Report from the Pension Front: Who is going to pay for billions in unfunded liabilities?

The Legislative Commission on Pensions and Retirement (LCPR or Commission) held two hearings last week. Kudos to Chair Sandy Pappas (DFL-St. Paul) and the Commission for using the quiet of these interim months to tackle big issues like the assumed rate of return and COLAs. The chaos and work load of legislative sessions do not lend themselves to the kind of careful analysis required by pension issues. That said, even the brightest and most diligent legislator would have to put in serious study time to begin to grasp the complexity of Minnesota’s defined benefit systems. That is why they rely so heavily on bureaucrats and union lawyers to guide them.

After several years of observing the pension players and attempting to find the right ingredients for a sustainable defined benefit system, I concluded a while back that it cannot be done. Politicians should not be in charge of anyone’s retirement but their own. And taxpayers should not have to guarantee anyone’s retirement but their own. The combination of political mischief and incompetence inherent in these long term promises are deadly to any recipe for success.

 

Just as importantly, we can set public employees up for financial success and independence with their own defined contribution savings plans. It is not a perfect solution but as I’ve said before, it’s the one we can afford.

Here are the current valuations and ratios (these are from last year—we should get new numbers later this fall): Unfunded liability/funding ratio for all plans: $16.666 billion/74.86%. These numbers may improve because of market gains.

Some plans like MSRS are getting closer to 90% funded which means they can kick in full COLAs again (which will deplete funds for future retirees). Others like the teacher’s TRA and local employees in PERA are still down in the mid-70% range, while police &fire PERA is at 78%. At the bottom are the teachers’ funds from Duluth (63%) and St. Paul (62%) that came to the state for a cash bail out last session and got one at least temporarily while the state figures out how to merge the funds under TRA.

So what happened last week? There were no votes; this time is used for hearings and discussion among the major players and anyone else who takes the time to sign up and get in front of the microphone. In addition to the usual cast of characters (the pension administrators from MSRS, TRA and PERA, the State Board of Investment’s soon to be retired director Howard Bicker, police and fire union lawyer Brian Rice, various union reps), there were lots of new faces in the audience. My guess is that they were public employees or retirees keeping an eye on their retirement.

If true, that is encouraging because it means that there is concern that the Commission might make some new, big changes. Talk about reform (lowering the assumed rate of return, decreasing COLAs, shifting to a hybrid plan) has become quite common so maybe the conversation is reaching the rank and file. Current retirees might be nervous but young employees might be thinking that change could be a good thing.

The pension administrators for the “big three” funds (MSRS, PERA and TRA) were asked by the chair to comment last week. Their contribution was weird. Rather than a hard –nosed discussion about the difficulties faced by their funds, they seemed upbeat about current assumptions. All three spent the bulk of their time praising the Commission members for legislative tweaks passed in 2010 and 2013 and noting market gains. It will be interesting to see what they tee up in 2014. They usually get what they want even if it is not what we need.

Interest rate assumption: Minnesota has adopted an odd version of a “select and ultimate” rate. The upshot is that we are shooting for an investment return of 8% to 8.5% on investments by the State Board of Investment over the next few years. We also use that assumption to calculate how much we should be setting aside to pay future promises.

I have written elsewhere about the fact that Minnesota is an outlier even among public pension funds (which are trending more toward 7.25%—which is still much too high). This means we are an outlier among outliers. That is not good.

I also wrote recently about Moody’s new approach to measuring pension liabilities (Among other changes such as a much shorter amortization period, Moody’s now uses a high-grade long term corporate bond rate of 5.5%-6.0% to assess a municipality’s pension debt. That is a game changer that should move the debate forward.)

The Pension Lullaby. A decrease in the assumed rate of return means serious political pain for our state legislators, governor and Minnesota’s municipalities because it would reveal that the funds are in much worse shape than anyone wants to admit. It would require much bigger contributions to the funds just to maintain current benefit levels let alone make up any lost ground. So it was no surprise that the hearings featured plenty of testimony in support of maintaining the status quo. I call this the “pension lullaby.” There was the usual parade of soothing investment experts and bureaucrats assuring the Commission that the markets and pension funds are recovering. Look! We have a 14% return! So getting a long term 8% -8.5%% return is no problem for Minnesota.

Good returns are welcome news, of course, but focusing just on returns is misleading. Good returns are not enough to back-fill the hole left by massive losses and the fact that Minnesota pays out more in benefits than it takes in via contributions. Minnesota has not paid the “Actuarially Required Contribution” or ARC since 2008. That means the hole is just getting bigger. For example, Minnesota missed the total requirements in 2012 contributions by $432 million.

The “New Normal.” The lullaby was interrupted by sobering testimony from state economist Laura Kalambokidis on the dangers and uncertainties inherent in the “New Normal” economy which features an aging population, slowing labor force growth and persistent federal budget deficits. Echoing advice offered in the past by Economist King Banaian, she warned the Commission that “past performance does not guarantee future results.”

