This newsletter from Reason Foundation’s Pension Integrity Project highlights articles, research, opinion, and other information related to public pension challenges and reform efforts across the nation. You can find previous editions here.
In This Issue:
- Michigan Pension Reform Case Study
- How Flexible Is the California Rule?
- Another Tool to Measure Pension Health: Net Amortization
- Positivity on Bad Pension Investment Returns?
- Ranking of State Finances Offers Insight on Public Pension Debt
- Contribution Rate Volatility vs. Long-Term Pension Underfunding
- Could Buffered Index Funds Help Struggling Public Pensions?
- Glossary of Pension Terminology
In 1996, the Michigan State Legislature passed a first-of-its-kind bill that closed the state employees’ defined benefit pension fund to new members and created a defined contribution retirement plan for future hires. A new report by Reason’s Anthony Randazzo finds that the legacy retirement system is more solvent today than if the legislature had not closed the defined benefit plan for new hires, with a full system funded ratio of 88% as of 2015, compared to an estimated 68% funded ratio without reform. However, while closing the defined benefit plan has prevented the state from taking on even more unfunded liabilities than without a change, the report finds that the positive effects of pension reform have been muted by the failure of policymakers to properly manage the defined benefit plan well as it is being closed over time.
» FULL REPORT
California is notorious for having the “California Rule,” a constitutional doctrine that is highly protective—some would say overprotective—of public-employee pensions and that has stymied public-employee pension reform for over half a century. Seeking at least some relief from rising pension costs, the California Legislature passed a statute in 2013 limiting the practice of “pension spiking,” by which government bodies allow public employees to artificially inflate their ending compensation in order to increase those employees’ pensions. This statute was recently upheld in an August 2016 appellate court ruling.
As Emory Law School Associate Professor Alexander Volokh writes in a new reason.org article, if the California Supreme Court upholds this decision, it could ease the state’s pension woes to a certain extent. But the Court of Appeals’ reasoning is questionable and rests on a strained reading of past California cases, according to Volokh. Thus, it wouldn’t be surprising if the Supreme Court eventually reversed this decision.
» FULL ARTICLE
One major reason why public sector pension plans’ unfunded liabilities have grown over the past decade is that actuarially calculated amortization payments are oftentimes less than needed to fully fund benefit payments. For example, a plan with a three-decade long, open amortization schedule is almost certainly making unfunded liability amortization payments that are less than the interest accruing on that same unfunded liability, leading to negative amortization. Highlighting such concerns can often require a detailed examination of a pension plan’s actuarial valuation, and as Reason’s Anil Niraula and Anthony Randazzo point out, a new project by The Pew Charitable Trusts is seeking to make it a bit easier to spot the troubled plans.
» FULL ARTICLE
Most pension plans with fiscal years ending June 30, 2016 have released their fiscal year investment return figures, and most have hovered around zero, with some posting modest returns of a few percentage points, and a few others trending into negative territory. Since pension plans typically have long-term investment return assumptions of between 7% and 8%, these figures mark a second straight bad year and will mean increases in the recognized value of unfunded liabilities for most plans. However, as Reason’s Anthony Randazzo’s recent article indicates, there has been more than once instance of real positivity from plan administrators who have managed to get returns north of 0%. Randazzo writes that just getting positive returns is a meaningless benchmark; what really matters is the number of years they’ve returned above or below their long-term investment return assumptions.
» FULL ARTICLE
A recent Mercatus Center study ranks the 50 states by fiscal condition based on a comprehensive assessment of 14 financial metrics linked to five criteria: cash solvency, budget solvency, long-run solvency, service-level solvency, and trust fund solvency. According to Reason’s Truong Bui, the Mercatus fiscal condition ranking provides a valuable benchmark to evaluate states’ fiscal health, which concerns not only conventional government debts but also often-overlooked pension and OPEB liabilities.
» FULL ARTICLE
In a new blog post, Reason’s Anil Niraula reviews a recent Rockefeller Institute simulation project that found that while common funding policies and practices of public sector retirement systems are effective at reducing year-to-year contribution rate volatility, there is a troublesome flip side to the equation: common funding policies are also increasing the likelihood of severe long-term underfunding.
» FULL BLOG POST
In a new blog post, Reason’s Daniel Takash examines the buffered index fund, essentially an index fund with bounded gains and a cushion to reduce losses that aims to achieve the benefits of equities, which traditionally have higher rates of return, while mitigating risk. But is this buffered index fund a solution for pension funds pursuing higher gains? Takash finds that a buffering strategy underperforms a simple S&P 500 index fund in various time periods, often by a wide margin. Nonetheless, the buffered index could be an excellent way for pension systems with more modest (read: realistic) rates of return to hedge against future risk.
» FULL BLOG POST
Research and discussions about public pension systems often involve technical terms that may be difficult to understand by lay readers, especially voters and even plan members. To assist the dialogue about pension reform, Reason Foundation has recently released a glossary covering frequently mentioned pension terms and phrases.
