Pension Reform Newsletter

Pension Reform Newsletter – July & August 2015

Cost-Effectiveness of DC plans vs. DB plans, Paying Down Unfunded Liabilities Through Asset Sales & Leases, Pension Bonds Encourage Underfunding, Pew Report on State Pension Debt, and more

This newsletter highlights articles, research, opinion, and other information related to public pension problems and reform efforts across the nation. To find previous editions, please visit http://reason.org/newsletters/pension-newsletter/.

Articles, Research & Spotlights

  • Examining the Cost-Effectiveness of DC plans vs. DB plans
  • Paying Down Unfunded Pension Liabilities Through Asset Sales and Leases
  • Proposed Pension Initiative Threatens the California Rule
  • Taking on Infrastructure, Pension Challenges in Georgia
  • New Jersey Residents Will Get Fewer Services as Public Pension Costs Skyrocket
  • California Public Employee Pension Funds Prepare for Year of Crappy Returns
  • Busting the Myth That Actuarial Assumptions Drive Costs
  • Pension Bonds Encourage Underfunding
  • Pew Report on State Pension Debt

Quotable Quotes on Pension Reform

Pension Reform Handbook

Contact the Pension Reform Help Desk

Articles, Research & Spotlights

Examining the Cost-Effectiveness of DC plans vs. DB plans
By Truong Bui, Reason Foundation

Critics of pension reform aiming at replacing defined benefit (DB) plans with defined contribution (DC) plans often argue that DB plans are more cost-effective thanks to their superior investment returns and annuity feature. A recent paper by pension expert Josh B. McGee at the Manhattan Institute examines the validity of those claims. Below are the key findings of the paper:

– Previous reports that found higher investment returns for DB plans overestimated those returns by conflating the effects of plan size and plan design (bigger plans tend to earn higher returns than smaller plans). Correcting for this bias considerably reduces the performance gap between DB plans and DC plans. The paper finds that the gap is generally not statistically significant.

– Accounting for plan size also shows negligible differences in money-management fees between DB plans DC plans

– A proper cost comparison between DB plans and DC plans must include the cost of carrying pension debt, which is a significant cost driver for DB plans. For example, carrying a 10 percent pension debt would increase annual cost as a percentage of payroll by about 70 percent, and carrying a 20 percent penson debt would increase the cost by 140 percent.

– Limited annuitization in private DC plans is largely the result of federal regulation. Yet, many private DC plans do offer annuities. Moreover, public DC plans not subject to such regulation can and have provided annuities that are priced similarly to those provided by public DB plans.

To read the full paper, go here.

Paying Down Unfunded Pension Liabilities Through Asset Sales and Leases
By Leonard Gilroy, Reason Foundation

State and local governments across the nation are facing massive unfunded public pension liabilities, with estimates ranging anywhere from $1.1 trillion to $4.7 trillion. Fortunately, there is now a robust discussion about pension reform, especially policies that are designed to make pension systems more financially sustainable and avoid additional unfunded liabilities.

However, there has been relatively little discussion about how to reduce existing unfunded liabilities, mainly because significant reductions in already-promised benefits receive little public support and face major legal and political obstacles. There is thus an urgent need to fund those liabilities in ways that impose the least additional burden on taxpayers.

One promising strategy that policymakers are starting to consider is the sale or lease of government assets-such as land, buildings, infrastructure or enterprises-and the use of proceeds to pay down existing pension debts and thereby put public pension systems on a healthier financial footing. A recent brief by Reason Foundation considers such an approach as a complement to comprehensive pension reform efforts that seek to reduce future unfunded liabilities by shifting away from traditional defined-benefit pension systems.

To download and read the full brief, go here.

Proposed Pension Initiative Threatens the California Rule
By Adam Crepelle, Reason Foundation

California unions have taken issue with a proposed statewide pension reform initiative that would give voters “the power to approve or reject compensation and retirement benefits of government employees.” Public employee unions do not like the initiative and are particularly concerned about its potential to overturn the “California Rule.”

The California Rule is a 1955 California court creation that forbids the reduction of pension benefits for current government employees unless the reduction is accompanied by an offsetting increase in benefits. A consequence of the California Rule is that pension benefits for public employees can never be decreased, even if the costs of the pension benefits are unsustainable. Thus, the California Rule limits pension reform efforts to future employees-those who haven’t been hired yet.

Granting contractual protection to pension benefits a worker has already earned is appropriate. Future pension changes, for work yet to be performed, are different matter. Employees do not have contractual rights to pension benefits they have not earned yet. The United States Supreme Court has held future public employee benefits, as well as any other condition of employment, can be changed. Yet,the state’s courts have given unearned pension benefits untouchable, sacred status.

To read the full article, go here.

