 27.

However, during the drafting process, it was diffi-cult to remain neutral when discussing the cur-rent state of ASOP 27. I agree with Mr. Todiscothat some of the principles set forth in ASOP 27represent a major reason why the “U.S. pensionactuarial practice is facing perhaps its most seriouschallenges in its existence as an identifiable disci-pline.”

Addressing the issues raised by Mr. Todisco andothers is essential to maintaining the integrity andcredibility of the actuarial profession. I stronglybelieve that the actuarial profession must be

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Discussions on A Reevaluation of ASOP 27, Post-Enron

Comments on Paper by Mr. Frank Todiscoby Robert C. North, Jr., F.S.A.

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dynamic, governed by the best science, and dedi-cated to the Society of Actuaries’ motto that “thework of science is to substitute facts for appear-ances, and demonstrations for impressions.”

Although the comments herein follow a some-what different path than that followed by Mr.Todisco, many of our concerns and ideas are thesame. All actuaries must be concerned when ourfinancial models are challenged and when ourethics are questioned because we have not revisedour models.

Mr. Todisco states that “this is a time for the pro-fession to lead.” He then offers some suggestionsand “welcome[s] vigorous debate and better sug-gestions.” I concur that the actuarial professionmust lead. Here I offer some of my own sugges-tions that, if not better, should at least help fosterthat vigorous debate.

Positives of the Current ASOP 27

Earlier in my professional career, I often favoredeither no ASOPs or else ASOPs that would per-mit a wide range of practice. After all, conscien-tious actuaries undertake only assignments forwhich they are qualified and perform thoseassignments with professional skill in accordancewith the Code of Professional Conduct.

In comments to the Actuarial Standards Board(ASB) in December 1992 regarding the first expo-sure draft to what eventually became ASOP 27, Iwrote that “our profession is headed in the directionof too many detailed standards, with too muchemphasis on technical precision.” I further wrotethat the proposed standard “emphasized technicalscience at the expense of individual, professionaljudgment and ‘actuarial art’” (North 1992).

However, over the years I have come to appreciatehow most of the ASOPs set forth, in articulatefashion, what seem to constitute reasonableranges of actuarial practice. In general, ASOPs do

appear to elevate the quality of generally acceptedactuarial practice across the profession. For exam-ple, the existence of ASOP 27 has generally elim-inated the use of rate of return assumptions thatare inconceivable relative to their related salaryscales. In addition, ASOP 27 fulfills, under theconcepts of traditional pension actuarial practice,my historical desire for flexibility.

Negatives of the Current ASOP 27

Notwithstanding the positives of ASOP 27 andmy historical inclination for flexibility and actuar-ial art, the financial world has changed greatlyover the last 12 years since my expression of con-cerns about “too much emphasis on technical pre-cision” and using “technical science at the expenseof individual, professional judgment.” The finan-cial world in which actuaries operate has becomeincreasingly based on scientific underpinnings.Thus, it may well be time for the actuarial profes-sion to undertake a serious review of ASOP 27and determine if the generally accepted actuarialpractices it sets forth remain appropriate.

Like Mr. Todisco, I have multiple concerns aboutASOP 27. Some of those concerns are that ASOP27 may be seen as

• Weak, to the point of allowing such a widerange of practice that the quality of theresulting work product could conflict withthe basic Code of Professional Conduct, or

• Flexible, to the point of permitting a standardof actuarial practice that is less rigorous thanmany actuaries would consider appropriate.For example, Mr. Todisco notes that theAmerican Academy of Actuaries, in a PensionPractice Council Practice Note dated May2001, appears to endorse the use of a 50%confidence interval for determining a best-estimate range. For a typical 70% equi-ties/30% fixed income asset allocation policy,ASOP 27 could support a best-estimate range

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for the rate of return on investment assump-tion that varies by as much as 4% (i.e., plus orminus 2% from the expected return) over a20-year planning horizon.

This wide range can provide a great deal of coverfor actuaries whose clients prefer to value theirfuture benefit obligations using interest rates atthe higher end of the range. This wide range canalso permit so much latitude in existing practicethat actuaries can readily weaken their true, best-estimate recommendations and still fit withintheir best-estimate ranges developed in accor-dance with ASOP 27.

Ultimately implementation of best-estimateranges provides the potential for actuarial practiceto follow a form of Gresham’s Law (i.e., bad prac-tice drives out good practice), resulting in itsacquiring the following bad practices:

• Allowing itself to become antiquated, set-ting forth what is purported to be “actuarialscience” that is not really science and isunable to recognize economic and financialrealities, resulting in•• Other professionals (e.g., investment

bankers) taking advantage of clientswhose actuarially determined financialstatus is inconsistent with the realitiesof the economic world and

•• Actuaries being at a disadvantage versusother financial experts who are notconstrained by our standards but whooperate with better science.

• Permitting, however inadvertently, actuariesto fail to protect (e.g., through inadequatefunding) the interests of plan participants,taxpayers and, possibly, clients.

• Acquiescing to the desires of bill-payingclients to the possible detriment of otherimportant constituencies.

• Arming, with unintended ammunition, crit-ics of the actuarial profession who arguethat, rather than speaking as a profession,

neutral in its politics, the profession oftenappears to be speaking on behalf of the man-agements of large employers who sponsordefined benefit pension plans.

• Ossifying, to the point of inhibiting neces-sary evolution, current actuarial practicewhere science suggests improvementsshould be made. For example, ASOP 27may not give sufficient latitude to allow forthe introduction of new ideas, such as thoseof financial economics.

Consequences of a Flawed ASOP 27

If it is determined that ASOP 27 does not repre-sent the best science or appropriate practice forselecting economic assumptions for measuringpension obligations, then some of the conse-quences of recent and potential future events maybe understood.

As Mr. Todisco notes in his paper, financial dis-closures based on higher interest rates have led tocriticisms of pension actuaries. For example,Warren Buffett, in a December 2001 article inFortune magazine, is quoted as saying “Heroicassumptions do wonders . . . for the bottom line.…The actuaries…know nothing special aboutfuture investment returns. What they do know,however, is that their clients desire rates that arehigh. And a happy client is a continuing client”(Loomis 2001).

Many actuaries believe that Mr. Buffett shouldhave directed his criticism at the plan sponsorswho prescribe those “heroic assumptions.”However, as Mr. Todisco notes in his paper, thesecomments challenge our ethics and are likely tolead to more scrutiny. As Mr. Todisco writes,“Will more people ask, ‘Where were the actuar-ies?’” In the same vein, with respect to the restric-tions placed on lawyers and accountants by theSarbanes-Oxley Act of 2002, Mr. Todisco asks,“Will the actuarial profession be next, if we don’traise our own standards first?”

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Along the same lines, over the years the InternalRevenue Service has developed more and more“bright line” tests as actuaries have stretched andpushed the limits of gray areas. With respect totheir clients, such pushing may be an indicationof actuaries’ providing the best possible serviceand value for those clients. However, the substitu-tion of bright line tests for “good faith” compli-ance may well represent the fallout from overlyvigorous advocacy and provide evidence that reg-ulators may feel that some actuaries are willing tocall black-and-white issues gray unless the regula-tors define the allowed colors.

Going forward in time, if the PBGC requires ataxpayer bailout because several major companiesdecide to terminate their underfunded pensionplans, will the public also ask, Where were theactuaries? What did the actuaries do to push theplan sponsors to properly fund their plans? Whydidn’t the actuaries use more conservativeassumptions or funding methods?

Will it be of any help when actuaries state thatfunding is the responsibility of the plan sponsoror that government rules and regulations prohib-ited strong funding?

Will the actuarial profession be able to defenditself by pointing to ASOP 27 with its prescribedassumptions and best-estimate ranges?

Will actuaries be given any slack because of theirnonfiduciary advisor role as consultants orbecause of the flawed structure of the PBGC?

When legislators, regulators, plan participants,and the public ask, Where were the actuaries?they are not likely to care about the intricacies ofASOP 27 or to give actuaries a pass because theprofession created an ASOP that represents gener-ally accepted actuarial practice. Consequently, Ijoin Mr. Todisco in asking the actuarial professionto consider the ethical implications of an ASOP27 that may be flawed.

In a speech entitled “Ethics, Investments andMarket Valuation” presented at the CFA InstituteAnnual General Session on May 11, 2004, Mr.Robert D. Arnott, chairman of ResearchAffiliates, LLP, and editor of the FinancialAnalysts Journal, challenged the investment com-munity “to play a proactive role in rewarding theethical conduct of business” (Arnott 2004). Manyof Mr. Arnott’s observations, including thoserelated to meeting promises to fund pensionplans, are useful for the actuarial profession if wewant to avoid reading more articles challengingour ethics like the one quoting Warren Buffett.

For example, Mr. Arnott notes that best practice(i.e., what is right) is better than legal practice(i.e., what is legal) and that the “more the businesscommunity embraces a legal definition of ethics,the more society tries to cure the resulting viola-tions of moral ethics with new legal restrictionson business activities.” Mr. Arnott also answersthe question “Is aggressive accounting an ethicsissues?” In a short answer he says, “It is.” As anillustration, he notes that the use of an “implausi-bly high pension return assumption…results in… deferring expenses—legally!”

ASOP 27 provides no impediment to the use of an“implausibly high pension return assumption.”When a plan sponsor selects a prescribed assump-tion, the actuary need not comment on its reason-ability, even if it is outside that actuary’s best-esti-mate range, no matter how unlikely any prescribedassumption could be outside most best-estimateranges given the width of those ranges.

Some Arguments of Financial Economics

Financial economics makes the case that actuarialliabilities usually should be discounted usinginterest rates that are consistent with assets whosedurations and probabilities of payment are com-parable to the duration and probabilities of pay-ment of the benefits. For example, for mostPublic Employee Retirement Systems (PERSs) in

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the United States, a combination of existing fund-ed status, taxpayer resources, and contractualrights or constitutional protection means that thebenefits of these PERSs are almost certain to bepaid. In such an environment, rates of return con-sistent with the yields on U.S. Treasury securitiesof comparable duration are the appropriate inter-est rates with which to discount expected benefitpayments.

For most pension plans with asset allocation poli-cies that include at least 50% equity securities, thebest-estimate range of ASOP 27 may be wide, butmay not be sufficiently wide to allow an actuaryto establish economic assumptions based on afinancial economics approach. To illustrate, ifactuarial liabilities are discounted without refer-ence to the risk premia of the supporting assets(such as by using the yields on U.S. Treasury secu-rities that average, say, 4.5% per annum, to dis-count the value of benefit payments of like dura-tion), then the actuary most likely would fail tomeet the existing actuarial standards of practiceset forth in ASOP 27 if the asset allocation were70% equities with an expected long-term rate ofreturn of, say, 7.5% per annum.

