Pension Reform Newsletter – March 2016

This newsletter from Reason’s Pension Integrity Project highlights articles, research, opinion, and other information related to public pension problems and reform efforts across the nation. You can find previous editions here.

Articles, Research & Spotlights

• Arizona Enacts Groundbreaking Public Safety Pension Reform
• A Collaborative Process for Pension Reform
• Did Pension Reform Improve the Sustainability of Pension Plans?
• Illinois Supreme Court Strikes Down Pension Law
• Pension solution blooms in the desert
• Governance-Based Solutions to Public-Pension Systems
• Global Pensions Facing a Crisis
• State Pensions Need More Transparency in Reporting Investment Returns
• States Can Learn from Federal Experience in Pension Reform

Quotable Quotes on Pension Reform

Pension Reform Handbook

Contact the Pension Reform Help Desk

Articles, Research & Spotlights

Arizona Enacts Groundbreaking Public Safety Pension Reform
By Leonard Gilroy, Pete Constant, and Anthony Randazzo, Reason Foundation

In February, Arizona policymakers approved comprehensive pension reform legislation that will put the state’s beleaguered public safety pension system on a path to financial solvency, reduce taxpayer exposure to financial risk, reduce long-term costs for employers and employees, and ensure retirement security for employees and retirees.

Arguably more notable than the reform itself is the process used to achieve stakeholder consensus on the reform package, as it avoided the adversarial dynamic of pension reform policy debates that typically pit employers/taxpayers against employees and labor interests. The legislation garnered extensive support from public safety associations and many other stakeholders in the government and business community.

Reason Foundation was a key player from the beginning of the process, with its Pension Integrity Project team providing education, policy options and actuarial analysis for all stakeholders. Reason also facilitated the development of consensus among stakeholders on the conceptual design and framework of the reform.

For more details of the reform, see our full write up here. For a more in-depth analysis of the fiscal components of the PSPRS reform, see our article on how the changes will improve the plan’s solvency.

A Collaborative Process for Pension Reform
By Pete Constant, Anthony Randazzo and Leonard Gilroy, Reason Foundation

At a time when differences of opinion regarding public policies are growing wider and partisanship is increasing rapidly, is there any hope for solving any of the vexing, complex issues of our time? Arizona’s recent experience with the challenging issue of pension reform suggests that there is.

Last month, Arizona Governor Doug Ducey signed comprehensive pension reform legislation for public safety officers into law. This pension reform is notable not only for the positive fiscal impacts for taxpayers and the sustainability it brings to the pension system, but also for the process used to craft the legislation and the widespread, broad bipartisan support it garnered along the way.

Any hope of stakeholder consensus on a reform package depended on overcoming personal preconceived opinions and putting all potential reform scenarios on the negotiation table for discussion, analysis and vetting. The Pension Integrity Team’s proposed general framework for the goals of pension reform helped stakeholders focus on whether a proposed plan change furthered the common goals.

To read more about how different shareholders can be brought together for successful reform, go here.

Did Pension Reform Improve the Sustainability of Pension Plans?
By Anthony Randazzo and Truong Bui, Reason Foundation

A fierce national debate is raging over whether closing public sector defined benefit plans to replace them with defined contribution plans improves the sustainability of retirement systems or creates further problems. We know what has actually transpired in states like Michigan and Alaska since their pension reform projects began, but until now there has been little robust forecasting of alternate scenarios against which to compare actual experience.

In a new policy study, Anthony Randazzo and Truong Bui at Reason Foundation examine what would happen if a state didn’t close its defined benefit plan by applying a new actuarial model to the cases of Michigan’s 1996 reform and Alaska’s 2005 reform.

They find that both states are better off specifically because they closed defined benefit plans compared to if they had made no changes. Unfunded liabilities have increased in both states since their reforms, but for reasons unrelated to the actual reforms: both states had underperforming investment returns, and both states failed to make 100% of their required employer contributions. Had Michigan and Alaska not closed their pension plans, unfunded liabilities would be even higher today than under actual experience. And had the states properly managed their pension reform projects they would be billions better off today.

Read a summary of the policy study here, and download the full study here.

To read a related article confronting the major myths about closing defined benefits plans, go here.

