Pension Reform Newsletter – September 2015

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 https://reason.org/newsletters/pension-newsletter/.

Articles, Research & Spotlights

• Best Practices for Setting Public Sector Pension Fund Discount Rates
• Pensions Continue Eating More of Local Budgets
• The Politics of Pension Reform
• Shift to Defined Contribution Plans Has Not Led to Lower Pension Wealth
• Wall Street Fees and Investment Returns
• Pension Reform: Lessons from Four Case Studies
• Are Government Pension Plans Back on Track?
• Review of Financial Health of 50 States

Quotable Quotes on Pension Reform

Pension Reform Handbook

Contact the Pension Reform Help Desk

Articles, Research & Spotlights

Best Practices for Setting Public Sector Pension Fund Discount Rates
By Truong Bui and Anthony Randazzo, Reason Foundation

What are the accrued liabilities of America’s public sector pension systems? This is far from a straightforward, arithmetic matter. Depending on whom you ask, the 50 states have accumulated pension debt of anywhere between $500 billion and $5 trillion. To put it mildly, that is a massive range of opinion about the level of unfunded state pension liability.

The principal cause of this variation between estimates is the discount rate, which is a critical factor for determining how much gets saved today to pay pensions in the future. The higher the discount rate employed, the lower will be the net present value of anticipated pension benefits, which are also known as accrued pension liabilities. The lower the present value of the accrued pension liabilities, the less the government and employees will need to pay into pension coffers today to cover those promised benefits when they come due.

Accurately identifying the present value of pension liabilities is not only important for understanding the current level of unfunded liabilities, but also critical to ensuring that state and local officials make sufficiently large annual contributions to their pension funds. Yet financial economists, actuaries and public officials disagree sharply over how the future benefit payments promised to public workers should be discounted.

A recently released policy brief by Reason Foundation lays out a case for how state and local officials should go about setting their discount rate. It begins with an outline of best practices for setting the discount rate. It then tackles several myths and misnomers about the discount rate that are prevalent in discussions about public sector pension reform nationwide. It concludes with recommendations.

To download and read the full brief, go here.

Pensions Continue Eating More of Local Budgets
By Pete Constant, Reason Foundation

As more and more tax dollars are siphoned off to pay escalating public pension costs, local governments across California are increasingly struggling to provide quality services to their residents. And the problem gets worse with each passing year.

Last month, the California Public Employees’ Retirement System indicated it is raising required contribution rates by more than 9 percent, a move that will cost state and local governments nearly $600 million. This is just the first in a series of rate hikes that CalPERS plans over the next several years in an effort to become fully funded. CalPERS was just 70 percent funded after 2013, but double-digit investment returns helped it rise to 77 percent funded in 2014. But the largest pension system in the U.S. still has a long way to go before it is fully funded and able to actually pay for all of the retirement benefits that have been promised to government workers.

To read the full article, go here.

The Politics of Pension Reform
By Truong Bui, Reason Foundation

Many believe that pension reform mostly concerns technical problems: funded levels, actuarial assumptions, discount rates, investment returns, etc. Daniel DiSalvo, a senior fellow at the Manhattan Institute, in a recent paper explains why it’s not the case. The deepest problem faced by troubled public pensions is political, not technical.

The political incentives surrounding public pensions are what ultimately destabilize those plans. Most voters have little understanding of how public pensions work, while voters who are public employees are better informed and have more interest in expanding pension benefits. Both public-sector unions and financial-management firms favor boosting pensions, and both groups are often more powerful and well established than tax-payer groups. The defined benefit model, which creates a long time lag between pension promises and payouts, encourages politicians to overpromise and underfund pension benefits, pushing substantial costs into the future. In many states, the legal framework heavily restricts reducing prospective benefits. And finally, the public and policymakers have become more comfortable with borrowing from future generations to pay for present expenses. All of these factors constitute a political dynamic that drives public pensions away from fiscal sustainability.

The recent pension crisis triggered by the Great Recession has forced many state and local governments to re-examine and modify their pension plans. However, most of the changes are largely symbolic adjustments rather than genuine, long-term reforms. The key elements that determine the effectiveness of reform include leadership, preexisting fiscal conditions, policy design, political alignments, and legal barriers.

To read the full paper, go here.

Shift to Defined Contribution Plans Has Not Led to Lower Pension Wealth
By Truong Bui, Reason Foundation

One common objection to pension reform that seeks to replace defined benefit (DB) plans with defined contribution (DC) plans is that such a shift will reduce retirement savings and consequently lessen retirement benefits for workers. A recent paper by Alicia Munnell et al. at the Center for Retirement Research at Boston College casts doubt on this claim.

The paper sets out to examine whether the shift to DC plans in the private sector since the early 1980s has led to lower retirement saving and wealth accumulation. To do this, the authors start by looking at the sum of DB benefit accruals and DC contributions as a percentage of private wages over time, using the new data from National Income and Product Accounts. For DB benefit accruals, a constant discount rate of 5.5 percent is used to revalue the accruals, measured by the change in the projected benefit obligation. Total DC contributions are determined by combining participant contributions, employer 401(k) contributions, and employer non-401(k) contributions, with leakages taken into account.

The paper finds that the decline in DB accruals has not been fully offset by the rise in DC contributions, resulting in a slight decrease in overall retirement saving. However, when investment returns are taken into consideration, the annual change in pension wealth has remained stable over time, thanks to higher returns associated with riskier investments for 401(k) plans.

To read the full paper, go here.

