Wednesday, August 31, 2016

A Long-Term Solution For Pensions?

Keith Ambachtsheer, Director Emeritus, International Center for Pension Management, Rotman School of Management, University of Toronto and author of The Future of Pension Management, wrote an op-ed for the Financial Times, Pension solution lies in long-term thinking:
If low investment returns are here to stay, those responsible for pension plans have a choice: wring their hands or fulfill their fiduciary duty by rethinking what it means for the design of their schemes.

Doing nothing is not an option. From 1871 to 2014 US equities produced an investment return, after inflation, of 6.7 per cent a year. Treasury bonds were good for 3 per cent.

In contrast, the Gordon Model — which calculates prospective returns from assumptions about growth and yields — suggests much lower returns are in prospect, a real equity return of 3.6 per cent and 0.6 per cent from Treasury bonds.

A recent Bank of England report, Secular Drivers of the Global Real Interest Rate , also supports this idea of the new normal. It shows the current low return regime correlates strongly with slowing economic growth, ageing populations, savings gluts in Saudi Arabia, China and other developing countries, declines in infrastructure investing, rising income and wealth inequality, and falling capital good prices.

Lower returns, meanwhile, make pensions more expensive. As rule of thumb, for every 1 per cent drop in annual returns contributions must rise 20 per cent. So how to squeeze higher long-term returns out of pension assets, while still providing retirees reasonable safety of payment?

Dutch economist and Nobel laureate Jan Tinbergen answered this question decades ago: achieving two economic goals requires two instruments, not one. For pension design this means separate instruments for achieving the higher long-term returns and the payment safety goals.

So the Tinbergen rule exposes a fundamental problem with traditional pension design, which attempts to meet both goals with one instrument. A confounding factor is the common practice of treating volatility in returns as a proxy for risk.

For most individuals, the dominant risk is the long-term rate of return will be too low. What is needed are sustainable long-term cash flows, such as dividends, which compound and grow over time.

Pension organisations that understand the need to distinguish between this long-term risk, and the danger of short-term fluctuations in asset prices, will split the assets in their care: into long-term return compounding and short-term payment-safety sub-pools.

Still, this is only the start of a solution. A big question remains about whether many pension managers truly understand pension economics.

The glass half-empty answer is that many organisations do not have the capability of finding long-term assets due to lack of scale, poor governance and improper staffing.

The glass half-full response is that there is a still small, but growing group of pension organisations with the requisite capabilities and the scale to exploit them. They have what Peter Drucker, the inventor of modern management, described as the dictates of organisational effectiveness: mission clarity, strong governance and the ability to attract talent.

Arguably, the reorganisation of Ontario Teachers’ Pension Plan in 1990 started this Drucker movement, from where it spread to other large Canadian funds and, more recently, around the world.

Today, these “Drucker funds” are poised to deliver an extra 2 or even 3 per cent per annual investment return on their long-term return compounding assets.

The rethink also made the old new again, recalling John Maynard Keynes 1936 attack on the destructive effective of short-termism when investing. Then managing the Cambridge university endowment fund, he wrote in his General Theory the behaviour of long-term investors will seem “eccentric, unconventional and rash in the eyes of average opinion”.

The logic is not hard to follow. Hire skilled and motivated investment professionals, and tell them to focus on acquiring and nurturing sustainable long-term cash-flows in the forms of interest, dividends, rents and tolls in a cost-effective manner.

Indeed, eight decades later long-termism is again showing it can generate above-market returns. Keynes outperformed the market by 8 per cent a year between 1921 and 1946. On a much larger scale, Ontario Teachers’ outperformed it by 2.2 per cent from 1990 to 2015.

Such crucial additional active returns will continue to be available as long as average opinion continues to think long-term investing is “eccentric, unconventional, and rash”.
When it comes to pensions, I like reading Keith Ambachtsheer's thoughts as he is widely regarded as an expert in the field. You can subscribe to the Ambachtsheer Letter at KPA Advisory services here and read more of his comments tailored to institutional investors.

You can also order Keith's book, The Future of Pension Management, on or I have not ordered this book yet but along with Jim Leech and Jacquie McNish's book, The Third Rail, I'm sure it's well worth reading if you want to understand the challenges confronting pensions on a deeper level.

(As an aside, in our phone conversation yesterday, Brian Romanchuck of the Bond Economics blog told me he is in the process of writing his third book. You can order all of Brian's books on Amazon here and trust me, they're definitely worth reading and a real bargain.)

Now, I don't always agree with Keith Ambachtsheer and have openly questioned some of his views on my blog but this op-ed is a great, albeit abbreviated, introduction to what is plaguing many pension plans today.

Alluding to Tinbergen and Keynes, two well-known titans in the field of economics (you should read about their famous debate on econometrics here and here), Keith cleverly highlights the problem with traditional pension design and how pensions which have the right (ie., Ontario Teachers, now Canadian) governance can use their internal expertise, scale and very long investment horizon to their advantage to generate above-market returns over a long period.

(By the way, retail investors reading this comment can also learn about the importance of dividends, diversification and long term investing. In my comment on building on CPPIB's success, I mentioned books like William Bernstein's The Four Pillars of Investing and The Intelligent Asset Allocator and Marc Litchenfeld's Get Rich With Dividends to help you understand how to manage and build your nest egg over the long run.)

I can't really add much to what Keith is arguing in his op-ed except to point you to my recent comment on why US public pensions are crumbling where I stated
the following key points:
  • Global deflation isn't dead; far from it and anyone who doesn't take the bond market's ominous warning seriously is doomed (I would also add there is no bubble in bonds).
  • If deflation does end up coming to America -- aided and abated by the Fed who is still following an übergradual rate hike path, acutely aware global deflation presents the mother of all systemic risks -- then this means ultra low rates and possibly even the new negative normal are here to stay.
  • Even if global deflation doesn't hit America, the bond market is warning every investor to prepare for lower returns ahead, something I've been warning of for years.
  • Low returns are already taking a toll on US public pensions, which is why they're increasingly looking at alternative investments like private equity, ignoring the risks, to shore up their pension deficits (CalPERS has cited macroeconomic challenges in private equity returns but I've already warned you of private equity's diminishing returns).
  • But assets are only one part of a pension plan's balance sheet, the other part is LIABILITIES. Declining or negative rates will effectively mean soaring pension liabilities. And in a world of record low yields, this is the primary driver of pension deficits. Why? Because the duration of pension liabilities (which typically go out 75+ years) is much bigger than the duration of pension assets so any decline in rates will disproportionately and negatively impact pension deficits no matter what is going on with risk assets like stocks, corporate bonds and private equity. 
  • Faced with this grim reality, pensions are increasingly looking to invest in infrastructure which are assets with an extremely long investment lifespan. But even that's no panacea, especially in a debt deflation world where unemployment is soaring (infrastructure assets in Greece are yielding far less than projected following that country's debt crisis. Now the vultures are circling in Greece looking to pick up infrastructure, real estate and non performing bank loans on the cheap).
  • The key point is pensions need to prepare for much lower returns and stop relying on rosy investment assumptions to get them out of a deep hole. Stop focusing on assets and focus on growing liabilities in a deflationary world where people are living longer and introduce risk-sharing and better governance at your public pensions.
In his comment above, Keith rightly notes that as a rule of thumb, for every 1 per cent drop in annual returns contributions must rise 20 per cent. That is a big reason why US public pensions are so hesitant to lower their discount rate, namely, because if they do lower it, contributions will go up and employees and the state governments will need to pay more to shore up their public pensions.

However, in my comment on the big bad Caisse, I explained why with the passage of Bill 15 which forces plan sponsors in Quebec to share the risk of their plan, it was in the best interests of Quebec City's public sector workers to transfer their pension assets out of their city pension plan to the Caisse where they can collect better risk-adjusted returns at a fraction of the cost.

