In July 2022, Reason Foundation’s Pension Integrity Project estimated that market performance would cause most public pension systems to report investment losses on average -6% for the year, causing the aggregate unfunded liabilities of state pension systems to rise to around $1.3 trillion in 2022, up from $783 billion in unfunded liabilities in 2021. Such a large growth in public pension debt has a major impact on annual costs, government budgets and taxpayers.
While a one-year negative investment return should not be the basis for making long-term funding policy decisions, it does provide an opportunity to ask the fundamental question: Who should own funding risk policy for public pension plans? The answer is important because negative investment results can have a direct and substantial effect on public pension contribution rates—a financial burden born ultimately and primarily by taxpayers.
The current state ownership of pension funding risk policy was addressed, in part, by the National Association of State Retirement Administrators (NASRA) in two papers examining the governance of state-sponsored public pension systems. The papers describe public pension governance systems with wide variations from state to state in the distribution of governance powers and duties between the state legislatures as the creator and settlor of the pension plan and trust, the plan’s chief executive function, the plans’ trustees, and, in some cases, separate pension oversight bodies. The stakeholder governance model theory described in the NASRA papers holds that it is valuable to disperse governance functions to “prevent one group from accumulating excessive authority in one area.”
The NASRA papers note, however, that in most states, the actuarial funding policy and methods are set and managed by the pension boards of trustees. Similarly, the investment policies for plan assets are usually set and managed by the pension trustees or, in some states, a separate pension plan investment board. The historical rationale for this delegation by the state legislatures of funding and investment risk policy is the reality that legislatures are simply not well equipped to set and manage public pension systems, and it is reasonable to defer to experts to help. The problem with this delegation of pension funding risk authority to the pension and investment trustees is that it violates the principles of the stakeholder governance model theory by allowing one group of stakeholders (pension plan staff and trustees) too much authority over how much actuarial and investment risk to take. Investment policy and actuarial funding policy are too often established without due regard to the needs of the plan sponsor and participating employers to manage the costs of offering the pension plan on an ongoing basis.
In a 2010 paper, the American Academy of Actuaries recognized the problems that occur when there is a structural misalignment of risk management functions for public pension systems. The paper noted there is, in many cases, a lack of aligned stakeholder incentives and a lack of reliable risk information for the stakeholders and their agents. It further noted that a major structural issue is the diffusion of responsibilities and controlling authorities amongst stakeholders. The paper observed that:
“Absent an external, independent authority or regulator, the need for a risk management system becomes critical. Such a risk management system can and should:
- establish boundaries of risk-taking; (emphasis supplied)
- establish policies and mechanisms to support the following priorities:
- continuous funding,
- education of administration and employees (unions) to better understand the risk of current benefit structures,
- develop processes for identifying plan provisions that create misaligned and/or mispriced risk incentives for plan participants and sponsors; and
- identify stakeholder incentives that clash with the health of the system as a whole.”
The immediate question then becomes, ‘what is the best way to create this better division of pension governance authority?’ The answer is to create, within each state, the very thing that is missing: an external, independent authority that owns public pension funding risk policy.
Examples of state public pension oversight bodies currently exist. The Texas Pension Review Board (PRB) is an independent state agency charged with reviewing state and local retirement systems’ actuarial soundness and compliance with state law. Another is the Ohio Retirement Study Council (ORSC), which provides oversight of the state’s retirement systems and advises the legislature on matters pertaining to benefits, funding, investment, and retirement system administration. The Louisiana Public Retirement Systems’ Actuarial Committee (PRSAC) reviews and studies the actuarial assumptions, methods, and funding policies used by public retirement systems in the state.
These examples of existing pension oversight bodies are a step in the right direction, but more is needed. It is time to consider expanding the authority of these oversight bodies to be more than mere oversight and guidance. They need to become the external, independent authority that actually establishes and manages the pension funding risk policy. This would generally require the public pension oversight body to set the boundaries of actuarial assumptions and methods that are used to determine the necessary funding for the pension plan. It would also mean the pension review board would be responsible for setting the boundaries of investment risk that can be taken by those charged with investing plan assets to properly manage contribution funding risk for participating employers. The fiduciary bodies for the pension plan, the pension administration, and investment boards would be responsible for executing their responsibilities in compliance with these independently set risk policies. The result would be a better allocation of authority among the pension plans’ stakeholders to better protect taxpayers from misaligned risk-taking.
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