An actuary might attempt to rely on ASOP 27,Section 4.3 (Deviation from Standard) to justify afinancial economics approach, but Section 4.3appears to establish a fairly challenging burden foralternative methodologies. Of course, if the assetsof a plan are invested entirely in fixed-incomesecurities, then the best-estimate range underASOP 27 for the expected rate of return on assetsmight well include a rate of return acceptableunder the methodologies of financial economics.

ASOP 27 is looked upon as flawed by actuarieswho support financial economics primarilybecause ASOP 27 establishes that the discountrate for determining the value of benefit pay-ments should incorporate the risk premium forthe asset portfolio supporting those benefits.Clearly the issues raised with respect to financial

economics present troubling concerns, not justwith respect to ASOP 27, but with respect to themodification of any other ASOP where new ideassuggest change is needed. If the ideas of financialeconomics are correct and the actuarial professionreally believes that it should develop its ASOPs asthe work of science (as its motto suggests), thenthere is a need to revise ASOP 27 to accommo-date these new ideas.

Saying the earth is round when an ASOP says it isflat may not result in being burned alive at thestake. However, if the world is actually round,then the actuarial profession needs to find a wayto transition from saying that the world is flat tosaying that the world is round.

Alternative Ideas for ASOP 27

Mr. Todisco suggests that ASOP 27 be reformedto

• Reinstate the concept within ASOP 2 thatthere should be disclosure where an actuarydisagrees with a prescribed assumption and

• Replace the best-estimate range approach ofASOP 27 with the “no significant gain/loss”approach of ASOP 35.

I agree with Mr. Todisco that the actuarial profes-sion should begin dealing with and improvingASOP 27. However, I am not in full agreementwith Mr. Todisco’s proposals. I offer some addi-tional ideas, beginning with consideration of afull range of possibilities such as the following:

1. Retain ASOP 27 as is.2. Retain ASOP 27, tighten the best-estimate

range, or, as suggested by Mr. Todisco,replace it with the ASOP 35 concept of noexpected actuarial gains or losses, and rein-state the ASOP 2 provision of additionaldisclosure requirements with respect to pre-scribed assumptions.

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3. Rescind ASOP 27 since the current status ofgenerally accepted actuarial practice is in fluxwith the debate over financial economics.

4. Make ASOP 27 more flexible so that itcould permit establishing economicassumptions based on the principles offinancial economics. This could also beaccompanied by tightening the best-esti-mate range and by expanding the require-ments for disclosure.

5. Rewrite ASOP 27 to require following theconcepts of financial economics.

Choice #1 leaves in place all of the issues, prob-lems, and criticisms of ASOP 27 raised by Mr.Todisco and others. Choice #2 appears to be con-sistent with Mr. Todisco’s proposal and mighthelp tighten existing practice. However, this pro-posal would continue to ignore the issues andconcerns raised by financial economics. Choice#3 would leave no ASOP in place to deal with theestablishment of economic assumptions by pen-sion actuaries.

At some point in the near future, assuming theideas of financial economics continue to gain con-verts, a point may come where existing actuarialpractice clearly does not represent generallyaccepted actuarial practice (or at least preferredactuarial practice if not restricted by ASOP 27). Ifthat situation does come to pass, as Mr. Todiscohighlights in his paper, the Actuarial StandardsBoard (ASB) appears to support the idea that if anASOP does not represent generally accepted actu-arial practice, then there should be no ASOP.

As this “lack of consensus on what constitutesgenerally accepted actuarial practice” was the jus-tification for withdrawing the proposed ASOP onbenefit illustrations in 2002 (Rackley 2002), thenASOP 27, as currently written, someday mightneed to be withdrawn from use. However, such amove could appear to other professionals, legisla-tors, regulators, plan participants, actuaries, andthe public at large as an indication of an actuarial

profession in disarray. Being in the midst of a vig-orous debate is an often ongoing situation withinmost professions. Having the world interpret thisdebate as a profession in disarray, however, couldbe a major problem.

Choice #4 may offer an excellent bridge to thefuture. Many actuaries have not yet fully exploredthe arguments of financial economics. Others have,but are not yet convinced that these argumentsshould lead to revisions in pension actuarial prac-tice. Those who are convinced are presented withthe dilemma of not being able to utilize themethodologies of financial economics without vio-lating the requirements of ASOP 27. ASOP 27could be amended to permit actuarial practice to beconducted using either traditional actuarial practiceor the concepts of financial economics.

At the same time, however, if there is concernabout ASOP 27 becoming a “do anything at all”standard, then other changes to ASOP 27 couldbe considered, such as

• A tighter application of the best-estimaterange;

• More disclosure of the concepts employedand the basis for choosing the economicassumptions; and

• A reinstatement of the requirement that anactuary disclose if a prescribed assumption isoutside the actuary’s best-estimate range (or,at least, not acceptable within the method-ologies permitted under the provisions of arevised ASOP 27).

Choice #5 may be the ultimate direction of theactuarial profession. Currently the professiondoes not yet appear to be ready to substitutefinancial economics for traditional actuarial prac-tice. However, if financial economics is ultimate-ly embraced by pension actuaries, then it wouldbe better if the actuarial profession arrived at thatpoint on its own rather than by having the impli-cations of financial economics forced upon it by

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economic realities and the probable upcomingchanges in accounting standards.

Suggested Revision to ASOP 27

I believe that choice #4 offers the actuarial profes-sion an opportunity to address several concernsexpressed about ASOP 27. In particular, choice#4 would allow the actuarial profession to recog-nize the issues raised by financial economics with-out forcing the entire profession to adopt thoseideas immediately.

Although choice #4 would leave the debateabout financial economics unresolved and createan ASOP with more than one acceptableapproach to the development of economicassumptions for measuring pension obligations,having these alternatives within ASOP 27 wouldalso mean that the debate about what economicmodel should be used by actuaries would beongoing. Ideally this would also make the ASBthe venue for conducting that debate and over-seeing the process of establishing a final, revisedstandard.

In the end, I believe the ideas of financial eco-nomics are likely to win out and that choice #5will come to pass. Until then, it may not be rea-sonable to continue having in place the existingASOP 27 that is at odds with what many actuar-ies who support the ideas of financial economicsargue is “best practice.”

Change happens, and, with respect to ASOP 27,the actuarial profession needs to address the issuesof financial economics as they would impact thisstandard of practice. The changes can come fromwithin, instituted by actuaries pursuing theirmotto of science. Alternatively, the changes canbe a response to outside forces accusing our pro-fession of being backward, irrelevant, and, worstof all, unethical.

In his comments in the Fortune article, Buffettwas more painfully accurate than most actuarieswould like to admit. It would behoove us all tolisten and address the issues raised by Mr.Todisco, the supporters of financial economics,and others like Warren Buffett.

Conclusion

Mr. Todisco has given the actuarial profession anexcellent treatise addressing the basic issues ofstandard setting and what would make a more-appropriate ASOP 27. In this discussion of Mr.Todisco’s paper I have reviewed some of the posi-tives and negatives of ASOP 27, discussed theconsequences of a flawed ASOP 27, reviewedsome of the arguments of financial economics,offered a range of alternatives for dealing withASOP 27, and, finally, suggested a revision toASOP 27.

I hope that the importance being given to Mr.Todisco’s paper by the Society of Actuaries willencourage all pension actuaries to engage in thedebate over what ASOPs should represent andhow they should be developed. I also hope thatthis debate will result in the creation of a newASOP 27 that will be viewed by actuaries andothers as the best science for the measurement ofpension obligations, result in better actuarialpractice, and, hopefully, eliminate challenges toour ethics.

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References

Actuarial Standards Board. 1996. ActuarialStandard of Practice no. 27: Selection of EconomicAssumptions for Measuring Pension Obligations.December. Washington, DC: Actuarial StandardsBoard.

________1999. Actuarial Standard of Practice no.35: Selection of Demographic and OtherNoneconomic Assumptions for Measuring PensionObligations. December. Washington, DC:Actuarial Standards Board.

American Academy of Actuaries. 2003. Code ofProfessional Conduct. Yearbook.

American Academy of Actuaries, Pension PracticeCouncil. May 2001. “Selecting andDocumenting Investment Return Assumptions.”

Arnott, Robert D. 2004. “Ethics, Investmentsand Market Valuation.” Speech at CFA InstituteAnnual Meeting General Session, May.

Interim Actuarial Standards Board. April 1987.Actuarial Standard of Practice Number 2.“Recommendations for Actuarial CommunicationsRelated to Statements of Financial AccountingStandards Nos. 87 and 88.”

Loomis, Carol. 2001. “Warren Buffett on theStock Market.” Fortune (December).

North, Robert C., Jr. 1992: “Comments toActuarial Standards Board in Re: ProposedActuarial Standards of Practice: Selection ofEconomic Assumptions for Measuring PensionObligations.” Letter to Actuarial StandardsBoard.

Rackley, Heidi. November 2002. “ASBWithdraws Proposed Pension Standard.”American Academy of Actuaries, ActuarialUpdate.

Todisco, Frank. 2005. “A Reevaluation of ASOP27, Post-Enron: Is It an Adequate Standard ofProfessionalism?” Pension Forum 16(1): 1-18.

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Frank Todisco’s paper, “A Reevaluation of ASOP27, Post-Enron: Is It an Adequate Standard ofProfessionalism?” seems to address two primaryconcerns and a number of minor ones regardingActuarial Standard of Practice (ASOP) 27,“Selection of Economic Assumptions forMeasuring Pension Obligations,” and to a lesserextent ASOP 35, “Selection of Demographic andOther Noneconomic Assumptions for MeasuringPension Obligations.”

I was asked to review and comment on Mr.Todisco’s paper based on my involvement in thedevelopment of a number of the citations in hispaper. I joined the ASB Pension Committee justas the comment period for the first exposuredraft for ASOP 27 ended. My participation onthe committee spanned the better part of adecade, which included the period when ASOPs27, 34, and 35 were completed and adopted, aswell as the effort to amend ASOP 4 to requireindividually reasonable assumptions and theinitial exposure draft on the projected benefitstandard.

I was also indirectly involved in the work onstandards and other materials cited by Mr.Todisco through the American Academy ofActuaries as a member of its Pension Committeeand Pension Practice Council. Notably, I wasactive in the small plan actuarial audit cases,reviewed the comments on each of the exposuredrafts before they were submitted by theAcademy, drafted the request on behalf of thePension Practice Council to have the ActuarialStandards Board (ASB) consider the projectedbenefit standard, and was the Academy VicePresident for Pensions when the ASOP 27Practice Note was issued and oversaw the initialdrafting of a practice note on applying FAS 87to cash balance plans.