In my opinion, the solution to the global pension crisis is to follow Canada's radical pensions and adopt the governance model that has allowed them to thrive over the very long run.

That brings me to another giant in the field of economics, the great Paul Samuelson who once fretted the day everyone starts following Burton Malkiel's advice in A Random Walk on Wall Street.

I too fret the day every public pension and sovereign wealth fund in the world adopts the Canadian pension model because it will necessarily mean more competition and less future returns for our large Canadian pension plans.

Luckily, we're a long way off that point and as the pension Titanic sinks, some public pensions will sink a lot deeper than others and never come back to fully-funded or even adequately-funded status. But I guarantee you Canada's large, well-governed defined-benefit pensions will weather the storm ahead and lead the way forward, always focusing on the long term.

Below, Ontario Teachers’ CIO Bjarne Graven Larsen sat down with P&I reporter Rick Baert to discuss what attracted him to Ontario Teachers, how the “Canadian model” of governance differs from Denmark, and investments at the pension fund.

Also, take the time to listen to a panel session from the recent International Pension Conference of Montréal (IPCM) featuring Leo de Bever, AIMCo's former CEO.

I already went over the conference here but noticed this session was made public after my post. You can watch all the sessions here.

Tuesday, August 30, 2016

Exposing Bond Bubble Clowns?

Ron Rimkus, CFA, wrote a comment for the CFA Institute, Is There a Bond Market Bubble?:
What is a financial bubble? A financial bubble occurs when the market price of a security or a group of securities increases well beyond the point where the long-term benefits of ownership fail to compensate the investor for the costs — market price, trading costs, liquidity, etc. — and risks of ownership.

Which brings us to the bond market.

If the results of a recent CFA Institute Financial NewsBrief poll are any indication, at least some of the global fixed-income market is in bubble territory. So if respondents agree with the above definition, then 87% of the 815 participants believe that owning at least some types of fixed income no longer makes sense.

Yet clearly many investors do own these bonds. What explains this dissonance?

The global policy response since the financial crisis of 2008 has been massive and unrelenting. While the US Federal Reserve has (at least for now) ceased its quantitative easing (QE) operations, it has struggled to return interest rates back to normal levels or reduce its balance sheet back to its former size. Japan has maintained QE at approximately 15% of its GDP for some time, and recently hinted that it may escalate it in the near future. In March of this year, the European Central Bank (ECB) increased its QE program from €60 billion to €80 billion in bond purchases per month.

All of this bond buying by central banks has been intentional, of course. By providing a bid under bonds, they have lifted bond prices and reduced interest rates. In many cases, like in Europe and Japan, this has created negative interest rates. The ECB now “charges” a negative interest rate of 0.4% for banks that borrow from the ECB. Of course, this means that the ECB is actually paying banks to borrow money.

In June, Germany became the second nation to issue a 10-year bond with a negative yield. In fact, according to a recent report by Bloomberg, more than 80% of German government bonds have negative yields. In Japan, 20-year bonds are now below zero. This is making it hard on global bond fund managers where Japanese bonds typically comprise 20%–35% of the global bond indices. (How would you like guaranteed losses on one-third of your holdings?)

Globally, over $13 trillion of the global bond market is now negative. “It’s surreal,” says Gregory Peters of Prudential Fixed Income.

Of course, this backward, underwater, upside-down world is just fine with some people. Certain investors suggest that negative yields are a “Sign of Prosperity.” And some bond managers have even figured out clever ways to make money in this market. For instance, PIMCO is buying negative yielding Japanese bonds and using swaps to lock in exchange rates, effectively quadrupling the yield on long-only US bonds of similar duration. So, they are buying negative yielding bonds, but using savvy finance skills to transform it into positive yield.

And that’s really the game, isn’t it? Low and negative rates are forcing legions of investors to seek higher yield, and in doing so, they are taking on more and more risk. Maybe it’s because they know that the central banks will maintain these policies despite potentially adverse consequences in the long term.

So, what do CFA Institute Financial NewsBrief respondents make of the fixed-income market today? As noted (click on image above), 87% of respondents see the bond market in bubble territory in some way. In other words, they believe that bonds today fail to compensate investors for the costs and risks of ownership.

The largest segment of respondents (30%) believe all bonds are in bubble territory. Another 24% see a bubble in sovereign bonds and at least one other class of fixed income. Somewhat surprisingly, only 14% of poll participants think high-yield bonds are over-inflated. And roughly 13% don’t see a fixed-income bubble anywhere. Perhaps this cohort should have attended the Financial Analyst Seminar in Chicago where Edward Altman suggested that “the benign credit cycle is in ‘extra innings‘” — an ominous sign of a coming default cycle.

Most investors recognize the vast power that central banks wield but, by and large, disagree with the wisdom of their policies. In order for the world to return to market pricing of bonds, there has to be a catalyst. The power of the central banks must be more than offset by something else. There has to be a fundamental wave — either positive or negative — to counteract it, or a political wave to change it.

Until then, investors will remain adrift on an ocean of negative yields.
There are so many things wrong with this comment but before I criticize it, Gerard MacDonell, my former colleague at BCA Research eons ago and former economist at SAC Capital (yes, THE SAC Capital) wrote a snarky blog comment, Don’t get a CFA or take BI seriously:
I am trying to tidy up this blog to take out the self-indulgent, puerile stuff and to leave only what strikes me as having some substance. I hope that airbrushing does not seem too Soviet to you, and I feel a pang of guilt compelling me to be direct about it.

Besides the guilt, there is another problem. I just don’t seem to have the discipline not to get sucked into expressing outrage over the crazy but unimportant stuff I see on the internets every day. They keep dragging me back!

For now, my solution is occasionally to let it rip and then to just delete it, once I smarten up and realize, well it seemed like a good idea at the time. Comparing Theresa May with Brit Marling would be an example. I undelete that, probably temporarily, so you can see what I’m talking about.

With that in mind, I thought this piece on Business Insider, almost inevitably BI, was a bit of a siren call striking while my hands were not tied to the mast. The article, which originally appeared at the CFA Institute, claims that there is a bubble in bonds because 87% of people surveyed say there is a bubble there “in some way.” I will get to whether such a claim is self-defeating on contrarian grounds in a second.

But first, they didn’t, did they? They didn’t just add up all the percentages that weren’t “None of the Above” to come up with their 87%. An institute whose main mission is financial numeracy would not sponsor such innumeracy. Would it?

Let me get about my Casio solar-powered calculator, available at Duane Reade. Yes, they did, although apparently they used the unrounded figures. And BI published it. No jury would convict me for breaking my promise to avoid the puerile to discuss this. Wow.

What about the super-obvious idea that an asset class cannot be in a bubble if everybody thinks it is. That is what originally raised my ire here. But I think my original impulse is wrong, and that this is the one area where the BI article was not far off base.

I like Richard Thaler’s definition of a bubble, which is far superior the conclusory silliness offered at the top of the BI article. Thaler has said — and I assume he still says — that an asset class is in a bubble when people believe it is overvalued but are invested on the expectation that it will become more overvalued based on the the stupidity of others. When the price is set by the greater fool theory, it is a bubble.

What I love about this definition is that it is at least in principle measurable. You can just ask people if they own and why they own, as Thaler has. Sure people lie and don’t know their own motivations, so your surveys may be wrong. But with Thaler, at least we know what we mean. The concept is, in principle, measurable. Plus Thaler applied this conception brilliantly to the NASDAQ bubble, as I have mentioned on another occasion.

So I think it is actually ok to claim that bonds are in a bubble because everybody believes they are. It is against my first instinct, but my first instinct is wrong, I think.

