Chair Dooling and members of the committee:

Thank you for the opportunity to offer our analysis of House Bill 226 (HB226).

My name is Steven Gassenberger, and I serve as a senior policy analyst for the Pension Integrity Project at Reason Foundation. Our team conducts quantitative public pension research and offers pro-bono technical assistance to officials and stakeholders aiming to improve pension resiliency and advance retirement security for public servants in a financially responsible way.

We received our first invitation to provide research and feedback to legislative members in 2019 and have closely monitored and commented on the condition of Montana’s largest public pension funds since, including during recent consideration of HJ8 (2021) by SAVA this interim.

HB226 makes two updates to the PERS system:

1. Rearranges the way the state funds PERS-DB benefits.

Every year, PERS-DB actuaries calculate the contribution amount needed to keep the fund on track to achieve full funding within the established debt payment—or amortization—schedule. This figure is commonly called the actuarially determined employer contribution, or ADEC.

Rather than using an ADEC approach to funding retirement benefits, the state’s contribution rate has historically been set in statute, making payments into the fund controlled and predictable but often rigid and unresponsive to year-to-year needs. Only when system administrators find that the current statutory rate results in the system taking more than 30 years to become fully funded, is the statutory rate increase requested and legislatively adjusted. According to a 2020 Legislative Fiscal Division report the “…current funding policies leave the systems heavily reliant on investment earnings and unable to adjust contributions to maintain an actuarially sound basis in times of significant financial declines.”

HB226 commits the state and participating employers to fully funding benefits by a set date, regardless of investment performance or political trends. During an August 2020 hearing of the Legislative Finance Committee, PERS actuaries pointed out that “states are getting away from the old statutory funding method” and that “an actuary’s dream funding policy” is a system that adjusts “to keep up with how the plan is doing.” ADEC funding is a clear way policymakers can protect retirement benefits in bad times while finally tackling an important and expensive debt on behalf of taxpayers.

2. Sets the PERS-DC benefit as the default benefit for new employees.

Upon starting their career in public employment, new hires are offered a choice between the PERS Defined Benefit (PERS-DB) retirement benefit and the PERS Defined Contribution (PERS-DC)

retirement benefit. Currently, if an employee does not make a choice within their first year of employment, they are defaulted into the PERS-DB option. Both DB and DC plans can be adequate retirement options, but the DC plan (with its portability and steady benefit accrual) tends to be more advantageous for workers who do not continue to work with their public employer for multiple decades. Since most new workers fall into that category, it is best practice to make the DC option the default.

According to PERS data, regardless of the benefit chosen, 70% of all newly hired public employees will find other job opportunities outside of public employment within five years. An additional 15% will leave within ten years. Less than 10% of employees hired between the ages of 22 and 32 will stay in public employment for the 30 years required to earn an unreduced PERS-DB retirement benefit. As designed, the current PERS-DB default policy leaves the vast majority of public employees in a nonoptimal retirement plan, subsidizing the benefits for those employees who do stay 30+ years.

What HB226 does not do.

1. HB226 does not change the PERS-DB benefit at all.

When changes to a pension system are suggested, anxiety and fear over the loss of post-employment income increases. However, HB226 does not change the PERS-DB benefit for retirees, current members, or future employees who will choose the PERS-DB benefit option going forward. In fact, the switch to ADEC funding included in HB226 should make those retirees and current members breath a bit easier as the state would now be committing to making whatever payments are necessary to fulfill the pension benefits promised to them.

2. HB226 does not make PERS benefits more expensive.

When a system and its employers move from a statutorily set contribution rate to one determined by actuarial necessity, model projections of future contribution rates are likely to show an increase in contribution rates in the short term, with a gradual decrease over time. Some misinterpret this initial increase as an increase in cost when it is in fact a reflection of the true cost of offering a guaranteed life-time benefit payment. The alternative has been a relative increase in unfunded retirement benefits (i.e. pension debt), which now total over $2.2 billion according to PERS data. The lower statutory rate has not adequately recognized this growing unfunded liability, whereas the proposed ADEC contribution would. HB226 would not only make the employer rate more proactive going forward from a debt reduction perspective, but more transparent in its acknowledgment and mitigation of accrued yet unfunded retirement benefits.

The changes offered in HB226 would address how PERS is only optimal to a fraction of public employees at an ever-rising cost, and turn the system towards best practices in public retirement benefit design. Having retirement benefit options aligned with employee trends, and on a sustainable funding regimen, empowers public employees to choose the best retirement path for themselves and their families with confidence.

Thank you again for the opportunity to speak today, and I would be happy to answer any questions.

Steven Gassenberger
Policy Analyst, Pension Integrity Project at Reason Foundation
steven.gassenberger@reason.org

The post Comments on Montana House Bill 226 (2023) appeared first on Reason Foundation.

Chair Regier and members of the committee:

Thank you for the opportunity to offer our brief perspective on House Bill 228 (HB228).

My name is Steven Gassenberger, and I serve as a policy analyst for the Pension Integrity Project at Reason Foundation. Our team conducts quantitative public pension research and offers pro-bono technical assistance to officials and stakeholders aiming to improve pension resiliency and advance retirement security for public servants in a financially responsible way.

We received our first invitation to provide research and analysis to legislative members in 2019 and have closely monitored and commented on the condition of Montana’s largest public pension funds since, including during recent consideration of HJ8 (2021) by SAVA this interim.

Over the last two decades, public pension systems in Montana and across the country have experienced a clear shift in their investment portfolios away from public assets like blue chip stocks to more private and opaque—and often, higher risk—“alternative” assets like private equity and hedge funds. An asset class comprising less than 6% of the Montana PERS portfolio in 2003 now accounts for nearly 30% of all assets held by the fund, making PERS and other public pension funds some of the largest, most active investors in the world.

Although it is reasonable and prudent at times for pension administrators to expand or contract the fund’s investments in various assets over time, the shift to private assets presents a new risk for policymakers and pension fund stakeholders—politicization of pension fund investments.

Nearly every lawmaker has heard at least one call for the state to invest in, or divest from, one particular company or industry sector based on political concerns of one type or another. Sometimes—like the recent calls by some pension systems to divest from Russian companies in the wake of the Ukraine invasion—geopolitics and other national security concerns may dictate certain shifts in investment strategy. Most investment or divestment calls, however, do not involve national security, but rather narrow political interests of various factions seeking to reward or punish particular industries via the investment policies of taxpayer-backed public trust funds.

Montana has two major pension systems that are underfunded by billions of dollars today, and both face a long-term challenge of hitting unrealistically high investment return assumptions in order to generate sufficient returns to fully fund promised pension benefits. Given such a difficult challenge, placing political constraints on pension fund investments would make the goal of fully funding earned benefits harder for administrators. By providing more explicit guidance and boundary setting to public trust fiduciaries with the intention of preventing politicized investment decisions, HB228 would improve governance and give stakeholders even more confidence in their system for future generations.

Thank you again for the opportunity to speak today, and I would be happy to answer any questions.

Steven Gassenberger
Policy Analyst, Pension Integrity Project at Reason Foundation
steven.gassenberger@reason.org

The post Testimony: Montana House Bill 228 (2023) appeared first on Reason Foundation.

Thank you for the opportunity to offer our brief analysis of Senate Bill 1192 and the need to clarify the fiduciary standards of public trustees. Recent changes to the U.S. Department of Labor’s rules governing fiduciary standards emphasize the need for state leaders here in Michigan to keep the attention of public pension and public trust fiduciaries focused on the needs of retirees and taxpayers. From our perspective, Michigan Senate Bill 1192 is unique in meeting those needs as it draws from the best practices of state and local pension systems throughout the country, including Michigan, in two major ways. 

First, SB 1192 sets objective investment standards and fiduciary guardrails without directing, limiting, or otherwise interfering with public pension trustees’ core mission of maximizing investment returns for active members, retirees, and taxpayers in order to deliver their constitutionally protected retirement benefits while also ensuring reasonable taxpayer costs.  

Public trustees have a duty to weigh the risks associated with each investment opportunity, and SB 1192 supports that duty by reinforcing the pecuniary factors that a public fiduciary must use to guide its decision-making, elevating risk and performance to their rightful position as central factors in the investment decision process. Depoliticizing the investment management of these important public trust funds while also providing trustees the opportunity to take into account quantifiable risk is in the best interest of all direct stakeholders.  