I also served on the Academy Board of Directorsduring the public denouncement of the profes-sion over the involvement of actuaries in the con-version of traditional defined benefit pensionplans to cash balance plans. So the issue of profes-sionalism was certainly at the forefront of myefforts on behalf of the profession for a number ofyears. In this response it is not my goal to discussthe merits of the current actuarial model versusfinancial economics, but rather to address theprocess by which standards are developed andadopted, any influences that can affect theprocess, the validity of the current standards, andthe need, if any, to revisit those standards.

The development of an actuarial standard of prac-tice can be an unusually arduous process. At onepoint I estimated that the value of the time andeffort devoted to the development of ASOP 27 bythe members of the ASB Pension Committee, theASB, and those who submitted comments easilyexceeded $1 million. Mr. Todisco noted that ittook over seven years to complete ASOP 27,which seems like a rather long period of time.Unfortunately the project got off to a slow start,and as a result the profession pushed for somechanges in the ASB Pension Committee to movethe project forward. These changes probablyadded two years to the time from the start of theprocess to the issuance of the first exposure draft.

One of the criticisms of the standards-settingprocess in this paper was the change in member-ship of the committee and the ASB itself duringthese seven years. I would note that in mostinstances the changes were gradual and were gen-erally consistent with the Academy’s policy oncommittee membership. No more than twomembers changed on the ASB in any one year,and usually it was only one member. So over thecourse of this lengthy project general continuity

Commentary on Frank Todisco’s Paperby James Turpin, F.C.A., M.A.A.A., E.A.

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existed in the oversight for the development ofthis standard. The size of the ASB PensionCommittee did vary from year to year, and thusthere appears to be more change in the commit-tee membership over time than in the ASB. To acertain extent, some of those changes in member-ship were, to be sure, so that the committee ade-quately reflected all aspects of the profession.Admittedly, as the committee membershipchanged, so did some of its collective philosophi-cal outlook. Based on Mr. Todisco’s statistics, itappears that the changes in committee member-ship were significant. However, during my tenurethe committee was relatively cohesive on an intel-lectual basis, and rarely was there a wholesalereversal of a previously adopted position.

While it is true that the financial world has expe-rienced a number of scandals in recent history, Idisagree with the author’s premise that actuaries,individually or as a profession, have actively par-ticipated in the formulation of the underlyingcause of those scandals. Certainly the financialeffect of pension plans on corporate balancesheets has been well documented, but at the sametime I believe that problem was primarily createdby accounting standards, not actuarial standards.

Integrity is at the essence of this debate. It is notwhat is or is not stated in an actuarial standard ofpractice that will ultimately determine whether anactuary has fulfilled his or her professionalresponsibility to a client, the profession, or thepublic interest. Rather, that professional responsi-bility is fulfilled when the actuary’s work productreflects the reasoned application of professionaljudgment consistent with accepted actuarial prin-ciples and practices.

One of the author’s core themes is ASOP 27invites abuse in the setting of actuarial assump-tions, notably when actuaries advise plan sponsorson the selection of the assumptions for FAS 87purposes. This potential exists regardless of howASOP 27 is written, and as I noted above, it is

professional integrity that will determine whetheran actuary can be adversely influenced in theselection of assumptions. This problem is not lim-ited to FAS 87, but can also exist in determiningminimum funding for a plan.

Long before the Enron debacle, the actuarial pro-fession was focused on promoting professional-ism. If one examines both the curriculum of theSociety of Actuaries examinations and the topicsat actuarial meetings, one will find this funda-mental issue extensively addressed for more thana decade before Enron became front-page news.Fallout from Enron, WorldCom, and their con-temporaries has certainly galvanized the issue, butI find it inappropriate to equate the obvious fraudthat was ingrained in a corporate culture with themanner in which actuaries provide services totheir clients and employers.

The implication in this paper that an actuary hasto be required to disclose disagreement with theplan sponsor’s selection of assumptions for FAS87 purposes before such disclosure will be forth-coming is a little disingenuous. If the accountingprofession wanted actuaries to be responsible forthe selection of assumptions as they are in deter-mining minimum funding, that could have beenincluded in FAS 87. However, since that is notthe case, the actuary prepares information pur-suant to FAS 87 using assumptions selected bythe plan sponsor. If the actuary disagrees withthose assumptions, I believe ASOP 41 has themandate that Mr. Todisco opines is necessary.Under ASOP 41 the actuary must state that theinformation presented complies with FAS 87. Ifthe actuary does not believe the assumptionsselected by the plan sponsor satisfy the require-ments of FAS 87, then the actuary must includethat disclosure as a part of the report. Whilemaybe not stated as explicitly as was the case withASOP 2, the requirement is still there.

An actuarial standard of practice is not going topreclude an actuary from using inappropriate

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actuarial assumptions any more than the law oraccounting standards kept certain employees oradvisors to Enron or WorldCom from cookingthe books. It does not appear that even the threatof jail would have kept that from happening. Ihope that the selection of appropriate assump-tions and the consequences of erring in thatprocess never need to rise beyond the scope of theActuarial Board for Counseling and Discipline.

The comment from Warren Buffett quoted byMr. Todisco about the actuary’s acquiescence toinappropriate FAS 87 assumptions is certainlytrue about any professional who ignores his orher professional responsibility and accedes to thedemands of a client. However, it should benoted that in this case the actuary is assisting theclient in complying with an accounting stan-dard, rather than exercising independent judg-ment to produce the final result. If the actuarydisagrees with the assumptions selected by theplan sponsor, the actuary has an obligation tostate that disagreement under ASOP 41, but canstill provide the calculations using those assump-tions. I have long maintained that FAS 87 resultsare inappropriate, even for their stated purpose,and have consistently used a disclaimer similarto the sample in ASOP 2, but modified toinclude a statement that the calculations for FAS87 purposes do not reflect generally acceptedactuarial principles and practices.

Based on my experience overseeing the debate(although frequently it was more like refereeinga wrestling match) during the initial develop-ment of a practice note on complying with FAS87 for cash balance plans, it is clear to me thatwe do not have a universal understanding amongactuaries on how to comply with the require-ments of FAS 87. Thus, anytime an actuary pro-fesses that a set of calculations absolutely com-plies with FAS 87, I am skeptical. After theadoption of ASOP 41, I modified my FAS 87report to indicate that the report may deviatefrom the requirements of ASOP 41, as I cannot

affirmatively state that the results comply withFAS 87, but rather, the results reflect my under-standing of FAS 87.

Actuarial standards of practice are a usually codi-fication of current practice. When there is inade-quate information on existing or proposed prac-tice, it is more difficult to formulate a standard.Certainly it is beneficial for standards to bedynamic treatises that will encompass the evolu-tion of practice and new techniques. However,one must remember that, to a certain extent, stan-dards are developed within a specific time frameand are more likely than not to reflect the profes-sion as it exists at that time. For example, thedevelopment of ASOP 27 began at a time whenthe selection of actuarial assumptions were beingattacked by the Internal Revenue Service, notablythe assumptions used to determine fundingrequirements for small pension plans. The IRScontended that overly conservative actuarialassumptions were inflating deductible contribu-tions to small pension plans. Today, some 15 yearslater, this effort might be focused at the other endof the spectrum, amid expressed concern over theuse of too liberal assumptions in larger plans,which results in potential underfunding. Again,only the integrity of the actuary ensures that plansare properly funded.

As long as professional judgment is a fundamen-tal part of actuarial work, the selection ofassumptions or any other component of the actu-arial model will be subject to challenge. In limit-ing the testimony on historical and theoreticalinvestment models in the small plan actuarialaudit cases, Judge Clapp noted that the selectionof actuarial assumptions requires more than justthe evaluation of historical rates of return on var-ious classes of assets: an understanding of notonly where we have been, but also where we maybe going in the future. It is within this frame-work that the concept of best-estimate range wasintroduced.

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The concept of best-estimate range was notarrived at easily, but it was a measured reflectionof the breadth of practice that needed to beaddressed in this standard of practice. Further, itwas a reflection of what many actuaries werealready doing, if not formally, at least informal-ly. As in most cases, if the parameters with whichone is working are narrow and focused, it is eas-ier to craft a solution. In the case of ASOP 27,the parameters were extraordinarily broad whenone considers the range of investment optionsavailable to plan trustees, the compensationissues in various industries or employer groups,the time horizon for plans from relatively shortperiods to 40 or more years, and so on. In addi-tion, there were certain statutory or regulatoryconsiderations that are not uniformly applicableto all plans. Thus, it was necessary to produce astandard that narrowed practice to an acceptablerange, without unduly constricting the properuse of professional judgment.

Extensive revisions were made between theexposure drafts due to the input from the profes-sion as well as the committee. It is clear theauthor does not agree with some of the commit-tee’s decisions in responding to the comments. Ican say that every comment was considered atlength, and only in a limited number of caseswhere the issue had previously been discussedthoroughly was a comment not reconsidered atleast two or three times. Every time a change wasmade to a section of the draft, the committeewas careful to revisit the comments to make surethat the change did not conflict with prior dis-cussion about the comments on that section.One of the problems with the presentation ofinformation in the appendix on various com-ments is that one cannot determine the degree ofdebate that resulted from a specific comment orset of comments. In many instances a single sen-tence in the appendix may cover what amount-ed to hours and hours of debate by the commit-tee over a period of several months.

The problem was “What is an acceptable range?” Ifone follows the author’s arguments, the rangeshould be a single point. Actually, under ASOP 27the actuary is required to select a single point. It isthe method for deriving that point that seems to bein question. The requirement is that that pointmust lie within a range that reflects the actuary’sbest estimate of where the result is more likely thannot to lie. Conceptually this seems rather simple,but in practice it can prove difficult.

Consider the following example from the debateover setting the range. A plan has only one asset.There is an equal probability that either the assetwill have a 5% investment return or it will pro-duce a 15% return. When each option wasweighted equally, the expected return was 10%.However, what would be the narrowest range thatwould be more likely than not to include theexpected result? This debate went on for whatseemed like months before it was recognized thateach committee member could find an examplethat would make application of the standard dif-ficult, if not impossible. Further, ASOP 27 doesnot restrict the actuary to use only one methodfor deriving a reasonable assumption. It providesseveral examples that were common practice atthe time, and in response to a comment, one willfind a statement in the appendix about the use ofnew or better processes that might be applicablein the future.

While the issue of FAS 87 assumptions was cer-tainly a consideration from the start of the ASOP27 project, the issue of mandated or prescribedassumptions became more of a focus followingthe passage of RPA’94, which added the deficitreduction contribution with more restrictiveassumptions than previously used for current lia-bility. The problem for the committee was theIRS position on current liability in which any ratewithin the current liability range was acceptable.An actuary’s best-estimate range might overlapthe current liability range, or it might not. If itdoes, is the actuary required to choose a current

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liability rate within the overlap? But if it does notoverlap, could the actuary then use any rate with-in the current liability range?