The problem is more that, umm, not everybody believes they are in a bubble. Indeed, according to the CFA guy, the vast majority of people believe they are not in a bubble. So of course, naturally, the story’s main point is the exact opposite.

BI, you’re doing a heckuva job! “The future of media,” as its owner never tires of saying. Maybe that guy didn’t change so much after all. Separate discussion.

Also a separate discussion is that Bloomberg seems to be competing on dumb with BI, because they too need the clicks. It is like Gresham’s Law applied to journalism. Of course Bloomberg has some non-stupid to balance it out. For example, there is Noah Smith.

Here is my view, for whatever it is worth. I am not a fan of Jim Grant usually, although I appreciate his sense of humor. He once opened a speech with the claim that he has been covering what the bond market would not do for about twenty years now. Good one.

He also says (or recently said) that Treasurys currently offers the exact opposite of the financial unicorn: “return-free risk.” That seems right and gets style points. Smartest guy in New York, according to a survey.

You can say to bonds meh, without claiming they are a bubble! And besides, whatever happened to just believing the price might be wrong because it discounts a fundamental premise that will end up being wrong. Not every price about to change reflects a bubble.

Plus the term premium, which is set by QE, as we all know, is now more negative than it has ever been, as QE gradually unwinds. Snigger snigger.*

Snark aside, the term premium is meant to be the expected excess return. And it is now negative. It seems you could be short or — more prudently — just interested in other things.

* Goldman has made the point that market for duration risk is global. As I read that, they are assuming that many investors have a preferred habitat in a type of trade, rather than in a currency of denomination. I am very skeptical that QE does much, but I think that is actually a pretty fun thought, and totally plausible. If it is right, then I can’t really declare victory on the grounds that US QE is unwinding and yet the term premium keeps sinking. So my snark would be misplaced. I just think GS overstates the scale of these effects, in part by conflating rates guidance (explicit and implied) with the supply effects of the government bond purchases themselves. This ain’t over. Somebody should add up all the 10-year equivalents not be taken down by QE, globally or in the OECD. Summers et al did it for the US, which I loved, because it made my point in spades. But other smart guys like GS should do it globally. The idea that global QE has made core market duration scarce assumes facts not in evidence, although it might end up being true. It would be fun to see the numbers.
Alright, Gerard could be a real jerk sometimes but he's right, this talk of a bond bubble is ridiculous as are those CFA and Business Insider articles.

Another former colleague of mine from BCA Research and the Caisse, Brian Romanchuk, publisher of the Bond Economics blog, shared these thoughts with me on the article above:
For most people, a "bubble" is a bull market that they were on the wrong side of. There are technical definitions, and bonds have no real hope of qualifying for those definitions. Does anyone believe that interest rates can be arbitrarily negative (which is what hyperexponential price movements would require)?
Brian and I actually spoke on the phone today and he told me that typically a bubble requires a parabolic move in prices and since he's never seen this in the bond market, it's hard to call this a bond bubble. "With rates at record lows, you can't get an exponential run-up in bond prices."

He did say that there have been bond bear markets in the past but nothing remotely resembling stock market bear markets.

We also had a lively discussion on the Fed and interest rates. Brian thinks the "level of interest rates don't really matter in this economy but if you work for the Fed, it's blasphemy to admit this". He thinks the Fed will continue to gradually hike rates and there may be some market dislocations but the real economy will keep humming along.

That's where I raised some objections. In my opinion, with China, Japan and Europe still struggling with deflation, the Fed would be nuts to raise rates and risk another emerging markets crisis and importing deflation in the US via the stronger greenback (which lowers import prices on goods).

The other point I made to him is after Jackson Hole and all the hawkish talk from Stanley Fisher and Chair Yellen, the yield curve actually flattened, a point which Charlie Bilello of Pension Partners demonstrated on his Twitter account (click on image):

Why is the yield curve flattening? Because while the short end of the curve reacts negatively to the Fed's endless chatter of raising rates, the long end of the curve only cares about inflation expectations and actually is telling you if the Fed raises rates, it will lower inflation expectations even more and risk a real recession (inverted yield curve).

Charlie also posted an interesting chart on US high yield bonds (HYG and JNK; click on image):

So, are bonds really in a bubble? Of course not. All this talk of a bond bubble makes my skin crawl! Whether it's hedge fund billionaire Paul Singer warning us that bonds are the "bigger short", or the Maestro's dire warning on bonds, or even Jamie Dimon's warning that the Treasury rally will turn into a rout, I tune off when people warn me of the scary bond market.

That brings me to the CFA article above. I have nothing against CFAs but if you're going to be covering the bond market, make sure you cover all angles properly. And make sure you understand portfolio theory and how to construct a well-diversified portfolio which protects against downside risks.

Importantly, as I've been warning for a very long time, deflation isn't dead and it remains the single biggest macro risk that policymakers and central banks are fretting over. But no matter what they do, the deflation tsunami is headed our way, and in a deflationary world, good old US bonds (TLT) will remain the ultimate diversifier even if rates are at record lows or negative.

I talk with a lot of people who are worried about bubbles in financial markets. They tell me everywhere they look, they see bubbles in stocks, bonds, real estate, venture capital, private equity and even in infrastructure.

I tell them everywhere I look I see DEFLATION on the horizon which is why I take the bond market's ominous warning very seriously and keep referring to six structural factors to explain why I'm worried of a global deflationary tsunami:
  • The global jobs crisis: Jobs are vanishing all around the world at an alarming rate. Worse still, full-time jobs with good wages and benefits are being replaced with part-time jobs with low wages and no benefits.
  • Demographics: The aging of the population isn't pro-growth. As people get older, they live on a fixed income, consume less, and are generally more careful with their meager savings. The fact that the unemployment rate is soaring for younger workers just adds more fuel to the fire. Without a decent job, young people cannot afford to get married, buy a house and have children.
  • The global pension crisis: A common theme of this blog is how pension poverty is wreaking havoc on our economy. Whether it's people retiring in pension poverty or chronic pension deficits forcing a huge increase in property taxes and utility rates, the pension crisis is deflationary. This is why I'm such a stickler for enhanced CPP and Social Security, a universal pension which covers everyone (provided governments get the governance and risk-sharing right).
  • Rising inequality: Rising inequality is threatening the global recovery. As Warren Buffett once noted, the marginal utility of an extra billion to the ultra wealthy isn't as useful as it can be to millions of others struggling to make ends meet. The pension crisis exacerbates rising inequality and directly impacts consumption and aggregate demand.
  • High and unsustainable debt in the developed world: Government and household debt levels are high and unsustainable in many developed nations. This too constrains government and personal spending and is very deflationary.
  • Technology: Everyone loves shopping on-line to hunt for bargains. Technology is great in terms of keeping productivity high and prices low, but viewed over a very long period, great shifts in technology are disinflationary and some say deflationary (think Amazon, Uber, etc.).
I know, I sound like a broken record on deflation and should give it a rest. But unlike all these talking heads and gurus warning us of a bond bubble, I've been right on my macro calls and continue to believe that global deflationary headwinds are what are driving bond yields lower and lower, and there's nothing in terms of policy to make me believe a major shift is on its way.

Quite the opposite, I'm more scared of a major deflationary crisis in the years ahead than the bursting of the bond bubble. But alas, this isn't something keeping me up at night, at least not yet.

Below, CNBC thinks you should stop worrying about the bond bubble and love the market. What does the yield curve say about economic growth? Boris Schlossberg of BK Asset Management and Jacob Weinig of Malachite Capital discuss with Michelle Caruso-Cabrera.

Also, Scott Mather, chief investment officer of US core strategies at Pimco, discusses bond market volatility and reducing risk in your portfolio. He speaks on "Bloomberg ‹GO›." Given my views on deflation being the primary risk, I don't agree with his comments on duration risk and nominal Treasury bonds.