Illinois Supreme Court Strikes Down Pension Law
By Adam Crepelle, Reason Foundation

Last week, the Illinois Supreme Court ruled that Public Act 98-641 of 2014 violated the state constitution’s pension protection clause which states: “Membership in any pension or retirement system of the State, any unit of local government or school district, or any agency or instrumentality thereof, shall be an enforceable contractual relationship, the benefits of which shall not be diminished or impaired.”

The Act tried to do three things. First, it increased employee contribution rates by 0.5 percent per year for five years, capping the contribution rates at 11 percent of the employee’s salary. Second, it curtailed employee annual annuity increases. And, third, it increased the city’s contributions to the pension system. The Act was also supported by 28 of the 31 represented unions.

Though the reform increased the pension fund’s financial stability, the court found that increased financial stability is not an offsetting benefit. According to the court, members gain nothing from the funding boost since they already have a constitutional right to receive their pension benefits under the state’s pension protection clause.

Read the full article here.

Pension solution blooms in the desert
By Leonard Gilroy and Pete Constant, Reason Foundation

New accounting standards are forcing California policymakers to confront the major financial risks inherent in public pension systems. At the same time, a recent overhaul of Arizona’s statewide pension system for public safety workers shows how governments and unions focused on reducing such risk can produce a bipartisan consensus on reform.

The routine releases of annual government financial statements are making big headlines this year because new accounting standards require unfunded pension liabilities to be reported on governmental balance sheets alongside traditional debt, not hidden as they’ve been historically. This simple reporting change added $60.5 billion in pension debt to California’s balance sheet. Orange County’s liabilities jumped 275 percent, or $3.8 billion, over the prior year after factoring in previously obscured pension debt.

The hope is that increased transparency will raise awareness of pension-related risks to taxpayers and inspire efforts to reform debt-ridden, financially unsustainable pension systems. Arizona’s recent experience may offer reason for optimism.

Read the full article here.

Governance-Based Solutions to Public-Pension Systems
By Truong Bui, Reason Foundation

A recent study by James Copland and Steven Malanga at the Manhattan Institute examines the substandard performance of public pensions and explores the role of pension-board governance in creating the outcome.

The study finds that since 2000, public pension-plan funding in aggregate has declined from fully funded to 74 percent funded, with 63 percent of the plans less than 80 percent funded and 20 percent of the plans less than 40 percent funded. The aggregate funded status would drop, however, to 50 percent if a market-based discount rate were used. The unreasonably high rate of return assumptions do not only understate unfunded liabilities but also incentivize plans to take unwarranted investment risks to keep up with the rising implied risk premium. In fact, the percentage of public plans’ assets invested in cash and fixed-income investments has dropped from 47 percent in 1992 to less than 19 percent in 2015.

Part of the problem is the lack of robust governance structures. Most public pension boards adhere to lenient standards of fiduciary duties, lacking in diversity and financial expertise. The majority of public pension boards are dominated by plan beneficiaries and elected officials. The study recommends improving board composition, adopting higher standards of fiduciary duties and other controls.

To read the study, go here.

Global Pensions Facing a Crisis
By Truong Bui, Reason Foundation

Citigroup recently released a new report painting a bleak picture of the global pensions system. The report finds that both public and private pensions are faced with a crisis. According its estimates, the total unfunded liabilities of government pensions in twenty OECD countries are $78 trillion, almost double the $44 trillion official national debt. In other words, the total global government debt may be three times as large as what people think it is. Corporate pensions are also in trouble, with an aggregate funded ratio in the US of only 82%.

The report notes the role of changing demographics, combined with optimistic economic and mortality assumptions in creating the crisis. Due to their long duration nature, pension liabilities’ valuations are highly sensitive to those assumptions. Lower than expected interest rates, higher than anticipated inflation, and longer than expected life expectancy all negatively affect the funded status.

Among the report’s recommendations for dealing with the crisis are more transparency in pension debt disclosure, raising the retirement age, utilizing collective defined contribution plans, and making full required contributions.

Read the report here.

State Pensions Need More Transparency in Reporting Investment Returns
By Truong Bui, Reason Foundation

While investment returns account for 60 percent of pension benefits, and investment fees can greatly affect the long-term costs of providing these benefits, state retirement systems differ widely in policies on disclosure of investment returns and transparency in reporting the costs of managing assets. This is a recent finding by the Pew Charitable Trusts, based on an examination of 73 largest state-sponsored pension funds.