The concept of prescribed assumptions was a fre-quently debated topic between the issuance ofexposure drafts, including whether or not torequire the actuary to opine on the reasonablenessof prescribed assumptions. In part, one considera-tion was, if the standard individually addressed thecurrent universe of prescribed assumptions such asFAS 87 and currently liability, but did not consid-er what might come in the future, would the stan-dard be deficient? Thus, a more expansive, perhapsless precise, approach was chosen to allow the stan-dard to cover other potential prescribed assump-tions in the future. A requirement that the actuarystate whether a prescribed assumption was reason-able was carefully considered by the committee,but not adopted for a number of reasons, includingthat it was likely to require the actuary to denouncean assumption as being unreasonable, when nei-ther the actuary nor the plan sponsor has any con-trol over the assumption.

Another of the author’s concerns is that standards ofpractice are developed by members actively practic-ing within the profession rather than being devel-oped in a more academic setting. The academicapproach has some appeal, as it might avoid placingtoo much emphasis on current practice and focusmore on elevating the level of practice. However,one also runs the risk of creating requirements with-in standards that are totally impractical for someplans. For example, the standards apply to all actu-aries, but do not make a direct distinction betweenwork on pension plans with many participants ver-sus those with only one or two participants, or plansthat use sophisticated models for investing planassets as opposed to those with limited assets andsimple investment strategies. By considering theimpact on actual practice, these issues are includedin a standard developed by active members of theprofession, but they might not be if developed usinga different, more academic, approach.

If there is a fundamental flaw in the author’sanalysis, it is the assumption that external dis-agreement with actuarial procedures and practicesautomatically indicates a need to reevaluate thosepractices and procedures. Actuaries have beenbuilding models of one form or another for a longtime, and it does not appear that any flaws inthose models have resulted in widespread finan-cial ruin for the businesses that have historicallyrelied on those models. As far as I can tell, themajor financial disasters have been created bygreed and fraud or by theoretical approaches thatdismissed the worst-case scenario as too remote aprobability to be given serious consideration. Inmost instances actuaries build models that reflectwhat is most likely to happen and then hedgetheir bets by recognizing the severe impact if theworst case does in fact occur.

The fact that people disagree with or attack aprofessional approach does not in and of itselfcreate the need to reexamine that professionalstandard. If the standard was well conceived tobegin with, it will withstand scrutiny on its own.In my experience one cannot effectively addressevery question that is raised by the media orother source of criticism. There is a legitimateneed to examine our professional standards asour practices evolve. Unfortunately, for pensionactuaries professional standards are not the mostrestrictive aspect of our work, but rather thestatutory and regulatory environment as well asother constraints, such as accounting standards.As the author noted, it may be time to reconsid-er the current actuarial model and embrace a newone, but that would place the profession at oddswith regulatory or statutory requirements.

ASOP 27 and its counterpart ASOP 35 are stillviable as guides to current practice. They containsufficient flexibility to adapt to new actuarialmodels. So I believe the call for their revision ispremature until it can be clearly demonstrated thestandards unduly restrict the use of these newtechniques.

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Response to Mr. Robert North

Mr. North begins by presenting his views of thepositives and negatives of the current ASOP 27,the consequences of a flawed ASOP 27, and somerelevant arguments of financial economics; I con-cur with his observations. He then offers a rangeof five possibilities for what, if anything, to doabout ASOP 27, a useful framework. My twoproposals make up his choice #2. Mr. Northadvocates choice #4, which would allow theoption of selecting economic assumptions basedon the principles of financial economics. He addsthat choice #4 “could also be accompanied bytightening the best-estimate range and by expand-ing the requirements for disclosure” (my empha-sis), that is, marrying a financial economicsoption to my two proposals.

Since my paper, by design, critiqued ASOP 27within the context of the current pension actuar-ial model, choice #4 was actually outside itsscope. Mr. North’s expansion of that scope is awelcome advance, as he has simultaneouslyengaged both the modeling and ethical critiques.

For clarification, I will define two versions of Mr.North’s choice #4: the narrow form would allowthe financial economics option but without anyaccompanying changes to the best-estimate rangeor the disclosure requirements for prescribedassumptions; the broad form would allow thefinancial economics option accompanied by thetwo proposals I have advocated. Adoption of thenarrow form, in my view, would be inadequate,but I wholeheartedly endorse Mr. North’s propos-al in its broad form.

Author’s Response to Comments of Robert North and James Turpin

by Frank Todisco, F.S.A., M.A.A.A., E.A.

I thank the Pension Section of the Society of Actuaries for republishing my paper, which wasfirst presented in June 2003 at the Society’s Vancouver symposium on financial economics andpublished online as part of the proceedings of that conference. To reiterate a theme from thepaper’s introduction, some of the same outcomes that motivate financial economists to criticizeactuarial models motivate others to criticize actuarial ethics or professionalism. While the (veryimportant) debate about financial economics continues, we also need to consider whether, inresponse to the ethical critiques and within the context of the current pension actuarial model,our standards of practice or code of professional conduct need to evolve further for the actuar-ial profession to thrive and to best serve the public interest in a post-Enron environment.

I have argued that we should raise the bar in our standards of practice in two ways: by rein-stating the old “disclosure of exceptions” rule from ASOP 2, requiring the actuary to disclosewhen employer-selected assumptions for financial reporting are unreasonable (Issue 1); andby either repealing, or substantially tightening, the ASOP 27 best-estimate range (Issue 2). Ithank Messrs. North and Turpin for their significant and sincere contributions to this debate.Since Mr. North and I are largely in agreement, and Mr. Turpin and I in disagreement, I willdevote more space to Mr. Turpin’s remarks.

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Mr. North also would like to consider requiring“[m]ore disclosure of the concepts employed andthe basis for choosing the economic assump-tions.” I endorse that suggestion as well.

Two points of clarification are in order. First, Mr.North refers to “disclosure requirements withrespect to prescribed assumptions.” My originalproposal to require disclosure when prescribedassumptions are unreasonable was limited to oneclass of prescribed assumptions: employer-select-ed assumptions under Statements of FinancialReporting Standards, the class of assumptionsthat had been covered in this manner underASOP 2. However, I do favor examining theappropriateness of a disclosure of exceptionsrequirement for certain other types of prescribedassumptions as well.

Second, my Issue 1 proposal extends to ASOP35 as well: demographic assumptions can be justas unreasonable as economic assumptions, anddisclosure in such instances is just as necessary.For this reason alone, the Issue 1 critique isbeyond the scope of financial economics tosolve. And an actuary adhering to the principlesof financial economics could still face anemployer prescribing unreasonable economicassumptions as well.

In fact, a disclosure of exceptions requirement isespecially necessary for the material “under-the-radar” assumptions that are not disclosed infinancial reports: for example, the 30-yearTreasury rate assumption for annuity/lump-sumconversions, the form of payment assumptionwhen there is a lump-sum option, assumedretirement ages, and mortality. The absence offinancial reporting disclosure, combined withemployer selection, can present even greateropportunity for mischief with these assumptionsthan with the three disclosed assumptions underFAS 87.

Response to Mr. James Turpin

In organizing my response to Mr. Turpin, I havegrouped his remarks into six categories:

• The process of creating ASOP 27• The role of ASOPs• Misinterpretations of my positions• Issue 1: Prescribed assumptions• Issue 2: The best-estimate range• External criticism of the profession

The Process of Creating ASOP 27

Mr. Turpin states that “[o]ne of the criticisms inthis paper of the standards-setting process was thechange in membership of the [pension] commit-tee and the ASB itself during these seven years[over which the standard was created].” Actually Idid not claim that there was anything improperabout these changes in membership or about thecommittee’s and board’s changes in position, butI can see how a reader might have drawn such aninference. So let me clarify for the record my cer-tainty that there was nothing improper about theprocess of creating ASOP 27. I have no reason todoubt Mr. Turpin’s testimony that “in mostinstances the changes [in Pension Committeemembership] were gradual and were generallyconsistent with the Academy’s policy on commit-tee membership,” and that “over the course of thislengthy project general continuity existed in theoversight for the development of this standard.”

Several months after the initial publication of mypaper, I was asked to join the Pension Committee,which I did in January 2004. While I am but onevoice on the committee, and the committee’sdecisions are subject to ratification by the board,it is to the credit of the profession that a critic ofone of its primary standards of practice was invit-ed to the table. I can attest to the integrity and

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good faith of committee members and, as Mr.Turpin aptly describes, the arduous care withwhich the issues are hashed and rehashed.

My motivation in chronicling the developmentalhistory of ASOP 27 was to demonstrate the divi-sions within the profession on the underlyingissues, the extreme difficulty of adopting a stan-dard, and paths taken and not taken. If ASOP 27represented such a difficult consensus in a pre-Enron environment, perhaps the balance mightnow tip in a different direction in a post-Enronenvironment. The profession needs to revisitthese issues.

The Role of ASOPs

Mr. Turpin states, “It is not what is or is not statedin an actuarial standard of practice that will ulti-mately determine whether an actuary has fulfilledhis professional responsibility to a client, the pro-fession, or the public interest.” And further, “Anactuarial standard of practice is not going to pre-clude an actuary from using inappropriate actuari-al assumptions any more than the law or account-ing standards kept certain employees or advisors toEnron or WorldCom from cooking the books.” Idisagree. One of the main purposes of ASOPs is todeter bad practice and, together with the Code,deter unprofessional, negligent, and even unethicalor fraudulent practice. I believe the existence ofASOPs does make actuaries more cognizant oftheir professional responsibilities. The ASOPsreflect the profession’s concrete interpretations ofits responsibilities toward the public interest.

Specifically with regard to ASOP 27, Mr. Turpinwrites, “One of the author’s core themes is ASOP27 invites abuse in the setting of actuarialassumptions. . . . This potential exists regardlessof how ASOP 27 is written.” I profoundly dis-agree. My position is that the potential for abusein the setting of assumptions can be significantlylessened by the two proposed changes to ASOP27 (with conforming change to ASOP 35). With

regard to both demographic and economicassumptions, if the actuary had to disclose whenemployer-selected assumptions were unreasonableand, with regard to economic assumptions, if thebest-estimate range were repealed or substantiallytightened, then there would be significantly lessabuse in the setting of assumptions.

I also explain in the paper that the unreasonableassumptions that draw criticism to the professionare often the outcome of proper compliance withour standards—that our stance toward prescribedassumptions and the best-estimate range are eachsufficient, by themselves, to allow some of theunwholesome outcomes.

Misinterpretations of My Positions

Mr. Turpin makes several erroneous characteriza-tions of my positions that I wish to correct.

Mr. Turpin: “While it is true that the financialworld has experienced a number of scandals inrecent history, I disagree with the author’s prem-ise that actuaries, individually or as a profession,have actively participated in the formulation ofthe underlying cause of those scandals.”

Response: I have never put forth such a prem-ise. The statement suggests an unsavory intenton the part of actuaries, which I do notbelieve. Nor am I claiming an actuarial link to“those scandals.” I do believe that the profes-sion can prevent some improper financialbehavior by strengthening our standards ofpractice, and that it would be a mistake not todo so.