Third, Richard Ross, Evercore ISI, discusses why he is keeping his eyes on the CBOE Volatility Index, crude and Brazil in September. The "Fast Money" traders weigh in. I agree with his comments on crude and emerging markets but don't agree with his comments on stocks (read my market views here to understand why volatility is so low and why biotechs and tech will continue to surge higher).

Lastly, an interesting discussion on BBC's HardTalk with professor Steve Keen, author of Debunking Economics, on why we shouldn't trust mainstream economists with our future.

Even though I don't fully agree with him, take the time to listen carefully to Steve Keen because he understands just how unstable the global economy truly is and how ignorant most economists are when it comes to understanding the real risks underlying our financial markets.

Monday, August 29, 2016

Are US Public Pensions Crumbling?

Nicole Bullock of the Financial Times reports, The crumbling assumptions of US public pension plans:
The governor’s office for Illinois, a state with notoriously weak finances, this week issued a stark warning about what might happen if it reduced the assumed rate of return for its Teachers’ Retirement System.

“If the board were to approve a lower assumed rate of return taxpayers will be automatically and immediately on the hook for potentially hundreds of millions of dollars in higher taxes or reduced services,” the state’s senior adviser for revenue and pensions wrote in a memo.

Unlike corporate pensions, US public pensions discount their liabilities using the rate of return they expect to generate on their investments. Some experts complain that these rates have been set unrealistically high. Lower return expectations would push up the cost of liabilities on their balance sheet, and force Illinois to make higher contributions. If costs to the pension were to increase by $250m it would nearly equal an entire year’s appropriation for six universities.

In spite of the warning, the board on Friday reduced the retirement system’s assumed rate of return to 7 per cent from 7.5 per cent.

Illinois highlights one of the most hotly debated issues facing state and local governments in the US: how to value pension liabilities and, in turn, what is the true nature of the deficits they face. As governments are already cash-strapped, these questions are now highly politicised.

Raising taxes and scaling back pension benefits are painful and difficult measures. It leads to a third issue: to justify these high expected rates of return plans are taking on more risk with money they are obliged to pay out.

”The attractiveness of assuming a high discount rate is that you tell the taxpayers, unions and the public that the liabilities are lower, but the only way to maintain that kind of discount rate is to have risky assets” says Don Boyd, a fellow at the Nelson A Rockefeller Institute of Government.

He estimates that extent to which high rates of return keep contributions lower is well over $100bn a year in the US (click on image).

On average US pension plans are assuming 7.6 per cent rates of return, according to the National Association of State Retirement Administrators. That is down from 8 per cent before the financial crisis, but many observers argue that it is still way too high given the persistently low level of interest rates and the outlook for investment returns.

In effect, the fear is that the maths mean plans are saying something costs $1 when it really costs $2 or $3. Corporate pensions value liabilities using a rate drawn from bond yields, which are far lower.

Joshua Rauh, a finance professor at Stanford University, has led the call for public pensions to use different discount rates. He argues for US Treasuries (currently yielding less than 2 per cent) since there is no guarantee that a plan will achieve the expected rate of return while the pension is a guaranteed promise. What is more, in the few municipal bankruptcies that have occurred to date pensioners have headed the queue even before bondholders.

Based on that he estimates that unfunded liabilities are $5tn-$6tn, including the latest downdraft in market rates post-Brexit vote, compared with the $1tn-$2tn figure based on the plans’ targeted rates of return.

Critics of the current accounting worry about “a day of reckoning” when US public pensions run out of money or their cost becomes so great that it cannibalises the money for public services and prompts tax increases to the extent that people leave the most troubled spots.

Others say concerns are vastly overblown except perhaps in the most extreme of cases. Troubled pensions played a role in Detroit’s bankruptcy and the debt crisis in Puerto Rico, two of the biggest blow-ups in US public finance in recent years. Chicago is another area that is grappling with particularly severe pension woes.

Keith Brainard, Nasra’s research director, says the rationale for using expected long-term rates of return to value pensions comes from the concept of “intergenerational equity” — each generation pays for the cost of services it receives — and that linking to current interest rates increases the chance of separating the cost of the service from the generation receiving that service.

And while the recent performance of public pension funds in the aggregate has been bleak — just 0.5 per cent for the year ended June 30, according to Callan Investments Institute, a research group — the idea is to reflect a long-term outcome (click on image).

“All those day of reckoning stories report unfunded liabilities assuming the plans will receive no benefit or reward from taking investment risk. That type of reporting can be misleading and make pension costs look a lot bigger than expected. That reporting, by itself, is not informative,” says Matt Smith, Washington state’s actuary. “On the flip side, if you only report the expected cost of a pension system assuming a long-term rate of return, that does not tell the entire story of the cost and risk of running a pension system. The truth is probably between those two points of view.”

Either way, the high return assumptions have prompted plans to move into riskier assets over the years with allocations to hedge funds, private equity and real estate.

“As they get into these potentially very volatile risk investments, they may get lucky, but it may just get a lot worse,” says Mr Boyd. “If we get a 20 per cent down year, with $3.6tn under investment, if they lose 20 per cent that is almost three quarters of a trillion dollars.”

Some plans are beginning to consider lower return expectations and the risk associated with alternative types of investing.

Calpers, the largest US pension fund, a few years ago decided to stop investing in hedge funds as part of a long-term plan to lower the risk, cost and complexity of the investment portfolio. More recently, it also embarked on a 30-year plan to reduce the discount rate from 7.5 per cent to 6.5 per cent.

The idea has traction elsewhere. Just this week, Connecticut’s treasurer, Denise Nappier, argued for lower investment return assumptions.

“Markets have largely recovered from the troughs seen in the Great Recession, but are susceptible to downside surprises stemming from changes to the global economic outlook,” she said. “If return assumptions are set at levels unlikely to be attained, it will be difficult to achieve them without pursuing high risk investment strategies. It is far more prudent to structure the portfolio based on what is achievable, rather than what is desirable.”

But any such changes will come with a cost, too.
This is a great article from Nicole Bullock of the Financial Times, one of the few serious newspapers left in the world.

Connecticut’s treasurer, Denise Nappier, who is rightly arguing for lower investment return assumptions, knows what she's talking about. I wrote a comment from May 2015 on delusional US public pensions where I noted the following:
This is another excellent comment discussing the pension rate-of-return fantasy. Unfortunately, NASRA is still smoking hopium and nobody wants to talk about the elephant in the room. I fear the worst for pensions as global deflation sets in, decimating them and forcing them to come to grips with the fact that 8% will turn out to be more like 0% or lower in coming decade(s).

Nonetheless, the talking heads on Wall Street are talking up global reflation and U.S. public pension funds are increasingly shifting assets into high fee private equity, real estate and hedge funds to make that 8% bogey. Unfortunately for them, they will fall well short of their target, but they will succeed in enriching a bunch of overpaid hedge fund and alternatives managers that are preparing for war.

In my humble opinion, U.S. public pensions should heed the wise advice of the Oracle of Omaha as well as that of the king of hedge funds and steer clear of this space (because most don't have a clue of what they're doing).

They should also pay close attention to Ron Mock, the President and CEO of the Ontario Teachers' Pension Plan, who recently sounded the alarm on alternatives. It's worth noting that unlike U.S. public pension funds, the Oracle of Ontario uses one of the lowest discount rates in the world to discount their future liabilities and they monitor all risks very closely as they try to match assets with liabilities.

In fact, Neil Petroff, the soon to be retired CIO of Ontario Teachers once told me flat out: "If U.S. public pension funds used our discount rate (now below 5%), they'd be insolvent."
I've been sounding the alarm on deflation and the pension Titanic sinking for as long as I can remember. Unfortunately, just like in the case of Harry Markopolos, no one was listening!!

