Thursday, November 2, 2017

Beware of the US Pension Ponzi?

A couple of days ago, Zero Hedge posted a comment, A Few Simple Charts Spell Disaster For Public Pension Ponzi Schemes (click on images to view them properly):
Earlier today, Milliman released their 2017 Public Pension Funding Study which explores the funded status of the 100 largest U.S. public pension plans. Not surprisingly, this study only served to confirm many of the rather alarming trends surrounding public pension Ponzis that we discuss on a regular basis.

Starting with a high-level status update, Milliman figures the largest 100 public pensions were roughly just as underfunded on June 30, 2017 as they were on June 30, 2016...not an encouraging development given that the S&P 500 surged 15% over that same period.
This 2017 report is based on information that was reported by the plan sponsors at their last fiscal year ends—June 30, 2016 is the measurement date for most of the plans in our 2017 study. At that time, plan assets were still feeling the effects of market downturns in 2014-2015 and 2015-2016. Total plan assets as of the last fiscal year ends stood at $3.19 trillion, down from $3.24 trillion as of the prior fiscal year ends (generally June 30, 2015). However, market performance since the last fiscal year ends has been strong, and we estimate that aggregate plan assets have jumped to $3.44 trillion as of June 30, 2017. We estimate that the plans experienced a median annualized return on assets of 11.49% in the period between their fiscal year ends and June 30, 2017.

The Total Pension Liability reported at the last fiscal year ends totaled $4.72 trillion, up from $4.43 trillion as of the prior fiscal year ends. We estimate that the Total Pension Liability has increased to $4.87 trillion as of June 30, 2017. The aggregate underfunding as of the last fiscal year ends stood at $1.53 trillion, but we estimate that the underfunding has narrowed to $1.43 trillion as of June 30, 2017.


Meanwhile, 32% of the top 100 plans were less than 60% funded.


Of course, the discussion gets far more interesting when Milliman analyzes the prevailing discount rates used by public pensions compared to independent analyses of where those discount rates should be set.

As our readers are well aware, we've long argued that public pension funds essentially hide their true funding status by simply choosing artificially high discount rates for future liabilities thus making their present values appear lower than they actually are. It's a clever scam but one that can only persist until the Ponzi runs out of cash.

As Milliman notes, the median expected return of the 100 largest public pension funds in the U.S. is somewhere around 5.9% based on the asset allocations of those funds.


That said, you can imagine our shock to learn that 83 of the top 100 funds used discount rates in excess of 7%.


So, what does that mean? Well, Milliman figures that overstating a fund's discount rate by just 1% artificially reduces its benefit liability by up to 15%. Therefore, given that the aggregate liabilities of the top 100 funds are roughly $5 trillion, each 1% adds about $750 billion in liabilities.
A relatively small change in the discount rate can have a significant impact on the Total Pension Liability. How big that impact is depends on the makeup of the plan's membership: a less "mature" plan with more active members than retirees typically has a higher sensitivity to interest rate changes than a more mature plan with a bigger retiree population. Other factors, such as automatic cost of living features, also come into play in determining a plan's sensitivity. Using a discount rate that is loo basis points higher or lower than the independently determined investment return assumption moves the aggregate recalibrated Total Pension Liability by anywhere from 8% to 15% (see Figure 13).


Adding insult to injury, Milliman notes that the ratio of retired pensioners (those taking money out of the system) to active pensioners (those still funding the Ponzi) has surged 16% over the past couple of years.


Of course, this ratio is only going to get worse over the coming decade as a wave of Baby Boomers retire...unfortunately, that wave of retirements will result in many of them finally realizing they've been sold a retirement fantasy for their entire life.
You can read the full study from Milliman here. I'm glad Zero Hedge is now adding "pension expertise" to its long list of accreditations in terms of being experts in everything in finance and markets.

Alright, let me give them credit, this is a decent comment minus the Zero Hedge garbage and right-wing biases.

However, I'm sorry to disappoint Zero Hedgies, there is no pension Ponzi just like there is no Social Security Ponzi. When the money runs out, contributions will be raised, benefits cut or more likely, US taxpayers will pay a lot more in income and property taxes to fund the US public pension beast.

