Are US Public Pensions Crumbling?
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.This is a great article from Nicole Bullock of the Financial Times, one of the few serious newspapers left in the world.
“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.
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).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!!
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."
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.
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.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.
(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.
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.
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