But unlike the Madoff scam, when US public pensions crumble, it will have far more devastating and widespread effects and hurt the economy for decades.

Now, it is true that Ontario Teacher's Pension Plan uses the lowest discount rate among public plans. There are several reasons for this including a well-known fact that teachers tend to live longer than the rest of the population (most likely because they are highly educated, live healthy lifestyles and unlike financial parasites, they have socially useful jobs).

Ontario Teachers' is also a mature plan which means it has to manage its assets and liabilities a lot tighter than other plans because the ratio of active working Ontario teachers relative to retired teachers is declining rapidly, placing more pressure on the plan to manage is assets and liabilities more carefully.

Despite these challenges, Ontario Teachers' has managed to deliver excellent long term results and is now fully funded. It is widely heralded as being one of the best pension plans in the world, and I concur, it is definitely a force to be reckoned with as is the Healthcare of Ontario Pension Plan (HOOPP), the super funded plan everyone wishes they had.

What do Ontario Teachers', HOOPP and the rest of Canada's radical pensions have in common that US public pensions are missing? World class governance that separates politics from the investment decision making and in the case of OTPP, HOOPP and other Ontario public pension plans, they have adopted a risk-sharing model that means plan sponsors share the risk of the plan equally.

In effect, this means when there's a deficit, plans sponsors don't assume investment returns alone will bail out their pension plan, they look into cutting benefits too (typically this is done by partially of fully reducing inflation protection).

Now, I'd like you to pause here and soak all this in because there's a lot of stuff I discuss on my blog that is second nature to me but for the novice, it's like trying to learn a foreign language.

The key points I want to make here are the following:
  • Global deflation isn't dead; far from it and anyone who doesn't take the bond market's ominous warning seriously is doomed.
  • If deflation does end up coming to America -- aided and abated by the Fed who is still following an übergradual rate hike path, acutely aware global deflation presents the mother of all systemic risks -- then this means ultra low rates and possibly even the new negative normal are here to stay.
  • Even if global deflation doesn't hit America, the bond market is warning every investor to prepare for lower returns ahead, something I've been warning of for years.
  • Low returns are already taking a toll on US public pensions, which is why they're increasingly looking at alternative investments like private equity, ignoring the risks, to shore up their pension deficits (CalPERS has cited macroeconomic challenges in private equity returns but I've already warned you of private equity's diminishing returns).
  • But assets are only one part of a pension plan's balance sheet, the other part is LIABILITIES. Declining or negative rates will effectively mean soaring pension liabilities. And in a world of record low yields, this is the primary driver of pension deficits. Why? Because the duration of pension liabilities (which typically go out 75+ years) is much bigger than the duration of pension assets so any decline in rates will disproportionately and negatively impact pension deficits no matter what is going on with risk assets like stocks, corporate bonds and private equity. 
  • Faced with this grim reality, pensions are increasingly looking to invest in infrastructure which are assets with an extremely long investment lifespan. But even that's no panacea, especially in a debt deflation world where unemployment is soaring (infrastructure assets in Greece are yielding far less than projected following that country's debt crisis. Now the vultures are circling in Greece looking to pick up infrastructure, real estate and non performing bank loans on the cheap).
  • The key point is pensions need to prepare for much lower returns and stop relying on rosy investment assumptions to get them out of a deep hole. Stop focusing on assets and focus on growing liabilities in a deflationary world where people are living longer and introduce risk-sharing and better governance at your public pensions.
Of course, it's business as usual at US public pensions which is why we're now hearing of disaster striking the Dallas Police and Fire Pension and "crippling tax hikes" to shore up the Illinois Teachers' Retirement System (TRS), the state's largest pension fund which is only 41.5% funded.

I've warned all of you living in the United States, Chicago's pitchforks and torches are coming to a city and state near you.

The sad part is it doesn't have to be this way. Public defined-benefit plans aren't the problem. On the contrary, they're part of the solution to America's retirement crisis if only they can get the governance and risk-sharing right.

What else do they need to get right? Well, they can start by being more honest about the true extent of pension liabilities. Somewhere between the $6 trillion pension cover-up and trillion dollar state pension funding gap lies the truth but make no mistake, the US pension Titanic is sinking and the solutions being offered, like switching from a DB to DC plan, are absolutely terrible decisions from a public policy perspective because they will only exacerbate pension poverty in America.

On this last point, my brother sent me the Financial Times John Authers' latest Long View, There is still time to alter the script of the pension crisis:
If we have done our job properly, you should by now be scared out of your wits. The FT has spent the last week examining a serious problem for all of us — that lower bond yields mean higher strain for pensions.

(The reason, for those who have not been reading, is that lower yields make it more expensive to buy a guaranteed stream of income from bonds. Thus companies and governments who have promised their employees a fixed pension, or so-called “defined benefit” plans, face a growing shortfall which must somehow be filled. And it means savers in modern “defined contribution” plans, who have no guarantees and have mostly failed to save enough so far, risk an impoverished old age).

The scale of the problem is dizzying. It is exacerbated by the fact that future returns on US stocks, the world’s most popular asset class, are likely to be weaker because they are so expensive. And yet they look cheaper than bonds.

Now, it is incumbent on me to come up with some solutions. As this is the long view, I will concentrate on defined contribution plans. In the short term, many employers face a serious problem plugging pension deficits. But most of us face a tougher future where the risks of retirement financing will lie squarely with us, and not with our employers.

While a technical actuarial problem carries a real risk of a social crisis, there are opportunities. Disaster is avoidable.

First, the problem is partly caused by the good news that we are living and maintaining our health for longer. It is not the worst hardship to expect to work a few years longer than our parents did. That increases our nest egg and reduces the time over which it has to be spread.

Second, compound interest is our friend. Small increases in the amount we save make a difference when compounded over a working lifetime. So we need to save more.

Third, the underlying driver of low yields is low inflation. If (big if) this continues, then our savings will hold their value more than they used to do.

Fourth, there is the matter of how we save. We need to get more bang for our buck. That means cutting down on fees wherever possible. It also means timing the market sensibly. It is never a good idea to take the risk of being out of the stock market altogether (even during the 2008 disaster this would have risked missing the dramatic bounce back in the spring of 2009). But it does make sense, within bands, to maximise allocations to investments that look cheap (as emerging markets do now), and minimise allocations to those that look expensive (such as US stocks).

It also requires exploiting pension plans’ greatest advantage; that they have time on their side. Globally, there is a need for better infrastructure, and a lack of funds from straitened governments to pay for it.

The most successful public defined benefits pensions — such as those in Canada — hold infrastructure. They are pools of patient capital to aid public investment. Defined contribution plans do not. The reason for this brings us to the most important point — the design of DC plans needs to be rethought, totally.

DB plans were well designed for a world of shorter life expectancy, high yields, high returns and long careers spent with the same company. They are now obsolete. But DC plans in many countries are not plans at all — they are a tax incentive to buy mutual funds. They have some of mutual funds’ advantages that a pension fund does not need — like the ability to buy, sell or switch between funds at any time — but lack advantages that pension funds should enjoy, such as the ability to buy illiquid assets.

This must be fixed. There is no reason why young investors’ long-term savings should not go into funding infrastructure, or clean energy, or other beneficial investments for the future. The funds to do this will be less liquid than a mutual fund, and that does not matter.

A second critical issue, beyond investing and accumulating assets, is to manage the “decumulation” phase, when savers start drawing their income. That can no longer be about buying bonds, thanks to low yields. It will have, increasingly, to be about selling stocks and other long-term investments. The plans need to be structured so that savers have clear guidance on how much of their fund it is safe to draw down each year. A large statement on retirement with a “target” or “maximum” annual withdrawal might be a good idea (as would earlier strong guidance, or even compulsion, towards saving more).

