Friday, May 26, 2017

The Pension Prescription?

A month ago, Adam Ashton of the Sacramento Bee reported, Unions kill bill to cut cost-of-living increases for CalPERS pensions:
Public employee unions presented a united front on Monday against a bill by Sen. John Moorlach that aimed to close California’s pension funding gap by eliminating cost-of-living increases and asking local governments to chip in a greater share of their revenue toward retirements.

Moorlach, R-Costa Mesa, shaped his Senate Bill 32 using the language of climate change laws the Legislature adopted to set goals for the reduction of greenhouse gasses. Last year’s SB 32, for instance, sought to cut greenhouse gas emissions to 40 percent below 1990 levels between now and 2030.

Moorlach’s pension bill similarly would demand that CalPERS and CalSTRS reduce their unfunded liability to 1980 levels by 2030. Today, both pension systems have about 64 percent of the assets they’d need to pay all of the benefits they owe.

Read more here: http://www.sacbee.com/news/politics-government/the-state-worker/article146516764.html#storylink=cpy

“The unfunded liabilities are killing us. The math is brutal,” said Dan Pellissier, president of an advocacy group called California Pension Reform.

Moorlach’s bill would have temporarily banned cost-of-living increases that pensioners receive, required local governments to increase their pension contribution rates by 10 percent and compelled public employers to offer 401(k) style defined contribution plans to supplement pensions.

The bill failed by a 3-2 vote in the Senate’s Public Employment and Retirement Committee after a parade of union representatives voiced opposition to it.

“This is really an attack on women,” said Jennifer Baker, a lobbyist for the California Teachers Association. She noted that some 72 percent of the state’s retired teachers are women.

She continued, “This is not going to incentivize more people to want to become teachers.”

Baker’s argument resonated with Sen. Connie Leyva, D-Chino, whose mother receives a pension worth about $22,000 a year.

“I really worry that we are always trying to balance the pension funding problem on the backs of the lowest paid worker,” Leyva said.

“We just have to be very thoughtful and I’m afraid that for me this doesn’t get me where I need to be,” she said.
On Friday morning, I updated my last comment on how to steal millions from CalPERS to include this article and stated this:
I'm against Moorlach's 401(k) proposal, for good reasons, but go back to read my recent comment why Ontario is easing its funding rules and watch the clips at the end which show how Ontario Teachers' Pension Plan has partially or fully removed inflation protection (ie. cost-of-living-adjustments) to lower its pension deficit in the past (and it's not alone, HOOPP has done so too).

In my opinion, California's public-sector unions are not interested in sharing the risk of their plan, and this sets up a very dangerous showdown in the future when taxpayers refuse to bail these plans out. Some form of risk-sharing must take place in order to bring these plans back to fully funded status.

I also added a couple of clips from the Ontario Teachers' Pension Plan which explain how small adjustments to inflation protection were instrumental in tackling their pension deficit and restoring fully funded status to their plan.

I sent the article above to Jim Leech, the former CEO of Ontario Teachers' and co-author of The Third Rail: Confronting Our Pension Failures.

Jim was kind enough to share this with me:
A number of years ago I was asked by a troubled plan “How did we ever convince the Ontario Teachers’ unions to voluntarily introduce Conditional Inflation Protection”.

My response was/is: “You start 10 years earlier to educate the union leaders and members on the value of such changes. It takes time, trust and transparency.”

Of course, there is the added advantage that in a Jointly Sponsored Pension Plan, the unions/employees have a joint responsibility to ensure the Plan is sustainable – there is no “us and them”, there is only “us”.