Takingon Infrastructure, Pension Challenges in Georgia
By Leonard Gilroy, Reason Foundation

In May 2015, Georgia Gov. Nathan Deal signed into law Senate Bill 59-the Partnership for Public Facilities and Infrastructure Act-which enables the state and local governments to use public-private partnerships (PPPs) for the private financing and development of “social infrastructure,” such as higher education facilities, schools, public health facilities and other public buildings. The passage of SB 59-the culmination of over two years of work to advance the concept by the bill’s sponsor, State Senator Hunter Hill-places Georgia among the early leaders in providing a statewide legal framework for social infrastructure PPPs, alongside pioneers like Virginia, Texas and Florida.

At the same time, Sen. Hill sponsored legislation to transition the state teachers’ pension system from a traditional defined-benefit pension plan to a hybrid defined-benefit/defined-contribution plan that would have lowered financial risks to the state and provided a more equitable retirement system for teachers of all experience levels. Like many pension plans covering public school teachers, the current system punishes younger teachers by backloading retirement benefits, pushing the bulk of benefit accumulation toward the years close to retirement.

Reason Foundation Director of Government Reform Leonard Gilroy recently interviewed Sen. Hill on his social infrastructure PPP legislation, the need to reform the state teachers’ pension system, and more.

To read the full interview, go here.

New Jersey Residents Will Get Fewer Services as Public Pension Costs Skyrocket
By Leonard Gilroy, Reason Foundation

It’s no secret that New Jersey’s government worker pension systems are a looming fiscal disaster. What may not be clear to taxpayers at this point is that unless meaningful reforms are enacted to rein in the problem, spending on pensions will increasingly poach funds from other government services. In effect, spending on government services like K-12 education, policing and higher education will be crowded out by the costs of benefits for a workforce that is no longer working.

The New Jersey Supreme Court recently ruled that the Christie administration’s $1.6 billion cut to the state’s required annual pension contribution for 2015 fiscal year to help balance the budget was legal. While the administration may be breathing a sigh of relief that it won’t have to restore those cuts given the state’s empty coffers, the ruling simply leaves more pension debts to be paid by future taxpayers.

Worse, pension costs are set to skyrocket regardless. The state treasurer estimates that those costs are set to rise to almost $6 billion annually in the coming years. It’s important to understand that the state is in this predicament because its leaders systematically underfunded pensions going back at least a decade, in part because they preferred to spend the money on other state services.

To read the full article, go here.

California Public Employee Pension Funds Prepare for Year of Crappy Returns
By Scott Shackford, via Reason.com

During the big recession, California’s pension funds took a pounding, earning just one percent in returns in 2012, by way of example. That is a bit of a problem when the fund promises 7.5 percent returns over the long run to retirees. The pension fund’s assets, as a whole, lost a quarter of its value during the financial crisis. Since the pensions are guaranteed, though, the plunge required municipalities and school districts to increase their contributions, thus adding even more to local government financial problems.

The funds bounced back big time last year, with the California Public Employee Retirement System’s (CalPERS) returns hitting 18.4 percent. But, the Wall Street Journal notes, the pensions are set to underperform again this year.

To read the full article, go here.

Busting the Myth That Actuarial Assumptions Drive Costs
By Truong Bui, Reason Foundation

In this article, Brian Septon at The Terry Group lucidly explains the flawed logic in “managing” actuarial assumptions to manage pension costs. The article addresses a common misconception that pension plans can reduce or raise costs by adjusting their actuarial assumptions. For example, it is often believed that assuming a higher rate of return reduces costs by lowering contributions, or that using newer mortality tables that reflect improved life expectancy increases costs.

Those beliefs are wrong. Assuming a higher rate of return doesn’t reduce costs if actual returns fall short of the assumption. Newer mortality tables simply recognize the reality that people are living longer and pension costs have already increased. Failing to recognize that reality doesn’t reduce costs. The truth is: “Assumptions don’t drive costs. Reality drives costs.”

While actuarial assumptions don’t change costs, they do affect the cost allocation over time. A higher than warranted assumed rate of return reduces today’s contributions at the expense of future taxpayers.

To read the full article, go here.

Pension Bonds Encourage Underfunding
By Truong Bui, Reason Foundation

Many economists consider Pension Obligation Bonds (POB) as risky gimmicks attempting to gamble on borrowed money. A recent article at ProPublica explains how a deeper problem with POBs lies not in mere investment risks, but in perverse political behavior.

Despite warning about their risks, POBs’ popularity among governments seems to have not waned. According to the article, governments issued $670 million of POBs during the first half of this year, more than double the amount sold for the whole last year. And more is yet to come.

Besides investment profits, new accounting rules may be an important factor driving the current POB boom. The new GASB rules require heavily unfunded plans to use a lower discount rate to value liabilities. This inadvertently encourages poorly funded plans to borrow money to resume using the high discount rate, creating a false impression that the funded status is better than it really is.

