This newsletter from Reason Foundation’s Pension Integrity Project highlights articles, research, opinion, and other information related to public pension challenges and reform efforts across the nation. You can find previous editions here.
In This Issue:
The application of financial economics to pension actuarial practices has been controversial in American actuarial circles. Hence, people paid attention when the American Academy of Actuaries (AAA) and the Society of Actuaries (SOA) jointly sponsored a pension finance task force to produce a paper about applying financial economics to public pension plans. Unfortunately, the task force was not immune from the politics surrounding public plan funding policies and the joint development of the paper was abandoned and decades-long running task force was disbanded. After the groups initially said they would not release the commissioned paper, the SOA eventually changed its position and posted a “draft” of the paper on its website. Reason’s Truong Bui reviews this report in a recent article and finds that it provides valuable information that challenges the standard actuarial practices in public pensions.
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Pension obligation bonds (POBs) are bonds issued by a state, county or municipal government specifically to finance its pension system. Oakland, California issued the first POB in 1985, trying to leverage borrowed money and make higher returns than otherwise possible using contributions alone. Higher investment returns means reduced future contributions; this is referred to as “actuarial arbitrage.” However, as Reason’s Daniel Takash writes, POBs are not a tool used by prudent pension funds to increase returns. Rather, they are straws that struggling funds grasp at when they’re already underwater.
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» RELATED: Alaska Backs Down from Pension Obligation Bond Issuance
A traditional conservative critique of public sector pensions usually includes some mention about how government workers, particularly teachers, are all bankrupting the system with their generous benefits. Yet, this is an overly simplistic narrative, as USC Santa Barbara’s Dick Startz discusses in a two-part commentary for the Brookings Institution. As Reason’s Daniel Takash writes, Startz finds that while unfunded teacher pensions are a “disaster waiting to happen for taxpayers,” most pension systems actually hurt teachers too.
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Fitch recently downgraded the City of Dallas (Texas) bond rating in light of the worsening public debt of its police and fire pension fund. For years, the Dallas Police & Fire Pension System has seen a steady erosion of its solvency that could be attributed to poor investment management, overly optimistic actuarial assumptions, and lavish benefit payments that weren’t properly pre-funded. Moreover, recent actuarial valuations suggest that time for prudent actions seems to be running out—the plan is only 45.1% funded and projected to run out of money as early as 2030 if not sooner. Meanwhile, the Deferred Retirement Option Plan—one of the most troublesome elements within this pension system—has already experienced an exodus of $220 million in withdrawals in less than six weeks. Reason’s Anil Niraula explores the Dallas situation in a new article.
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We frequently see the same pattern in troubled U.S. pension plans: poor funding policies and faulty investment return assumptions that combine to drive growth in unfunded liabilities and volatility in the pension contribution rates paid by employers/taxpayers. These very factors have plagued the financial state of Houston, Texas’ public pensions; without major reforms, the city’s unfunded pension liability and required contributions are expected to continue growing indefinitely. Houston Mayor Sylvester Turner recently announced a pension reform proposal that includes lowering the assumed rates of return, negotiated changes to COLA and DROP benefits, and adopting a more prudent amortization policy. Nonetheless Reason’s Truong Bui writes that all of these measures are steps in the right direction, though other elements of the reform proposal are problematic. Given the size of Houston, the coming reforms—whether successful or not—can provide valuable lessons for other local and state governments.
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Most public sector pension funds finished their fiscal years on June 30, and reports on their 2015–16 investments are starting to trickle in. The reports thus far are showing that virtually every plan has missed its assumed rate of return for the year, in part because public plans are heavily exposed to returns on U.S. equities, which struggled between July 1, 2015 and June 30, 2016. The S&P 500 index returned only 2.62% over that time span, and companies in Dow collectively produced just 3.07%. In a new article, Reason’s Daniel Takash explores the effect that these kinds of returns have on the long-run investment performance of a plan.
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As public sector pension plans have sought to supplement falling yields from bonds and equities, real estate has emerged as a top choice for alternative investment. Real estate is an attractive investment because pension plans are managing funds that have long-term commitments, and real estate tends to be an asset to hold for the long term. However, pension plans also are managed several steps removed from the taxpayers that ultimately bear the responsibility for investment losses, and it’s impossible to define risk tolerance for a multi-generational group of taxpayers. As Reason’s Anil Niraula writes, there is a limit to the degree of diversification that a public plan should take on, and there are strong arguments for public plans heavily weighting less risky assets in their portfolios.
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Rockefeller Institute Warns of Large Risks in Public Pension Funds: A recent presentation by the Rockefeller Institute’s Donald Boyd and Yimeng Yin at the National Conference of State Legislatures summit in August finds that, despite pension reforms and increased employer contributions, public pension underfunding remains at a near-record high as a percentage of state and local taxes. Further, public pension funds have increased their risk exposure over time, increasing the risk of funding shortfalls and higher taxpayer contributions. Boyd and Yin also find that for every dollar in increased state and local tax revenue between 2007 and 2015, there has been a 59-cent increase in pension contributions, leaving relatively little left for other budget priorities. The presentation is available here.