The recent British reform to allow savers to take more of a lump sum at retirement is a confident and irresponsible step in exactly the wrong direction.

One final point. Reading the mass of feedback we have received, it grows clear that the issue of pensions divides us, particularly along generational lines. Many view it in moral terms. This is all wrong. We are all in this together, whether we are generationally lucky or not. We can wait for a social disaster of widespread poverty for the elderly — or we can adapt, design a new system for a new economy, and treat a long-lived, low-inflation world as a blessing.

Mr. Authers raises many excellent points but he misses the biggest point of all as he glazes over the brutal truth on defined-contribution plans and under-appreciates the long term benefits of well-governed defined-benefit plans like the ones we have here in Canada.

He does praise Canada's large DB pensions for investing directly in infrastructure but then he goes on to say to say DB pensions are "obsolete". Excusez moi? This is total rubbish and the proof is that Canada's radical pensions are thriving even in a deflationary world (because they got the governance and risk-sharing right).

Also, anyone can invest in infrastructure stocks like Brookfield Infrastructure Partners (BIP) in their personal savings or retirement account, but when it comes to secure public pension savings, I'd much rather have what the members of Ontario Teachers, the big bad Caisse, PSP, CPPIB, OMERS and most of Canada's Top Ten have in terms of direct infrastructure investments.

All this to say John Authers needs to talk to Jim Keohane, Ron Mock, Mark Wiseman, Mark Machin, Leo de Bever, and other pension experts here in Canada, including yours truly, to "fine-tune" his solutions to the global pension crisis to put well-governed DB plans front and center.

At least John Authers and Nicole Bullock of the Financial Times are discussing the pension crisis in an open and constructive way. The silence from the financial media on this critically important issue is deafening.

Below, John Authers analyzes the problems facing US public pension plans, and explains what New York might be able to learn from Canada. Smart man, listen to his comments even if he's wrong on DB pensions being obsolete.

Friday, August 26, 2016

The Trillion Dollar State Pension Fund Gap?

John W. Schoen of CNBC reports, States face pension fund gap approaching $1 trillion:
After years of not setting aside enough money, state pension funds are looking at a $1 trillion shortfall in what they owe workers in benefits, according to to a new analysis from The Pew Charitable Trusts.

State retirement systems caught a break with strong investment returns in fiscal 2014, but the gap is expected to top $1 trillion in fiscal 2015, the last fiscal year with full results (click on image).

"The lesson here is that state and local policymakers cannot count solely on investment returns to close the pension funding gap over the long term," the report said.

While many states have cut benefits for new workers and frozen plans for current staff, they cannot cut benefits that have already been earned by public employees. That means they have to find money to make up the shortfall by cutting other programs, raising taxes or both.

The report is based on the most recent data from all 50 states, which are typically reported as much as a year after each fiscal year ends.

States were to make up $35 billion of their unfunded liabilities in fiscal 2014, leaving a shortfall of $934 billion. That's because of unusually strong returns averaging 17 percent in 2014, according to the study. But average returns fell sharply in 2015, it said, to just 3 percent.

The numbers for fiscal 2016, which ended on June 30 for most states, won't be reported for some time. But investment gains are expected to work against them. Pew reports that public pension funds had negative average returns during the first three quarters of the latest fiscal year.

Those lower returns mean states with badly underfunded retirement plans will have to set aside more tax dollars to fill the shortfall.

States with the biggest funding gaps include Illinois and Kentucky, the two worst-funded systems, with just 41 percent of what's needed to pay the benefits promised to public employees. New Jersey has set aside just 42 percent (click on image):

Only three states have set aside enough money to fully pay retirement benefits owed to current and futures retirees: South Dakota (107 percent of liabilities), Oregon (104 percent) and Wisconsin (103 percent).

State pension fund debts have been growing since 2000, after falling in the preceding decades. The last time they were fully funded was the late 1990s, when a stock market boom generated returns that left them with a surplus of funds to pay benefits (click on image).

Let's have a closer look at The Pew Charitable Trusts's analysis on state pension deficits, The State Pension Funding Gap: 2014:
The nation’s state-run retirement systems had a $934 billion gap in fiscal year 2014 between the pension benefits that governments have promised their workers and the funding available to meet those obligations. That represents a $35 billion decrease from the shortfall reported for fiscal 2013. The reduction in pension debt was driven primarily by strong investment results, with public plans in fiscal 2014 averaging a 17 percent rate of return.

This brief focuses on the most recent comprehensive data from all 50 states and does not reflect the impact of weaker investment performance in fiscal 2015, which averaged 3 percent. Performance has been even weaker in the first three quarters of fiscal 2016, with negative average returns. Preliminary data from fiscal 2015 point to increases in unfunded liabilities for the majority of states. Total pension debt is expected to be over $1 trillion for state plans, an increase of more than 10 percent from fiscal 2014.

When combined with the shortfalls in local pension systems, this estimate reaches more than $1.5 trillion for fiscal 2015 and will likely remain close to historically high levels as a percentage of U.S. gross domestic product (GDP). The lesson here is that state and local policymakers cannot count solely on investment returns to close the pension funding gap over the long term; they also need to follow funding policies that put them on track to pay down pension debt.

These data follow new standards from the Governmental Accounting Standards Board (GASB), the independent organization recognized by governments, the accounting industry, and capital markets as the official source of generally accepted accounting principles for state and local governments. As of June 15, 2014, GASB required governments to report pension debt as a net pension liability (NPL) on their annual balance sheets and to disclose more details on the cost of new pension benefits earned by current workers. In addition, some poorly funded plans must now use more conservative assumptions when calculating pension liabilities for reporting purposes.

Under the new rules, reporting on pensions is more closely tied to general accounting standards, rather than to plans’ individual funding policies. In particular, plans are no longer required to report the actuarial required contribution, known as the ARC, which had been the most common metric for assessing contribution adequacy. Although most plans have continued to include the ARC as a supplemental disclosure—or produced a similar metric known under the new GASB standards as the actuarially determined contribution (ADC)—these measures are based on each plan’s own assumptions and do not always signal true fiscal health. The Pew Charitable Trusts did not include those calculations in this brief because the ARC is not consistently available and the ADC does not have to meet minimum standards. Neither metric on its own provides sufficient information to evaluate the policies that states are following to fund their pension promises.

The analysis also looks at net amortization, a new 50-state metric that can help state and local governments understand whether their funding policies are adequate to reduce pension debt. Net amortization serves as a benchmark to assess contribution policies and helps gauge whether payments to a pension plan are sufficient, both to pay for the cost of new benefits and to make progress on shrinking unfunded liabilities. The calculation is based on the assumptions that plans use to determine liability and estimate long-term investment returns; it also accounts for employee contributions, given that workers in most states contribute to pensions.


What Is Net Amortization?

Net amortization measures whether total contributions to a public retirement system would have been sufficient to reduce unfunded liabilities if all expectations had been met for that year. The calculation uses the plan’s own reported numbers as well as assumptions about investment returns. Plans that consistently fall short of this benchmark can expect to see the gap between the liability for promised benefits and available funds grow over time.


Under this new metric, states that follow contribution policies that are sufficient to pay down pension debt if plan assumptions are met are achieving positive amortization. States where contributions allow the funding gap to continue to grow are facing negative amortization. The analysis in this brief shows that 15 states currently follow policies that meet the positive amortization benchmark—exceeding 100 percent of needed funding—and can be expected to reduce pension debt in the near term. The remaining 35 states fell short; those performing the worst on this measure typically had the largest unfunded pension liabilities.