Wall Street Fees and Investment Returns
By Truong Bui, Reason Foundation

A recent report by the Maryland Public Policy Institute examines the relationship between Wall Street fees and investment performance for 33 state pension funds over the last five fiscal years. The report finds that pension funds that pay higher fees tend to earn worse investment returns. Specifically, the top 10 states in terms of fees underperform the bottom 10 by 26 basis points in the median annualized five-year return.

This result sheds doubt on the ability of active money managers to achieve superior returns for pension funds. In fact, the report also shows that passive investing by indexing, with considerably lower fees, would have outperformed the median state pension fund by a significant margin. An index portfolio that mimics the asset allocation of the typical state pension fund would have earned a five-year net annualized return of 14.45 percent, which is 1.62 percent higher than the median net return for the 33 state pension funds. Indexing most of those funds’ portfolios would save those state plans about $5 billion a year, equivalent to a reduction in unfunded liability of $70 billion.

Despite the high costs and inferior performance, active management is popular among state pension plans due to irrational optimism and entrenched interests.

To read the full report, go here.

Pension Reform: Lessons from Four Case Studies
By Truong Bui, Reason Foundation

Drawing from the four state case studies (Utah, Rhode Island, New Jersey, and Illinois), Patrick McGuinn at the Brookings Institution provides a number of important lessons and recommendations for policymakers to navigate the challenges of pension reform:

• States should make their complete annual actuarial payment
• Need a credible and visible reform champion
• Gather and disseminate the hard data
• Communicate and educate
• Build a diverse coalition and a statewide advocacy campaign
• Avoid turning pension reform into an ideological issue
• Demonstrate pensions’ impact on taxes and other state spending priorities
• Sell the benefits of pension reform to state workers and school reformers

To read the full article, go here.

Are Government Pension Plans Back on Track?
By Truong Bui, Reason Foundation

The market recovery after the Great Recession has prompted many to claim that most government pension plans are now back in good shape, and that pension reform is largely no longer necessary. Pension expert Andrew Biggs in this paper shows how the recovery is exaggerated and that pension reform is still imperative.

Despite the recent strong investment returns, less than half of government pension plans (41 percent) paid in full their annual required contributions (ARC) in 2013. The worse thing is that the current ARC is already a very low bar to meet, due to the excessively high discount rates and the long amortization periods adopted by US public pension plans. If those plans used a lower discount rate and a shorter amortization period, in line with the rules governing private plans, the total employer ARC as a percent of payroll would quadruple.

The high discount rate, combined with declining yields on low-risk investments, has also encouraged public plans to take increasing investment risk, leading to higher volatility of pension contributions. This means more difficulty for governments in planning budgets and higher chances of contribution shortfalls.

Using a corporate bond yield to discount pension benefits would drop the average funded ratio for public plans from the official 71 percent to 46 percent in 2013, and would more than double the aggregate unfunded liability to $2.6 trillion.

To read the full paper, go here.

Review of Financial Health of 50 States
By Truong Bui, Reason Foundation

Truth in Accounting (TIA) last month released a comprehensive review of the financial reports of 50 states, revealing that states have accumulated unfunded pension and OPEB liabilities of nearly $1.2 trillion. However, only $229 billion of these liabilities are reported on state balance sheets due to outdated accounting standards.

The review also ranks each state by taxpayer burden, the amount each taxpayer would have to pay to rid the state of all debt. According to this standard, the top five states with the highest taxpayer burden are New Jersey, Connecticut, Illinois, Kentucky, and Massachusetts. The top five states with the highest taxpayer “surplus” are Alaska, North Dakota, Wyoming, Utah, and South Dakota,

To read the full review, go here.

Quotable Quotes on Pension Reform

“From the self-interest of many state politicians, the best solution was to trim a little, which offered the symbolism, if not the substance, of reform, and then push as much of the costs into the future. This is what, by and large, has happened.”
– Daniel DiSalvo, Senior Fellow, Manhattan Institute

“The weaknesses in the traditional pension actuarial model must therefore be addressed. The principles of financial economics offer an important tool in addressing some of the weaknesses and developing a more robust actuarial model for the valuation of pension plans. The new model, to survive the next few decades, must shift the focus from calculating expected values to assessing the risk of underfunding, and must strive to be more transparent.”
– Charlene Moriarty, Consulting Actuary, Buck Consultants

“This board session should worry not only CalPERS’ beneficiaries but also California voters, since CalPERS, like virtually all public pension funds, is underfunded, and taxpayers are liable for shortfalls. Thus the concerns we have raised about CalPERS’ program, that private equity has over the last decade persistently not generated enough in the way of performance to justify the risks, that private equity firms charge indefensibly high fees (and worse, CalPERS and other investors are ignorant of the full amount they are paying), and that SEC officials have determined many private equity general partners are stealing from investors, are all hazards to taxpayers’ health.”
– Susan Webber (“Yves Smith”), President, Aurora Advisors Incorporated

“One of the big problems in the accounting of the pension plans is the costs of providing these services have been buried or hidden or [are] hard to find. That’s been one of the main sources of the crisis is that citizens didn’t understand how much their government costs. It costs a lot more than what they’re being told,”
– Bill Bergman, Director of Research, Truth in Accounting

“By choosing an unreasonably high assumed rate of return, trustees both reduce the set-aside and artificially suppress the reported size of pension promises, making the liabilities associated with the pension promises appear smaller than they really are. But eventually that choice cuts the other way. In fact, the more liabilities were artificially suppressed upfront, the greater the rebound effect in the future. That’s in large part why pension costs keep galloping ahead even though the stock market has more than doubled since 2009.”
– David Crane, Lecturer in Public Policy, Stanford University

Pension Reform Handbook

For those interested in the process and mechanics of pension reform, Reason Foundation 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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Adrian Moore
Vice President, Policy
Reason Foundation