This Year in Pensions: Five Things We Learned

To say confidence has been fully restored might be overstating things, but thanks to the 18.6% return the State Board of Investment (SBI) reported for 2014 the mood of legislators on the state Pension Commission and of the directors of Minnesota’s public pension plans have noticeably improved. For those keeping score, that’s now four times in the last five years that the SBI’s pension-related investment returns have exceeded 14%.

So with pension plans reporting improved financial health, it’s not surprising that the 2015 legislative session was a relatively quiet one for the Pension Commission. However, some developments are worth noting. And although these developments give the appearance of change, they also serve to illustrate how in the world of pensions, the more things change, the more they stay the same.

1.  Public pension reporting now offers even more potential for confusion (if that’s even possible)

One of the problems which has long plagued pension transparency is the existence of two sets of numbers that both describe pension plans’ financial health. The primary barometers – funded ratios and contribution sufficiency levels – are reported using both the current market value of each pension plan’s assets and the “actuarial value” of assets, in which investment gains and losses are phased in over a five-year period. Although the official valuation studies use actuarial values, plan officials and government representatives have been emphasizing the current market value-based numbers; not surprising since the actuarial reports are currently excluding sizable investment gains.

The difference between these two sets of numbers can be very large – especially in times of significant market volatility like those we have experienced – offering two very different representations of pension health. Table 1 illustrates the discrepancy that currently exists for the three major state funds based on the latest reporting

Now yet another curve ball has been introduced, thanks to reforms the Government Accounting Standards Board has enacted.  Under the new GASB rules, the discount rate a pension plan employs to calculate the present value of its future liabilities for financial reporting purposes may be different than the rate it uses when determining its funding requirements.  So a curious person with a careful eye might notice some material differences between what a pension plan’s valuation study says and what its audited financial reports say – with implications for funded ratios and measures of contribution adequacy – as illustrated in the table below.

Like an actuarial Old Country Buffet, there is now an even bigger selection of options to choose from for information on the status of pension plan health – with greater potential for confusion among stakeholders, reporters, and the public in the process.

2. Accounting standards reforms in Minnesota have done what many predicted: little of consequence

The new GASB accounting standards address only financial reporting, so anyone expecting them to suddenly transform state pension policy was destined for disappointment. However, the aforementioned standard regarding the discount rates used in calculating the present value of a pension plan’s liabilities had real potential for fueling reform discussions. That’s because any change had the capability to radically alter perceptions about public pension fund conditions.

Unsurprisingly this particular standard was the hot button issue and the focal point of the reform debate. It pitted financial economists and analysts against most state and local governments, and their highly influential retirement advocacy and research organizations. The former group urged the use of government bond or bond-like rates to discount pension liabilities – a practice employed by all public sector defined benefit plans outside of the United States as well as private sector defined benefit plans in the United States. State and local government representatives and stakeholders tended to argue for the continued use of expected investment returns to discount liabilities. The prospect of suddenly adding billions upon billions in unfunded liabilities to pension plans’ financial statements across the country with resulting political pressure to “do something” was at stake in this decision.

The standard GASB actually implemented allows pension plans to continue to use their expected rates of return to discount liabilities unless pension assets (including projected contributions and projected investment returns) are scheduled to “run out” before all pension obligations are covered. Any remaining obligations must be discounted a lower bond based rate to calculate the remaining debt.

As a political compromise, the new standard was a stroke of genius. As practical reform, it left a lot to be desired. The Rockefeller Institute of Government stated, “recent accounting rule changes by GASB have not addressed (this issue) properly.” Other critics were far more blunt, noting that aside from simply being inadequate, GASB’s discount rate reform actually turns financial logic completely on its head. As Barton Waring, retired Chief Investment Officer of Barclays Global Investors – and staunch defined benefit plan supporter – stated in his submission to GASB:

“From the point of view of a rational discount rate scheme supported by sound financial principles, this is completely upside down, with the (more or less) risk-free rate applied to the unfunded and therefore most risky portion of the portfolio, and the risky expected return on the asset portfolio applied to the most free-of-risk portion of the portfolio, the portion that is fully funded!

 It’s a bad compromise, completely backwards to what actually happens when financing anything else, anywhere else. And backwards in a manner that continues to hide the biggest portion of the true monetary size of governmental pension deficits.”

For Minnesota’s pension plans, the new standard has had essentially no policy effect. Most every plan passed its “run out” test – assisted by using some of, if not the highest, assumed rates of investment return in the nation (7.9% to 8.5% depending on the plan.) With the exception of a couple smaller plans, therefore, most pension plans in Minnesota will continue to be able to use their assumed investment return rate to discount all of their liabilities. And as noted earlier, the fact that the numbers do look worse on financial statements for those few plans does not impact funding decisions.

3. Assumptions change when it’s deemed affordable to do so

Back in 2009 actuaries for all three major statewide funds recommended reducing the assumed rate of investment return to 8.0%. The resulting implications for funded ratios and annually required contributions (ARC) were a recipe for heartburn given the economic circumstances at the time. As a result, the actuaries’ recommendations lay dormant for years. (Legislative enactment in 2011 of an 8.0% rate for five years followed by a return to 8.5% thereafter gave the appearance of change but had no long term actuarial impact.)

Now fast forward to 2015, when legislators are proposing an omnibus pension bill that would lower the assumed rates of investment return for some, but not all, pension plans. Both MSRS and PERA as well as the pension plan for teachers in St. Paul have now endorsed lowering their assumed rate of return to 8.0%. Even though they remain underfunded, on a market value basis contributions to all of these plans now exceed the ARC, creating more ability to accommodate the recommendations of their actuaries. (MSRS has an added incentive: this move would avoid triggering a 0.5% increase in the annual cost of living adjustments for retirees, thereby keeping more money in the fund.)

