But even under the proposal’s optimistic outlook, the casino’s annual revenue is only a fraction of the annual required contributions to the city’s police and fire pension fund. Due to the gargantuan amount of unfunded liabilities the city already owes, this move is unlikely to mitigate future tax hikes, and a significant effort to fulfill the pension promises made to workers still lies ahead.

For context, Chicago’s police and fire pension fund is about $12.5 billion underfunded. Those unfunded liabilities are expected to grow even bigger this year due to the poor investment returns generated in 2022. The estimated $200 million in annual revenue from the casino is only 9% of the $2.3 billion contribution the city must make yearly to avoid further falling behind in debt. Mayor Lightfoot’s most recent budget does allocate $2 million in extra funds to police and fire, some of which will go to paying down pension debt. Yet even with this and the casino revenue, it is still not enough.

While this is the first time a city is taking this particular approach to filling a public pension funding gap, using gambling revenue to plug a pension hole is an extension of a more common practice among underfunded government pension systems—selling lottery tickets. This type of revenue stream is historically unreliable, seeing as lottery revenues dropped heavily during the COVID-19 pandemic, with people staying home and ordering groceries online (most people buy lottery tickets at grocery stores). While the pandemic was an outlier event, lottery revenues have fluctuated a decent amount from year to year.

The use of novel sources of revenue is not new for Chicago, and unfortunately, other methods policymakers have attempted have been less free-market oriented. In 2003, Chicago introduced red-light cameras as a way to curb traffic accidents, but this later became a crucial revenue source for the city, so much so that, at one point, Chicago lowered yellow-light intervals to catch more people and generate more through fines. Chicago has also tried many unique taxes to gin up revenue, such as a Netflix tax, a soda tax, and, perhaps most controversially, a commuter tax. The commuter tax was intended to tax city government workers who worked in the city but lived in the outlying suburbs, implying they were “freeloading.”

While there are ethical differences between generating revenue from something like a red-light camera vs. a casino, these tax and revenue plans all highlight that Chicago is using desperate tactics in hopes of generating revenue to pay for decades of budgetary mismanagement.

The truth is that the casino revenue will barely make a dent in Chicago’s pension funding shortfalls. The city needs to make substantive pension reforms rather than look for these stopgap measures. Even should the casino succeed, Chicago still needs to raise its contributions, whether through a larger portion of the city’s budget or some shared sacrifice between city employees receiving the pensions and taxpayers. When it comes to retirement benefits, policymakers need to consider alternative plan designs for new employees that do not risk piling unexpected costs on the city’s taxpayers.

Pension reforms will likely be an uphill battle for Chicago, considering legal restrictions set at the state level. The Illinois Supreme Court has struck down public pension reform efforts, such as cost-of-living adjustments and salary caps for benefit payments, as unconstitutional. Despite formidable legal obstacles, these are the types of public pension reforms that Chicago needs to address the source of its hemorrhaging pension debt.

Pursuing inadequate solutions with highly politicized taxes or through a brand-new casino is a futile way to dodge the city’s public pension debt and fiscal challenges head-on.

The post Chicago wants to open a casino to help pay down its public pension debt appeared first on Reason Foundation.

Public pension plans have mostly avoided direct investments into cryptocurrencies, and for good reason. Public pension benefits are constitutionally protected, meaning taxpayers are on the hook for paying for unfunded liabilities. If a highly volatile investment, such as crypto, were to go sour, the public pension fund—thus, taxpayers—would be on the hook to make up for the shortfall and pay for the retirement benefits promised to public workers. Even though there is a potential upside in generating significant returns by investing in cryptocurrency at the right times, the risks and market swings far outweigh the potential benefits for public pension systems. 

But some U.S. public pension systems are already reporting minor financial losses related to FTX, including the Kansas Public Employee Retirement System, according to the Topeka Capital-Journal:

Kansas’ pension fund reported a small investment in the ill-fated cryptocurrency company FTX, a spokesperson for the Kansas Public Employee Retirement System said Monday. The fund’s exposure, or investment, in FTX and its affiliated companies was $187,400, Kristen Basso, a KPERS spokesperson, said in an email. That accounts for 0.0008% of the pension fund’s total holdings as of the end of the 2022 fiscal year in July.

Similarly, “The Missouri State Employees’ Retirement System lost roughly $1 million because a private equity firm it invested in was invested in FTX, the embattled cryptocurrency exchange that filed for bankruptcy last week,” the Kansas City Star reported.

While these are small losses, and there seems to be limited exposure for public pensions directly investing in FTX, there are larger concerns about indirect exposure to cryptocurrencies like those described for Missouri. For example, Sequoia Capital was one of the largest investors in FTX, with its potential losses totaling over $200 million. Tiger Global was another large investor in FTX, with losses totaling around $38 million. Both funds had recently partnered with the largest public pension plan in the nation, the California Public Employees Retirement System (CalPERS), which committed roughly $300 million each to Sequoia Capital and Tiger Global in search of higher yields.