Second, SB 1192 recognizes the fact that public pension fund investing has changed dramatically over the last two decades, often taking on more risk in private and opaque markets in an effort to meet investment return expectations.  

Standardizing and making public board meetings, proxy votes and limited partnerships activity increases transparency in a significant portion of the public trusts and leads to greater confidence in the system’s management by taxpayers and members. While Michigan’s pension boards appear to be generally operating with decent transparency, SB 1192’s reporting process would simply standardize an already common, but not universal, practice.  

Pension benefits are paid from net investment returns, not aspirations. Senate Bill 1192 would help ensure the goals of public pension and trust fiduciaries align with reality and the means by which trustees achieve those goals are consistently monitored so that managers can be held accountable for the effectiveness of investments relative to the overall growth and resiliency of the state’s public pension and other Treasury-managed funds. 

The post Testimony: Michigan Senate Bill 1192 would depoliticize pension investments and protect taxpayers appeared first on Reason Foundation.

With the challenge of inflation likely to continue to be at the forefront of all of the state’s major financial discussions when the Texas legislature reconvenes in January 2023, it is essential to understand how the state government determines the health of its public pension funds and how policymakers can protect public retirees from the degradation effects of inflation. 

How Texas defines “actuarially sound”  

In the Sept. 8 hearing, members of the Texas House Appropriations Committee explored the importance of being “actuarially sound” in response to the numerous calls by lawmakers and retired educators to follow up on 2019’s 13^th check by issuing more inflation relief to provide cost-of-living adjustments to retirees during the next legislative session.

Rep. Carl Sherman (D-Desoto) asked Teachers Retirement System of Texas (TRS) Executive Director Brian Guthrie about the health of the state’s largest public pension plan. In posing his question, Rep. Sherman focused on the term “actuarially sound” specifically. Guthrie noted that Texas currently defines “actuarially sound” as taking less than 31 years to amortize, or fully fund, every pension dollar earned by members of the pension plan. That definition is set in statute and applies to all the state’s major public pension systems.  You can watch Guthrie’s full response on being actuarially sound and the timeline for paying off the state’s unfunded liabilities below. 

What does a cost-of-living adjustment (COLA) for retirees have to do with a technical definition? 

This technical issue is on the minds of retirees because the Teacher Retirement System (TRS) of Texas and the legislature can only issue a cost-of-living adjustment or a 13th check if the pension fund is determined to be “actuarially sound.” As Guthrie noted, this is currently defined as the pension fund’s amortization period not exceeding 31 years.

With this year’s high inflation rates hitting retirees living on fixed incomes the hardest, it is not surprising that retiree groups and their allies are advocating for a cost-of-living adjustment in the next legislative session. But just as was the case in 2019, when the state legislature opted to issue a 13th check to make up for the past decade’s inflation instead of adding liabilities to the fund, giving a permanent cost-of-living benefit increase next session would attach future obligations to the state and taxpayer in perpetuity. These obligations should be fully prepaid to limit their impact on the long-term financial health of the pension system. If state policymakers want to address the issue once and for all, they should look at launching a new TRS tier for new hires that includes a predictable cost-of-living adjustment as a core benefit in retirement.

Did TRS suggest the state’s definition of “actuarially sound” is outdated? 

To be “actuarially sound” is less of a universal definition or number than a collection of policies reflecting short and intermediate timeframes. Policymakers would do well to listen to Teacher Retirement System’s Guthrie and talk to other actuaries and the Texas Pension Review Board about a more contemporary idea of how the state should judge the financial stability of its public pension systems. For example, Guthrie notes that other groups, including the Society of Actuaries, recommend public pension amortization periods be no longer than 15-to-20 years. Setting an amortization period and allowing rates to adjust—the policy the Employees Retirement Plan (ERS) recently adopted—is also more actuarially sound than the current TRS policy of setting rates and allowing amortization periods to adjust. 

Teacher Retirement System actuaries have now built the increased contributions from 2019’s pension reform, Senate Bill 12, into the plan’s funding valuation. The effect was a shorter amortization period calculation, from 87 years to 29 years, if TRS manages to do something it’s never done: meet all of its actuarial predictions, like investment returns and mortality rate, 100% accurately.

After the market turmoil in 2020 and then record-breaking investment returns in 2021, TRS actuaries are now reporting a 26-year calculation, which is about where the system stood in 2013. The impact of the 2022 investment year, likely well below the pension system’s long-term expectations, has yet to be reported. But the low-to-negative investment returns expected are bound to bring that amortization figure closer to, if not beyond, the 31-year mark.  

If retirees and budget managers want predictable inflation relief that protects the value of pension benefits in a financially prudent manner, updating the state’s definition of “actuarially sound” to align with the Society of Actuaries’ recommendations would be a good first step. 

The post Is Texas’ definition of an actuarially sound public pension system outdated?   appeared first on Reason Foundation.

The post Examining the Teachers Retirement System of Texas after the pension reforms of 2019 appeared first on Reason Foundation.

Chair Huffman and members of the committee:

Thank you for the opportunity to offer our brief perspective on the three interim charges before you today as they pertain to the state’s public pensions.

My name is Steven Gassenberger, and I serve as a policy analyst for the Pension Integrity Project at Reason Foundation. Our team conducts quantitative public pension research and offers pro-bono technical assistance to officials and stakeholders aiming to improve pension resiliency and advance retirement security for public servants in a financially responsible way. Our work in Texas includes actuarial modeling and technical analysis related to the state’s most recent and impactful reforms, Senate Bill 12 of 2019 and SB 321 of 2021. These public pension reforms represent critical initial steps toward making the state’s pension systems as strong and effective as possible.

Increasing contributions to the Teacher Retirement System of Texas (TRS) and modernizing the Employees Retirement System of Texas (ERS) benefit have taken two public pension systems that were on a financially unsustainable path and have redirected them toward long-term solvency. However, the interim charges being discussed today show us there is still an opportunity to improve on how the state and taxpayers offer retirement security to public employees. These improvements can be secured without taking on the risks of unfunded liabilities and surprise cost overruns borne by taxpayers.

Between 2000 and 2019, ERS went from having an $867 million surplus to having $14.7 billion in unfunded pension obligations. By 2019, 64% of new hires under 35 were expected to leave public employment within five years, forfeiting their contributions made on their behalf by their ERS employer. Only 14% were expected to reach a full-career, un-reduced retirement benefit. For many years the state contributed a fixed percentage of payroll toward ERS that fell far short of what actuaries calculated was necessary every year to properly fund the plan. Worse, investment markets also shifted away from high-yielding fixed assets over that period, with many public pension systems opting to increasingly rely on less transparent—and generally higher risk—alternative asset investments to achieve expected returns.

In short, Texas was structurally underfunding a retirement plan designed to address a shrinking cohort of public employees’ needs while taking on more investment risk in an unsuccessful effort to stop the problem.

During the 2021 regular session, Senate Bill 321 tackled these problems head-on. It established a debt payoff plan and a date for when all ERS’ unfunded liabilities must be fully funded. It also provided a new, risk-managed retirement option for new hires that will help ensure that state workers of the past, present, and future can rely on a strong and sustainable ERS system. These solutions also minimize taxpayer exposure to severe long-term financial risks.

Unfortunately, many of the elements that plagued ERS at that time continue to plague TRS today. Although additional state contributions and historic market returns have improved the fiscal posture of TRS on paper, outdated assumptions, funding policies, and benefit offerings make it less likely that the increased contribution levels set by SB 12 in 2019 will ever fully fund all earned benefits going forward or meet the needs of modern educators.

Actuaries advising the TRS board recently warned members about a critical element underpinning the future solvency of the system that needs updating: the current 7.25% investment return assumption. By showing how TRS uses one of the highest investment return assumptions among major public systems—the national average has fallen to 7% over the years, with major plans like CalPERS now lowering assumptions into the 6-7% range—plan actuaries offered legislators a hint of what is in store for the retirement system over the next two decades. Investment revenue is expected to underperform in the next decade relative to expectations, which combined with contribution rates being artificially capped through statute creates the conditions for unfunded liabilities to steadily accrue over the next decade—just as it has done over the last two. 

