Pension Systems on the Brink?

Leo Kolivakis's picture

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Robert Powell, editor at Retirement Weekly, wrote an editorial for MarketWatch on pension systems on the brink:

A
train wreck waiting to happen. That's the only way to describe the mess
that state pension systems are in right now, according to a report
published today by the Pew Center on the States. According to Pew, there's a $1 trillion gap
between the $3.35 trillion in pension, health care and other retirement
benefits states promised their current and retired workers as of fiscal
year 2008 and the $2.35 trillion they have on hand to pay them.

 

What's
worse, the gap may be even higher given that the study was conducted
prior to the market collapsing in 2008 and given the way most states
allow for smoothing of investment gains and losses over time.

 

How did this come to pass? And more importantly, what can be done to solve it?

Investment losses account for part of the funding gap. But the bigger
problem, according to Pew, is that many states simply fell behind on
their payments to cover the cost of promised benefits -- and that was
even before the Great Recession.

 

"Many states
shortchanged their pension plans in both good times and bad, and only a
handful have set aside any meaningful funding for retiree health care
and other non-pension benefits," Susan Urahn, managing director of the
Pew Center on the States, wrote in her report.

 

And
now, state policy makers who ignore the current shortfall do so at
their own peril. Indeed, states that fail to address under-funded
retirement systems face the very real possibility of raising taxes or
taking taxpayer money that could be used for education, public safety,
and other necessary services just to pay public-sector retirement
benefit obligations.

 

To be fair, not all states are
in the same pickle. Illinois and Kansas are in really bad shape. Those
states each have less than 60% of the necessary assets on hand to meet
their long-term pension obligations, Pew said. Illinois is in the worst
shape of any state, with a funding level of 54% and an unfunded
liability of more than $54 billion. Meanwhile, nine states had pensions
funded above 90% and Florida, Idaho, New York, North Carolina and
Wisconsin all entered the current recession with fully funded pensions.

 

Most experts suggest
at least an 80% percent funding level. Pew found that 21 states were
funded below that recommended level in 2008. Of those 21, eight had
more than one-third of the total liability unfunded: Connecticut,
Illinois, Kansas, Kentucky, Massachusetts, Oklahoma, Rhode Island, and
West Virginia.

 

In all, Pew said just 16 states are "solid performers"; meanwhile, 19 are in serious trouble.

Other benefits pose similar problems

As for retiree health care and non-pension benefits, Pew said that's
another huge bill coming due. In fact, the total needed to pay for
current and future benefits is $587 billion. Unfortunately, only $32
billion -- or just over 5% of the total cost -- was funded as of fiscal
year 2008. Half of the states account for 95% of the liabilities. As
with pension funding, some states are worse off than others.

 

"Only two states had more than 50% of the assets needed to meet their
liabilities for retiree health care or other non-pension benefits:
Alaska and Arizona," Pew said. "Only four states contributed their
entire actuarially required contribution for non-pension benefits in
2008: Alaska, Arizona, Maine and North Dakota."

Bridging the gap

What can be done to make up the $1 trillion gap? In a word, reform. Not
extreme reform. Rather, reform that brings the public sector more in
line with the private sector. Here's what Pew recommends:

1. Keep up with funding requirements

According to Pew, generally, the states in the best shape are those
that have kept up with their annual funding requirements in both good
and bad times. Arizona and Connecticut are required to fully fund their
obligations. But that's just part of the battle.

"States also need to make sure the assumptions used in calculating the
payment amount are accurate -- for example, estimating the lifespan of
retirees or the investment returns they expect." For instance, many
states based their assumptions on investment returns of more than 8%.
By contrast, the top 100 private pension plans had an average assumed
investment return of 6.36% as of December 2008.

 

Yes,
some states, Utah and Pennsylvania among them, are reducing the
assumptions on investment returns. But more states need to address
funding requirements and investment return assumptions.

2. States should reduce benefits or increase the retirement age

Most states can't reduce pensions for retirees or current employees,
but they can for new employees. And that's exactly what several states
are doing now. According to Pew's report, Nevada, New York and Rhode
Island recently reduced benefits for new employees either by altering
the pension formula or raising retirement ages. More states need to
examine and consider this tactic.

3. States should share the risk with employees

A few states, the Pew report notes, have taken a page out of the
private sector's pension world. They are "sharing more of the risk of
investment loss with employees by introducing benefit systems that
combine elements of defined-benefit and defined-contribution plans,"
the report said. "These hybrid systems generally offer a lower
guaranteed benefit, while a portion of the contribution -- usually the
employees' share -- goes into an account that is similar to a private
sector 401(k)."