She also testified that a “common view” in finance and among economists suggests that instead of using an expected rate of return, a better way to calculate the present value of pensions is to use a “fair-value method” which discounts future pension liabilities by a market rate that reflects the risk characteristics of the obligations.  In other words, the more certain you are that the pension will be paid, the lower the rate of the risk. This is why private pension funds assume much lower rates of return.

Absent bankruptcy, Minnesota’s defined benefit pensions are guaranteed no matter how much money is in the pension funds, so this would argue for a much lower risk rate than 8% or 8.5%. Elected officials have done the opposite, arguing that the certainty of payment (taxes) is a justification for assuming a higher rate of return. Rep. Phyllis Kahn, who has been on the Commission for years often points out that in theory the government will never go out of business, so don’t worry about it. I wonder how her grandkids will feel when they get the bill.

Same old, same old? So while retirees are perking up to possible changes, there is just as much concern that the Commission might not do anything big to address the massive unfunded liability (again, just under $16.7 billion as of last year, though pension experts including me argue that the real liability is double or triple that number). Why not kick this can a little further? Like so many things today, our elected officials have painted themselves into tight financial corners that require extraordinary bi-partisan leadership to solve.

Testimony from Retirees. Here’s some encouraging news: Two impressive retirees testified about their concerns for the long term health of the funds (and their willingness to share in the pain if it solves the problem). One is a retired sheriff who did not jack up his pension with over-time (an accepted practice in law enforcement especially). He is glad that sheriffs are making better money these days but he thinks they should contribute more to their pensions instead of the taxpayer. After all, he reasons, they get the money not the taxpayer.

The other gentleman is a retired teacher and principal who objects to the break in faith with younger generations of students and taxpayers. He sees the unfunded liability as the responsibility of his generation—not a bill he wants to hand off to his kids and grandkids. He knows it will result in fewer teachers in the classroom as budgets strain to pay retirees more than current teachers.

A retired teacher who is now a union rep testified in support of keeping the assumed rate of return high because lowering the rate would “make the funds look bad.” He did not offer any ideas about how to make up the unfunded liability though he did offer criticism of “pension critics.” That was my cue to testify!

My testimony on the assumed rate of return: I asked the Commission not to focus on annual snap shots of the pension funds’ performance—good or bad—to judge the rate. It swings dramatically (80% of pension funds are in equities and the portfolio has a high risk profile because SBI is shooting for a high rate of return). Instead, I asked them to consider how much money is flowing in and out of the fund– and whether there is enough in the fund to earn the returns needed to pay the promises they have made to employees.

Note: Howard Bicker from SBI testified that there is more going out than coming in—and that he has to sell assets at inopportune times in order to pay pensions.

I went on to note that Minnesota has not paid the Actuarially Required Contribution (ARC) since 2008. This is the amount estimated to cover the cost of pension promises—and even the ARC is probably too low because of the unrealistic assumed rate of return and the fact that retirees are living much longer. So even if SBI exceeds 8.5%, we will never make up that lost ground. This means that the “New Normal” for pension funds is a perpetual unfunded liability.

The state has tried to address these dramatic shortfalls with modest increases in contribution levels and other tweaks to the system (lower COLAs, etc.). These changes, while good, do not address the full liability or the full risk faced by taxpayers. Instead, we are passing the costs on to future employees (in higher contributions and lower benefits), and to our kids and grandkids in the form of unfunded liabilities. How can we justify these generational inequities?

These unfunded liabilities represent a tax on future generations that violate a basic principle of pension funding and our most basic sense of fair play. Quoting from an LCPR memo on the subject, “Over the extended time period that public employee defined benefit retirement plans are financed, the goal is to ensure that the generation of public jurisdiction taxpayers that were served by the public employees appropriately fund the public employees retirement benefits accrued by those employees during that period without shifting costs to a future generation of taxpayers.” (Emphasis added)

The memo also noted that the amount of a defined benefit pension is determined by a formula that has no connection to the actual dollar value of the pension fund.

Post-retirement adjustments or COLAs: I also testified on the issue ofprotecting retirees pensions against inflation. It seems so reasonable to offer this protection, especially if it is funded up front over the career of an employee.

But as with all issues surrounding public pensions it is also reasonable to consider how pensions and other retirement plans function in the private sector. Most pensions do not offer a COLA—and if they do, it is tied to an inflation index. (Minnesota’s pensions are not tied to an index but rather the COLAs are set in statute by the Pension Commission.) Minnesota pensions are also not funded, up front or otherwise.

I also asked the Commission to consider how COLAs hurt the overall health of the funds putting retirees and taxpayers at risk.

I concluded my remarks by noting, with all due and sincere respect, that even if the legislators on the Pension Commission had nothing else to do, that designing and managing the pension funds was beyond the competence of state legislators.

What’s next? The Commission will meet again next week on September 11 and 12. The agenda has not been posted yet but the Commission will continue to focus on these big issues including how to transition away from a defined benefit system.  If you would like to join me at the hearing to testify, sign up with Lisa at the LCPR or drop me an email at [email protected].

We need you to show up now and during the session next year. Please help me interrupt the pension lullaby.

Cross-posted at CAE