Pensions & Investments reported on other public pension plans in similar situations:

The Alaska Permanent Fund Corp., the Washington State Investment Board and other institutions were indirect investors [in FTX] via Sequoia Capital and other venture capital firms. Among investors in Institutional Venture Partners fund with exposure to FTX are Tennessee Consolidated Retirement System; City & County of San Francisco Employees’ Retirement System; Maryland State Retirement & Pension System; and Alaska Permanent Fund Corp. Illinois Municipal Retirement Fund was invested in Lightspeed Venture Partners, which also had exposure to FTX.

These examples highlight that while there might not be a lot of direct investments in FTX or cryptocurrencies by public pension funds, their indirect exposure may also need to be closely monitored and evaluated. 

One public pension plan with a fair amount of crypto-related risk is the Fairfax County Police Officers Retirement System. MarketWatch reported:

The Fairfax County Police Officers Retirement System, a defined-benefit pension plan covering law-enforcement officers in the sprawling northern Virginia county, has over 7% of assets invested in crypto-related holdings, according to a person familiar with the fund, spread across venture capital and hedge fund holdings as well as “yield farming” through funds that provide short-term loans to crypto-related firms. 

Many public pension plans are unfortunately stuck in a precarious situation where, due to their lofty investment return assumptions, they are searching for unrealistically high returns in an increasingly challenging market environment. This has led some pension plans to look at instruments like crypto, as well as non-fungible tokens (NFTs) and special purpose acquisition companies (SPACs) to keep up with overly optimistic investment return assumptions and their plan’s funding requirements.

Overall, the story of FTX is a cautionary tale for all investors. When it comes to public pension systems, which have largely steered clear of making direct investments in crypto, pension funds should resist the growing pressures to seek higher returns and take on risks that could expose taxpayers to major financial losses and more public pension debt.

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How does LDI work? 

In practice, liability-driven investing often involves instruments known as derivatives, which are financial contracts where the value is derived from an underlying asset. For example, a real estate investment trust (REIT) is a derivative of the real estate market. LDI does not necessarily have to involve derivatives and could theoretically use purely physical assets with no leverage. The advantage of using derivatives is that it frees up capital to invest in other areas, such as equities and alternatives. The idea is that you secure your unfunded liabilities from shocks on one end and free up capital to grow your assets on the other end. 

In the case of the United Kingdom, pension liabilities are hedged with a combination of derivatives such as interest rate swaps and U.K. government bonds called “gilts.” The derivatives being used for hedging are sensitive to interest rates (the same rates used to discount the liabilities), which is why they are effective at hedging unfunded liabilities. Interest rate swaps would not be effective at hedging risk for U.S. pension funds since they are pegged to the assumed rate of return as opposed to the market interest rate. In the event that interest rates rise, the fund would have to put up more cash either through available cash reserves on hand or by selling other assets, including gilts, which are very liquid. Conversely, if rates fall, the fund’s counterparty has to put up more cash to the benefit of the pension fund. The fund generally keeps enough cash on hand to mitigate some fluctuation in interest rates.  

Liability-driven investing has grown rapidly in recent years in the U.K., tripling to £1.5 trillion. The U.K.’s reliance on gilts for LDI has made sovereign debt have much longer average maturity periods, around 15 years, compared to its peers in Europe at around eight years or the U.S. at six years, according to Bloomberg. 

Why the sudden selloff? 

When then-Prime Minister Liz Truss’s new tax plan was announced, the market did not feel confident about the fiscal direction of the country, and bond yields spiked by 75 basis points. The spike was so sudden that the pension funds could not simply rely on cash on hand to mitigate the margin call and thus had to sell off gilts to put up more cash. This led to a downward spiral where the high volume of gilts that the pension funds were selling to raise cash for the margin call caused the price of gilts to decrease, which caused interest rates to increase further, thus resulting in a “doom loop” scenario. 

The Bank of England (BOE) did step in and buy a large number of gilts, around £65 billion, thereby stopping the bleeding of the selloff and devaluing of the gilts. However, this may not be enough as the Bank of England would have to continue to buy the bonds until the funds have enough short-term cash. Some pension funds have resorted to selling non-LDI bonds, stocks, and other investments to avoid this doom loop. But in the end, it is still a very messy situation. 

A spike in bond yields and interest rates could be good for pension funds as it means that long-term liabilities are reduced (remember their liabilities are pegged to interest rates and not return assumptions). The issue with LDI in the U.K. is that the pension funds were hedged using those same bonds, meaning that while the debt was being devalued, so too were their assets. 