While 40 states reported decreased unfunded liabilities in 2014, only a small number met the positive amortization benchmark because the calculation is based on the long-term assumptions that plans use to set funding policy, including expectations for the rate of return on investments. In the short term, states experienced stronger-than-expected investment returns, which helped reduce reported pension debt. However, investment returns vary widely over time, and most governments that sponsor pension plans made contributions that were not large enough to reduce debt based on expected long-term rates of return.
New accounting standards spotlight poorly funded plans

The new disclosure rules require that state balance sheets now include the net pension liability, which is the difference between pension plan assets, reported as plan net position, and total pension liability. Net pension liability is essentially the pension debt, or unfunded liability, for that plan. All plans now calculate assets based on the market value of investments on the reporting date, rather than smoothing investment gains and losses over time, which had previously been allowed. This means that the 2014 results fully reflect the impact of strong market gains. Going forward, reported asset values will be more volatile from year to year. For example, funded levels are projected to decline for fiscal 2015 because the average returns of 3 percent were well below plans’ long-term return targets.

In addition, the new standards now require certain plans with low funded ratios to report pension liabilities using more conservative investment return assumptions. (See Appendix B for a more detailed explanation.) So far, this new requirement has had an impact on only eight of the 100 largest state-sponsored pension plans. Looking at restated 2013 results, this accounts for about $72 billion in increased reported pension liabilities and pension debt in total. Plans in Illinois and New Jersey, along with the Kentucky Teachers’ Retirement System and the Texas Employees Retirement System, account for over 90 percent of this amount.

The new rules also require that all public pension plans use the same methodology to calculate liabilities. Previously, state pension plans could choose from multiple approaches, though most had been using the approach that is now required.

Primarily because of market gains, the state pension funding gap dropped in 2014, the first decline in reported pension debt since 2000. Lower investment returns in 2015, however, indicate that pension debt will increase when valuations for that year are complete.

The volatility in investment returns between 2014 and 2015 demonstrates that states cannot rely on higher-than-expected returns to eliminate unfunded liabilities. Pew’s net amortization analysis provides a benchmark for measuring the sufficiency of contributions based on long-term investment return assumptions. This analysis shows that states in aggregate fell short of the net amortization benchmark by $29 billion in 2014.

Figure 2 shows the impact that changes in accounting standards had on total reported pension debt in 2013 as well as the effects of investment gains and other factors in 2014.

Figure 2 (click on image)

While these new standards are required for all plans, most continue to report information using the previous standards as well. The prior rules allowed plans to report assets smoothed over multiple years and did not require the use of more conservative assumptions to report liabilities, as described above. In this analysis and going forward, Pew will use data reported under the most recent set of GASB standards because they provide a standardized point of comparison across plans and reflect the most up-to-date industry standards, consistent with our past work and the most recent government accounting guidelines.

Figure 3 shows trends in aggregate assets and liabilities since 1997. Fiscal 2014 data reflect the new reporting standards, which use the market value of assets and a different method for calculating liabilities. Figure 4 shows total state and local pension debt as a share of GDP.

Figures 3 and 4 (click on images)

New data provide for better measures of plan health

The new disclosure requirements under GASB allow for improved analysis of plan contribution policies compared with previously available data. Before the change, most researchers, including Pew, had to rely on the ARC as a means of comparison. But meeting contribution targets based on this reporting standard never ensured that states and cities were actually paying down their pension debts.

The new data included in public pension financial statements allow for measurement of whether an employer’s contribution policy achieves net amortization. That is the level at which employers’ annual contributions to a plan are sufficient to pay for the cost of new benefits in that year as well as offset any projected growth in pension debt after netting out employee contributions.

The National Association of State Retirement Administrators (NASRA) accurately notes that using net amortization may not always recognize funding policies that are sustainable and that could reduce pension debt over the long term. However, for states following policies expected to address unfunded liabilities, the net amortization benchmark can help pension plan sponsors measure progress. In addition, Moody’s Investors Service’s latest analysis of contribution policies follows a very similar approach in terms of measuring whether states reduced unfunded pension liabilities in the current budget year. The Society of Actuaries Blue Ribbon Panel also noted the importance of contribution polices that pay down pension debt over a fixed time period.

Plan administrators also point out that the numbers disclosed under GASB rules will often differ from those that drive contribution policies. Most notably, GASB requires plans to report assets on a market basis, but plans’ funding policies typically calculate contributions using asset smoothing to recognize gains and losses over time. Other differences can affect liabilities, but these are expected to be limited. For instance, the discount rate requirements under the new GASB rules affect only a select number of troubled plans. Additionally, most plans were already calculating their liabilities using an entry age actuarial method—which takes into account workers’ likely pay increases in calculating pension costs—as required for new GASB disclosures.

Any credible approach to achieving full funding of pension promises needs to pay down pension debt over a reasonable time frame. Prior to this year, GASB standards provided state pension plans with significant leeway in calculating the ARC, which allowed for contribution policies that fell short of this goal. For example, these standards allowed states to reset the maximum 30-year payoff schedule annually. This approach may provide near-term budget relief, but it allows pension debt to grow and costs more in the long run. Because of its limitations, the ARC proved to be a minimum reporting standard rather than a model approach for pension funding.

The net amortization measure assesses the results of contribution policies without taking into account unexpected gains and losses. If plan assumptions are correct, plans receiving contributions meeting the net amortization benchmark will have their unfunded liabilities shrink. Pew’s analysis shows that most state pension plans didn’t receive sufficient contributions to meet this benchmark in 2014.

It is important to note that the net amortization calculation does not use the same discount rate for all plans—it relies on plans’ own individually chosen assumptions. Plans with higher assumed rates of return will have lower estimated costs of benefits, and that will lower the benchmark for positive amortization.

There is still no single measure of plan fiscal health, but effective contribution policies eventually achieve positive amortization. Along with funded ratios and supplemental disclosures on funding policy—including ARC calculations—net amortization provides an important benchmark for states and cities to consider.

Figure 5 shows each state’s net amortization as a share of covered payroll, the total salaries paid to current employees.

Figure 5 (click on image)

Net amortization provides fuller picture of contribution policy

Net amortization provides policymakers a clear picture of the effectiveness of a state’s contribution policy in terms of paying down pension debt in the near term. The data show that many states are not contributing enough to their pension funds to reduce unfunded liabilities—including some states that have paid the full ARC. The new net amortization benchmark provides a better assessment of contribution policies than prior measures did.

Under the new metric, Kentucky, New Jersey, Illinois, and Pennsylvania experienced the largest negative amortization, when adjusted by covered payroll. Plans in these states face significant challenges and have low funded ratios. And without the strong overall investment returns in 2014, net amortization shows that these states would have lost further ground. All four also fell short of paying what would have been the full ARC in 2014. Pennsylvania, however, has committed to large and steady increases in contributions, and is projected to reach positive amortization by 2018.

Of the 10 states with the strongest results on positive amortization, seven have historically paid about 95 percent of ARC. But this group includes three states—Nebraska, Oklahoma and Louisiana—that reported paying less than full ARC payments in recent years. Still, the three continued making progress in reducing pension debt.

Oklahoma’s performance reflects a 2011 change to cost of living adjustments (COLAs). After that policy change, the state’s current contribution policy was adequate to pay down the remaining pension debt. Louisiana sets higher standards than typical state pension plans in calculating its actuarial contribution. As a result, even though the state fell short of full ARC funding in 2012 and 2013, its contributions were enough to make progress on paying for pension debt in 2014. Nebraska’s numbers were driven by contribution timing as well as changes to the state’s contribution policy in 2013. Pew’s research indicates that most states with contribution policies sufficient to pay down pension debt used more conservative approaches targeted at reducing unfunded liabilities compared with states that failed to meet net amortization.