Pension bonds themselves are not as much a problem as the ensuing political behavior. Plans that issue POBs tend to subsequently have “pension holidays”, failing to pay the required contributions in full. A review by ProPublica of the 20 largest POB issues since 1996 found that governments in three-fourths of the issues underpaid pension contributions after the bond sales. This is consistent with public choice theory: issuing POBs makes the pension plan look artificially better, allowing politicians with short-term political horizon to shift money to more immediate needs at the expense of future taxpayers.

To read the full article, go here.

Pew Report on State Pension Debt
By Truong Bui, Reason Foundation

State pension plans remain to be significantly underfunded with many plans failing to properly pay annual required contributions (ARC), according to a new brief by Pew. The aggregate unfunded liability for state plans was $968 billion in 2013, and is expected to remain over $900 billion despite recent reforms and favorable investment returns. Only 24 states paid at least 95% of their ARCs in 2013, and states that consistently did so from 2003 to 2013 had pension plans that were 75 percent funded, while those states that didn’t were funded at 68 percent.

Even paying the ARC in full does not necessarily improve a plan’s funded status. Part of the ARC is the debt payment, intended to pay down the unfunded liability. However, many plans adopt rolling amortization policies that lead to perpetual negative amortization (i.e. the debt payment never exceeds the interest cost), so that the unfunded liability is never paid off even if the ARC is paid in full. The brief notes that new GASB accounting standards can help policymakers better evaluate the sufficiency of a plan’s funding policy.

To read the full brief, go here.

Quotable Quotes on Pension Reform

“Your political horizon is relatively short term and these types of obligations are really long term in that you’re not just talking [about paying it off] over decades, but sometimes generations,”
Todd Ely, assistant professor at the University of Colorado at Denver

“Conditions that led to large market returns in the 1980s and 1990s no longer exist. It is not reasonable to look at 30 or 40 years of returns and assume they will continue.”
Matthew Smith, state actuary for Washington

“States discount their liabilities – I think Illinois uses a discount of 7.5 percent [it’s between 7 and 8] – arguing that’s the expected [annual] return on their portfolio. But the expected return on a portfolio is totally irrelevant. What counts is, how risky are the claims that you have to meet? You’ve made a promise to your employees that you’ll pay them a certain fraction of their income that is usually indexed. Which means it’s a risk-free real outcome. What’s the risk-free real rate? Is it anywhere near 7.5 percent? It isn’t. Historically, it’s like 2 percent. A 2 percent discount rate would approximately triple Illinois’s pension liabilities.”
Eugene Fama, Nobel laureate in Economics

“If you’re AAA or AA rated and you’ve got significant and visible unfunded pension obligations, you’ve only got one direction to go in terms of rating, and that’s potentially down.”
Jeff Lipton, head of municipal research in New York at Oppenheimer & Co

“Unions do not like to draw attention to the deficits, for fear benefits will be cut. Politicians do not want to pick a fight with the unions, or increase taxes and annoy voters. Instead, states and cities tend to hope that rising markets will make the problem disappear.”
The Economist

“The recommendations made by pension actuaries, like which mortality table to use, are largely hidden from public view, but each decision ripples across decades and can have an outsize effect.”
Mary Williams Walsh, The New York Times

“The money manager knows to a penny what the fees are. The only explanation is that the pension fund has chosen not to ask the question because, from an accounting and legal perspective, those numbers have to be readily available. They are intentionally not asking because if the fees were publicly disclosed, the public would scream.”
Edward A. H. Siedle, pension fraud investigator and former lawyer at the Securities and Exchange Commission

Pension Reform Handbook

For those interested in the process and mechanics of pension reform, Lance Christensen and Adrian Moore published a comprehensive starter guide for state and local reformers. This handbook aims to capture the experience of policymakers in those jurisdictions that have paved the way for substantive reform, and bring together the best practices that have emerged from their reform efforts, as well as the important lessons learned.

To access the handbook, go here.

Contact the Pension Reform Help Desk

Reason Foundation set up a Pension Reform Help Desk to provide information on Reason’s work on pension reform and resources for those wishing to pursue pension reform in their states, counties, and cities. Feel free to contact the Reason Pension Reform Help Desk by e-mail at pensionhelpdesk@reason.org.

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Follow the discussion on pensions and other governmental reforms at Reason Foundation’s websiteor on Twitter @ReasonReform. As we continually strive to improve the publication, please feel free to send your questions, comments and suggestions to adrian.moore@reason.org.

Adrian Moore
Vice President, Policy
Reason Foundation

Adrian Moore

Adrian Moore, Ph.D., is vice president of policy at Reason Foundation, a non-profit think tank advancing free minds and free markets.