* * *Mr. Turpin: “Fallout from Enron, WorldCom,and their contemporaries has certainly galva-nized the issue, but I find it inappropriate toequate the obvious fraud that was ingrained ina corporate culture with the manner in whichactuaries provide services to their clients andemployers.”

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Response: I did not “equate” Enron andWorldCom with the manner in which actuar-ies provide services. I did say that Enron haschanged the environment in which we prac-tice; that actuaries and other professionals areunder greater ethical scrutiny (more on that inthe final section); that ASOP 27, when faith-fully complied with, produces practices thatcan be challenged on ethical grounds; and thatwe had better pay attention.

* * *Mr. Turpin: “Another of the author’s concernsis that standards of practice are developed bymembers actively practicing within the profes-sion rather than being developed in a moreacademic setting. The academic approach hassome appeal, as it might avoid placing toomuch emphasis on current practice and focusmore on elevating the level of practice.However, one also runs the risk of creatingrequirements within standards that are totallyimpractical for some [small] plans.”

Response: To clarify, I did not state a position onwho should write the standards. I posed a ques-tion, and I quoted the opinion of Bader andGold. I have taken a position on what the stan-dards should represent, as evidenced by my sig-nature on the comment letter, included in thisvolume, on the Proposed Introduction to theActuarial Standards of Practice. As for Mr.Turpin’s concern about elevating the level ofpractice beyond the reach of small plans, suchconcern is proper, but I believe my two particu-lar proposals to be both practicable and neces-sary for plans of all sizes.

Issue 1: Prescribed Assumptions

Mr. Turpin explains the conceptual difficulties facedby the committee in grappling with the broad “uni-verse of prescribed assumptions,” both current(especially following the passage of RPA ‘94) andfuture. He relates that one reason for the commit-tee’s decision not to include a disclosure of

exceptions requirement was that it would be “likelyto require an actuary to denounce an assumption asunreasonable, when neither the actuary nor the plansponsor has any control over the assumption” (myemphasis). I share the view that the actuary shouldnot be required to opine on that type of prescribedassumption; but I don’t extend that conclusion toall types of prescribed assumptions. As I discuss inSection 2.1 of my paper, “Unbundling PrescribedAssumptions,” while drawing a line separating dif-ferent types of prescribed assumptions might not beeasy, it can be done, and it is incumbent on the pro-fession to do so.

Regardless, Mr. Turpin now declares the disclo-sure of exceptions issue moot; he argues thatASOP 41 restores the ASOP 2 requirement thatASOP 27 had nullified:

If the actuary disagrees with those [employer-selected FAS 87] assumptions, I believeASOP 41 has the mandate that Mr. Todiscoopines is necessary. Under ASOP 41 the actu-ary must state that the information presentedcomplies with FAS 87. If the actuary does notbelieve the assumptions selected by the plansponsor satisfy the requirements of FAS 87,then the actuary must include that disclosureas a part of the report. While maybe not stat-ed as explicitly as was the case with ASOP 2,the requirement is still there.

I believe Mr. Turpin’s interpretation to be incor-rect. ASOP 41, Section 3.1.9, appears to be thebasis for his conclusion:

When methods or assumptions are prescribedby law, regulation, or another profession’srequirements, the actuary should disclose thathis or her work has been conformed in compli-ance with such requirements unless this isapparent from the form and content of thecommunication. (ASB 2002, sec. 3.1.9, p. 4)

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With regard to prescribed assumptions, I believemost actuaries interpret this section as merely arequirement to disclose that the assumptions areprescribed, that is, chosen by others who have theauthority to do so. ASOP 41, Section 3.2, con-firms this view:

If other ASOPs contain communicationrequirements that are additional to or incon-sistent with this standard, the requirements ofsuch other ASOPs supercede the requirementsof this ASOP. (ASB 2002, sec. 3.2, p. 4)

ASOPs 27 and 35 are inconsistent with Mr.Turpin’s view of the communication requirementsof ASOP 41, and so ASOP 27 and 35 wouldsupercede ASOP 41 in this regard.

The Actuarial Board on Counseling and Discipline(ABCD) agrees. In a recent article in Contingencies,a situation is posited in which a client selects aninappropriate discount rate. It is clear from theABCD’s response that there is no requirement to dis-close that the assumption is unreasonable (Rietz2004, Question 2, pp. 59, 61).

Since Mr. Turpin believes that ASOP 41 alreadyhas the mandate that I seek, and since he seems toconcur with it, I would hope he would supportrevisions to ASOPs 27 and 35 if it is agreed thatASOP 41 does not in fact have such a mandate.

In a recent article in the Enrolled Actuaries Report,Mr. Turpin refers accurately to “the conflictbetween following Precept 8 and adhering to therequirements of the standards of practice” (myemphasis). “The quandary for the actuary,” hewrites, “is the interplay between complying withthe standards, which when taken literally couldresult in providing possibly misleading informa-tion on the funded status of a pension plan, andcomplying with the code, which discouragespreparation of misleading information” (Turpin2004, p. 8). To his credit, Mr. Turpin goes on toadvocate the high road of disclosing when

assumptions are inappropriate. But the ABCD’sresponse cited above reflects the prevailing viewthat such disclosure is not required.

Reinstating a disclosure of exceptions require-ment would give the actuary vital strength andprotection in situations where a client wants touse unreasonable assumptions. Under the pres-ent standards, the actuary who chooses to gobeyond the minimum requirements of theASOPs by expressing an opinion about employ-er-selected assumptions can be replaced by a lessdemanding actuary: good practice is driven outby ordinary practice, to the detriment of thepublic interest and the profession. We need toraise the bar.

Issue 2: The Best-Estimate Range

Mr. Turpin relates the torturous deliberations thateventually resulted in the creation of the best-esti-mate range. “In many instances a single sentencein the appendix may cover what amounted tohours and hours of debate by the committee overa period of several months.” I know what he istalking about. The good faith and dedication ofthe committee is not in question. Mr. Turpin alsonotes that “it was necessary to produce a standardthat narrowed practice to an acceptable range”—indicating one sense in which ASOP 27 repre-sented an improvement over, say, the significantlywider IRS audit guidelines.

But the new “acceptable range” has proven to betoo permissive, and it’s time for the next step inthe evolutionary advance of this standard. I standby the arguments put forth in my paper, that thebest-estimate range remains a hazardous construc-tion for the profession: it is a contradiction interms; it can be interpreted, and has been bymany, as permitting the selection of any pointwithin the range; it is arbitrarily wide; it is toowide; and its permissiveness is a ceiling on furtherimprovements in practice.

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External Criticism of the Profession

Mr. Turpin writes, “If there is a fundamental flawin the author’s analysis, it is the assumption thatexternal disagreement with actuarial proceduresand practices automatically indicates a need toreevaluate those practices and procedures.” Andfurther, “The fact that people disagree with orattack a professional approach does not in and ofitself create the need to reexamine that profession-al standard. If the standard was well conceived tobegin with, it will withstand scrutiny on its own.In my experience you cannot effectively addressevery question that is raised by the media or othersource of criticism.”

I am not calling for changes to ASOP 27 (and 35)because of the existence of external attacks on theprofession. I am calling for changes because Iagree with some of the discontent—not with anyimpugnments of actuarial integrity, but with thesubstance of the complaints, the dissatisfactionwith outcomes—of which my analysis has tracedmuch to two flawed aspects of a well-intentionedstandard.

As a profession, we do need to pay attention to out-side criticism—which has not come solely fromWarren Buffet, as some have suggested. In theUnited Kingdom, in the wake of their EquitableLife debacle and pension scheme deteriorations,the entire actuarial profession is undergoing a com-prehensive governmental review: the MorrisReview of the Actuarial Profession (led by SirDerek Morris), which issued an interim assessmentin December 2004 and intends to deliver its finalreport and recommendations in the spring of2005. The Financial Times has noted the “key role”played by “overly optimistic actuarial assumptions”in sparking the review, and one of the questionsbeing investigated is “Is there an appropriate levelof disclosures by actuaries to protect the publicinterest?” (Cohen 2004b, p. 8; Morris Review2004a, Q2.26, p. 37). In its interim report theMorris Review identified “inadequate protection of

the public interest” as one of the weaknesses of theU.K. profession, and stated that the Review’s cur-rent thinking is to recommend independent over-sight of the profession (i.e., by nonactuaries)(Morris Review 2004b, pp. 4–7, 121–34).

Some of the associated criticisms voiced in thepress have been unsparing:

The UK’s actuarial profession has passed awatershed, acknowledging, perhaps for thefirst time, the wider public responsibility thatactuaries bear beyond their duties to those whosign their pay cheques. (Cohen 2004b, p. 8)

[C]ommercial considerations have come tocloud the judgement of some—if not many—of those who claim to practice “actuarial sci-ence” (chiding actuaries on both sides of theAtlantic). (Cohen 2004b, p. 8)

[I]t is a wonder that the [actuarial] professionhas not come in for the opprobrium given to,say, accountants. (Cohen 2004a, p. 6)

Actuaries, too, know the truism long agolearnt by accountants, lawyers and investmentbankers: bend over backwards to give a clientadvice he wants to hear. (Cohen 2004a, p. 6)

The Investors’ Association, which has beenhighly critical of actuaries, called on the pro-fession to be put on probation for five years inits submission to the Morris Review. SteveHuxham, a spokesman for the group, said:“We are extremely concerned by its culture ofsecrecy and opaqueness. We don’t believe thatit can be reformed without a radical shake-up.Actuaries have a deeply ingrained culturewhich is cynical, self-serving and indifferent tothe public interest. (Hunter 2004, p. 6)

I know from my own experience that the ASOPsare developed in a spirit that is anything but “cyn-ical, self-serving and indifferent to the public

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interest.” The standards now need to be elevatedto match that spirit.

Here at home, the SEC, concerned that suchassumptions could have been used to manipulateearnings, has begun investigating assumptions usedfor pension and retiree medical programs (e.g.,Schulz 2004, p. A3). In reporting on this story, TheEconomist has pointed a finger at “the rosy assump-tions of actuaries”: “at the stroke of an actuary’s pena company can make heroic assumptions about thereturns its pension assets will earn.” “If the SECsets a ball rolling, so much the better. Accountingrules are clearly too lax. But there are other weakspots. The SEC and European regulators shouldcall the actuarial profession to account. It is impli-cated in pension-accounting fiddles, because it hasallowed firms far too much leeway on the assump-tions they set” (The Economist 2004a, p. 78; 2004b,pp. 12, 17).

