Wednesday, July 17, 2013

Slowing Deterioration at U.S. Public Pensions?

Lisa Lambert of Reuters reports, U.S. public pensions weaken, but deterioration slowing:
The ability of U.S. public pensions to cover their liabilities weakened again, although the deterioration is slowing, two major rating agencies said on Tuesday.

Both Fitch Ratings and Standard & Poor's Ratings Service added that they expect improvements in pension finances in the near future.

Since most systems use an accounting mechanism known as "smoothing" to spread changes in assets over many years, losses related to the 2007-09 recession have persistently hurt pensions' funded levels, they said. Recent stock market gains will likely bolster improvements, but the agencies warned that public pensions still face large obstacles, namely state budget strains, an aging population, accounting rule changes and legal challenges to reforms.

The average funded ratio for all 50 states' pension plans was 72.9 percent in 2011, a drop of 1 percent from the previous year, and the median ratio was 69.8 percent, 2.2 percent lower than the year before, according to S&P. The funded ratio represents how much in assets pensions have to cover liabilities.

S&P said the declines in previous years were larger. The national average fell 1.6 percent in 2010 and 7 percent in 2009, according to the rating agency, which said 2011 was the latest year complete data was available.

The smaller declines could lead some "to believe that the worst is over and that pension funded levels have bottomed out," but the road to improvement "will be bumpy," it said.

Public pensions receive most revenue - more than 60 percent - from earnings on investments, which were devastated by the financial crisis. Over the last decade, funded ratios dropped from a peak of more than 100 percent in 2000, S&P said.

In its report, Fitch found states' median unfunded pension burden is equal to 3.6 percent of personal income. Wisconsin has the lowest unfunded pension obligation at zero percent of personal income and Illinois, considered the worst state for pension funding, had the highest at 19.1 percent. The agency uses personal income as a measure because it represents the "resource base that will ultimately cover the obligations."

"Pensions remain a growing pressure for numerous states' budgets. Nearly all states are pursuing reform and remain well-positioned to address these burdens. While the positive effects of reform for most are decades away, a proactive approach to managing pension challenges is a credit positive," said Douglas Offerman, a senior director at Fitch, in a statement.

Fitch said investment performance in 2012 "was relatively flat for most plans and well below their investment return assumptions," but that 2013 will likely show gains.

For the 100 largest public-employee retirement systems, cash and security holdings totaled $2.93 trillion in the first quarter of 2013, the highest on records going back to 1968, according to a U.S. Census report released last month. The previous peak was just before the financial crisis in the fourth quarter of 2007, $2.929 trillion.

For years, states had shortchanged their public pensions. When their own revenues collapsed during the recession, they pulled back further while laying off employees, effectively shrinking the pool of contributors to the pension system. Fearing public employees would not see retirement money and funds for key services would have to be diverted to pensions, almost all states rushed to reform their systems.

According to Fitch more than 38 statewide plans dropped their investment return assumptions, lowering funded ratios but reflecting "a more prudent approach to estimating the long-term asset performance of a plan."

"The vast majority of states have pursued reforms lowering benefits for future hires, which are much easier to enact, although the beneficial impact of such reforms will only manifest itself in pension metrics over decades," it added.

Meanwhile, the board overseeing governments' accounting is changing pension obligation calculations. Implementing the changes "will result in the reporting of a greater and more volatile unfunded pension liability," S&P said, especially because pensions will have to use a market valuation of assets.

The third major rating agency, Moody's Investors Service, took a slightly different tack while reviewing pensions, saying in a report last month that for more than half the states their pension liabilities are equal to at least half their annual revenue.
The slowing deterioration of U.S. public pensions is a function of higher stock markets and more importantly, higher interest rates. As rates climb, future liabilities shrink, bolstering the balance sheets of public pension plans.

But these figures hide gross variability as some states are in far better shape than others. Wisconsin is one of the best-funded public employee retirement systems in the U.S. while Illinois is following Greece, preparing for savage cuts in public employee retirement benefits.

And while the vast majority of states have pursued reforms lowering benefits for future hires, there is little being done to bolster governance at U.S. public pension funds. New York City's pension chief faces huge hurdles in trying to increase compensation at his public plan and he's not alone.