Pew shows that state pension funds have invested in an increasing share of alternative asset classes, such as private equity and hedge funds. These investments tend to carry higher fees due to their higher levels of risk, and those fees, especially carried interest, are treated differently across the plans studied.

The ways state pension plans report their investment returns are also varied. While most of the state plans disclose their returns net of fees, a significant minority of those plans report only gross of fees returns. Some plans report 20-year investment performance and break it down by asset class while many plans do not. The lack of consistency and transparency make it difficult to evaluate those pension funds’ performances.

To read the report’s findings and recommendations in full, go here.

States Can Learn from Federal Experience in Pension Reform
By Truong Bui, Reason Foundation

State’s public policies often act as natural experiments to inform federal actions. In the case of pension reform, the situation is reverse. A recent paper by the Brookings Institution examines the key aspects of the federal pension reform 30 years ago, and analyzes the similarity between the state’s situations now and the federal government’s in the 1980s.

In 1986, Congress created the Federal Employees’ Retirement System (FERS) to replace the old Civil Service Retirement System (CSRS), a defined benefit plan. FERS has three components: Social Security benefits, a smaller defined benefit plan, and the Thrift Savings Plan (TSP), which operates like a 401(k).

The paper shows that the issues faced by the states with underfunding problems today are quite similar to those faced by the federal government back then. Those issues include large unfunded liabilities, political controversy, Social Security coverage, expensive pension costs, and budgetary pressures. The paper identifies four key elements of the federal reform that states can model after:

• Leaving the existing workers in the old defined benefit plan
• Create a new less costly defined benefit plan
• Create a defined contribution plan with generous matching contributions
• Enroll all workers in Social Security.

To read the full paper, go here.

Quotable Quotes on Pension Reform

“Under GASB’s rules, a plan that takes more risk immediately reduces its (measured) liabilities and can contribute less. Under the more market-oriented rules governing U.S. corporate pensions or pensions in Canada, the U.K. or the Netherlands, the discount rate is fixed and taking more risk doesn’t let plan sponsors lower contributions. So those plans don’t have incentives to take excessive investment risk. GASB’s rules, even the supposedly reformed Statements 67 and 68, facilitated what amounts to gambling by public sector pensions by effectively crediting plans with higher investment earnings before any of those earnings have actually taken plan. And we’re not talking small amounts here. Public pension investments today are close to $3.5 trillion, according to Federal Reserve data.”
– Andrew Biggs, resident scholar, American Enterprise Institute

“I’ve been involved in five divestments for our fund. [On] all five of them we’ve lost money, and all five of them have not brought about social change.”
– Christopher Ailman, Chief Investment Officer, California State Teachers Employees Retirement System

“One of the things that is perverse about pension accounting is that the convention is that the liabilities, that is, what the pension fund expects to pay out over time, are discounted at the same rate as the assumed returns. However, for a government pension plan, where taxpayers are on the hook for any shortfalls, the risk of CalPERS beneficiaries getting their money is not the risk measured in terms of what CalPERS projects in terms of future employee contributions, expected returns, and expected payouts; it’s ultimately California state risk, which means the liabilities should be discounted at California’s long term borrowing rate. With California rated S&P AA3, Moody’s Aa-, and 20 year AA muni yields 2.75% and A at 3%, no matter how you look at it, the discount rate on the liability side is indefensibly high.”
– Susan Webber (“Yves Smith”), President, Aurora Advisors Incorporated

“Today’s pension crisis is due to policy decisions made years ago by legislative bodies that created unsustainable systems, lulled by years of a bull market into thinking they could increase benefits based on unrealistic and risky market expectations. But bull markets don’t last forever. When the bottom falls out, taxpayers are left to pick up the shortfall”
– Chuck Reed, former mayor of San Jose; and Dan Liljenquist, former Utah state senator

“We project unfunded pension liabilities on a reported basis will grow by at least 10% in fiscal 2016 under even our most optimistic return scenario”
– Thomas Aaron, analyst, Moody’s Investors Service

“Millions of Americans-including state and local workers, retirees, and taxpayers-have a stake in the financial health of these plans. Ensuring that relevant, useful information is readily available about the assets and obligations of state and local pension plans is in the public’s best interest. And while making more information available is important, it is also important that the purpose of disclosed information be clear to the intended audience.”
– Tom Wildsmith, President, American Academy of Actuaries

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