Then there is TRA. According to TRA testimony before the Pension Commission, lowering the assumed rate of return from 8.5% to 8.0% may be good timing for others “but not for TRA” as it would add about $1 billion in additional unfunded liabilities. With plan officials anticipating that additional sustainability measures may be forthcoming, it’s clear that making those efforts more challenging on paper at the present time is not in their interest.

4. More responsibility for protecting the public interest in pension policy is now in the hands of pension plan officials

Who should be trusted more to look out for the public interest in pension policy: elected officials or pension plan trustees? It’s an interesting question and the answer is perhaps less intuitive than one might initially think. At first glance, it would appear plan trustees by definition would tend to subordinate the public interest to advancing the private interests of plan members and beneficiaries. Examples of such behavior over the years are not difficult to find. However, pension plan officials must deliver on their fiduciary responsibility, and promoting ultimately self-defeating policies that put benefits at risk over the long-term conflicts with that responsibility. Meanwhile, if pension disasters elsewhere around the country tell us anything it’s that elected officials are too often unwilling to implement the annually required contributions needed to support these plans.

This is the context for a subtle but noteworthy change in pension contribution policy this year. Under the proposed omnibus bill, pension plans’ governing boards will have more authority and flexibility to establish contribution policy. It will relax the current mechanisms that require pension trustees to make virtually automatic rate adjustments when circumstances dictate, giving trustees greater latitude to consider circumstances before recommending contribution changes to the Pension Commission. Importantly, the contribution changes governing boards make remain “opt-out” – legislators will continue to need to override any changes. Plan officials and local government lobbyists support this change on the basis that the current rate adjustment mechanisms do not provide the appropriate flexibility needed to fine tune contribution changes and timing in light of economic and budget realities.

The acid test of this new arrangement, which will indicate whether we can trust pension boards to responsibly serve the public interest, may come sooner rather than later. As part of the rate adjustment mechanism changes, each pension plan’s governing board could reduce contribution rates down to the ARC-plus-1%. As the appearance of contribution sufficiencies materialize under assumed returns of 8.0% or 8.5%, pressures to lower employee and employer contributions will likely mount. It might seem ridiculous to suggest pension plans would inflict financial damage on themselves anytime in the near future through contribution cuts. However, it’s worth noting that one long time pension commission member has gone on record saying full funding of pension plans is not a good idea because it builds pressure to raise benefits, which in turn creates new funding issues.

To properly manage pension risk pension boards should take a chapter from the playbook used by Minnesota Management and Budget with respect to recommending the size of the state budget reserve in accordance with state law. MMB evaluates the adequacy of the budget reserve based on the state’s general fund revenue volatility and recommends a budget reserve that would be needed to accommodate 95% of recessions. What funding level would pension plans need to accommodate 95% of market downturns assuming the volatility and market risk of investment portfolios designed to yield 8.0% or 8.5% returns in perpetuity? We wouldn’t be surprised if such a study concluded plans ought to achieve funded ratios of 120% or more –and, of course, contribution levels would need to remain high to get there.

5. The fiscal illusion persists

The need for such a study is based on the perpetuation of the fiscal illusion surrounding public pension plans. Demonstrating the illusion is best accomplished by considering the accompanying table describing the investment performance and results of the Minnesota State Board of Investment over the last 25 years.

To say the SBI’s performance has been outstanding is an understatement. The simple mean return (excluding compounding effects) over this period is 9.72% – exceeding the historically assumed rate of return by a whopping 122 basis points. (Going back further into history SBI’s annualized return exceeds 10%.) SBI realized double-digit returns in 17 of the past 25 years compared to only four years of actual losses.

And yet, despite this historically amazing performance, on a current market value basis our public pension plans collectively are reporting $11.24 billion in unfunded liabilities. That’s even after discounting the value of future pension liabilities at an 8.5% rate, making them appear as low as any state or local government would attempt to present them. Every stakeholder needs to ask how this is even possible.

The only explanation is a problem in pension governance – practices that have prevented the money from being there to turn those paper returns into actual pension wealth. Two issues are often recognized as contributing factors. First, a sizeable chunk of the problem can be traced to the atrocious benefits policies of years past when “excess” investment returns were given to retirees in the form of base benefit increases. Policymakers fixed that many years ago, but having assets distributed rather than invested created a compounding hangover that persists today. Second, lag times between when contributions are needed and when they are implemented also contribute to the problem.

But another part of the problem is systemic – discounting practices which mask the true costs of pension benefits and result in chronic underfunding. This systemic problem continues to be ignored by lawmakers and plan trustees. Whether through lack of understanding or willful inattention, there is no recognition of the mathematical fact that difference between expected returns and actual returns accumulate and compound over time making actual pension fund wealth to pay benefits more volatile and risky with time, not less as commonly believed. As a result, choosing to invest in riskier asset classes (which we most certainly do) demands being willing to also accept much more volatile contribution levels. Current Minnesota pension policy wants it both ways – the high returns associated with riskier asset classes, but the most modest and stable contribution policy possible. And discounting liabilities at assumed rates of return is the enabling mechanism.

Come to grips with this fiscal illusion, and the accompanying myths surrounding it, and the real world juxtaposition of SBI performance and current pension condition makes sense. A British plan trustee has called the idea that the composition of the assets should determine the size of the liabilities “one of the weirdest emanations of the human mind. It's a metaphor – like saying that the advent of jet planes made the Atlantic narrower – and metaphor has limited place in finance.” To offer another metaphor, building pension sustainability on this premise is a house of sand.