 

Nebraska and Georgia have hybrid
plans in place for new employees, while Michigan and Alaska have 401(k)
plans in place for new workers. But movement away from defined-benefit
plans to defined-contributions plans is easier said than done. "Because
unions and other employee representatives often have vigorously opposed
defined-contribution plans, it is unclear whether any state will find
such a switch viable, or if such plans are primarily being proposed as
a starting point for hybrid plans or other compromises," the Pew report
said.

4. Increase employee contributions

Employees already contribute about 40% of non-investment contributions
to their own retirement. "But states are looking toward their workers
to pay for a larger share," the Pew report noted. "In many states, the
employee contribution is fixed at a lower rate than the employer
contributions." But some states have put in place reforms to change
that. Arizona, for instance, has a system where employee and employer
contribute the same amount. And other states, such as Iowa, Minnesota
and Nebraska, have the ability to raise employee pension contributions
if needed.

 

What's more, Pew noted that several states
also began asking employees and retirees to start making contributions
for their retiree health-care benefits -- just as happened with
retirees from the private sector.

5. Improve governance and investment oversight

In recent years, Pew noted that "some states have sought to
professionalize the complex task of pension investments by shifting
oversight away from boards of trustees to specialized bodies that focus
on investment." Other states have worked on making sure boards of
trustees for pensions are well trained, that the division of
responsibilities between board and staff makes sense, and that the
composition of the board is balanced between members of the system and
individuals who are independent of it. States being praised for reforms
in the right direction include Vermont, Oregon, and even Illinois.

 

To be fair, states aren't standing still when it comes to reform.
According to Pew, 15 states passed legislation to reform some aspect of
their state-run retirement systems in 2009, compared with 12 in 2008
and 11 in 2007. Still, it would seem that more need to get on the
reform bus. Especially given the alternative.

 

In the
absence of paying down this $1 trillion deficit, Pew said the debt will
increase even more significantly. "This will leave the states, and
tomorrow's taxpayers, in even worse shape, since every dollar needed to
feed that growing liability cannot be used for education, health care
or other state priorities," the Pew report said.

You can read the Pew report by clicking here. You can also read Mike Shedlock's analysis of this report, by clicking here.

I
do not plan on going into great details on this report as its findings
didn't surprise me. Instead, I want my readers to keep in mind of
certain basics governing pension funding:

  • First, pensions are not just about assets, they are there to meet future liabilities. In other words, it's all about asset-liability matching.
    This is important because while pension fund managers try to "shoot the
    lights out", often taking excessive risks to meet their actuarial rates
    of return (which are way too high), they expose funds to serious
    downside risk.
  • Second, there is a growing gap between public
    sector pensions and private sector pensions that is fueling anger and
    discontent out there. In an era of fiscal deficits, there will be
    increasing pressure to reign in all benefits, including public sector
    pensions. is this justified? In some cases, yes, but in other cases no.
    Governments will use any excuse to reign in public sector pensions but
    they allowed this situation to spiral out of control.
  • Third, and most importantly, governance matters.
    I can't stress this last point enough. Governance means that there are
    appropriate checks and balances governing pension funds and all their
    activities.

The last point is important because since last
March, stocks have been on a tear, and many public pensions funds,
including New York state's Common Retirement Fund (CRF), are moving up again:

The
New York State Common Retirement Fund (CRF) announced it has returned
22.3% through the first three quarters of 2009. As of Dec. 31, 2009,
the end of the fiscal third quarter for the pension, the plan’s
holdings were valued at $129.4 billion. That was good for a 3.4% rate
of return in the third quarter.

New York State Comptroller
Thomas DiNapoli has been working hard at increasing the transparency of
the CRF since he took office following the resignation of Alan Hevesi.
Part of DiNapoli’s effort has included releasing quarterly performance
reports to the public. This plan was started last year. Prior to that,
the plan released annual performance reports.

DiNapoli
has also released monthly investment reports for the fund. In those
reports, DiNapoi discloses where CRF capital has been committed, the
amount and the date of the closing of the investment.

In
the plan’s latest monthly investment report for November 2009, the CRF
closed seven transactions worth more than $591 million. Nearly all of that capital was committed to alternative investments.

The
CRF closed two deals in its private equity portfolio worth $40 million,
three deals in its absolute return strategy totaling $300 million, and
one deal in its opportunistic alternatives portfolio valued at $250
million. The remaining deal included a real estate transaction worth
$1.4 million.