In other cases, states and participating local governments made full ARC payments but still fell short of reducing their pension debt because they followed 30-year payment plans that were refinanced annually. Alabama and Arizona, for example, have historically set actuarial contribution rates based on approaches that would not make progress on paying down pension debt. As a result, while both states paid every dollar that plan actuaries asked for, their unfunded liabilities increased and their funding rank relative to other states declined. Both states’ pension plans have recently changed contribution policies, with a goal of hitting positive amortization over time.

Low funding levels make it harder for states to make progress. Those with larger unfunded pension liabilities require substantially higher contributions to pay down debt because they generate less in the way of investment earnings. Connecticut is only 50 percent funded, but the state’s current contribution policies, which include a fixed amortization period to pay off the unfunded liability, are anticipated to start reducing debt in fiscal 2017. The state has made progress by increasing payments every year; in 2014, it made the highest contributions relative to payroll of all but three states.

Connecticut’s pension funds assume relatively high 8 percent returns, which means that the current policy is sustainable only under risky assumptions. This example shows the difficulties that face a fiscally challenged state trying to pay down pension debt, as well as how a state can improve funding policies over time.

Elsewhere, Virginia shows how states that recently adopted more responsible funding policies might not pay down pension debt immediately, though they will close their funding gaps over time. In 2013, the Virginia Retirement System (VRS) board adopted a stronger funding policy to pay off the unfunded liabilities over a fixed time period, a method known as a closed amortization schedule. State policymakers also enacted legislation to make full actuarial contributions by 2018.

West Virginia stands apart as having made the most progress on pension funding, increasing its funded ratio from 40 percent to 78 percent from 2003 to 2014. West Virginia has averaged payments equal to 95 percent of the ARC or higher for a decade, as have 21 other states, but it has followed a more aggressive funding policy than many of its peers. Tracking net amortization highlights the importance of analyzing how actuarial contributions are set.

Looking at net amortization allows policymakers to better compare contribution policies by measuring outcomes rather than inputs, using a consistent formula for liabilities and using the market value of assets. However, plans still use a range of investment return assumptions under which higher assumed rates of return lead to the reporting of lower liabilities and costs.
Looking forward: Measuring and managing cost uncertainty

Net amortization assesses what happens under current policy if everything goes as expected. However,in providing a fixed benefit, public employers take on a variety of risks—in particular, investment risk. In calculating the fiscal sustainability of a pension plan, looking at different scenarios in what is called sensitivity analysis or stress testing gives a more complete picture of future pension costs and projected pension debt.

The new GASB rules include some sensitivity analysis: Plans are required to estimate liabilities based on projected returns 1 percentage point above or below their assumed rate of return. The Society of Actuaries commissioned a Blue Ribbon Panel to issue recommendations on pension funding and governance, which included a more detailed stress testing approach. Finally, states such as California and Washington have taken the lead by publishing sensitivity analyses on their public pension plans to assess their fiscal sustainability under multiple investment scenarios. Given the importance of risk in understanding pension plans’ fiscal condition, Pew will be working to incorporate stress testing and sensitivity analysis into future reports on state pension funding levels.


The gap between the pension benefits that state governments have promised workers and the funding to pay for them remains significant. Many states have enacted reforms in recent years to help shrink that divide, but they also have benefited from strong investment returns.

Over the long term, however, these returns are uncertain. In addition, many states have not made contributions that would reduce plan debt under expected returns. New tools, such as net amortization, stress testing, and sensitivity analysis, provide policymakers with additional information to better evaluate the effectiveness of their policies and ensure that plans can achieve full funding over time—and that pension promises can be kept.
You can read the full Pew report on state pension funding gaps as of 2014 by clicking here. The report contains end notes and appendices. You can also download an Excel spreadsheet with state by state data from the report here.

Also, as shown below, the funded ratios increased in most states in FY 2014 (click on image):

Of course, as mentioned in the report, returns have come down over the last fiscal year and more importantly, interest rates have also declined and that is the primary driver of pension deficits.

The report is very useful and basically offers hope to many states struggling to address the problem of chronically underfunded public pensions. In this report, states like Kentucky, Illinois, New Jersey and Pennsylvania should look at the success of the Virginia Retirement System and try to adopt better funding policies (ie. no contribution holidays, keep topping up your state pensions!).

However, the Pew report leaves out a lot of information. For example, it singles out "West Virginia as standing apart, having made the most progress on pension funding, increasing its funded ratio from 40 percent to 78 percent from 2003 to 2014."

All this is true but there is no mention of a recent report by the National Institute of Retirement Security (click here to read it) which shows that West Virginia and other states that switched from a DB to DC plan did not help their existing underfunding problem and in fact increased pension costs (again, click here for more information)

All this to say you have to be extremely careful reading these reports because there is a lot of stuff left out, important things like switching from a DB to DC plan which is an absolutely terrible decision from a public policy perspective.

Importantly, switching to a DC pension plan won't stop the pension Titanic from sinking, it will only accelerate widespread pension poverty and increase social welfare costs (and the national debt).

None of these important policy questions are discussed in The Pew Charitable Trusts's report. Sure, it's a useful report that gives us a snapshot of state pension funding gaps using the net amortization measure (and even that is deficient because they use their own assumed discount rates), but if offers little in terms of insights and policies that will improve retirement security in the United States.

Also, the trillion dollar gap has been contested. In the $6 trillion pension cover-up, I discussed why some experts think the figures being reported on state pension funding gaps by the Society of Actuaries vastly understate the real extent of the US public pension gaps. I'm not suggesting they're right but we need a more fruitful, honest and transparent debate on all these important public policy issues or else succumb to Chicago's pitchforks and torches.

What else do US state pensions need to do? They desperately need to adopt the governance that has allowed Canada's radical pensions to forge ahead and become global leaders in terms of managing pension assets and liabilities.

In other words, there is a gross misconception that if you improve the funding policy, you will magically fix state pension deficits. Sure, this will no doubt help a lot but unless you fix the governance at these state pensions, you won't make real long-lasting change to secure their long-term sustainability.

Instead of fixing their governance so they can manage more assets internally, it's business as usual for US public pensions which are shifting more assets into private equity, ignoring the risks and forking over huge fees for mediocre returns. That's a subject for another day but it's not a winning strategy.

Lastly, I want to share with you an email I received earlier today from someone who thinks I don't know what I'm talking about when discussing why the pension Titanic is sinking:
You're missing the boat. Returns, including returns on pension funds, are ALWAYS spreads, not absolute numbers.

It does not matter how much pension funds return as an absolute number. What matters is how much they return with respect to inflation or deflation (the spread). What matters is purchasing power, not the absolute return number!

In a world that is deflating at 3% a year, a 1% return will do just fine!
I replied back:
I think you are missing the point, pensions are all based on a promise that they will have enough money to cover future liabilities. In a deflationary world, rates will remain ultra low or negative for years, which means low returns and more importantly soaring liabilities. The only spread that counts is the one between assets and liabilities and since the duration of liabilities is much bigger than the duration of assets, deflation will kill pensions, especially poorly governed, chronically underfunded US pensions.
On that note, enjoy your weekend, and try not to worry too much about Janet Yellen and Stanley Fisher's remarks. I still maintain that the Fed would be very foolish to raise rates in a world struggling with strong deflationary headwinds.

And while some like Morgan Stanley's Jonathan Garner see emerging markets turning the corner, I would caution all of you to be very careful with emerging markets, energy and commodity shares going forward, regardless of what the Fed decides to do (read my market insights here and here).

Lastly, please take the time to support this blog with your dollars by subscribing and/ or donating via PayPal at the top right-hand side under my picture. I thank all of you who value the work that goes into these write-ups and support my efforts. Have a great weekend!