Mr. Turpin concludes that “ASOP 27 and its coun-terpart ASOP 35 are still viable guides to currentpractice.” I believe otherwise: we ignore the weak-nesses in these standards at our peril. We must leador be led. Strengthening these ASOPs in the twoareas I have proposed would bring about betterassumption setting, better financial reporting, a lessscandal-prone defined benefit pension system, anda stronger actuarial profession.

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References

Actuarial Standards Board (ASB). 2002. ActuarialStandard of Practice no. 41: ActuarialCommunications. March. Washington, DC:Actuarial Standards Board.

Cohen, Norma. 2004a. “How ActuariesOverlooked Longevity: The Scale of theImprovement in Our Life Expectancy Has BeenImmense and Is a Human Triumph, but theImpact on Pensions Has Been Underestimated bythe Actuarial Profession.” Financial Times(February 9): 6.

________2004b. “Actuaries RecognizeExpanding Duties: UK’s Insurance Experts TakeCritical First Step toward Acknowledging TheirProfession Has a Wider Social Responsibility.”Financial Times (November 8): 8.

The Economist. 2004a. “Murk in the Gloom: AnSEC Investigation Will Shine Much-NeededLight on the Sorry State of Accounting for RetireeBenefits.” The Economist (October 28): 77–78.

The Economist. 2004b. Time to End a Scandal:Companies Should Not Be Allowed to PlayAccounting Games with Their Pension Funds.The Economist (October 28): 12, 17.

Hunter, Teresa. 2004. “Government Actuary’sDepartment Faces Abolition: Damning ReviewCalls for Reform of Profession over Its Failure toStand Up for Britain’s Savers.” Sunday Telegraph(December 12): 1.

Morris Review. 2004a. Morris Review of theActuarial Profession: A Consultation Document.(June).

Morris Review. 2004b. Morris Review of theActuarial Profession: Interim Assessment.(December).

Rietz, Robert J. 2004. “Working with theABCD.” Contingencies (November/December):56-62.

Schulz, Ellen E. 2004. SEC Investigates SixCompanies on Pension, Benefit Accounting. WallStreet Journal (October 18): A3.

Turpin, James. 2004. “Actuarial Communication:Misleading or Just Plain Confusing?” EnrolledActuaries Report (summer): 1, 6–8.

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Editor’s Note: The present paper was not written todiscuss Todisco’s paper but was written independentlyas a stand-alone paper offered here as a complement toTodisco’s. It does not discuss his paper per se, butTodisco has considered this work in his response to dis-cussants in this volume.

1. Introduction

Todisco (2004) discusses the shortcomings ofActuarial Standard of Practice (ASOP) 27 as a stan-dard of practice and disclosure. In this paper weaddress its shortcomings as a statement of actuarialand economic science.

ASOP 27 guides actuaries in selecting economicassumptions for valuing pension plans (excludingassumptions prescribed by regulation).1 Its guid-ance, however, fails to apply the lessons of eco-nomics—most egregiously in Section 3.6, whichdirects us to use expected returns on risky assets todiscount benefit cash flows.

The lens of ASOP 27 distorts everything it meas-ures. It prescribes discount rates that systematicallyundervalue pension liabilities. The projection offuture salaries overstates costs for young employeesand understates costs for the old. These actuarialdistortions lead to bad decisions about investment,plan design, compensation and financing. Thesesame mismeasures have led the FASB and GASB toflawed standards for financial reporting and feder-al and state legislators to weak funding rules.

In this paper we highlight key portions of ASOP27, trace the roots of existing practice, and showhow ASOP 27 prescribes mismeasurement. We

look at the influence that traditional pension actu-arial discounting has had on financial reportingrules and funding statutes. We conclude by recom-mending changes that would rescue ASOP 27from its own history and the defined benefit worldfrom its distorting lens.

2. What ASOP 27 Says

ASOP 27 provides guidance on the selection ofeconomic assumptions for measuring definedbenefit pension plan obligations, including dis-count rates, compensation scales, and investmentreturns (sec. 1.1). The standard incorporates vari-ous precepts:

• Selection of rates expected to prevail overthe (long) term of the liabilities (sec. 3.3b)

• Consistency among assumptions (e.g., com-mon role of inflation) (sec. 3.10)

• Reliance on actuarial judgment (sec. 3.1)• Reasonable range estimation (sec. 3.1)• Consideration of the purpose for the valua-

tion (e.g., ongoing vs. termination) (sec.3.3a)

• Recognition of prescriptions imposed on theprocess (e.g., FAS 87, ERISA) (secs. 1.2,3.11)

• Discount rates and investment returns beingsynonymous (sec. 3.6)

• Inclusion of expected risk premiums (sec.3.62).

3. The Roots of ASOP 27

Actuarial cost methods (also known as fundingmethods) were developed to solve the employer’s“budgeting problem” (Trowbridge and Farr 1976,

What’s Wrong with ASOP 27?Bad Measures, Bad Decisions

Lawrence N. Bader, F.S.A. and Jeremy Gold, F.S.A., M.A.A.A., M.C.A.

1 As, for example e.g., by FAS 87 and by IRC Section 412(l).

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chap. 1), that is, how much (and when) to con-tribute to achieve and maintain actuarial balance—to wit, funded assets and future contributions plusearnings thereon are expected to meet all benefitsearned or to be earned by the current plan members.

With this goal in mind, and without competingobjectives such as statutory solvency or financialreporting, best estimates of future rates of returnand future pay increases are necessary inputs toan actuarial model. Reflecting these needs,ASOP 27 prescribes a best-estimate range as “thenarrowest range within which . . . results . . . aremore likely than not to fall” (sec. 2.1). This is amedian concept. For symmetric distributions,the median matches the mean, and thus we cansay that the central best estimate is the expectedinvestment return and the expected annualsalary increase.

Budgeting methods anticipate deviations fromthe expectation that are unbiased in the sensethat year-to-year gains and losses are equallylikely and of equal expected magnitude. Suchgains and losses are amortized over forward peri-ods in a symmetric and presumably unbiasedfashion with the result that, on average, thebudget meets the goal.

Once we understand that the goal is to makefuture values match—on average—we can seethat the use of expected asset returns to discountcontribution and benefit flows is merely a deviceto state the future balance in present valueterms, that is, “discounted” liabilities less “dis-counted” contributions equal plan assets. Unlikediscounted values used by investors, these dis-counted values have no economic meaning.They give us no useful information about howthe plan affects the earnings or the value of thesponsor and tell us little about whether the planwill be able to pay the promised benefits.

4. Measuring the Economic Value ofFuture Cash Flows

The anticipation of risky investment returns mis-measures the economic value of future cash flows,as discussed in Bader (2001), Bader and Gold(2003), Day (2004), and Gold (2002).

4.1 Swaps and Futures Show That theMarket Value of the Equity RiskPremium Is Zero

Total return swap contracts allow two investors toexchange the total return on one asset (e.g., a zero-coupon bond) for the total return on another(e.g., the S&P 500 Index). Periodically through-out the life of the contract, one party (whom wewill call the “long” position) receives the totalreturn on the S&P and pays the “short” party thetotal return on the bond. Because of arbitrageconsiderations, the price for such a swap (involv-ing marketed instruments) must be zero.

If we define the payment interval to be the entirelength of the swap (shorter periods are used toreduce counterparty default risk, which weignore), we find the following relationships:

V (S 0)=V (E 0-B 0)=0EV (S 1)=EV (E 1-B 1)=ERPEV (S t)=EV (E t-B t)=ERPt

where V ( ) and EV ( ) represent market valueand expected market value, S , E , and B rep-resent the swap, equity index, and bond, ERPis the equity risk premium, and subscripts denotetime.

Thus the long position represents ownership ofthe total ERP for the life of the contract, and itsvalue today is zero. Similar contracts, such as S&P500 Index Futures, trade every day at this samezero price.

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Why should the future ERP be worth zerotoday? Think about someone who owns the $100zero-coupon bond and, preferring an equity return,takes the long swap position. She will now receivethe total return on $100 of the S&P Index. Theswap cannot be priced above zero because thepotential long would then forgo the swap and sim-ply sell the $100 bond and buy $100 of the S&P.Symmetry shows that the swap could no more bepriced below zero than above zero.

4.2 How Anticipating Risky ReturnsOvervalues the Equity Risk Premium,Making $100 in Stocks Worth More than$100 in Bonds

Suppose the length of time and the interest rateapplicable to the zero-coupon bond are such thatthe bond will be worth exactly $200 when itmatures and the swap is settled. It is clear that thepresent value of this future $200 is $100.

Consider the present value of the same $200future payment (a pension benefit cash flow)when a party obligated to meet it (a defined ben-efit pension plan) invests in the S&P 500.According to ASOP 27, we discount the future$200 using the expected rate of return on theS&P. We estimate the annual ERP and add itto the bond rate of return and find that the calcu-lated present value is $50.

From this we conclude that $50 worth of stock isequal in ASOP 27 value to $100 in bonds or, equiv-alently, that $100 worth of stock is twice as valuableas $100 worth of bonds. Of course, actuaries whoanticipate risk premiums in pension valuations donot literally value a $100 equity portfolio morehighly than a $100 bond portfolio. They achievethe same result indirectly, however, when they valueliabilities financed by equity more cheaply than thesame liabilities financed by bonds.

5. Financial Reporting

The objective of financial accounting is to reportvalue-relevant information to interested parties—information about assets and liabilities, andchanges therein, that would alter the price that abuyer would be willing to pay, or a seller toaccept, for a share of the firm.

Transparency, a high priority for modernaccounting, describes an ideal condition in whichall interested parties have costless access to thebest information. Rational agents operating in atransparent environment make efficient decisions.Lack of transparency is costly.

In recent years financial standards setters havemoved their central paradigm from historic costand internal consistency toward transparency andeconomic value relevance. With these new priori-ties, the weaknesses of FAS 87 have become evident.Several of these weaknesses may be traced to the tra-ditional actuarial model and to the support that itreceives from ASOP 4, ASOP 27, and the proposedASOP in regard to asset valuation methods:

• Reported income shold not anticipate theERP. Although FAS 87 does not use theexpected return on assets to discount liabili-ties (and thus the ABO is a value-relevantliability), the expected return on assets goesdirectly into the profit-and-loss statementwith no adjustment for risk. This overstatesearnings—and encourages unnecessaryinvestment risk taking (Gold 2000b;Coronado and Sharpe 2003).

• The market value of plan assets is relevant.The actuarial asset value is a distortion thatreduces transparency and relevance.

• The inclusion of a salary scale in the project-ed benefit obligation and in the service costoverstates liabilities and misstates income.

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In the common case where there is no com-mitment to grant total compensationincreases in excess of those necessitated bycompetitive forces, there can be no recogniz-able liability based on estimated futureincreases. The inclusion of a salary scaleoverstates the benefit costs for youngemployees (and employers with youngworkforces) and understates the cost forolder employees (and their employers).