Moody’s Projects Rising State Pension Debt: An analysis by Moody’s Investors Service released earlier this month found that the aggregate adjusted net pension liabilities (ANPL) at the state level totaled $1.25 trillion in fiscal 2015, and is poised to rise to $1.75 trillion by fiscal 2017. The report also found that the states with the highest pension burdens, as measured by the three-year average ANPL as a share of state revenue, were Illinois (280%), Connecticut (209%), Alaska (179%), Kentucky (162%), and New Jersey (157%). More information is available here.
New Manhattan Institute Report Finds Rising Teacher Pension Costs and Debt: A new report on teacher pensions by Manhattan Institute senior fellow Josh McGee finds that retirement costs per pupil are already approaching 10% of all education expenditures and that, absent reform, pension costs are likely to increasingly crowd out other education spending (e.g., salaries, supplies, facility maintenance, etc.), given that pension debt costs are rising faster than total annual per-student education spending. The report finds that pension debt per pupil increased by an inflation-adjusted $9,588 between 2000 and 2013, which was over nine times larger than the increase in total annual education expenditures per pupil. The full report is available here.
New Milliman Public Pension Funding Study: Milliman recently released its annual Public Pension Funding Study 2016 examining the funded status of the 100 largest U.S. public pension plans. The report, which recalibrates the plans’ reported liabilities based on an independent assessment of expected investment returns, finds a decline in the aggregate funded ratio from 71.7% in 2015 to 69.8% in 2016, given disappointing market returns. Further, the report finds that the difference between the average sponsor-reported assumed rate of return of 7.50% and Milliman’s independently determined assumption of 6.99% is the highest it has ever reported, suggesting continuing pressure on the plans to lower rate of return assumptions. The full report is here.
“There is some justice, I suppose, in the [Pennsylvania] Legislature sending Gov. Tom Wolf a bill that finally allows beer distributors to sell six-packs. It’s now that much easier for the rest of us to drink away our sorrows over the Legislature’s abject failure (again) to clean up their own mess and pass a bill fixing Pennsylvania’s financially disastrous public employee pension system.”
—John L. Micek, “The sound of a pension can being kicked … again … rings hollow,” The Patriot-News, October 27, 2016.
“The private-sector funding problem will, at least, diminish in the long run as old DB schemes run down. But there will be no respite for governments. They have been slow to switch workers to DC schemes, because the power of public-sector trade unions to resist lower benefits is greater than in much of the private sector. A two-tier system may emerge, with retired private-sector workers finding themselves worse off than their public-sector counterparts, but still funding those luckier workers through their taxes.”
—”Fade to grey,” The Economist, September 24, 2016 print edition.
“The benefits workers have already accrued and that are promised by their current contracts should be sacrosanct; the ones they have not yet earned for work they have not yet performed should be subject to limited amendment if necessary to ensure the health of the pension fund. This can serve the employees’ interests too—for example, they may prefer to increase their pension contributions in order to avoid layoffs or pay freezes. Nor is anyone served when local governments go bankrupt, raising the possibility of cutting benefits for current retirees too.”
—”More flexibility over public worker pensions could help save them” (editorial), Los Angeles Times, October 21, 2016.
“If you’re counting on the stock market bailing you out of this, it ain’t gonna happen.”
—Oregon PERS Executive Director Steven Rodeman on rising pension contribution rates through 2023 even under healthy investment return scenarios, quoted in Taylor Anderson, “Legislators hold their own PERS hearing, amid huge projected shortfall,” The Bulletin, September 22, 2016.
“You cannot expect outsize returns in an environment with such low interest rates and with equity markets at valuations that are high relative to historical data.”
—Tom Byrne, chairman of the New Jersey State Investment Council, quoted in Samantha Marcus, “N.J. pension fund lost money on investments last year,” NJ.com, September 29, 2016.
“There appears to be a lesson to be drawn from Wisconsin’s fully funded public pension system, along with promising pension reforms recently enacted in Arizona: More risk sharing between employers and employees can be a major ingredient in creating fiscally sustainable state- and local-government retirement systems.”
—Charles Chieppo, “Risk Sharing’s Key Role in Strengthening Public Pensions,” Governing.com, October 4, 2016.
“The recent decision by several of [Illinois' state pension] funds to lower expected rates of return to a more realistic level is reasonable, but also means that the state will have to pay even more now to stay on its funding plan […] Staying in an actuarially sound plan is one step to limiting the cost of these plans to current and future taxpayers. Illinois needs to continue to explore all options, including a constitutional amendment clarifying that the pension protection clause applies only to accrued benefits and not future benefits.”
—Civic Federation of Chicago President Laurence Msall, quoted in Yvette Shields, “Illinois Pension Shifts Further Pressure State Government,” The Bond Buyer, September 23, 2016.
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Senior Managing Director, Pension Integrity Project
Managing Director, Pension Integrity Project