Obviously, lowering investment revenue expectations will mean actuarial cost projections will reveal previously unrecognized costs. Other states have used surplus funds or large investment gains to cover the actuarial cost of using a lower investment return assumption to avoid accruing debt. That method of minimizing risk may be particularly interesting to lawmakers looking for ways to effectively use supplemental surplus revenue without growing government, as well as retirees who depend on the plan being on the path to full funding in order to receive a cost-of-living adjustment (COLA).

Our team will be sharing actuarial modeling throughout the legislative interim that covers both ERS and TRS, highlighting areas of opportunity from a technical perspective. We hope this will help facilitate productive dialogue among stakeholders.

Finally, nearly every lawmaker has heard at least one call for Texas to invest in or divest from one particular asset or another. Sometimes—like the recent calls by some pension systems to divest from Russian companies in the wake of the Ukraine invasion—geopolitics and other national security concerns may dictate certain shifts in investment strategy. Most investment or divestment calls, however, do not involve national security, but rather narrow political interests of various factions.

The impact investment returns have on both the cost and effectiveness of retirement benefits makes placing political constraints on pension fund investments a dangerous proposition. Not only does it make the goal of fully funding earned pension benefits harder for administrators, but it rarely achieves the intended political impact. Instead of preferential treatment for certain industries, an across-the-board update of the rules and expectations set for public pension fiduciaries and enhanced reporting requirements would improve governance and give stakeholders even more confidence in their system for future generations.

The Texas state legislature has been a national leader in updating public retirement design options that empower public employees to choose the best retirement path for themselves and their families. But there is more work to do. We look forward to following up with more technical analysis and exploring these issues in greater detail throughout the interim.

The post Testimony: Teacher Retirement System of Texas can improve funding policies to benefit taxpayers, employees appeared first on Reason Foundation.

The post Evaluating the potential impacts of Louisiana Senate Bill 438 appeared first on Reason Foundation.

• Arizona state government accounts for nearly $473 million (5%) of the current unfunded pension liabilities held by the Public Safety Personnel Retirement System (PSPRS)—including $431 million in pension debt accrued by the Department of Public Safety (DPS).
• Unfunded pension liabilities accrue interest at the same rates as the PSPRS discount rate—currently 7.3% annually—making PSPRS unfunded liabilities among the most expensive taxpayer-backed debt held by the state. For comparison, the Arizona State Retirement System (ASRS) accrues interest at a 7.0% rate annually.
• Major reforms to PSPRS enacted by the legislature since 2016, along with several prudent policy and assumption changes made by the PSPRS Board of Trustees, have dramatically reduced the system’s risk, prompting dozens of employers, like Tucson, Flagstaff, and Prescott, to adopt various new funding tools designed to pay down their PSPRS debt faster, thus avoiding the high costs of pension debt accrual.

Paying Down Pension Debt Faster Is Prudent

• The proposed supplemental, one-time appropriation would pay down unfunded liabilities for state agency employers participating in PSPRS.
• Paying down debt associated with promised, constitutionally protected pension benefits faster is a time-tested way to save taxpayers money by avoiding interest costs.
• Actuarial modeling by the Pension Integrity Project at Reason Foundation finds that Gov. Doug Ducey’s proposed supplemental $611.3 million infusion into PSPRS would:
  • Yield between $137 million and $322 million in taxpayer savings over the next 30 years, depending on investment performance.
• A $1 billion infusion into PSPRS similar to that outlined in Senate Bill 1087 would:
  • Yield between $240 million and $564 million in taxpayer savings over the next 30 years, depending on investment performance.

Takeaway: The proposed “catch-up” payments for PSPRS’ unfunded liabilities would benefit taxpayers by reducing pension debt and producing long-term cost savings.

Paying Down PSPRS Debt Faster Is a Win for Taxpayers

The post Paying down PSPRS debt faster is a win for taxpayers appeared first on Reason Foundation.

The most notable measures being considered align closely with three national public retirement plan trends dealing with the current rise in the cost of goods, states’ difficulty retaining public workers, and the politicization of public pension fund investments. Here’s the Pension Integrity Project’s overview of these trends and the public retirement-related legislation currently being considered in Louisiana.  

Cost-of-Living Increases

The United States is experiencing the highest rate of inflation in 40 years, making everything more expensive, and several state bills under consideration in Baton Rouge grapple with how inflation impacts public pensions and retirees. Without Social Security, many retired from Louisiana’s public workforce have only their fixed public pension benefit through their golden years, leading retirees to be especially vulnerable to inflation. To address this issue, Louisiana public retirees depend on a complicated set of rules tying market returns to their pension systems’ ability to grant a cost-of-living adjustment (COLA). The result over the last decade has been “confusion surrounding when a COLA is likely to be granted as well as how much the ultimate cost to employers will be,” according to state actuaries. 

In an effort to address retirees’ inflation concerns, State Sen. Edward Price, chairman of the Louisiana Senate Retirement Committee, introduced a suite of bills granting retirees of the three largest state-sponsored retirement systems a supplemental retirement benefit. For public employees, House Bill 5 would issue a supplemental benefit in the form of a one-time bonus—commonly referred to as a 13^th check—that does not increase the base pension benefit for retirees in any future year. 

The additional pension check is expected to cost the state approximately $85 million for retirees in the Louisiana State Employees’ Retirement System (LASERS). This cost is expected to be limited to the one-time check being issued and would not carry over to subsequent years. 

The 13^th check concept is not unique to Louisiana. In 2021, Texas lawmakers issued a 13^th check to retired teachers, who hadn’t seen a cost-of-living adjustment for over a decade at the time. The mechanism for adjusting benefits to accommodate inflation built into the Texas system failed to trigger a payment. This was due to decades of inadequate funding into the pension system, stemming from a combination of outdated funding policies and underperforming investments. Texas lawmakers decided to issue a supplemental, one-time benefit payment from the state’s budget surplus to retirees. This differs from Louisiana’s proposal for an additional check, which would be funded with part of LASERS’ investment gains. 

If lawmakers feel a 13^th check is needed, the Texas approach would be better for Louisianans because it ensures the cost associated with this bonus is limited to one-time appropriations. In contrast, the cost of the proposed LASERS 13^th check would extend beyond the initially reported price because the pension system would be paying for the bonus check by reducing its assets that should be generating investment returns over time.

Louisiana’s House Bill 6 and House Bill 7 would permanently increase public pension benefits, with state taxpayers as underwriters. Expected to initially cost the Teachers’ Retirement System of Louisiana (TRSL) $369 million and the Louisiana State Police Retirement System (LSPRS) $9.5 million, both TRSL and LSPRS permanent benefit increases bump retiree benefits indefinitely. This means the accuracy of each plans’ assumptions would dictate the ongoing costs of the benefit increase. If investment returns for either pension plan perform below expectations, the difference would either increase the systems’ unfunded liabilities or employer costs. 

These bills use funds from each systems’ respective experience account to issue the one-time payment. Louisiana’s public pension experience accounts—created in 1992—use returns on pension investments above a set threshold to fund cost-of-living adjustments. The problem with this policy is that actuaries and plan administrators depend on good investment years to make up for any funding ground lost in the years that investments don’t meet expectations. Each plan’s experience account skims and redirects investment returns from each fund to pay for permanent benefit increases and this way of funding cost-of-living adjustments, Louisiana’s legislative auditor warns, empties each pension system’s experience account resulting “in an increase in expected future employer contributions.” 

State Rep. Tony Bacala introduced a cost of living measure relating to the Municipal Police Employees’ Retirement System (MPERS). But instead of issuing an immediate, one-time 13^th check or a permanent benefit increase, the measure would create a deposit account to hold employer contributions in anticipation of issuing a COLA. The measure differs from the LASER 13^th check and other bills that include permanent benefit increases in that the bill funds COLAs by prefunding a separate account through employer contributions rather than excess investment returns. 