• The amortization of gains, losses, benefitimprovement costs, and the value ofassumption changes defies transparency andvalue relevance. During 2001 and 2002 asthe financial position of virtually every U.S.defined benefit plan deteriorated sharply,the sponsors continued to report pension“income.”

Neither pension actuaries nor financial standardssetters stand behind FAS 87 today. Robert Herz,the chairman of the FASB, has said FAS 87 is“one of the prime examples of bad accounting”(Burkholder 2003). Although we might be able toblame the FASB for adopting our budgetingmodel, a fair review of the history of FAS 87shows that actuaries and plan sponsors vociferous-ly resisted efforts of the FASB to make FAS 87more transparent and value relevant.

6. ERISA Funding

ERISA was enacted to correct numerous perceiveddefects in the U.S. private pension system in thepreceding two decades. A primary concern was thefailure of plans that terminated with assets that wereinsufficient to cover benefits that had been prom-ised. Despite what amounted to a solvency concernthat should have pointed to the relationship of planassets and liabilities (the plan’s balance sheet), theminimum funding rules were built on the actuarialbudgeting model, focusing on the stream of contri-butions from the sponsor to the plan.

6.1 Why Is It Public Policy ThatPension Plans Be Well Funded?

Society has concluded that promises made byemployers to their employees should be kept.Bader (2004) shows that requiring full funding ofaccrued benefits at all times is economically effi-cient. The societal motivation for adequate fund-ing is more likely to derive from our collectivesense of fairness, the damage done by plan fail-ures, and the recognition that employers and non-represented employees do not bring equalstrength and knowledge to the contractingprocess. To mitigate this damage ERISA alsoestablished the PBGC. Unless full funding is aconcomitant requirement, however, the PBGC ismerely the conduit whereby weak firms withpoorly funded plans take advantage of strongsponsors of well-funded plans. A side effect ofsuch game playing is that defined benefit plansbecome less attractive to strong sponsors.

6.2 What Is Wrong with the BudgetingModel and ASOP 27 for StatutoryFunding?

The basic ERISA budgeting model is satisfied whenthe future contribution stream plus existing assetsplus expected investment returns thereon are suffi-cient to meet all promises to current members, pro-vided that the contribution schedule has beenmaintained to date (non-negative credit balance).

Companies that sponsor defined benefit plans dogo bankrupt and are more likely to do so duringperiods of economic weakness. During these sameperiods, pension plans invested in equities arelikely to be poorly funded, and there is a substan-tial correlation between bankruptcy and poorfunding. Companies approaching insolvencyoften fund at or below minimum statutory levels.

The inadequacy of the budgeting model, partic-ularly in tough economic environments,prompted the introduction of IRC Section

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412(l). This section directly attacks the problemof asset adequacy, focusing on accrued benefitsdiscounted at bond or annuity rates. This con-cept, which (from the perspective of ASOP 27)is fully prescribed, ignores the budget model andsubstitutes a “collateral” model. The budgetmodel requires a lower asset value when assetsare risky, but a sound collateral model wouldrequire greater assets when assets and liabilitiesare mismatched (Bodie and Merton 1992).Although Section 412(l) does not take mis-matches into account, the PBGC has recentlypointed out the need for new legislation tostrengthen funding levels and to take account ofmismatches in the computation of its variablepremiums.

6.3 What Modern Actuarial ScienceShould Tell the World about Funding

A critical element in any plan to strengthen fund-ing levels must be the discount rate used to valuethe accrued benefits. If, when the sponsor goesbankrupt, the assets are not sufficient to acquire ariskless portfolio of matching bonds, some partyother than the promise maker must bear the riskor make up the deficiency. Therefore the publicpolicy that minimizes the gaming possibilities byweak employers must eventually incorporate theuse of the riskless yield curve into the determina-tion of liabilities and required assets. In light ofthe weak state of present plan funding and thepersistence of mismatching, we will need a sub-stantial transition period.

Actuarial science, informed by the teachings ofmodern economics, points to the logic of the col-lateral model and for rigorous measures of plansolvency in the public policy arena. To the extentthat our practice standards should reflect our bestscience (Bader et al. 2005), ASOP 27 must sup-port a collateral-based funding method with risk-less discount rates.

7. Public Plan Funding

Public plans (covering governmental employees)might seem to be the place where all we are inter-ested in is a budget that balances assets, contribu-tions, investment returns, and benefits over “thelong term.” As long as the long-term budget canbe maintained, we might argue that solvency andfinancial reporting are relatively unimportant.With PAYGO as a possibility, one might ask,why should a governmental plan fund at all?Peskin (1999) answers that intergenerationalequity (fairness among taxpayers over time) is theprimary reason that public plans are funded.Each taxpayer generation should pay its fair shareof multigenerational plan costs.

Gold (2002) looks at the intergenerational effectof using expected returns to discount benefitflows. When the plan invests in risky assets, actu-arial methods can lead to equal expected costsacross generations or to equal risk-adjusted costs,but not both. Anticipating equity premiums—which equates expected costs across generations—lowers the risk-adjusted costs for current taxpay-ers, plan participants, and politicians at theexpense of future taxpayers.

Following ASOP 27, which overly discounts ben-efits earned today, leads to bad decision making:

• Today’s elected “management” offers toomuch in future benefits in exchange for toolittle in current wage concessions.

• Although taxpayers are ultimately responsi-ble for all the benefits promised, workersoften argue that they are entitled to extrabenefits when risky assets do well for awhile. Elected officials find these demandseasier to meet than wage requests and arelikely to provide ad hoc increases or moreformal “reward-sharing” schemes known as“skim funds.”

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• Because ASOP 27 credits equity returnswithout charging for equity risk, public pen-sion plans credit returns in excess of the bor-rowing rate for most governments. Thisencourages the issuance of PensionObligation Bonds, which may be sold as an“arbitrage” or an “actuarial arbitrage” when,in fact, they usually represent an expensiveway to borrow in order to invest in equities(Gold 2000a).

8. Conclusion

ASOP 27 reflects the budgeting history of actuar-ial methods and assumptions. As such it presumesthat the expected return on assets is the singular-ly proper way to discount liabilities—regardless ofthe purpose of the valuation. The “liabilities”developed by expected-return discounting repre-sent no economic value and are useless for anypurpose other than budgeting. For ongoing valu-ations of pay-related plans, ASOP 27 presents anequally flat-footed prescription: always include anactuarial estimate for future pay increases. ASOP27 devotes much of its text to telling actuarieshow to build expected returns and expectedfuture salaries.

Employer budgeting is an all-but-forgotten pieceof pension actuarial science. Our science needs tohave answers to two much more important ques-tions today: what amount of assets should berequired as a matter of public policy, and whatmeasures of funding and expense should appearin financial reports to investors?

ASOP 27 must be amended to recognize that

• Anticipation of the ERP is not appropri-ate for liability discounting (except as a cal-culation convenience in the budgetingprocess), nor for financial reporting, nor forstatutory funding.

• Inclusion of a salary scale is not appropriatein measuring liabilities for financial report-ing and solvency purposes.

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References

Bader, Lawrence N. 2001. “Pension Forecasts,Part 2: The Model Has No Clothes.” PensionSection News, Society of Actuaries 37 (July):30–31.

________2004. “Pension Deficits: AnUnnecessary Evil.” Financial Analysts Journal(May/June) 15-20.

Bader, Lawrence N., et al. 2005. “Comments tothe ASB in re: Proposed Introduction to theActuarial Standards of Practice.” Pension Forum16(1): 47-50.

Bader, Lawrence N., and Jeremy Gold. 2003.“Reinventing Pension Actuarial Science.” PensionForum 14(2): 1-13.

Bodie, Zvi, and Robert C. Merton. 1992. “Onthe Management of Financial Guarantees.”Financial Management (winter).

Burkholder, Steve. 2003. “FASB Adds Limited-Scope Project on Pension Disclosures to Agenda.”BNA Inc., Daily Tax Report—Tax, Budget, &Accounting (March 13).

Coronado, Julia Lynn, and Steven A. Sharpe.2003. “Did Pension Plan Accounting Contributeto a Stock Market Bubble?” In Brookings Paperson Economic Activity, edited by William C.Brainard and George L. Perry. Washington, DC:Brookings Institution.

Day, Tony. 2004. “Financial Economics andActuarial Practice.” North American ActuarialJournal 8(3): 90–102.

Gold, Jeremy. 2000a. “Actuarial Assumptions forPension Plans Invite Arbitrage: The Case ofPension Obligation Bonds.” Risks and Rewards,Society of Actuaries 35 (September): 6–7.

________2000b. “Accounting/Actuarial BiasEnables Equity Investment by Defined BenefitPension Plans.” Working Paper WP 2001-5,Pension Research Council, Wharton School,University of Pennsylvania.

________2002. “Risk Transfer in Public PensionPlans.” In The Pension Challenge: Risk Transfersand Retirement Income Security, edited by OliviaS. Mitchell and Kent Smetters, pp. 102–15.Oxford: Oxford University Press.

Peskin, Michael W. 1999. “Asset-LiabilityManagement in the Public Sector.” In Pensions inthe Public Sector, edited by Olivia S. Mitchell andEdwin C. Hustead, pp. 195–217. Philadelphia:University of Pennsylvania Press.

Todisco, Frank. 2005. “A Reevaluation of ASOP27, Post-Enron: Is It an Adequate Standard ofProfessionalism?” Pension Forum 16(1): 1-18.

Trowbridge, C. L., and C. E. Farr. 1976. Theoryand Practice of Pension Funding. Homewood, IL:Richard D. Irwin.

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Section 3.1.2

Section 3.1.2 states, in part, that “ASOPs are writ-ten to reflect generally accepted practice, i.e.,practices that, over time and through commonuse, have come to be broadly accepted by quali-fied actuaries as appropriate.…In most cases, theASB promulgates a standard only when practice… has evolved to the point where it can be codi-fied as an ASOP.”

We understand that this accurately describes theASB’s approach throughout its fifteen-year exis-tence. This approach, which amounts to “cata-loging” existing practice, invites stagnation.Section 3.1.2 assumes that qualified actuaries willevolve the practice. How might such evolutionoccur? Section 3.1.2 suggests that developmentsin actuarial science will inform the practitioners,who will modify their practice accordingly. This“practice-filtering” process will not suffice. Therule-making ASB must connect directly withadvances in actuarial science. We are concernedthat many such advances will not even enter intothe practice, because

• advances in actuarial science may be unat-tractive to those who consume our services.For example, better appreciation of underly-ing risks may require recognizing higher lia-bility values. Under these circumstances,competition from less well-informed or more

permissive actuaries will prevent such recog-nition. This may be seen as a form ofGresham’s Law—inferior, but popular, prac-tice may bar better practice from entry intothe marketplace.

