"Once More Unto the Breach, Dear Friends"

The political battle to get a signed pension bill has taken on the characteristics of a Shakespearean play.  From the Jan-Feb 2018 edition of Fiscal Focus.

In 2016, despite passing through both the House and Senate with only four “nay” votes, Governor Dayton vetoed the omnibus pension bill.  Under the bill, retirees would have had their cost of living increases reduced.  But school district officials were adamant they simply could not afford their portion of the shared sacrifice – the proposed contribution increases for FY 2017 – and insisted the state cover the cost with increased school aid.  That commitment never materialized in the non-budget year.  So contribution increases were not included for TRA which meant – out of “fairness” of course – contribution increases for any of the state plans had to be tabled for the time being.  Even though everyone acknowledged employer and employee contribution increases would absolutely have to be part of the 2017 omnibus pension bill, retirees were upset at the perceived gross injustice of being a first mover, communicated that to the Governor, and down it went.

In 2017, state aid materialized for school districts (and others) in the Governor’s budget, and, as expected, the omnibus pension bill provided for employer and employee contribution increases.  However, the legislature handcuffed the pension bill to the very controversial local government preemption provisions creating a “take it or leave it” scenario.  Unsurprisingly, the governor decided “taking” the preemption measures would be far more distasteful than “leaving” changes to the state’s pension plans, which brought out the Governor’s veto pen once again.

Now in 2018 pension stakeholders once again are gathering in Minnesota’s Harfleur, otherwise known as Room 1150 of the Senate Office Building, girding themselves for yet another difficult push to get a pension bill enacted into law.

Time is Money:  The Opportunity Costs of Delay

Market performance over the last year combined with the implications of the federal Tax Cuts and Jobs Act (TCJA) loom large over these legislative failures.    On the progressive community’s rogue list of biggest tax reform beneficiaries, one very prominent group never gets mentioned:  public sector employees.    Public pension stakeholders may not have wanted that tax reform, but likely deep down in places not talked about at parties, they admitted they needed that tax reform.  In anticipation of the signing of the TCJA, companies announced over $70 billion in stock buybacks over just 10 days last December.  Since January 1 companies have announced another $88.6 billion in stock buybacks – more than double the amount reported during the same period last year.     Ironically, the fiscal irresponsibility of the federal government is proving to be a salve for the fiscal irresponsibility of state governments.  The TCJA is by far the best thing to have happened to public pensions in a very long time. 

According to the most recent data from the Federal Reserve, public defined benefit pension plans in the U.S. hold $4.16 trillion in assets heavily weighted toward equities and alternative investments like private equity and real estate – the type of investments necessary to try to get 8% per year in a 3.0% 30-year treasury environment.  The asset mix for Minnesota’s defined benefit plans is 80% public equity and alternatives representing $54.6 billion of its investment portfolio.1  A typical blog headline we came across regarding the TCJA read, “Republicans Chose Corporate Shareholders Over Working Families.”  In the Venn diagram of public sector pensions, those circles are one and the same.

It’s important to recognize the opportunity costs these vetoed bills represent.  According to the Legislative Commission on Pensions and Retirement (LCPR), the veto of the haircut in retiree cost of living increases cost $125 million just in FY 18 alone.  There is also the opportunity cost of lost contribution increases which the LCPR pegs at $40 million for FY 2018.  Using fiscal year-to-date S&P returns as a proxy, the lost earnings on that $165 million represents roughly $15-20 million in additional assets in just over 7 months.  Add in the opportunity cost of the 2016 veto in which retained cost of living adjustments over a full year would have benefitted from SBI’s 15.1% return in FY 2017 as well as current year to date returns and that $15-20 million increases substantially.  Then compound all that over a decade at the state’s expected investment return and the phrase “real money” applies.

Strong Markets and Weak Demographics

The latest actuarial valuation reports indicate Minnesota’s public pension plans should have an additional $16 billion under management right now just to pay for retirement benefits that employees have already earned.  That’s based on the current market value of assets and assumes realizing annual investment returns of 8% (or 8.5% in the case of TRA) indefinitely.  The good news is this number actually reflects about $4 billion of progress in reducing unfunded liabilities over the previous year thanks to the SBI’s 15.1% return in FY 17.  And so far FY 18 is looking to be another excellent year with the state’s equity benchmark, the Russell 3000, up 12.5% since July 1 as of this writing.

But even if the bear hibernates indefinitely and markets continue to perform well, pension plans face a major headwind – the cash flow dynamics of these increasingly mature plans.  In the FY 16-17 biennium the cash flow net of investment returns for the state’s pension plans was a negative $4.5 billion.  In other words, $4.5 billion more went out of these funds in the form of benefit payments, refunds and administrative expenses than came in through contributions and state aids.  These net outflows are guaranteed to increase as the baby boomer retirements pick up in earnest and the number of retirees drawing a pension increases sharply relative to any increases in the public employment base.  In Minnesota’s underfunded plans, this capital drain means the assets that remain must work that much harder to make progress on achieving full funding.  

These cash flow dynamics also make the inherent risks associated with our 80% asset allocation in more volatile equity and alternatives markets much greater.  As the accompanying table shows, a quarter century ago these pension plans had 17% more money coming in than going out (again net of investment performance) allowing the state to weather the occasional bad market year without too much trouble.  Today, with twice as much money going out than coming in, our margin for error with respect to experiencing a really bad year or chronically missing expected returns for several years is gone.    

Meaningful Reform Remains in Hibernation

To the considerable credit of the members that sit on the Commission, the frequency of LCPR hearings and the agenda content reflects the seriousness with which legislative members are taking this issue.  Commission agendas have included presentations from a wide variety of public pension practitioners, managers, researchers, and scholars from around the country offering important insights into the current state of affairs and various types of sustainability pursuits.  

But buoyed by very cooperative investment markets, pension plan leaders are feeling no need to deviate from the repair proposals offered last year (and for that matter many years before that).  Even TRA, which has long pushed back on the idea, has enough confidence to sign off on reducing the assumed rate of return to 7.5%  --albeit provided some other assumptions get tweaked like cutting projected wage inflation by over half (!) for the next ten years.  Repair specifics depend on the plan, but elements generally include reducing retirement benefit increases, contribution increases occasionally accompanied by state aid, cost-saving tweaks specifically targeting early retirees and anybody who doesn’t want to spend their entire career in government, and last – but certainly not least –  yet another 30-year reset of the period to pay off existing pension debt.

There is a palpable sense of urgency among all stakeholders as they ready themselves for another assault on the complicated politics surrounding public pensions.  Everyone agrees that something absolutely needs to be done this year.  However that “something” is still rooted in ideas and strategies that expose taxpayers, pension beneficiaries, and future government services to unacceptable risks.

Or as the Bard would say:

Commission members, public employees, retirees, government officials and their agents all,

Stand like greyhounds in the slips,

Straining upon the start. The game's afoot:

Follow your spirit, and upon this charge

Cry “God, please let this market melt-up continue for several more years.’

  • 1 Minnesota State Board of Investment Comprehensive Performance Report, Quarter Ending December 31, 2017