Riley: A Lively Thought Experiment
Tuesday, March 22, 2016
A few weeks back I was asked what are the chances that that Rhode Island pension plan would be fully funded using our current assets and assumptions. The question is simple -- and the answer is simple -- yet the calculations can be enormously complicated.
A recent panel on A Lively Experiment contained a political science professor, a newspaper editor, a politician, and myself.
The premise was that Rhode Island currently at 56% funded using a 7.5% discount rate in March 2016 would be fully funded by 2040. The politician agreed with the assessment of Treasurer Magaziner that since over 5 out of the last 6 fiscal years the State earned 9.3% that we would be fine and easily be fully funded in 2040. The newspaper editor immediately agreed despite the fact that neither the politician nor the editor has any actuarial skills or basis for their prediction that we will be “fine."
GET THE LATEST BREAKING NEWS HERE -- SIGN UP FOR GOLOCAL FREE DAILY EBLASTSo first let’s define what “fine” means. In politician parlance, we’ll be “fine” means the comment he made will not be remembered and he can go on pretending he knows something about pension finance for the rest of his political career. In Rhode Island he can sit in the Statehouse next to dozens of others with similar skills. We’ll be “fine," to the editor means that his newspaper will certainly be dead and buried by 2040 and he may need a government job soon. So why not double down on his lack of knowledge, and on his ridiculous endorsement of a kindergarten teacher for the Treasurer of a critical status State like Rhode Island. Wisely the political Science Professor, passed on having any idea how to answer the question and calculate the odds.
My answer was there was a less than 10% chance of being fully funded by 2040. Appropriately “fine" to me was Rhode Island pensions would be 80% or more funded in 2040. There are various ways to calculate this number. In my next article I will get into a few of those methods that will show almost zero chance of fully funded RI pensions by 2040. The danger of remaining critically underfunded is Rhode Island and the cities and towns will need cut spending (fire people), issue more debt or raise taxes very soon.
For now, just assume I am right. Let’s have some fun.
A Lively Thought Experiment!
Years ago there was a TV show called Monty Hall. Audience members were asked make deals. At the end of the show one contestant was asked to face the stage where there were three large doors and a model prepared to reveal what was behind the doors. One door had a valuable prize behind it and the other two doors were gag gifts worth very little.
When I was on Wall Street this was a favorite question of LETCO or Susquehanna who were leading derivative traders tasked with hiring promising candidates from the top universities. After a few difficult math questions the interviewer would pose the following scenario and question.
The Monte Hall Problem
The Monty Hall problem is a counter-intuitive statistics puzzle:
• There are 3 doors, behind which are two goats and a car.
• You pick a door (call it door A). You’re hoping for the $25,000 car of course.
• Monty Hall, the game show host, examines the other doors (B & C) and always opens one of them with a goat (Both doors might have goats; he’ll randomly pick one to open).
• Let’s say he opens B with the goat behind it?
Question 1) What are the odds that your original pick door A was right?
Question 2) Lets say you were happy with the original pick. If Monte offered you $1000 dollars to change your pick to door C would you? Should you?
Question 3) What percentage of people when posed question #1 above would change their pick?
Warning: The internet has improved the world greatly but it has ruined the careers of bar trivia experts and puzzle solvers. Try this without Google.
The findings are very interesting and say a lot about behavioral finance and the false assumptions used in financial academia still today. Now ask yourself if the politician and the newspaper editor would change their answer when presented the facts of pension funding.
Michael G. Riley is vice chair at Rhode Island Center for Freedom and Prosperity, and is managing member and founder of Coastal Management Group, LLC. Riley has 35 years of experience in the financial industry, having managed divisions of PaineWebber, LETCO, and TD Securities (TD Bank). He has been quoted in Barron’s, Wall Street Transcript, NY Post, and various other print media and also appeared on NBC News, Yahoo TV, and CNBC.
Related Slideshow: Timeline - Rhode Island Pension Reform
GoLocalProv breaks down the sequence of events that have played out during Rhode Island's State Employee Pension Fund reform.
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