• advances in actuarial science may occasional-ly call for better practices that lie outside therange of today’s generally accepted practice.We recognize that the existing ASOPs incor-porate a procedure for using and defendingsuch an outlier. But when the outlier is morerigorous and less favorable to clients, it ishighly unlikely that practice will embrace theoutlier without leadership from the ASB.

The Appendix illustrates these problems underexisting ASOPs.

Section 3.1

A broader review of Section 3.1 confirms its con-sistency with some of the finest actuarial tradi-tions—individual responsibility and judgmentapplied within a flexible environment.Unfortunately, recent difficulties experienced byactuaries and some sister professions suggest thateven our most honored traditions may conflictwith our role in the modern world.

Letter to the Actuarial Standards Board

March 31, 2004

ASOP IntroductionActuarial Standards Board By e-mail: comments@actuary.org1100 17th Street NW, 7th FloorWashington, DC 20036-4601

ASB Board and the Special Task Force on Introduction:

We are writing to comment on the Proposed Introduction to the Actuarial Standards of Practice. Our comments address Section 3.1, particularly Section 3.1.2.

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Section 3.1.5 rejects narrow prescriptions in favorof actuarial science informed by education, expe-rience and judgment. This misstates the choicesfaced by the profession today. We operate in anintensely prescriptive environment. We, however,have not been doing the prescribing. Others haveprescribed for us—filling public needs that ourstandards have not met. The ASB need notchoose between principles of actuarial science andprescriptive rules. Rather it must choose betweentraditional principles and new principles thatchallenge today’s practice.

We created the ASB, in part, to make our self-reg-ulation more credible. The public may questionthe profession’s commitment to self-regulation ifit perceives that the ASB is reluctant to grapplewith modern challenges to historic principles.Although we value broad principles highly andfind detailed rules (particularly those imposed onus by others) irksome, the profession’s case forself-regulation will be enhanced by an ASB thatmakes judgments, sorting out good from badactuarial principles regardless of popular practice.

Session 39 at the 2002 annual meeting of theConference of Consulting Actuaries was titled“ASOPs—Swords or Shields.” An ASB memberand co-panelists addressed the increasing mal-practice exposure of actuaries. Practicing actuarieswho diligently follow the ASOPs may enjoy theshield effects, while those who are less diligentmay meet the sword.

Some suggest that stronger standards (which bol-ster our self-regulation case) might increase thepracticing actuary’s exposure to the ASOPs asswords. Others suggest that, if the ASOPs get toofar ahead of existing practice, many actuaries willnot follow. The second of these observations isanswered by the first—fear of exposure meansthat actuaries will follow stronger ASOPs.

As the plaintiff ’s bar sharpens its swords, we needto strengthen our shields. Section 3.1.6 (“The

ASOPs intentionally leave significant room forthe actuary…”) may appear to shield many actu-aries in the short term—because it is looseenough to cover a wide range of practice—but itwill not protect us against our collective failure toadvance our science and our practice. We mustchoose between calling actuaries to stricter stan-dards—a smaller but stronger shield for thosewho comply—and the danger of being discredit-ed en masse—as suggested by the recent experi-ence of U.K. actuaries.

Some are concerned that strengthened actuarialstandards may be cited in litigation challengingearlier practice. Every profession faces this issueand must treat it with care. The ASB will want toemphasize that such changes incorporate recentactuarial advances and apply only on and after aneffective date.

It has been argued that Section 3.1.3 is the mecha-nism that allows the ASB to recognize and adoptnew principles that flow from advances in actuari-al science. More accurately, Section 3.1.3 may beused occasionally to prune particularly unaccept-able practices (or to fill a new-area vacuum).Nothing in 3.1.3 suggests that the ASB will choosebetween popular existing practice and more rigor-ous innovations in the underlying science.

Section 3.1.7 reminds us that much of the disci-pline that chafes us (“where an actuary is preventedfrom applying professional judgment”) has beenimposed by others. Might we conclude that othersbelieve that our laissez-faire approach is insufficient?

Section 3.1.8 identifies various sources for inno-vation in actuarial science. It is at just this point,however, that the ASB needs to study, judge andchoose among alternative claims for actuarialadvancement. The profession needs a focal pointwhere innovation meets learned judgment. Wecannot be assured that innovations will filterupwards. Like it or not, judgment must be exer-cised by our leaders, who must rise to the

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occasion with knowledge, commitment andattentiveness.

Our comments should not be taken as proposalsfor specific restrictions on practice. Rather, we areasking the ASB to accept the responsibility thatmust inure to the leaders of our profession.

Conclusions

The Proposed Introduction to ActuarialStandards of Practice formalizes the ASB’sapproach to standard setting. Section 3.1 codifiesa traditional flexibility-preserving approach thatrelies on the informed judgment of practicingactuaries. Standards are generally promulgatedonly after practice has evolved. There are excep-tions for new areas, for rare pruning of unaccept-able practices, and for individual actuaries todefend variant practices.

Section 3.1 (especially Section 3.1.2) articulates a“hands off ” philosophy that must be reconsideredin light of the challenges actuaries face today andwill face in years to come. The core of our profes-sion is actuarial science. It is subject to analysis,argument, innovation, and evolution. Our prac-tice derives from the science, and, although thereis room for the practice to inform the science,judgments must be made by learned leadersembracing the best principles of actuarial sciencelest inferior principles lead a “race to the bottom.”

The signers believe that the ASB and its practicecommittees are the proper location for the exer-cise of professional analysis and judgment. Even ifour profession lacks the resources to fund a full-time leadership institution à la the FASB, our vol-unteers must be committed to independent deci-sion making informed by in-depth study of theactuarial science issues at hand. They mustadvance our science in front of our practice.Following, rather than leading, the practice is aprescription for stagnation and an invitation foroutsiders to impose their rules upon us. We mustlead or we will be led.

We welcome the review of the role of the ASB andthe ASOPs that is implicit in the promulgation ofthe Proposed Introduction at this time. In light ofrecent challenges to our profession around theworld, the time has come to wrestle with the his-toric implications of Section 3.1 and to establisha more rigorous and vigorous approach to rule-making by actuaries.

SIGNED

Lawrence N. Bader, F.S.A.

Bryan E. Boudreau, F.S.A., M.A.A.A.

H. J. Brownlee, F.S.A., M.A.A.A.

Bruce Cadenhead, F.S.A., M.A.A.A.

Richard Daskais, F.S.A.

Robert P. Eramo, A.C.A.S., M.A.A.A.

Edward W. Ford, F.C.A.S., M.A.A.A.

Paul A. Gewirtz, F.S.A., M.A.A.A.

Luke N. Girard, F.S.A., M.A.A.A.

Jeremy Gold, F.S.A., M.A.A.A.

Arshil Jamal, F.S.A., M.A.A.A.

Eugene M. Kalwarski, F.S.A., M.A.A.A.

David R. Kass, F.S.A., M.A.A.A.

Gordon J. Latter, F.S.A.

Christopher Levell, A.S.A., M.A.A.A.

Kevin M. Madigan, A.C.A.S., M.A.A.A.

Robert C. North, Jr., F.S.A., M.A.A.A.

Michael W. Peskin, A.S.A., M.A.A.A.

Mark T. Ruloff, F.S.A., M.A.A.A.

William J. Schreiner, F.S.A., M.A.A.A.

Mitchell I. Serota, F.S.A., M.A.A.A.

Mark R. Shapland, F.C.A.S., A.S.A., M.A.A.A.

Frank Todisco, F.S.A., M.A.A.A.

Trent R. Vaughn, F.C.A.S., M.A.A.A.

Appendix—Illustrative Problems underExisting ASOPs

1. Pension—asset valuation. The Exposure Draft:Selection and Use of Asset Valuation Methods forPension Valuations states no preference betweenmarket value and various techniques designed tosmooth out market value. Plan sponsors prefer

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asset smoothing, which cushions the effect ofchanging market values on their cash flow andfinancial reports.

Many accountants and actuaries now questionwhether smoothing is ever appropriate for planfinancial reporting. Given the plan sponsor pref-erences, though, only an ASB designation of mar-ket value as a preferred practice can prompt apractitioner migration and help practicing actuar-ies wean clients away from smoothing. In the nextseveral years, the FASB will likely require marketvalue without smoothing. Under the philosophyespoused in the Proposed Introduction, our pro-fession must abandon any hopes of leadership inthis area and await FASB action. Will we bemoanyet another intrusion from outside?

2. Pension—discount rate selection. To select a dis-count rate, ASOP 27 looks generally to theexpected return on plan assets. Financial econom-ics, on the other hand, calls for a discount ratethat will often lie below the range defined byASOP 27. Because the lower rates are not favoredby clients and would constitute a deviation fromASOP 27, practicing actuaries cannot move in thefinancial economics direction on their own. Thepractice cannot evolve.

The implications of financial economics are nowbeing debated by pension actuaries. The signers ofthis letter are not, therefore, suggesting that theseimplications should be accepted by the ASB today.It is, rather, our view that the ASB must review,analyze, and judge the merits of the arguments offinancial economics regarding the discount rate.The existing prescription of ASOP 27 has beenchallenged. On what basis shall this challenge beadjudicated and resolved? The ProposedIntroduction implies that the ASB will not addressthe question until and unless a critical mass ofpractice has migrated on its own initiative.

3. Casualty—loss reserving methods. ASOP 9states, “Detailed discussion of the technology and

applicability of current loss reserving practices isbeyond the scope of this statement. Selection ofthe most appropriate method of reserve estima-tion is the responsibility of the actuary. Ordinarilythe actuary will examine the indications of morethan one method when estimating the loss andloss adjustment expense liability for a specificgroup of claims.”

This is all the guidance that the AAA and/or ASBgives the actuary with regard to evaluating theadequacy of P&C loss reserves. It has been knownfor decades that standard link-ratio methods areextremely poor tools for projecting ultimate lia-bilities for a given block of business. Nonetheless,many opining actuaries rely exclusively on them.A rigorous, detailed, sufficient analysis (e.g., sto-chastic reserving methods) will frequently cost aclient much more than they are willing to spend,and furthermore, the opinion is often viewed as aregulatory hurdle to be cleared, not a valuablesource of management information. This lack ofclearer guidance and more explicit standardsmakes it very hard for practitioners to migratetoward state-of-the-art practice.

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Procedure for Preparing Articles for The Pension Forum

Pension Section News is intended as a medium for the timely exchange of ideas and information ofinterest to pension actuaries. The Pension Forum is for the publication of full papers and is issued onan ad-hoc basis by the Pension Section.

All articles will include a byline (name, with title and employer, if you wish) to give you full creditfor your effort. The Pension Forum is pleased to publish articles in a second language if the authorprovides a translation.

So that we can efficiently handle articles and papers, please use the following format when submittingarticles and papers to either Pension Section News or The Pension Forum:

Send either a Microsoft Word file or mail the article on diskette. Headlines are typed upper andlower case. Carriage returns are put in only at the end of paragraphs.

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