» FULL GLOSSARY
“[W]hile a public employee does have a ‘vested right’ to a pension, that right is only to a ‘reasonable’ pension—not an immutable entitlement to the most optimal formula of calculating the pension. And the Legislature may, prior to the employee’s retirement, alter the formula, thereby reducing the anticipated pension. So long as the Legislature’s modifications do not deprive the employee of a ‘reasonable’ pension, there is no constitutional violation.”
—State of California Court of Appeal, First Appellate District (San Francisco), Marin Association of Public Employees et al., vs. Marin County Employees’ Retirement Association et al., & the State of California, August 2016
“The [Marin County] ruling, if upheld by the state Supreme Court, punches a very big hole in the California rule, one large enough to accommodate some substantial changes in state and local pension promises to future retirees if politicians or voters are willing to make them. It brings something new to the pension debate and gives new life, or at least new hope, to pension reformers who have repeatedly collided with the California rule.”
—Dan Walters, “California court opens door to changing public employee pensions,” Sacramento Bee, August 22, 2016
“The California system is great at promising pensions, but it is a failure at properly funding those promises. The first domino fell in 1999, when the state legislature granted retroactive pension payments to retirees, and they have continued to fall since with taxpayers left to pick up the pieces. Those falling dominoes have taken CalPERS from a surplus to a pension debt of more than $100 billion in just 17 years. So while ‘100K Club’ may be on everyone’s lips when referring to CalPERS, I think the expression ’17 Years of Failure’ is more synonymous with the organization, and more appropriate.”
—Former San Jose Mayor Chuck Reed, “Isn’t 17 Years of Failure Enough?,” Retirement Security Initiative blog, August 11, 2016
“The cost of political inertia in Sacramento and shortfalls in pension fund investment earnings will be extracted from the budgets of local government. While issues regarding anticipated investment returns and long-term debt obligation can be complex, the cost to taxpayers in taxes, fees and strained municipal finances is not.”
—”New strategies needed for public pensions (editorial),” Marin Independent Journal, August 13, 2016
“American public-sector pension deficits are more than $1 trillion, even on the most generous assumptions. This is an issue in which debate should not be stifled.”
—”No love, actuary,” The Economist, August 13, 2016
“Consistent lowballing of pension costs over the past two decades has made it easy for elected officials and union representatives to agree on very valuable benefits, for very much smaller current pay concessions.”
—Jeremy Gold, quoted in Steven Malanga, “Covering Up the Pension Crisis,” The Wall Street Journal, August 25, 2016
“Pension actuaries estimate the cost, accumulating liabilities and required funding for pension plans based on longevity and numerous other factors that will affect benefit payments owed decades into the future. But today’s actuarial model for calculating what a pension plan owes its current and future pensioners is ignoring the long-term market risk of investments (such as stocks, junk bonds, hedge funds and private equity). Rather, it counts “expected” (hoped for) returns on risky assets before they are earned and before their risk has been borne. Since market risk has a price—one that investors must pay to avoid and are paid to accept—failure to include it means official public pension liabilities and costs are understated.”
—Ed Bartholomew and Jeremy Gold, “The $6 trillion public pension hole that we’re all going to have to pay for,” Marketwatch.com, August 20, 2016
“Oregonians, along with the children they send to school, rightfully expect tax and employer dollars to bear fruit, not burden, and throwing money into an expanding fire is useless. Unless lawmakers prepare to act in the next legislative session, PERS threatens to undermine the capacity of the state to meet its basic obligations. Fewer school teachers, larger class sizes and the diminution of other critical government services loom.
It’s human nature to think that some problems, if ignored long enough, will just go away. The Legislature, following the court’s dial-back on reforms, gave PERS no attention in its 2015 session and ignored it again this year. Yet earnings on PERS investments last year were 2.11 percent, and this year through June just 1.24 percent — well below the unrealistic PERS-set expectation, upon which the system is configured, of 7.5 percent. Problem: The problem’s not going away. It’s getting worse.”
—”Oregon must contain the roaring PERS fire (editorial),” The Oregonian, August 2, 2016
“[C]onditions in public pensions tend to echo those before the savings and loan crisis really began to blossom and boil in the late 1980s. Back then, regulators allowed many effectively-insolvent S&Ls to stay open, with aid of less-than-truthful accounting. This helped unleash a wave of risk taking and other less-honorable behavior to multiply the costs of resolving the S&L crisis. Let’s hope we aren’t facing a similar set of issues in public finance, today.”
—Bill Berman, “Another sign public pension funds may be overleveraged,” Truth in Accounting blog post, August 23, 2016
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Senior Managing Director, Pension Integrity Project
Managing Director, Pension Integrity Project
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Reason Foundation’s Pension Integrity Project has helped policymakers in states like Arizona, Colorado, Michigan, and Montana implement substantive pension reforms. Our monthly newsletter highlights the latest actuarial analysis and policy insights from our team.