More on The Public Pension Problem
The main driver of public pension deficits isn't the financial crisis, it's decades of fiscal mismanagement. For years states willfully ignored their pension payments, borrowing money from public pension plans to create the illusion that they were balancing their budget every year.BruceS of Palo Alto California comments:
To keep contributions down, stakeholders of public pension plans, including unions, deluded themselves into believing the pension rate-of-return fantasy -- a fantasy because it is based on the erroneous assumption that public pension funds will be able to attain their 8 percent investment bogey over a sustained period. With interest rates at historic lows, it's clear that discounting future liabilities using such rosy investment assumptions will only make matters worse.
These ridiculous investment targets have led to an even bigger problem, excessive risk taking among U.S. public pension funds that have allocated a large portion of their assets into alternative investments like private equity, real estate and hedge funds. In some cases, this approach is warranted and successful but in most cases, U.S. public pension funds are wasting billions in fees praying for an alternatives miracle that will never happen.
The legislative response to public pension deficits is predictable and shortsighted. Some reforms, like raising the retirement age and using career average earnings for determining pension benefits, are necessary as people are living longer.
Other reforms, however, are silly and promote long held myths on public pensions. In particular, shifting public sector workers into defined-contribution plans shifts retirement risk entirely onto workers, ensuring more pension poverty down the road.
Legislators need to understand that defined-benefit plans are superior to defined-contribution plans, and they must take measures to maintain public pensions and expand defined-benefit coverage to private sector workers. This will actually help reduce fiscal debt in the long-run as retirees earning predictable benefits will spend more money and pay higher taxes.
But there is a caveat to all this. U.S. pension reforms need to incorporate the shared risk model that has worked so well in the Netherlands. This way workers, retirees and plan sponsors will share the risk of the pension plan. Moreover, U.S. pension funds need to incorporate the same governance model that has allowed Canadian public pension funds to flourish. This means adopting independent investment boards that operate at arms-length from the government and compensating public pension fund managers more in line with what private sector fund managers receive.
Until U.S. public plans get the governance right by implementing independent and qualified investment boards and compensating their public pension fund managers properly, all other reforms are cosmetic and do nothing to slay the pension dragon.
An interesting article, but I was disappointed with the lack of a link for the proposed shared risk model. If anyone here has one, I'd appreciate it..New Brunswick recently implemented a shared risk model. It's not perfect but you can read more about it here and here.
Susan Sisson of Salinas California comments:
Why has no one, neither your commentators nor your excellent citizen letter writers, mentioned the excellent track record of the California State Teacher's Retirement System (CalSTRS) or the California Public Employees Retirement System (CalPERS)? Both funds are extremely well managed with management fees of only 1%. For at least the last ten years, if not more, public school teachers and state employees contribute about 8% of their monthly paycheck towards their own retirement, an amount which is matched by their funding agencies/employers. I believe the funds are so well managed that they came through the 2008 recession without serious, unrecoverable losses.I agree that for the most part CalSTRS and CalPERS are well managed large funds but they have had their share of problems. They recovered nicely from the crisis and posted some strong recent gains but they're not out of the woods by any measure.
Retirees who receive defined benefit pensions forego between 70 and 85% of the benefit they would have earned through Social Security, a particularly egregious blow to workers who turn to teaching as a mid-life career choice, but that is another issue. The point is, California retirees who benefit from these funds pay significantly to their own earned retirement, and cost the taxpayer much less than is thought by naysayers and anti-unionists. The defined benefits provided not only provide the security of an adequate living to workers, but to the taxpayers as well, since these retirees are not a burden to the state in their final years.
We do not have to go to Canada or Europe for a model retirement system. If all the states emulated the citizens on the Left Coast, we would be better off nationwide as well!
Importantly, CalPERS has an estimated unfunded liability of $100 billion, while CalSTRS reports a funding gap of $70 billion. They both still discount their future liabilities using a ridiculously high rate of 7.5% based on rosy investment projections (if they used Ontario Teachers' discount rate of 4.75%, they'd be insolvent). And in the case of CalPERS, it pays hefty fees on private equity and hedge fund investments.
Don't get me wrong, they're both excellent pension funds with a stellar reputation but they're far from perfect and they can learn a lot by emulating their Canadian counterparts by cutting fees and managing more assets in-house (however, their Canadian counterparts can learn a lot from CalPERS and CalSTRS on governance, especially when it comes to transparency, communication and benchmarks).
Tom Rowe of Stevens Point Wisconsin comments:
I am a retiree in the Wisconsin State system. We have (I think) the 9th largest retirement fund in the nation and it is and has been healthy for some time. The reason for that has been the ability to keep politicians hands off the system (though Scott Walker is trying hard enough) and a highly competent board of directors, independently elected by the people whose money it it. Its not all that complicated a model.Indeed, Wisconsin's public pension fund is one of the best managed state funds precisely because it got the governance right. Wisconsin and a few other states have adopted the Canadian governance model, which is what all states should be doing.
