Tuesday, January 18, 2011

The Utah Pension Model?

The WSJ reports on the Utah Pension Model:

As Illinois and New Jersey struggle to reform their broken public pension plans, we thought you might like to hear a success story for change. Witness Utah, which last March replaced defined benefit pensions with a 401(k)-style plan for new state and municipal workers.

The sponsor of the Utah reform was Senator Dan Liljenquist, who watched in horror during the 2008 stock market plunge as the state pension fund lost 22% of its assets. From nearly 100% funded in 2007, it fell to 70% funded by 2009. Utah suddenly faced a long-term $6.5 billion funding gap, and the state would have had to nearly double its annual contributions out of the current budget to make up the shortfall.

Mr. Liljenquist requested an analysis to determine the real and unvarnished financial condition of the pension fund. The state was assuming a 7.75% annual return on investment, and actuaries found that if that return fell to only 6% the system would be technically insolvent. The Utah constitution limits total state debt to 1.5% of the value of all property in the state, and the unfunded pension liability was one and a half times over that limit.

Utah's constitution bars pension changes for current workers—short of an imminent financial crisis in the fund—so the legislature created a defined contribution plan for all new hires starting this year. The state contributes 10% of each worker's salary (12% for public safety workers and firefighters), a generous amount by private company standards. If they wish, new workers can choose a defined benefit plan, but the state contribution to such a plan is no longer open-ended but is legally capped at 10%.

The reform has benefits for taxpayers and public employees. Workers own their retirement account and can carry it to another job. They also benefit because politicians can no longer steal from the pension plan to pay for other government spending. As for taxpayers, the reform will eventually slash state pension liabilities in half and they no longer bear the risk of having to pay higher taxes if the stock market declines.

Union leaders nonetheless resisted the plan, holding public rallies and threatening to defeat any legislator who dared to vote for it. But polls found that Utah voters supported reform, recognizing that the changes were fair and financially imperative. Not a single Republican who voted for the reforms lost, and the GOP picked up seats in 2010.

From now on in Utah, tax increases or spending cuts for schools, parks or roads won't be necessary to make legally required payments to retired state workers. The contrast couldn't be sharper with California, New York, New Jersey, Illinois and other states in which pension contributions are squeezing out other priorities. We hear Montana could be the next state to adopt the Utah model, and something like a dozen more are interested in what looks to be a winner for taxpayers, workers and state budgets.

I bring this to your attention because I think other states are going to follow Utah's lead and start shifting new workers into defined-contribution plans or defined-benefit plans with caps on state contributions.

This trend of converting into defined-contribution plans is worrisome and it has been going on for quite some time in the private sector. Paul Delean of the Montreal Gazette reports, Times are changing for company pension funds:

Canadian companies with large pension-fund deficits are starting to play hardball with employees, and it may just be the tip of the iceberg.

"Used to be that few employers were ready to fight over it, but times are changing," Michel St. Germain, a partner at Mercer Canada and pension-fund consultant, told the firm's annual pension-outlook conference in Montreal on Tuesday.

In Sudbury, a year-long strike did not deter Vale Ltd. from its plan to switch new employees to defined-contribution plans, in which it makes an annual pension contribution per employee but assumes no financial risk beyond that. Vale's defined-benefit pension fund had a shortfall of $729 million.

In Hamilton, U.S. Steel Canada locked out 900 employees at the former Stelco plant last fall, in part because it wants to introduce a defined-contribution pension plan for new employees and end indexing for the defined-benefit plan it inherited after purchasing Stelco in 2007. That plan had a deficit of $1.2 billion.

Defined-benefit plans, in which companies provide employees with a set payment in retirement based on years of service, are becoming the exception in Canada, because of their cost and the financial responsibility placed on the corporations.

"They're excellent for employees," St. Germain said, "and very bad for shareholders."

Most companies with such plans are running sizeable pension deficits, and St. Germain said two years of strong equity markets have done little to improve the solvency level because they've also featured rock-bottom interest rates. (Mercer has the solvency index for Canadian plans below 60 per cent, down from almost 100 per cent in 2000).

At a time when they should be getting more conservative, along with their aging workforces, many plans still are carrying a high level of risk because their managers feel it's the only way to generate the returns needed to make up lost ground, St. Germain noted.

Public-sector plans have the same problems but not the same pressure, since they can pass on shortfalls to the taxpayer, as homeowners who received increased property-tax bills recently can attest. St. Germain said.

"The challenge," he said, "will be to justify (those increases) to taxpayers."

Defined-contribution plans put the onus on employees to manage their retirement funds, something many are "completely incapable" of doing, St. Germain said. It's not unusual to find young employees with less than 20 per cent of their nestegg in equities and older ones holding 100 per cent in stock, the exact opposite of what's advisable, he said.

Still, St. Germain isn't sold on recently-floated proposals to make retirement saving mandatory.

Paying down debt or a mortgage or investing in your children's future might well be a better option than an RRSP for many people, he said.

But he urged Quebec to take action sooner than later in boosting the contribution rates for the Quebec Pension Plan, since it's been known for four years the provincial plan is headed for capitalization problems. "At some point, you have to stop analyzing and take a decision," he said.

I'm not as concerned as Mr. St. Germain about pension funds (or individuals) taking high risk in equities right now. The Fed's master plan remains reflate and inflate at all cost and do everything it takes to avoid deflation. So far, it's working, and while some fear major inflation is on its way, I tell them to relax. What I see on its way is another major bubble in stocks as banks and hedge funds get ready for the next big ramp job. Everyone is so skeptical and bearish. Some are warning us that we've seen this movie before. Maybe, but I think stocks will keep grinding higher and all those skeptical portfolio managers will be chasing indexes later this year.

Sure, there will be pullbacks, but top funds will be buying them, navigating through the volatility. And that's why I don't like this shift into defined-contribution plans. The Utah pension model may look reasonable but it's just based on what is going on in the private sector where the retirement onus is increasingly being put on individuals. You can't compare this to a defined-benefit plan where workers enjoy the peace of mind and benefits that come with a professionally managed pension fund that invests across public and private markets. But given the fiscal woes that states face, I fear that the Utah pension model is going to become the norm, and workers will lose out.

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