Monday, November 27, 2017

Time To Dismantle US Public Pensions?

Rebecca Moore of Plan Sponsor reports, Public Pensions Have Been Able to Pay Promised Benefits:
Some policymakers want to close participation in a public pension plan to all new hires, cut benefits and increase employee contributions, or convert defined benefit (DB) plans pensions into defined contribution (DC) plans. They usually cite the underfunding of public pension plans as the reason for these ideas.

New research shows that funding status has little correlation with a pension fund’s ability to pay its promised benefits. Michael Kahn, director of research for the National Conference on Public Employee Retirement Systems (NCPERS) used data from the annual survey of public pensions by the U.S. Census Bureau for 1993 to 2016 and other data and found that during the last quarter century or so, state and local pension plans have always been able to meet their benefit and other payment obligations.

In four years (2002, 2008, 2009 and 2012), income from contributions and investment earnings was less than benefit obligations, but in the remaining 20 years, when income from contributions and investment earnings was more than benefit obligations, pension funds were building up a cushion that enabled them to weather the 2001 recession, the Great Recession of 2008, and other economic downturns. Today, state and local pension funds have about $3.9 trillion that will provide a cushion during future economic recessions, the NCPERS analysis says.

While assets have grown, so have pension obligations. During 2012 to 2016, state pension obligations grew from $3.52 trillion to $4.19 trillion. Other sources of data show that pension obligations have steadily grown since 2000, when plans were almost 100% funded. NCPERS analysis shows that despite rising liabilities during the last quarter century, pension plans have been able to meet their annual benefit payments from contributions and investment income due to the cushion they built up in good years.

The analysis shows four states—Illinois, Kentucky, New Jersey, and Connecticut—had pension funds whose liabilities were more than twice their assets (that is, they were less than 50% funded) in 2016. On the other end of the funding spectrum are New York, Tennessee, South Dakota, and Wisconsin, which were all more than 94% funded. The majority of states’ pension plans were more than 70% funded. Twenty-eight out of 50 states (56%) had pension funding levels that were 70% or above. Overall, the 299 state plans had total assets of $3.05 trillion and pension obligations of $4.2 trillion—which translates into a funding level of 72.6%. However, using quarterly earnings data for 2016, the assets for the 299 state plans were $3.26 trillion, which results in a funding level of 77.6%.

According to the analysis, states in both top- and bottom-funded groups on average experienced situations in which contributions and investment income was not enough to meet annual benefit obligations about six out of 24 years during 1993 to 2016. The cash flow shortfalls were caused by the 2001 and 2008 recessions as well as other economic downturns. But both types of funds—partially and almost fully funded public pension plans—had adequate cushions to cover the cash flow shortfall.

The experience of the last quarter century suggests that state and local pension funds will face economic recessions in the next quarter century and beyond. To strengthen the ability of these pension funds to weather future recessions, NCPERS suggests state and local policymakers may consider the following policy options:
  • Stop dismantling public pensions because they aren’t 100% funded;
  • Strengthen funding mechanisms by adhering to principles that help determine the appropriate levels of required employer contributions;
  • Establish a pension stabilization fund that can set aside money from a certain revenue stream to be used in special circumstances such as a recession; and
  • Implement a mechanism to ensure that full employer contributions are made on a timely basis, perhaps by making employer contributions a nondiscretionary part of the budget.
“Our analysis demonstrates that pension plans can tolerate ups and downs in the markets and still meet their current obligations,” says Hank H. Kim, NCPERS’ executive director and counsel. “While funding ratios are an important actuarial tool, they are not a proxy for a plan’s ability to pay benefits here and now.”

Critics of public pensions often cite funding ratios of less than 100% as evidence of pressing financial problems, but this is faulty logic, Kim says. Contributions and earnings continue to flow into plans even as benefits are being paid out, he notes. “Shutting down a pension plan because it is not fully funded is … an incredibly short-sighted action that destabilizes workers and their communities, and we want it to stop,” Kim says.
First, I agree, shutting down a public pension because it's not 100% funded is incredibly shortsighted and downright dumb. Just because Kentucky lost its pension mind, doesn't mean everyone else needs to.

Second, take the time to read the NCPERS paper, Don't Dismantle Public Pensions Because They Aren't 100 Percent Funded, which is available here.