But even in an employer sponsored plan, employee leadership needs to take some responsibility to ensure employees have a sustainable plan – a “guarantee” is only as secure as the “guarantor”.
I completely agree with Jim and when people ask me how Ontario Teachers', HOOPP and other Canadian plans were able to tackle their pension deficit and restore fully funded status, I say it's because of two critical factors:
  1. They got the governance right which means they operate at arms-length from the government. This allows them to get the compensation right so they can attract and retain qualified staff to manage a big chunk of the assets internally, significantly reducing operating costs, as well as invest and co-invest with external partners (to lower fees) where they see great investment opportunities which they can't invest in internally.
  2. They got the risk-sharing right which effectively means their sponsors share the risk equally if the plan experiences a deficit. Risk-sharing means both employees and employers share the risk of plan if it runs into trouble.
In particular, risk-sharing means either the contribution rate needs to increase, benefits need to be cut or both to restore the plan's funded status and make it sustainable for future generations.

In the past, OTPP and HOOPP made cuts to their benefits by making small adjustments to their inflation protection as a means to restore their plan's funded status. And when I say a small, I mean small, we are talking about a few dollars off the benefit payments to restore the plan's funded status.

Earlier this week, when I went over why Ontario is easing its pension funding rules, I mentioned this:
[...] as an aside, the key difference between Ontario Teachers' and HOOPP relative to OPTrust and OMERS is in the form of risk-sharing. The latter two plans guarantee inflation protection, which means no matter what, they never reduce benefits to their beneficiaries.

OTPP and HOOPP have both partially or fully cut inflation protection (otherwise known as cost-of-living adjustments or COLA) when their plans have experienced a deficit in the past. This has been a very useful mechanism to allow them to become fully funded again (watch this OTPP clip to understand why).

OPTrust and OMERS guarantee inflation protection so they have a harder job attaining an maintaining a fully funded status which in my view isn't right (their members need to share the risk of the plan more if they run into trouble).

Still, there's no denying that the problems at Ontario's DB plans aren't with OTPP, HOOPP, OPTrust, OMERS or even CAAT which is also fully funded and has a 50/50 shared risk model.

The problem lies with private-sector DB pensions that are either poorly managed or that don't have the flexibility to address their (going concern) pension deficits. And a lot of these pensions are going to get whacked hard in the near future as rates decline to a new secular low (as the US economy slows).
I still maintain that OPTrust and OMERS should follow OTPP and HOOPP an introduce conditional inflation protection but somehow they have managed to obtain fully funded status by guaranteeing full inflation protection (good on them but it makes their job more difficult in managing assets and liabilities and it makes more sense if they can partially adjust inflation protection when their plan runs into a deficit).

Still, despite these minor differences, it's clear that large Canadian public pensions are in much better shape than their US counterparts, many of which are chronically underfunded.

Earlier this week, I also discussed The Big Squeeze on US public pensions, going over a new report by the American Federation of Teachers which basically claims US public pensions are doling out huge fees to alternative investment managers and that is making their plans more underfunded.

I was careful when writing that comment, agreeing with some of the assertions from the report but I also stated the following:
The problem isn't paying fees when risk-adjusted performance is met. The problem is paying big fees for subpar or average returns in a low-return environment over a long period as your pension deficit gets worse.

Importantly, in a deflationary world, all those fees add up fast, impinging on the net performance of these external managers and this certainly doesn't help chronically underfunded pensions, many of which still cling to unrealistic return targets.

Very few public pensions were raising a big stink on fees when rates were much higher, performance was decent and their funded status was fully funded or close enough to fully funded status. A little inflation also helped justify these fees.

But in a low yield, low return deflationary world, costs matter a lot more and pensions are focusing on lowering operating costs across the board, including on the fees they pay to external managers.

Of course, we need to be realistic here. Some external managers have delivered great long-term results and therefore have a lot more clout than others. You're not going to go to Blackstone, Bridgewater, or any other brand name fund and dictate the terms of the deal. It's not going to happen because if they make one exception, they need to make it for all their investors which signed a most favored nation clause.

The other thing I'd like to bring to your attention is that a solid case can be made to increase the exposure to alternative, illiquid investments, especially if you can co-invest on bigger deals alongside your external partners to lower the overall fees.

This has been the driving force behind the success of Canada's large public pensions, otherwise known as the mighty PE investors. Where they can, Canadian pensions will invest directly and where they can't, they will invest with external partners and engage in co-investments to lower fees.