Labor Market Challenges

A second major trend impacting the 2022 regular session is the growing challenge of retaining teachers, first responders, and other public workers amid a dramatic post-COVID-19 rise in retirements. Like many of their private sector counterparts, public employers are struggling to recruit and retain effective workforces in the wake of the pandemic’s economic impacts and a highly competitive labor market. Although there is scant evidence to support claims that retirement benefits a playing any factor whatsoever in worker retention decisions, especially for workers early in their professional careers, policymakers often try to influence employee decisions via retirement benefit policy because they may view it as the easiest carrot, in part due to the deferred cost of retirement benefits.

One example of the clearest examples of using retirement benefits as a carrot this session is State Sen. Jay Morris’ idea to give members of the TRSL Optional Retirement Plan (ORP), who previously made an irrevocable election to join the ORP, the right to revoke that irrevocable election and become participants in the TRSL defined benefit plan. Although ORP members would be responsible for the initial cost of TRSL credits, state actuaries warn that “comparatively generous assumptions” will undercalculate the final cost of each transfer.  

Claims that the bill is cost neutral with respect to changes in TRSL’s unfunded accrued liability were also debunked by state actuaries. In the actual note, actuaries said the passage of Senate Bill 10 “results in an ORP member being able to purchase guaranteed benefits (e.g. a retirement annuity, disability, and death benefits, all guaranteed by TRSL and backed by the State of Louisiana) at a price that is significantly less than the cost of similar benefits on the open market.” 

Similar bills have popped up around the country using similar arguments. For example, the Alaska State House recently passed a measure allowing  transferees to move from their defined contribution plan to a defined benefit plan. The unknown cost and minimal actuarial scrutiny given to the Alaska measure, including the lack of long-term forecasting and stress testing, mirrors the level of review given to SB 10 to date. If market outcomes diverge from TRSL assumptions, the funds transferred will end up being inadequate to provide the promised pension benefits and responsibility for the shortfall will once again fall to taxpayers.

State Sen. Price and State Rep. Bacala introduced a major overhaul to LASERS addressing the fact that only 2.5% of new hires joining LASERS at age 35 will receive full, unreduced retirement benefits. Over two-thirds of LASERS members will leave public employment with only their contributions refunded, leaving more and more Louisianans without Social Security and very little savings for retirement. The new LASERS-specific plan intends to provide non-career members a better means to build their own retirement nest eggs by offering a traditional predefined retirement benefit combined with contributions toward individual retirement accounts. However, as proposed, the measure offers lower individual retirement account contributions than other similar hybrid systems in favor of higher than standard predefined benefits. For the vast majority of LASERS members, the hybrid approach would be an improvement over the current retirement benefit, but the reform falls short in other critical areas. Unfortunately, the hybrid structure being proposed in this legislation not only lacks the technical reforms needed to address the LASERS benefit gap, but it also leaves the state with as much risk going forward, if not more. 

Beyond those two major issues, State Rep. Bacala also introduced a measure that would allow retired members of the Municipal Police Employees’ Retirement System to essentially come out of retirement and accrue additional pension benefits while they are already collecting pension benefits. State Rep. John Illg introduced a similar measure covering the District Attorneys’ Retirement System (DARS) retirees, while a proposal from State Reps. Larry Frieman and Rick Edmonds want to allow teachers to return to work without a suspension or reduction of their retirement benefits.

On a similar note, a number of legislators are attempting to increase the compensation for retirees returning to public employment. State Rep. Lance Harris wants to repeal a required benefit suspension for retirees who are reemployed in certain positions in MPERS, while State Rep. Troy Romero wants to increase the amount a retired teacher may earn while reemployed without a reduction of retirement benefits. State Rep. Phillip DeVillier wants to take a more direct approach and open the LASERS Hazardous Duty Service Plan to certain employees of the state fire marshal’s office not eligible for benefits. 

Pension Fund Investment Activism 

The third trend in pension legislation identified by the Pension Integrity Project at Reason Foundation in the 2022 regular session deals with activism in public pension fund investing. Nearly every state lawmaker has heard at least one call for their respective state to divest from Russian assets in the past weeks. Both the American Federation of Teachers and the American Federation of State, County and Municipal Employees (AFSCME) are urging their pension trustee members to immediately review public pension systems’ investments with ties to Russia following the country’s invasion of Ukraine. 

Calls for activism through public pension fund investments are not new. Even Louisiana Attorney General Jeff Landry recently sent a letter to Louisiana State Treasurer John Schroder asking him to follow the lead of West Virginia State Treasurer Riley Moore, who announced his state would no longer invest with BlackRock, Inc., which has been under fire from Republicans since its CEO talked of “decarbonizing the global economy”

“Divesting from entire sectors – or simply passing carbon-intensive assets from public markets to private markets – will not get the world to net zero. And BlackRock does not pursue divestment from oil and gas companies as a policy. We do have some clients who choose to divest their assets while other clients reject that approach. Foresighted companies across a wide range of carbon-intensive sectors are transforming their businesses, and their actions are a critical part of decarbonization. We believe the companies leading the transition present a vital investment opportunity for our clients and driving capital towards these phoenixes will be essential to achieving a net-zero world.” Blackrock CEO Larry Fink wrote:

“Based on nothing more than a political calculation, many of these calls for divestment run afoul of fiduciary obligations and veer from the primary purpose of public pension systems. These divestment calls would leverage retirement benefits to achieve political goals. As honorable as it is to want assurances that public dollars are not being used to support authoritarian regimes, the complicated global investment strategies propping up these public pension systems make achieving those goals through legislation detrimental to the financial health of these important systems.”

Other Retirement Bills Worth Mentioning

Outside of the national public pension trends that have already made their way to the Louisiana legislature, a few other of the state’s standalone measures related to pensions are worth exploring briefly. 

State Reps. Richard Nelson and Phillip Tarver both offered constitutional amendments requiring a minimum of 50% of all nonrecurring state revenues to be applied to the debt being serviced by Louisiana’s public pension systems. The process by which the infusion is deposited and the impact those transfers would have on the state’s financial health is unclear, but any supplemental appropriation to underfunded pension systems protects retiree benefits and saves taxpayers from costly interest payments on unfunded liabilities. 

Louisiana State House Appropriations Committee Chairman Jerome Zeringue also introduced a supplemental funding measure that would appropriate more than $69 million in additional state general funds from nonrecurring revenue. 

Although previous experience would dictate that many of these measures now under consideration by lawmakers in Baton Rouge are not likely to make it through this session, each touches the financial security of thousands of Louisianians—public workers in the retirement systems and the taxpayers funding them. Like almost everything being considered this session, these bills come with costs and trade-offs that put millions of taxpayer dollars on the line.

The post Louisiana legislature considers several bills that would change public pensions and impact taxpayers appeared first on Reason Foundation.

Several states facing major pension challenges have successfully transitioned to lower-risk retirement designs, including Oklahoma. House Bill 2486 attempts to undo that progress by eliminating the current Pathfinder defined contribution retirement plan and reopening the legacy pension plan, re-exposing the state to unnecessary unfunded liabilities, financial risks, and costs that would ultimately be borne by taxpayers.

Closing one of the best defined contribution plans in the country to reopen the shuttered Oklahoma Public Employees Retirement System (OPERS) defined benefit pension plan would unwind important reforms and threatens the financial condition of legacy benefits.

• Closing the OPERS defined benefit pension to new hires and adopting other prudent policy changes dramatically improved the financial solvency of the legacy OPERS pension in the last decade. OPERS was 66% funded in 2010, in the wake of the Great Recession, but stands at over 99% funded today.
• HB 2486 would move the state away from its current risk-free retirement design—where employers bear no financial liability for new hires—back to a system exposed to the same risk of unfunded liabilities that prompted the closing of that pension almost a decade ago.

Transferring defined contribution account balances to OPERS at the current discount rate would create major immediate risks.

• HB 2486 would allow current Pathfinder DC plan participants to transfer their account balances over to OPERS to fund an actuarially equivalent pension benefit, but their previously earned service would be transferred using a relatively high discount rate of 6.5%.
• Such transfers would create the risk of a pension-obligation-bond-like situation where any downturn in market performance or lowering of return rate assumptions would quickly create unfunded liabilities in the newly reopened—and currently fully-funded—OPERS system.