In the analysis, we can find some interesting state data, like the worst funding levels by state (click on image):


There are more but I wanted to focus on the worst offenders for a reason. NCPERS claims in Table 3 there is no significant difference between the top- and the bottom-funded state and local pension plans in terms of the plans’ ability to meet their benefit obligations (click on image):


This is quite a claim, one that has its share of skeptics. In fact, this analysis prompted Andrew Biggs of the American Enterprise Institute to tweet the following (click on image):


I guess fully-funded levels aren't worth it, especially if you believe the Mother of all US pension bailouts is in the works.

While the report is right, a bad funding level hasn't disrupted pension payments, it places an inordinate amount of stress on a plan to manage liquidity risk much more closely because if another crisis erupts, at one point, poor funding levels will not sustain pension payments, especially for mature (more retirees than active workers), chronically underfunded plans (less than 50% funded).

NCPERS suggests state and local policymakers may consider the following policy options:
  • Stop dismantling public pensions because they aren’t 100% funded;
  • Strengthen funding mechanisms by adhering to principles that help determine the appropriate levels of required employer contributions;
  • Establish a pension stabilization fund that can set aside money from a certain revenue stream to be used in special circumstances such as a recession; and
  • Implement a mechanism to ensure that full employer contributions are made on a timely basis, perhaps by making employer contributions a nondiscretionary part of the budget.
I agree with these recommendations but even more needs to be done:
  • US public pensions need a wholesale change in their governance model. They can learn a lot from the evolution of the Canadian pension model
  • Introduce a shared-risk model at all US public pensions which means contributions can be raised or benefits cut when these pension plans experience a deficit. Public-sector unions need to accept that pensions are all about managing assets and liabilities and investment income alone won't be enough to sustain public pensions over the long run. When plans run into trouble, contributions need to be raised, benefits cut or both.
The problem with the NCPERS analysis is it perpetuates this myth that nothing is broken, keep everything the way it is and just ensure full employer contributions are made on a timely basis.

This is pure rubbish. There are plenty of things wrong with the way US public pensions are being managed and my biggest fear is that when the pension storm cometh, it will expose these weaknesses and place many pensions in an even more dire situation.

Let me end however with one warning, shutting down public defined-benefit pensions isn't the solution. It will exacerbate deflationary pressures and reduce economic growth over the long run. We need to bolster public DB plans, not shut them down.

When it comes to public pensions, we need to be realistic and informed. Are there real issues with US public pensions? You bet but the solution to the problem most certainly isn't to dismantle them.

Below, students from Bath County School Television examine how Governor Matt Bevin's Proposed Plan and The Shared Responsibility Plan might affect classified and certified employees of Kentucky's school systems. I applaud these students for getting informed on a subject that isn't always easy to decipher and understand.

Update: Malcolm Hamilton, a retired actuary and astute reader of my blog, shared this with me after reading this comment (added emphasis is mine):
The NCPERS analysis is somewhere between embarrassing and incompetent. The findings are true but largely irrelevant.

A pension plan that is 50% funded may have enough money to pay pensions for 10 years while simultaneously declaring a contribution holiday. This doesn't prove that the plan is in good shape. It is basically living on borrowed time. After 10 years there will be no money in the pension fund. At that point the plan can still be sustained by raising contribution rates to the "pay as you go" level, which would typically be around 40% of pay for a mature public sector DB plan. The plan can be sustained, but will anyone want to sustain it at that price?

The CPP (Canada Pension Plan) is a good example of the consequences of low funding levels. The CPP is currently about 20% funded - but the 20% is slowly trending up, not down as is the case for many badly funded U.S. public sector pension plans. The CPP can be sustained for a very long time as long as we are willing to pay the 9.9% contribution rate. Canadians don't notice that the CPP is expensive because they are accustomed to paying 9.9% for a benefit that would cost 5% to 6% if the CPP was fully funded. According to the CPP actuarial report, the pension fund needs to earn a 4% real return in order to give future members a 2% real return on their contributions. If the CPP was fully funded, members would earn the same rate of return as the pension fund.

Badly funded pension plans are not a good thing. They may be sustainable - but only at a price. People may be prepared to pay the price but the plan will not do a good job for whoever ends up footing the bill (members or taxpayers).
I thank Malcolm for his poignant insights and think NCPERS should go back and rework their analysis.

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