Monday, September 10, 2012

Are US Pension Funding Woes Out of Control?

Hilary Russ of Reuters reports, Local public pension funding ratios up to 80 percent:
Large local public pension funds in the United States were, on average, 80 percent funded as of June 30, 2011, up from an average of 72 percent the previous year, according to a survey of plans released on Monday by Wilshire Associates.

The plans have seen their funding ratios -- the difference between total assets and the retiree benefits to be covered -- swing wildly over the last decade, said Wilshire Vice President Russ Walker, who co-authored the report.

Local government retirement systems were 95 percent funded in fiscal 2001, then slipped as a recession took hold. They improved mid-decade only to fall again after the financial crisis of 2008 and the ensuing Great Recession, to close out 2011 about where they were in fiscal 2002, Walker said.

"We talked about the lost decade of the U.S. stock market, and now it looks like we see a decade that you might call a kind of lost decade in the funding ratios of our public pensions," he said.

The pension funds are also likely to return just 6.2 percent on investments in the next 10 years if asset allocations and other factors don't change, compared to the 7.75 percent median assumed rate of return, Wilshire predicted, noting that the pension funds themselves usually project return rates over a longer 20 to 30-year horizon.

Wilshire surveyed 106 large city and county retirement systems, including: Boston, New York City, Detroit, St. Louis and Los Angeles.

The Wilshire study is the latest to try to measure the scale of the nation's public pension problem, after years of underfunding and poor investment performance left many such systems at both state and local levels with big unfunded liabilities.

There are thousands of independent local public pension plans of all sizes in the United States, making it difficult to measure their overall health.

A June study from the National Conference of Public Employees Retirement Systems found that public pensions had funding ratios of 74.9 percent on average, down from 76.1 percent in 2011.

Also that month, the Pew Center on the States estimated that states were short $757 billion to pay retiree pension benefits in fiscal 2010. Pew also found that public pensions for 34 states were funded at less than 80 percent, although some have recovered slightly since fiscal 2010.

New accounting rules approved in June by the Governmental Accounting Standards Board will likely reveal that public pension funds are weaker financially than previously believed. Some changes take effect June 2013, with others to be implemented a year later.
As the article states, there are thousands of independent local public pension plans of all sizes in the United States, making it difficult to measure their overall health. I suspect the larger ones are doing somewhat better because they have the resources and governance structure that smaller ones don't have.

Another Wilshire study on state retirement funds released in early March found that the funding ratio for all 126 state pension plans was 77% in 2011, up from an estimated 69% in 2010. This improvement in funding ratio was fueled by strong global stock market performance in the twelve months ending June 30, 2011. Growth in fund assets managed to outpace growth in plan liabilities over fiscal 2011.

In that report, Wilshire projected a long-term median plan return equal to 6.4% per annum, which is 1.6 percentage points below the median actuarial interest rate assumption of 8.0%. Wilshire states its assumptions range over a conservative 10+-year time horizon, while pension plan interest rate assumptions typically project over 20 to 30 years.

Still, even attaining a median return of 6.4% per annum will not be an easy feat in this environment. The era of deleveraging isn't over, placing huge pressure on public plans to find stable, high yield. J.P. Morgan thinks the solution lies in shifting a quarter of the assets into alternative investments, something they call a new asset allocation tipping point.

But as I've often stated, shoving more assets into hedge funds, private equity, real estate and infrastructure is no panacea. And since most state plans are approaching their alternative investments the wrong way, all they're doing is doling out huge fees, getting low profits in return.

Finally, want to bring to your attention a Harvard study on underfunded public pensions in the United States. Released in early May, it was written by Thomas J. Healey, Carl Hess, and Kevin Nicholson. The authors state the following:
As this funded ratio shrinks, unfunded liabilities necessarily grow. The sooner plan sponsors (states and, in many cases, local governments) implement meaningful reforms, the less likely the problem will continue to spin out of control. However, many states and municipalities face an uphill climb in implementing reforms, with legal and political obstacles impeding progress. In the case of pension reform, time is money, and any delay in implementing needed changes will likely cost taxpayers — and public pension beneficiaries — significant resources.
Among the potential benefit design changes, the authors suggest the following:
1. Eliminate legislative end runs around the collective bargaining process (i.e., sweeteners). Benefits would be either negotiated or legislated, but not both.
2. Eliminate final-salary plans in favor of final average compensation (FAC), career average or hybrid (e.g., cash balance) designs.
3. Reduce/eliminate post retirement cost-of-living adjustments, or make them subject to affordability (possibly conditioned on funded status).
4. Tighten up eligibility for heavily subsidized benefits, such as disability and early retirement.
5. Tighten up eligibility for overtime hours to reduce opportunities for pension padding.
6. Raise the age of eligibility for full retirement benefits. When early retirement is offered, it should be actuarially fair (i.e., the PV of benefits received under early retirement must be equal to the PV of benefits that a retiree would have received if he or she had delayed receipt of benefits until normal retirement age).
7. Reduce benefit accruals (i.e., use lower percentages of compensation to calculate benefit accruals).
8. Combine pensions with Social Security participation.
9. Raise employee contributions.
These are all sensible reforms to which I would add, improve the governance model at US public funds by adopting elements from Canada as well as their Dutch and Danish counterparts.

In my opinion, the people managing US public pensions are grossly underpaid and they are subjected to constant political interference. This governance model needs to be nuked and replaced by one which has an independent investment board that operates at arms-length from the government (read this document on CPPIB's governance and management) .

You'll notice I began talking about funding woes and ended up recommending changes on pension governance. This was deliberate on my part because ultimately a sound funding policy is a crucial part of good governance. You can't have one without the other.

Below, California Senate President Tem Darrell Steinberg reacts to pension reform in that state. Like what he said about eliminating defined-benefit pensions: "Recognizing that most folks in the private sector don't have it, I think our efforts need to be on bringing everyone up to a middle class and not bring everyone down to being subject to the whims of financial markets which is what goes on now."