HB 2486 has not received a rigorous actuarial analysis or stress testing, nor has it received scrutiny from legislative finance committees, leaving important questions for taxpayers unanswered.

• Pension systems operate over generations, but legislators have only been presented with minimal administrative cost projections based on an assumption that the proposed new pension benefit would do the impossible: get 100% of its assumptions 100% right, 100% of the time.
• Major retirement plan design changes necessitate long-term actuarial analysis and stress testing to ensure financial risks to governments are transparent and clearly understood beforehand.

Bottom Line: Changes of the magnitude being proposed should receive rigorous actuarial and risk analyses that ensure future generations’ interests are protected.

The post House Bill 2486 threatens Oklahoma’s pension progress  appeared first on Reason Foundation.

Thank you for the opportunity to share our project’s perspective on Senate Bill 10 (SB10) and the proposal for allowing Optional Retirement Plan (ORP) participants to transfer their accrued liabilities to the Teachers’ Retirement System of Louisiana (TRSL).

My name is Steven Gassenberger, and I serve as a policy analyst for the Pension Integrity Project at Reason Foundation. Our team conducts quantitative public pension research and offers pro-bono technical assistance to officials and stakeholders aiming to improve pension resiliency and advance retirement security for public servants in a financially responsible way. 

Allowing ORP participants in higher education to revoke an irrevocable election they made upon entering the system, and transfer retirement liabilities to TRSL, contradicts the principles of sound pension funding and is likely to add to the system’s $9.3 billion in debt. 

The Legislative Auditor’s actuarial note makes clear SB10 is “likely not cost-neutral because the actuarial cost for the purchase is based on TRSL’s ‘comparatively generous assumptions’ and the “lack of individual underwriting that an insurance company would undertake.” 

The reason the proposed transfer of ORP funds creates a real risk of near-term TRSL unfunded liability increases lies in the system’s 7.25% assumed rate of investment return. Considering most state pension plans across the country are lowering their growth rate expectations down to, or below, 7%, any future investment underperformance—which capital market forecasts suggest is likely in the decade ahead—and/or adjustments to TRSL’s investment return assumptions will automatically create additional unfunded liabilities. 

Although the state auditor points out that this proposed change will cost more for state taxpayers, there is still no formal actuarial analysis, stress testing, or concrete reporting on exactly how much this added cost will be. Without a detailed analysis of the costs and financial risks that the state could incur under various investment outcomes, it is impossible to properly evaluate the merits of this proposed policy. 

Transferring ORP assets may not be a good deal for employees either. From the transferee’s perspective, ORP vendors may have investments with liquidity restrictions limiting the ability to comply with the 100% transfer requirement within the transfer window period. Other investments may also have early withdrawal reductions that affect the amount eligible for transfer. Even the timing of market conditions could lead to employees withdrawing their ORP at a low value.

SB10 is likely to shortchange members, increase the state’s pension debt, and weaken a TRSL system already burdened with $9.3 billion in unfunded but constitutionally protected retirement benefits.

We commend legislators, members, and stakeholders willing to examine these important issues and thank you again for the opportunity to share our perspective.

The post Testimony: Louisiana Senate Bill 10 is likely to increase pension debt and weaken retirement system appeared first on Reason Foundation.

Download Backgrounder: Senate Bill 10 Undermines TRSL Pension System

The post Senate Bill 10 undermines the Teacher Retirement System of Louisiana appeared first on Reason Foundation.

Thank you for the opportunity to share our project’s perspective on Senate Bill 7 (SB7) and issuing a permanent benefit increase to retirees and beneficiaries of the Louisiana State Police Retirement System (LSPRS).

My name is Steven Gassenberger, and I serve as a policy analyst for the Pension Integrity Project at Reason Foundation. Our team conducts quantitative public pension research and offers pro-bono technical assistance to officials and stakeholders aiming to improve pension resiliency and advance retirement security for public servants in a financially responsible way. 

While offering retirees some sort of inflation protection is commendable, especially when such a large part of the community relies solely on their fixed retirement income, the funding mechanism that SB7 would rely on is structurally flawed, financially questionable, and a national outlier in terms of providing inflation protection in a pension system.

The state currently relies on an experience account funding mechanism that skims what are deemed “excess” returns from the core pension fund. Those funds are then deposited into the system’s experience account to pay for permanent increases to members’ benefit or potentially one-time, so-called “13th check” bonuses. This is nothing like the typical inflation-based cost-of-living adjustments (COLAs) commonly used by U.S. public pension systems. The current process is also similar to a mechanism abandoned in recent years by the retirement systems for Arizona’s public safety employees, judges, and elected officials that was replaced with a simple, prefunded compounding COLA tied to real inflation trends.  This change was due to the resulting debt owed by taxpayers and ongoing financial risks posed by the skimming of investment returns. 

Skimming excess returns drastically alters the way a plan funds its benefits. Returns above the plans’ assumed rate of return are needed to offset years in which returns come in below what was assumed. The state structurally redirecting much-needed investment gains away from its underfunded pension systems—only to fund permanent benefit increases that increase liabilities—prevents plans from enjoying the full benefit of investment gains and weakens fund performance.

According to the state legislative auditor, this method of funding long-term pension obligations also “accelerates the patterns of future transfers expected to go into and out of the Experience Account, which results in an increase in expected future contributions to the plan.” 

Using experience account funds at this time triggers statutory rules that will lead to future transfers from the core pension fund into the experience account, and the timing could not be worse. Even after a historic bull market and 2021 returns, TRSL remains only 71% funded with $9.3 billion in debt. Given the expected market volatility ahead, reactivating experience account transfers out of the core pension would be counterproductive to furthering the system’s financial progress. The rules used to trigger the release of permanent benefit increases do not correspond at all to actual inflation in the economy, so the nature of the benefit itself is not particularly predictable or reliable for the recipients. 

As you consider this legislation, we believe it is important to keep in mind that the reason you are having this conversation at all is because the state’s current method of granting benefit increases does not work well for the state, public employees, or taxpayers.

We commend legislators, members, and stakeholders willing to examine these important issues and thank you again for the opportunity to share our perspective.

The post Testimony: Senate Bill 7 could weaken Louisiana State Police Retirement System appeared first on Reason Foundation.

Thank you for the opportunity to share our project’s perspective on Senate Bill 6 (SB6) and issuing a permanent benefit increase to retirees and beneficiaries of the Teachers’ Retirement System of Louisiana (TRSL).

My name is Steven Gassenberger, and I serve as a policy analyst for the Pension Integrity Project at Reason Foundation. Our team conducts quantitative public pension research and offers pro-bono technical assistance to officials and stakeholders aiming to improve pension resiliency and advance retirement security for public servants in a financially responsible way. 

While offering retirees some sort of inflation protection is commendable, especially when such a large part of the community relies solely on their fixed retirement income, the funding mechanism that SB6 would rely on is structurally flawed, financially questionable, and a national outlier in terms of providing inflation protection in a pension system. 

The state currently relies on an experience account funding mechanism that skims what are deemed “excess” returns from the core pension fund. Those funds are then deposited into the system’s experience account to pay for permanent increases to members’ benefit or a potentially one-time, so-called “13th check” bonuses. This is nothing like the typical inflation-based cost-of-living adjustments (COLAs) commonly used by U.S. public pension systems. The current process is also similar to a mechanism abandoned in recent years by the retirement systems used by Arizona’s public safety employees, judges, and elected officials that was replaced with a simple, prefunded compounding COLA tied to real inflation trends. This change was due to the resulting unfunded liabilities and ongoing financial risks posed by the skimming of investment returns. 

Skimming excess returns drastically alters the way a plan funds its benefits. Returns above the plans’ assumed rate of return are needed to offset years in which returns come in below what was assumed. The state structurally redirecting much-needed investment gains away from its underfunded pension systems—only to fund permanent benefit increases that increase liabilities—prevents plans from enjoying the full benefit of investment gains and weakens fund performance.

According to the state legislative auditor, this method of funding long-term pension obligations also “accelerates the patterns of future transfers expected to go into and out of the Experience Account, which results in an increase in expected future contributions to the plan.” 