Notice how pensions are now moving
back into alternative investments, meaning more hedge funds, more
private equity and more "alternatives" like commodity funds. While I'm
not against moving some assets into alternatives, I warn public pension
funds that they carry their own sets of risks and most U.S. public
plans are at the mercy of their pension consultants when investing in
these alternative investments. And many of these pension consultants do
not properly understand how to evaluate these alternative investments
in a portfolio context.

The NYT reports
that New York City’s freshly elected comptroller, John Liu, announced
this week what he called major reforms in the way the city’s pension
fund works. Mr. Liu said he wants to ease a ban on the placement agents
to help mostly smaller funds, including those run by women and
minorities, that don’t have the staff or expertise to win contracts on
their own.

I remain highly skeptical on placement agents as most
offer no value added whatsoever. These smaller pension funds should not
even exist. They should be rolled up into a larger plan which has
proper oversight and expertise to manage pension monies.

Finally, the NYT published an AP article, Missouri Auditor Calls for More Pension Oversight:

Lawmakers considered a bill Thursday to give the Missouri state auditor legal authority to monitor state pension systems.

 

The
bill comes in response to a recent court ruling that found the state
auditor only has the authority to review internal audits completed by
the pension systems. A Cole County Circuit Court judge quashed a
subpoena from the auditor to review more documents and interview
employees with the state's Local Government Employee's Retirement
System.

 

The auditor's office has appealed the court's decision.

 

The
bill's sponsor, Sen. Jason Crowell, R-Cape Girardeau, told the Senate
pensions committee that many other state retirement systems allow the
auditor to perform a full audit despite the ambiguous language.

 

His bill would permit a full audit of any retirement plan created by the state.

 

State
Auditor Susan Montee said Missouri has performed audits on pension
funds without a problem since the 1980s, but it is better to clean up
the language.

 

''The ability to have oversight into our retirement systems is beneficial,'' Montee said.

 

The
state auditor goes beyond a simple fiscal audit to examine whether
agencies spend money properly. This includes looking at bidding
processes and travel expenses.

 

Montee said it doesn't make sense for her office to only review fiscal audits completed by independent auditors.

 

''It's an exercise in futility for us to come in and look at someone else's work,'' she said.

Officials
with other state retirement funds spoke in favor of the change, saying
they encourage the extra level of accountability.

 

A Pew Center on
the States report released Thursday found that Missouri's overall
pension system is considered healthy despite the state's current
economic woes.

 

The report states that the systems ''need
improvement.'' Missouri is still better off than neighboring Kansas and
Illinois, which had less that 60 percent of the necessary assets on
hand in 2008.

Interestingly, the Board at the Missouri State Employees' Retirement System (MOSERS), recently announced it is reviewing staff compensation structure:

The
MOSERS board voted to revise the MOSERS staff compensation structure
for the fiscal year that begins July 1, 2010. At the November meeting,
the board directed staff to develop a compensation proposal that
included recognition of the investment performance of the system’s
assets but limited incentive payments to staff to only those years when the fund’s return is positive.

 

Executive
Director Gary Findlay offered a proposal at the January 21, 2010,
meeting to eliminate the performance-based pay plan and instead, adopt
a base pay compensation structure that is market-based. The proposal
was adopted by the board. The board will consider hiring a compensation
consultant to evaluate and recommend market-based pay levels for all
staff positions.

I am following compensation
structures at public plans very closely and I have a feeling what is
happening at MOSERS will affect other plans too. Also, like in other
states, the fiscal situation is dire in Missouri, and they're tightening their belt:

As
part of the most recent announcement of additional expenditure
restrictions necessary to balance the state budget, the State of
Missouri, Division of Budget and Planning announced yesterday that the
employer incentive (match) associated with the State of Missouri
Deferred Compensation Plan (the Plan) will be suspended at least
through June 30, 2010.

Please keep in mind that MOSERS is
one of the best public pension funds in the United States. Their
governance puts most other US plans, and Canadian plans, to shame. They
don't just talk transparency, the actually deliver on it.

Are
pensions on the brink? The answer to this question ultimately depends on whether
the Fed, central banks and governments around the world are able to
re-engineer inflation through asset reflation. If they fail, and we run
into a protracted period of deflation, the majority of pension funds
that are highly exposed to private/public equities, real estate, and
alternatives like hedge funds are cooked. All other pension reforms are
useless if deflation sets in.