Please repeat after me: Pensions are all about managing assets and liabilities. And since those liabilities are long-dated (go out 50++ years), the duration of liabilities is a lot higher than the duration of assets.

What this means is when interest rates drop, the decline in rates disproportionately impacts liabilities and swamps any gain in asset values, especially when rates are at historic lows like now.

Canada has some of the very best defined-benefit pensions in the world because they got the governance right, but even they know that asset management alone cannot achieve a fully-funded status.

This is why the very best pension plans in Canada have adopted a shared-risk model which essentially means plan sponsors (unions and governments) will equally share the responsibility of a plan deficit, meaning higher contribution rates, lower benefits or both until fully-funded status is restored.

The key difference is while almost all our large public pensions are fully-funded or close to it, US public pensions are flirting with disaster which will be a significant drag on the US economy in years ahead.

"No problem Leo, we will just implement what Kentucky did, and shift everyone to a 401(k) plan, private and public sector employees." This is another bonehead move which will also detract from economic growth and potentially do a lot worse damage over the long run. Just because Kentucky has lost its pension mind, doesn't mean everyone else needs to follow.

Also, there are those who question whether we need fully-funded US public pensions. I happen to agree with some arguments but I worry that this line of thinking runs into trouble when chronically underfunded plans reach a point of no return.

A couple of days ago, I asked whether Canada has all the answers to US retirement woes, stating the US needs to ensure a few things first:
  • Get the mission statement right: What is the purpose of this new retirement system and how will the mission statement govern all activities at this new fund?
  • Get the governance right: Make sure the board overseeing this new pension plan is experienced, informed on all aspects (not just investments but HR, IT, etc.) and most importantly, independent. This board can then hire a CEO who will hire his or her senior team to carry out the day-to-day operations of this new pension. Most importantly, there can be no government interference whatsoever, and they need to get the compensation right to hire qualified staff able to bring assets internally and manage money at a fraction of the cost of outsourcing to external managers.
  • Get the risk-sharing right: If you look at the best pension plans in Canada, they have all adopted a shared-risk model which means higher contributions, partial or full removal of inflation-adjustments when the plan experiences a deficit or both. Investment returns alone will not be able to restore a plan's fully-funded status no matter how good the investment managers are. 
Now, there are a lot of other things that US plans need to get right, like lower their discount rate to estimate future liabilities which is still unreasonably high for many plans.

The biggest impediment for US plans to adopt the Canadian model is governance. I just don't see US public pensions doling out Canadian-style compensation packages to their public pension fund managers. It's never going to happen and there are powerful vested interests (unions, funds, etc) who want to maintain the status quo even if the long-term results are mediocre at best, especially compared to Canada's large, well-governed DB plans.

And by long-term results, I don't just mean performance, I mean funded status which Hugh O'Reilly and Jim Keohane emphasized in a joint op-ed they wrote last year. Long-term results matter but what ultimately matters most is a plan's funded status.

Now, it should be noted that Canada's large pensions have certain degrees of freedoms that their US counterparts don't have. They are piling on the leverage nowadays to take advantage of their pristine balance sheets which are a direct result of good governance, excellent risk management and to be truthful, a long bull market and investment policies that allow them to leverage their portfolio to improve overall risk-adjusted returns.
Lowering the discount rate, raising the retirement age, getting the right governance to do more direct investing lowering fees and costs, and adopting a shared-risk model all make sense but common sense is thrown out the window in the age of entitlements.

Of course, lowering the discount rate implies raising the contribution rate, and that doesn't sit well with many unions or local governments, like the one in Sacramento.

Lastly, on a more humorous note, Jim Leech, Ontario Teachers' former President and CEO and co-author of The Third Rail, sent me this funny Dilbert cartoon last weekend (click on image):


I think Jim meant it as a joke or maybe not given the sad state of affairs at many US public pensions.

Below, the Retirement Security Project at Brookings just hosted an event with senior Canadian officials and American experts to discuss the Canadian system and its relevance to American policy debates.

The live stream ended a few minutes ago so I hope the Brookings Institution will post the entire discussion featuring a few panelists including HOOPP's Jim Keohane and OPTrust's Hugh O'Reilly shortly (it was hard to follow the live stream as it kept cutting on my end).

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