Using experience account funds at this time triggers statutory rules that will lead to future transfers from the core pension fund into the experience account, and the timing could not be worse. Even after a historic bull market and 2021 returns, TRSL remains only 71% funded with $9.3 billion in debt. Given the expected market volatility ahead, reactivating experience account transfers out of the core pension would be counterproductive to furthering the system’s financial progress. The rules used to trigger the release of permanent benefit increases do not correspond to actual inflation in the economy, so the nature of the benefit itself is not particularly predictable or reliable for the recipients. 

As you consider this legislation, we believe it is important to keep in mind that the reason you are having this conversation at all is because the state’s current method of granting benefit increases does not work well for the state, public employees, or taxpayers.

We commend legislators, members, and stakeholders willing to examine these important issues and thank you again for the opportunity to share our perspective.

The post Testimony: Louisiana Senate Bill 6 relies on a structurally flawed funding mechanism appeared first on Reason Foundation.

Thank you for the opportunity to share our project’s perspective on Senate Bill 5 (SB5) and the potential one-time, lump-sum payment to retirees and beneficiaries of the Louisiana State Employees’ Retirement System (LASERS).

My name is Steven Gassenberger, and I serve as a policy analyst for the Pension Integrity Project at Reason Foundation. Our team conducts quantitative public pension research and offers pro-bono technical assistance to officials and stakeholders aiming to improve pension resiliency and advance retirement security for public servants in a financially responsible way. 

Unlike some of the other bills under consideration, SB5 providing a one-time bonus to beneficiaries is not expected to permanently increase future benefit payments. Offering retirees a bonus to protect the value of their earned benefit in a way that also protects the financial health of the LASERS system is a win-win for all stakeholders. However, the funding mechanism used to pay for the bonus leverages the entire balance of the system’s experience account, which is likely to undermine the claim that SB5 is a one-time cost.

The state currently relies on an experience account funding mechanism that skims what are deemed “excess” returns from the core pension fund. Those funds are then deposited into the system’s experience account to pay for permanent increases to the base benefit or potentially one-time, so-called “13th check” bonuses. This is nothing like the typical inflation-based cost-of-living adjustments (COLAs) commonly used by U.S. public pension systems. The current process is also similar to a mechanism abandoned in recent years by the retirement systems for Arizona’s public safety employees, judges, and elected officials retirement systems that was replaced with a simple, prefunded compounding COLA tied to real inflation trends. This change was due to the resulting unfunded liabilities and ongoing financial risks posed by the skimming of investment returns. 

Skimming excess returns drastically alters the way a plan funds its benefits. Returns above the plans assumed rate of return are needed to offset years in which returns come in below what was assumed. The state structurally redirecting much-needed investment gains away from its underfunded pension systems—only to fund permanent benefit increases that increase liabilities—prevents plans from enjoying the full benefit of investment gains and weakens fund performance.

According to the state legislative auditor, this method of funding long-term pension obligations  “accelerates the patterns of future transfers expected to go into and out of the Experience Account, which results in an increase in expected future contributions to the plan.”

Using experience account funds at this time triggers statutory rules that will lead to future transfers from the core pension fund into the experience account, and the timing could not be worse. Even after a historic bull market and 2021 returns, TRSL remains only 71% funded with $9.3 billion in debt. Given the expected market volatility ahead, reactivating experience account transfers out of the core pension would be counterproductive to furthering the system’s financial progress. The rules used to trigger the release of permanent benefit increases do not correspond to actual inflation in the economy, so the nature of the benefit itself is not particularly predictable or reliable for the recipients. 

As you consider this legislation, we believe it is also important to keep in mind that the reason you are having this conversation at all is because the state’s current method of granting benefit increases does not work well for the state or for taxpayers.

We commend legislators, members, and stakeholders willing to examine these important issues and thank you again for the opportunity to share our perspective.

The post Testimony: Louisiana Senate Bill 5’s bonus payment unlikely to be a one-time cost appeared first on Reason Foundation.

Third-party investigators recently released a highly anticipated report on errant investment return figures used by Pennsylvania’s largest public pension system. Although the report cleared current and former managers of the Pennsylvania Public School Employees’ Retirement System (PSERS), investigators made clear that the plan’s investment consultant, Aon PLC, played a central role in the pension fund’s misreported investment performance. This ongoing story highlights how traditional public pension systems—in response to growing pressures to meet lofty investment return expectations—have evolved into complex global investment funds that often rely on expensive outside consultants to allocate billions of employee and taxpayer contributions. 

According to the report, the Pennsylvania Public School Employees’ Retirement System’s (PSERS) 2020 investment returns were low enough that a fraction of a percent difference in a single quarter’s investment revenue dictated whether or not member and state contribution rate hikes would occur. Commissioned to conduct a special investigation into the circumstances surrounding the certification of contribution rates in Dec. 2020, investigators from the law firm Womble Bond Dickinson pored over hundreds of communications between system executives and consultants.

Pinpointing the Error

Ultimately, the third-party investigators found no evidence of crime or self-dealing among PSERS executives or consultants. Investigators did detail how PSERS is increasingly dependent on highly specialized and expensive consultants to meet its fiduciary responsibilities. Investigators found “a series of unfortunate oversights and a lack of transparency from a key consultant led to the Risk Share error.”

Financial services firm Aon PLC was the key consultant investigators were referencing, according to subsequent reporting. In the end, investigators noted that PSERS employees and consultants could not speak to what broke within the system that allowed the error.  

Once the investment return was misreported by Aon PLC, the error was repeated quarterly and factored into contribution rate requirements. Despite the fact that millions of dollars of annual contributions were at stake, Aon PLC relied solely on the earlier erroneously entered numbers in their internal system instead of verifying the data when giving their annual report. For its part, Aon PLC described the situation as a data entry issue perpetrated by an unnamed staff member and has continued to serve as the PSERS investment consultant since the error came to light in March of 2021. The PSERS board voted to adopt a new, lower investment return rate assumption in April of 2021, raising contributions requirements on nearly 100,000 education staff members across Pennsylvania.

About Aon PLC

Aon PLC is one of the largest public pension investment consulting and financial service firms in the world, with public pension clients in almost every state. If one considers the funds contributed by taxpayers and members toward pension benefits as public funds, Aon has become one of the largest appropriators of public funds in the country through its role as an investment consultant to state and local public pension plans. 

The Chicago-based firm is paid nearly $750,000 annually to work with PSERS staff on investment management and other financial services, according to Spotlight PA. Yet, when approached by investigators, Aon only agreed to supply limited answers to limited questions and refused an interview by Womble Bond Dickinson outright. 

Why the Error and Investigation Matter to Other Pension Systems

For decades, traditional public pension systems like PSERS were able to prefund members’ accrued retirement benefits and avoid running up debt by using an investment strategy not too dissimilar from the average American’s. Member and employer contributions, added to the revenue generated by a mix of common public stocks and bonds, were enough to fully fund traditional pensions with little risk of cost overruns before globalization took root.

But, by the early 2000s, the Pennsylvania Public School Employees’ Retirement System and other public pension plans across the country began experiencing lower investment returns, triggering the need for influxes in revenue from other sources—mainly taxpayers by the way of state and local employers. Alternatively, to avoid contribution hikes, some states simply decided to do nothing and allow the pension debt to grow, which it did, expanding rapidly with the 2008 financial crisis. 

Facing pressure to achieve overly optimistic investment return assumptions and avoid contribution hikes that would be paid by taxpayers and/or public employees, pension trustees and managers across the country, including at PSERS, have turned to private, alternative investments with greater upside potential. Although investigators in the PSERS case found the error was associated with a public investment, their report highlighted a lack of both transparency and general understanding of the complex financial strategies being executed. Going forward this means the likelihood of another similar error automatically stifling future PSERS revenue remains a very real possibility. 

A Quick Fix

Public pension systems like PSERS are trending towards more volatile and opaque investments. This means Aon PLC and firms like it will continue to be increasingly pivotal figures involved with traditional pension plans. However, reversing the trend does not necessarily resign the state and members to a heavier contribution burden.

Many state legislatures across the country are experiencing an increase in general state revenue due, in part, to the COVID-19 pandemic economic recovery. Using this surge in funds to pay off public pension debt would help make up for past shortfalls and shore up a state’s public pension system in preparation for the next economic downturn or market correction.