However, in order to do this, they implemented world class governance allowing them to operate at arms-length from the government. This allows them to compensate their pension managers properly in order to attract and retain talented individuals who are able to do direct deals independently or (as is more often the case) by co-investing alongside external partners.

More direct investments (either independently or through co-investments) allows Canada's large pensions to lower overall fees of their private equity program.

In the US, there is way too much political interference in public pensions and the results are they cannot pay their public pension fund managers properly to do what their Canadian counterparts do.

Then, one day, the American Federation of Teachers puts out a report highlighting The Big Squeeze, and all of a sudden teachers, police officers and other public-sector workers wake up to the reality that everyone is milking their public pension dry. And by the time they're done milking these pensions, there will be little left to pay the benefits that were promised to them.

I'm being very cynical but there is a lot of truth in the report the teachers put out. If their pensions are doling out huge fees to alternative investment managers, they have a right to know what they're getting in return for all those fees.

Having said this, I want to be balanced here because I maintain the view that good performance is worth paying for. Chronically underfunded US pensions with unrealistic return targets can't expect to make their target rate of return simply by investing in index funds. They need to invest in top-tier managers in the alternatives space to add value over and above their public market benchmarks.
There is a misconception that allocating to external private equity and hedge fund managers is a waste of time and money and that these pensions can improve their funded status by removing these funds from their asset mix (in most cases, their funded status will deteriorate if they remove these funds).

Sure, in some cases, it makes sense to cut external managers, like when CalPERS nuked its external hedge funds (it never invested enough dedicated resources to that program and never took it seriously like OTPP and CPPIB do).

But cutting all allocations to private equity isn't wise, nor in the best interests of pension plan beneficiaries. These programs have added significant value-added to most US public pensions, net of all fees.

We can argue whether fees in alternative investments are still outrageously high -- and I believe they are and should be cut in half (1 and 10, not 2 and 20) for the big funds managing multi-billions -- but you would be hard-pressed to make a convincing case that public pensions can attain their required actuarial rate-of-return without allocating a percentage of their assets into alternatives, both liquid (hedge funds) and illiquid alternatives (private equity, real estate, infrastructure and private debt).

I also ended that comment by stating:
[...] it's very fashionable these days to blame everything on greedy bankers, hedge fund managers, and private equity managers, but from my vantage point, there is plenty of blame to go around when it comes to America's pension crisis. Unions, state and local governments and Wall Street all have unrealistic expectations on return targets, benefits, contribution rates, risk-sharing, and fees.

In the meantime, the pension storm cometh, and unless all these stakeholders come together to figure out a real long-term solution to this crisis, things will only get worse.
The biggest problem with pensions these days are stakeholders with inflexible views. Unions that don't want to share the risk of their plan, governments that shirk their responsibility in topping out these public pensions and making the required contributions, pension funds with poor governance and unrealistic investment targets, and powerful private equity and hedge funds that refuse to cut their fees in order to contribute to solving this crisis.

From a social and moral view, I truly believe that a case can be made to a group of elite private equity and hedge fund managers that they need to cut their fees in half and be part of the pension solution. In return, public pensions can perhaps allocate more assets to them over a longer period, provided alignment of interests and performance are maintained.

I don't know, I've been thinking long and hard of a pension prescription which will go a long way into solving a looming crisis that is only going to get worse. There are no easy solutions but in my mind, we absolutely need to bolster defined-benefit plans and avoid defined-contribution plans, and make sure we get the governance and risk-sharing right. And to do this, everyone needs to be committed to the best interests of the plan, including unions, governments and alternative investment managers.

If you have anything to add to this comment, feel free to reach out to me at LKolivakis@gmail.com an I'll be glad to post your thoughts.

Below, please take the time to once again watch a couple of clips from the Ontario Teachers' Pension Plan which explain how small adjustments to inflation protection were instrumental in tackling their pension deficit and restoring fully funded status to their plan.

The pension prescription isn't rocket science folks. If we want defined-benefit pensions to be sustainable over a long period, we need good governance and sponsors need to share the risk of their plan.


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