Worse still, Bloomberg reports that under a Senate bill that seeks to diminish public-pension deficits, state and local governments in the U.S. would be permitted to turn their retirement systems over to life insurers:
Voluntary participation by states and municipalities would reduce the threat of insolvency by removing the possibility of pension-plan underfunding, according to Senator Orrin Hatch of Utah, the top Republican on the Senate Finance Committee and author of the bill introduced today. The measure, which would alter federal tax law, also would permit changes in non-government retirement plans to boost employee savings at small and mid-size companies.

The legislation, S. 1270, comes as more Americans say they want to save yet can’t afford to, and as Illinois tries to fix the nation’s worst-funded state retirement system. The 18-month recession that ended in June 2009 eroded pension assets and led some governments to reduce contributions as a way to balance budgets. U.S. state and local funds lack as much as $4.4 trillion to cover promised benefits to retirees, Hatch said.

“The problem is getting more serious every day and cannot be remedied merely by fine-tuning the existing pension structures available,” Hatch said today on the Senate floor. “A new public-pension design is needed -- one that provides cost certainty for state and local taxpayers, retirement-income security for state and local employees, and does not include an explicit or implicit federal government guarantee.”
Competitive Bidding

States that want to transfer their plans to annuity companies, such as life insurers, would be required under the bill to seek competitive bids. The bond ratings of Illinois, Connecticut, Kentucky, New Jersey, Hawaii and Pennsylvania have been cut over the past three years, in part because of how those states have managed growing pension liabilities, according to Moody’s Investors Service Inc.

“The new pension structure for state and local governments will solve the pension underfunding problem prospectively while delivering retirement-income security, in the form of a deferred fixed-income life annuity, to public employees,” according to a summary of the legislation provided by Julia Lawless, a Finance Committee spokeswoman for Hatch.

“The life-insurance industry invests the assets, pays the retirement benefits and bears the risks,” the summary says. “Involvement by the federal government will be limited to certifying the tax-qualified status of the plan.”

The annuities would be re-bid every year and would be portable, following workers from job to job, Hatch said today.
Costly Solution

“Shifting to annuities is just an unnecessarily expensive approach to the issue,” said Steven Kreisberg, collective bargaining director of the American Federation of State, County and Municipal Employees. The Washington-based union has more than 1.6 million members.

“Where we have pension-funding issues in the public sector, it’s not because of exposure to risk,” Kreisberg said today in a telephone interview. “It’s simply because employers have failed to make contributions that they should have made.”

A Bloomberg National Poll published last month found that while 31 percent of Americans say they expect to save more for retirement this year, 42 percent say they need to, yet can’t.

One provision in the bill would let employers that don’t sponsor a 401(k) defined-savings plan for workers to initiate what is known as a Starter 401(k), which would let employees save as much as $8,000 a year in tax-preferred retirement accounts. The new plan wouldn’t be taxed by the federal government, though it would be regulated at the state level.
Bill’s Supporters

Hatch’s proposal has the support of MetLife Inc. (MET), the largest U.S. life insurer, as well as the U.S. Chamber of Commerce, the American Council of Life Insurers and Americans for Tax Reform, the Washington-based anti-tax advocacy group led by Grover Norquist.

Jurisdiction over rules prohibiting certain transactions involving individual retirement accounts would be transferred from the Labor Department to the Treasury Department under the bill. The Treasury Department would work with the Securities and Exchange Commission in determining professional standards for brokers and investment advisers for IRA participants.

The Treasury Department, instead of the Labor Department, also would have jurisdiction over rules pertaining to prohibited transactions for employer-sponsored retirement plans.
I've been telling my readers to stay long life insurance companies as rates rise and they continue to benefit from pension risk transfers. Pension politics is just heating up in the U.S. and I expect an increase in pension risk transfers in the private and public sector over the next decade.

Below, historically low interest rate environment is taking a toll on pension funds. Janet Cowell, North Carolina State Treasurer, provides perspective stating "bonds are one of the highest risk areas you can have your money these days."

Like many of her peers, Ms. Cowell favors alternatives in this environment and she has done an excellent job managing her state's public pension fund, negotiating hard on fees. I will also point out the valiant work of South Carolina's  Treasurer, Curtis Loftis, who has meticulously exposed high fees and low returns in his state which blindly invested in alternatives prior to his arrival.