Furthermore, using supplemental appropriations to maintain contribution rates while investment return rate assumptions are lowered would relieve some of the pressure being applied to public pension investment managers, who may be feeling the need to meet overly optimistic return assumptions. The higher an investment return assumption, the less likely investment earnings will meet expectations, requiring more frequent and less predictable contribution hikes. A lower investment return bar means investment performance is more likely to meet the pension plan’s assumptions, leading to more stable and predictable contributions. 

If policymakers and public pension trustees continue walking the investment assumption tightrope, the more pivotal that internal and external analysts, like those at Aon, become to these important pension funds. Active members, retirees, and taxpayers should be wary of this trend and demand public pension system managers not only improve how they report on the overall status of pension plans but also share more about the role and compensation of a system’s consultants. 

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My name is Steven Gassenberger, and I serve as a policy analyst for the Pension Integrity Project at Reason Foundation, a national 501(c)3 public policy think tank. Our team offers pro-bono consulting to public officials and stakeholders to help them design and implement policy solutions aimed at improving plan resiliency and promoting retirement security for public employees. We have played a technical assistance role in major retirement system reforms in states like Texas, Michigan, Arizona, Colorado, South Carolina, and New Mexico since 2015.

Regarding House Bill 971 authorizing the State Board of Administration (SBA)—which manages the Florida Retirement System Pension Plan trust fund—to expand their holding of alternative assets from 20% to 30%, we are not taking a position on House Bill 971. Rather, this testimony is intended to contextualize the underlying logic behind, and implications of, the investment class expansion based on our analysis of the FRS data. To mitigate the implications of HB 971, we highlight two opportunities before legislators to build on the legislation in a way that ensures the FRS Pension Plan’s long-term resiliency and solvency.

Florida Retirement System Investment at a Glance

• The FRS Pension Plan trust fund holds nearly $200 billion in assets, making it one of the largest investors in the world.
• According to the latest FRS reporting, historic post-pandemic market gains in the 2021 fiscal year resulted in private rquity investments returning 67.93%, followed by global equity with 41.78%, strategic investments with 17.14%, real estate with 8.58%.
• According to SBA Investment Reports, since 2013, the FRS Pension Plan trust fund has spent over $250 million in alternative asset management fees and commissions each year, most recently spending nearly $467 million in FY 21.
• Lowering the artificially high investment return bar for SBA and requiring fee reporting broken down by limited partners would build on House Bill 917 and give future members and taxpayers a more resilient FRS Pension Plan trust fund.

What Are Alternative Assets?

Alternative assets are investments that fall outside traditional cash, publicly traded stocks, and bonds. Commonly, alternative investments take the form of shares in limited partnerships, such as with private equity funds. As a statutorily protected fund worth nearly $200 billion, the Florida Retirement System is one of the largest institutional investors globally and, along with other state-level public pension systems across the country, is considered a major source of capital for alternative investment providers.

Why Would the SBA Seek to Expand its Alternative Asset Holdings?

Globalization taking hold of the world economy began the shift from high bond yields to today’s low-yield environment, pushing fund managers away from safe fixed-income sources to more exotic assets with increased potential upside.

According to the latest SBA annual investment report, private equity has been the highest performing asset class for three of the past four years for FRS. In the same report, SBA classifies private equity assets as having the greatest expected future returns along with the highest annualized risk, followed by global equities and hedge fund assets.

With an investment return assumption set at 6.8% and low-risk bonds yielding less than 4%, the SBA wants to double down on success by moving more of the FRS investment portfolio to high-risk, high-reward-style alternative assets. That logic is used widely by public pension plans throughout the country because many, like FRS, remain underfunded by billions of dollars and are seeking higher risks in hopes of avoiding the fiscal pain of higher contributions. Those missing funds need to be made up somehow. Florida House Bill 917 suggests the SBA be allowed to try its hand in the alternative asset market to make up that difference over time.

Concerns with Expanding Alternative Investments

Ask a group of public pension investment managers if a portfolio full of alternative assets is as safe as a classic large-cap stock and bond mix and odds are some will say yes, others no, and some will say it depends on your investment goals. Calling an investment “safe” implies a guarantee that no investments can claim outright, but traditional fixed income assets like U.S. Treasury bonds come close. Returns on bonds and large, publicly-traded stocks are what sustained large public pension systems like the FRS Pension Plan for generations without the need for unexpected infusions of public funds to close pension funding gaps.

Until the mid-1990s, Treasury bond rates were well above the FRS Pension Plan’s assumed rate of investment returns used by plan actuaries to calculate the cost of constitutionally protected retirement benefits until the mid-1990s. The FRS Pension Plan then began slowly drawing down its surplus, which totaled $13.5 billion in 2000 until the 2008 financial crisis flipped the fund from having a surplus to being underfunded.

The FRS Pension Plan historically assumed an investment return rate as high as 8%, before lowering the assumption to 7.75% in 2004. The plan adjusted the investment return rate assumption routinely throughout the years to reach the current 6.8% for 2022.

With the average FRS market valued returns between 2001 and 2020 barely reaching 5.6%, it would seem that investment market changes over the last two decades have left SBA managers with an outdated and artificially high investment return bar to exceed. The results have seen SBA investing more of the FRS Pension Plan trust fund into assets that they hope will not only meet expectations but greatly exceed expectations to make up for years of underfunding.

That kind of actively managed asset comes with management, administrative, and performance fees that can drain hundreds of millions from the FRS Pension Plan trust fund. Such hefty fees are not inherently bad for the Florida Retirement System if they result in equally hefty returns for the fund, but just like other investments, there is no guarantee those extra fees will result in returns that exceed those gained by passively managed, much less expensive, assets like index funds.

Currently, FRS is a leader in investment reporting among its peers because it provides details regarding its commitments and returns from limited partners, and reports fees by asset class. Combining those two reports to show which limited partners are receiving funds for little return and which deserve additional commitments increases stakeholder involvement and confidence in the funds’ ability to drive strong investment performance overall.

Building on House Bill 917

Although alternative assets are not inherently harmful to public pension systems, it would be prudent for policymakers to install boundaries around the investment decision-making process as well as provide increased oversight capabilities to the public.

Option #1 – Systematically Reduce the Need for Higher Investment Returns

Because SBA feels that alternative assets are more likely to produce the higher yields necessary to avoid the need for future funding increases—and their ability to eventually achieve this greatly depends on the assumed rate that they must achieve—our first suggested course of action is to continue to systematically reduce the assumed rate of return (ARR) used by the SBA from its current 6.8% set in Oct. 2021 by the Florida Retirement System Actuarial Assumption Estimating Conference.

Option #2 – Increase Investment Cost Reporting Details

Shifting to alternative assets usually involves higher costs, as actively managed private equity and hedge funds tend to demand higher fees for the services. A 2018 report by the Pew Charitable Trusts found pension plans spend at least $2 billion a year on investment fees alone, and FRS is no exception to this trend. Despite efforts to reduce fees through increased in-house investment management, unreported fees such as carried interest (i.e., performance fees) are not addressed in the current SBA reporting on FRS. Performance fees for private equity investments are typically far higher than the ordinary management fees for those assets, and most public pension funds—including FRS—do not report those performance fees.

Improving current fee reporting by adopting a robust investment cost report would directly address the issue of opaque fee reporting by outlining the fees and other expenses the public pension system incurs in the process of managing its portfolio. California’s teacher pension system, CalSTRS, offers a model in this regard. CalSTRS produces a report showing investment costs by type and asset category. An example of the report can be found at resources.calstrs.com.

This report is designed to provide stakeholders with detailed fee data and trends over a four-year period for each asset class and investment strategy. Reporting this ratio analysis to show the cost-effectiveness of the total fund, asset classes and strategies over time provides a quantitative metric to compare costs against the returns generated from those costs.

The retirement benefits of the Florida Retirement System’s members are paid for from net returns and not from gross returns. Since increased investment costs reduce net returns, the system’s fees and expenses should be consistently monitored and managers should be held accountable for the effectiveness of investments relative to the overall growth and resiliency of the Florida Retirement System.

The post Testimony: Florida House Bill 971 would allow more investment in alternative assets appeared first on Reason Foundation.