By the way, one of my favorite U.S. public pension funds is the Missouri State Employees' Retirement System (MOSERS). This plan is way ahead of pretty much everyone else, including Canadian funds, when it comes to top notch governance. Its CIO, Rick Dahl, is one of the best among global pension fund managers and he's one of the nicest guys I've ever had the pleasure of speaking with. Great guy who really knows his stuff and he's not paid anywhere near the hefty payouts his Canadian counterparts receive (which is a joke since he is much better at is job than many of them).
S. Mirow of Philadelphia comments:
I was 100% with you until you stepped into the same quagmire of investing pension funds via “independent and qualified investment boards.” What can be invested in should be set by law & not determined by any sort of board that is tempted to chase ever higher returns. If there is no choice as to what to invest in then having such a board serves no purpose. For many years that worked splendidly & we never had problems with pension funds.Unfortunately, I do not agree with this. There are laws which govern investment policies but the day-to-day management of a pension fund requires qualified pension fund managers and a qualified, independent investment board.
Having said this, two of the best pension plans in the world -- the Ontario Teachers' Pension Plan (OTPP) and the Healthcare of Ontario Pension Plan (HOOPP) -- have a different board composition. OTPP's board is made up entirely of professional qualified board members whereas HOOPP's board has some union members.
I have nothing against union representation on a board but think that unions should nominate truly independent and qualified people to represent their interest. For example, in a shared risk model, unions can nominate a professor of finance with no industry ties to hedge funds or private equity funds, or they can nominate an independent consultant like Ted Seidle of Benchmark Financial Services or me, and we'll make sure your pension fund managers are not wasting billions in fees, taking on too much illiqudity risk which will come back to haunt them.
Bernard Dussault, former (1992-1998) Chief Actuary of the Canadian government for the CPP, OAS and Public Sector Pension Plans, shared these superb insights with me after reading all six contributions:
“The Public Pension Problem” as reported December 5, 2013 in the New York Times is the same all around the world and is not new, it is only exacerbated by the unusually large investment losses incurred by most pension plans in the world.Below, Gretchen Tegeler, executive director of the Taxpayers Association of Central Iowa, says there are alternate approaches that could be considered to take stress of the Iowa Public Employees Retirement System (IPERS) and other public pensions. One would be to include a 401k-type of retirement plan. She says ultimately, taxpayers are on the hook for fully funding pensions.
All pension plan sponsors should have adopted a long time ago the simple and effective financing measures that are shortly described in slides 9 and 10 of the PowerPoint presentation that I made to the May 7, 2013 IFEBP Conference in Charlottetown PEI as well as in my related paraphrasing article that the IFEBP published in its September 2013 Newsletter, which can be accessed with the link http://www.ifebp.org/inforequest/0164303.pdf.
In an nutshell, for any pension plan facing outstanding or emerging financial issues,
1. FINANCING: The financing rules of the plans should first be examined and revised as follows, which would optimize intergenerational equity and the reduction of fluctuations/volatility in the contribution rate from one year to the next:
2. AMOUNT OF BENEFITS: If the pension plan cost would be deemed too expensive following the adoption the above financial rules, then the amount pension benefit accruing on future service should reduced in a fair and consistent manner, which excludes any conditional indexation provision similar to those recently enshrined in the pension plans covering members the public service of the State if Illinois in the USA and of the New Brunswick province in Canada. Here are some examples of areas of such prospective benefit reductions:
- contribution holidays are fully prohibited;
- any existing or emerging actuarial pension surplus or deficit is amortized over a reasonable and consistent period, let say 15 years, which takes the form upon the release of any periodic (ideally annually) actuarial valuation report (normal cost, assets and liabilities) of adjusting accordingly the normal cost (expressed as a percentage of salary/payroll);
- plan members share no more no less than 50% of the pension costs, in respect of both the normal cost and the amortization adjustments thereto;
- actuarial valuations are prepared on a going concern (as opposed to solvency) basis using realistic economic and demographic assumptions erring on the safe side
- Gradual increase (e.g. 2 months per year) in the entitlement age, consistent with ever increasing longevity
- Age/service rules (e.g. 55/30) should disappear
- Changing the pension formula from “final average salary” to “career average indexed salary” (e.g. the Canada Pension Plan formula)
- Amount of, and entitlement to, survivor benefits should not depend on marital status.
Unfortunately, as I've covered in America's 401 (k) nightmare, shifting retirement risk entirely onto individuals will only exacerbate pension poverty, driving up social welfare costs and the national debt (watch below). Informed voices understand the benefits of defined-benefit plans and want to expand this coverage to private sector workers. That's smart pension and economic policy.