Quick Facts—Sunset Commission Findings and Recommendations:

• Staff Report Issue #3: “As One of the Largest Public Pension Funds in the U.S., TRS Would Benefit from Additional Oversight and Greater Transparency of Its Investment Practices.”

• Staff Report Finding: “TRS lacks stakeholder- and member-friendly investment reporting on alternative investments.”

• Staff Report Recommendation #3.3: “The Sunset Commission staff recommends TRS clearly indicate in its Comprehensive Annual Financial Report the percentage of the trust fund held in alternative investments for the past one, three, five, and 10 years in a graphical representation such as a pie chart or bar graph.”

• Staff Recommendation #3.3 Goal: “Reporting this information in the Comprehensive Annual Financial Report would improve transparency, helping TRS members, the Legislature, and the public better understand how TRS manages its assets.”

• TRS Response of Staff Recommendation #3.3: “TRS agrees with this recommendation and will add an easy-to-understand graphical representation of alternative investments to the fiscal year 2020 CAFR.”

Where Do the Sunset Review Commission’s Concerns Regarding Alternative Assets Come From?

From the 1950s through the early 2000s, TRS was mostly invested in relatively safe fixed-income and large U.S. equity assets. Through the 1990s and up until the 2008 financial crisis, TRS was able to maintain a fully funded status and consistent contribution rates. However, with declining interest rates and the lasting impact of the financial crisis, TRS has struggled to maintain its funding levels, resulting in its funded status dropping below 80% and requiring higher contribution rates. To address those rising costs, TRS turned to investment managers to increase the performance of its investment portfolio. These investment managers have moved away from safe, reliable, yet low return fixed assets and towards potentially higher-yielding—and more volatile—alternative assets to increase revenue from investments. International equities, hedge funds, private equities and other alternative investment categories now make up the majority of assets upon which TRS relies to fund their pension benefit obligations.

According to the 2021 Sunset Commission staff report, TRS has increased the allocation of its alternative investments from 20% in the fiscal year 2009-10 to 46% in the fiscal year 2019-20. Because asset managers often charge high fees, it is likely that this shift to alternative investments has drastically increased TRS’ investment costs.

Figure 1: TRS Asset Allocation from 2001 to 2021

Despite this transition to high risk, lower transparency assets, TRS continued to accumulate unfunded liabilities as a result of returns routinely falling below expectation over the last decade. The plan returned only 6.5% on assets between 2015 and 2020, according to Sunset staff, which fell short of the plan’s 7.25% assumed rate of return. It wasn’t until last year’s historic one-year return on investments that TRS saw any meaningful increase in its funding.

What are Alternative Assets?

Alternative assets are investments that fall outside traditional cash, publicly traded stocks, and bonds. Commonly, alternative investments take the form of shares in limited partnerships, as with private equity funds. As a statutorily protected fund worth over $165 billion, TRS is one of the largest institutional investors globally and along with other Texas and state-level pension systems across the country is considered a major source of capital for alternative investment providers.

Many of the TRS assets deemed alternative are classified as “Level 3” under fair value accounting rules promulgated by the Financial Accounting Standards Board. Level 3 assets are the most challenging to value, requiring assumptions to be made about future cash flows and valuation multiples that could be obtained during a future sale.

When public pension boards choose to engage in alternative asset investing, they must manage these investments either in-house or via hired investment consultants paid to manage the planning and execution of the board’s stated investment goal. When contracted, these services often involve fees decoupled from the portfolio’s performance. These service providers are tasked with helping the board determine where to invest, making them important appropriators of retiree and taxpayer dollars. The limited partnerships managing the alternative asset enjoy the standard “2 and 20” compensation package where managers take 2% of all assets being managed and 20% of all returns.

The Challenge with “Alternative Assets” & Importance of Transparency

Despite alternative assets being a type of security, they are usually exempt from registration and disclosure rules set by the Securities and Exchange Commission (SEC). Because these alternative assets provide limited reporting, they are hard to value. This can create a circumstance where it is possible that TRS will experience unexpected losses when their alternative assets are liquidated due to previous valuations of those assets being too optimistic. In many cases, TRS is a limited partner in an investment vehicle operated by a private equity firm, which acts as the general partner. Only when a partnership is liquidated, typically over 10 to 12 years, can the true value of the investment be determined; however, annual valuations of TRS are conducted and subsequent policies based on those valuations are developed on an annual basis, creating a lag between data and policy decisions.

Although it may not be possible for the public to value holdings within private equity and other alternative investment funds, knowing which funds TRS participates in would allow external observers to follow TRS alternative investments by knowing the identity of the general partner.

Despite the challenges in valuing and assessing the performance of private equity funds, increased transparency through a basic disclosure of the assets, funds committed, and investment costs would provide independent observers a better opportunity to assess TRS’ investment policies and results.

How to Strengthen Sunset Commission Staff Recommendations

The issues highlighted by the Sunset Commission staff recommendation 3.3 reflect how the last two decades have changed the funding landscape for large pension systems like TRS. As treasury bond yields remain low and policymakers remain sensitive to unexpected contribution increases, funds like TRS will continue to meet the needs of their members by attempting to secure the highest investment returns possible. If traditional fiduciary standards are used to determine the usefulness of alternative investment to TRS, then investment advisors and board members should feel free to engage in those opportunities. However, without increased transparency and reporting on these assets, the capability of underwriters (taxpayers) to achieve any oversight is drastically limited.

TRS and its membership, as well as every other state-sponsored public pension member and system in Texas, would benefit from two annual reports regarding the system’s alternative investment holdings. Both suggested reports below are currently produced by comparable state-sponsored pension systems outside Texas and would not require any additional appropriation from the legislature.

Suggested Report #1: Private Equity Portfolio Performance

The Private Equity Portfolio Performance report would publicize specific information regarding the private equity holdings of TRS for third-party monitoring and evaluation. The report takes the form of a simple six-column table populated with the following data points per holding:

1. Name of Each Investment Vehicle
2. Date of Each Investment
3. Amount of Capital Committed
4. Amount of Capital Contributed
5. Amount of Capital Distributed
6. Internal Rate of Return (Annualized Return Estimate on Capital Invested)

This level of transparency is provided by other similar-sized public pension systems like the California State Teachers’ Retirement System (CalSTRS). CalSTRS’s publishes a report, which can be found on  CalSTRS’s website, that lists these data points in a stakeholder-friendly format. CalSTRS’s private equity performance report, including the internal rate of return, is maintained internally by CalSTRS and published annually.

Suggested Report #2: Annual Investment Cost Report

Shifting to alternative assets usually involves higher costs, as actively managed private equity and hedge funds tend to demand higher fees for the services relative to passively managed assets like index funds. A 2018 report by the Pew Charitable Trusts found pension plans spend at least $2 billion a year on investment fees alone, and TRS is no exception to this trend.

Last year, TRS administrators set the system on a five-year plan to reduce fees by over $1.4 billion through increased in-house investment management. However, unreported fees such as carried interest (i.e. performance fees) are not addressed in the recent operational changes set in motion by TRS. Performance fees for private equity investments are typically far higher than the ordinary management fees for those assets, and most public pension funds—including TRS—do not report those performance fees.

An Investment Cost Report directly addresses the issue of opaque fee reporting by directly outlining the fees and other expenses a pension system incurs in the process of managing its portfolio. Again, CalSTRS offers a model, producing a report showing investment costs by type and asset category. An example report can be viewed directly from CalSTRS.

This report is designed to provide stakeholders with detailed fee data and trends over a four-year period for each asset class and investment strategy. Reporting this ratio analysis to show the cost-effectiveness of the total fund, asset classes, and strategies over time provides a quantitative metric to compare costs against the returns generated from those costs.

The benefits of TRS members are paid from net returns and not from gross returns. Since increased investment costs reduce net returns, fees and expenses should be consistently monitored and managers held accountable for the costs and benefits of investments relative to the overall growth and resiliency of TRS as a long-term provider of pension benefits to Texas educators.

Contact Information:

Marc Joffe (Marc.Joffe@reason.org), Senior Policy Analyst

Steven Gassenberger (Steven.Gassenberger@reason.org) Policy Analyst

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