What can American pension plans learn from this? 

U.S. public pension plans do not rely on liability-driven investing, however, they do have large stakes in private equity and alternative investments. After the U.K. liquidity crunch, Goldman Sachs stated it was seeing a 20-30% discount on private equity funds because investors are discounting illiquid assets in favor of liquid assets. Private equity funds rely on a blend of cash, debt, and equity to purchase assets, and so from the debt perspective, issues could emerge when interest rates rise or the underlying asset, such as real estate, devalues.  

In addition, some public pension funds utilize leverage in their portfolio, such as the Pennsylvania Public School Employees Retirement System (PSERS), which has built the flexibility to invest up to 13% of its total portfolio in private equity and other alternatives. For pension funds utilizing leverage, if there is a margin call and they have to put up more cash than anticipated, they would have to sell assets at unfavorable prices. Public pension funds in the U.S. are generally not directly susceptible to interest rate shocks, but they are indirectly vulnerable and, therefore, should be very cognizant of how much cash on hand they have to handle situations like this. Most U.S. public pension funds have less than 3% of their asset allocation in terms of cash, which is not nearly enough given the recent volatility in the market. 

The post The UK’s margin call offers warning signs for public pension funds in the US appeared first on Reason Foundation.

Which plan type does a better job of actually delivering benefits to the most people?  

It is important to understand the often-overlooked concept of benefit efficiency in concrete conditions. To demonstrate, a hypothetical retirement plan called PERS (Public Employee Retirement System) can serve as a stand-in. This hypothetical pension system uses common characteristics among public retirement plans that offer both DC and DB options. A full list of parameters used for this modeling is provided at the end of this piece. 

Using these parameters and other turnover and mortality data, this piece will examine how a DB plan compares to a DC plan for a cohort of 1,000 employees by comparing their accumulated benefits over a potential lifetime (based on mortality rates). This analysis demonstrates that the DB plan does become optimal when compared to a DC plan for an individual around age 55-60 depending on the entry age. However, for a group of 1,000 employees and for certain entry ages like 22, the DB plan as a whole is never more valuable than the DC plan as a whole. 

For this hypothetical plan, only 33% of workers starting at age 22 remain in their jobs after five years, which is in line with expected retention rates for most public pension plans. For later entry ages, retention beyond the first five years goes as high as 50%. At the 30-years-of-service mark, only about 8%-to-12% of employees remain in their jobs, depending on the entry age. 

DB vs DC analysis for a group of employees 

To include a valuable comparison of how portable DB benefits are compared to DC benefits, the comparison of accumulated benefits will only be made for employees who leave the system. This analysis assumes that a person in a DB plan will try to attain their maximum possible benefit, meaning that if a PERS employee separates (in other words, take another job) at age 35, this comparison would be for their accumulated DC balance to the maximum possible DB benefits they could collect by waiting until the pension systems retirement eligibility. 

The first scenario looks at the cumulative benefits distributed between DC versus DB plans for a standard entry age of 22. Figure 1 shows the cumulative benefits of a DC versus DB plan for every new employee that leaves the system. The first thing that stands out is the stark increase in balances at age 60 for both the DC and DB plans.  

This increase is for two reasons: a spike in retirement rates and a spike in individual DB benefits. For retirement rates, about 940 people leave the system by age 60 and within just six years only two-thirds of them remain. Therefore, even though the individual DC balances grow steadily over time, the cumulative DC balances also spike because this analysis looks at cumulative balances for those who leave the system.  

As for the spike in individual DB benefits, it is a little more nuanced. The DB benefit becomes better than the DC benefit for an individual around age 56 when the person has worked for 34 years and is eligible for full retirement under the “Rule of 90” (see appendix). This relative value of a DB over a DC plan increases and peaks at age 60 where the maximum possible DB benefit at age 60 is 35% more valuable than the DC plan. This combined with increased retirement rates leads to a massive spike in cumulative DB balances around age 60.  

Despite the rise, the DB never crosses the DC plan in cumulative terms for this entry age. That is because the DB plan eventually becomes worse than the DC plan if the person waits too long to retire, specifically at a cutoff point around 70. While the annual benefits will increase for those working longer, a person may not live long enough to reap the full benefits, and thus it is no longer advantageous.  

Figure 1: Cumulative Benefits Distributed (Entry Age 22) 

This trend differs slightly but is still similar to other entry ages. In Figure 2, the ratio (vested DB benefits to vested DC benefits) is used to make a similar comparison of cumulative benefits for an aging workforce using different ages of entry. 

Figure 2: Ratio of Cumulative Benefits (DB/DC) for different entry ages 

At the entry age of 52, the defined benefit plan quickly becomes a better option when compared to the defined contribution plan due to early retirement eligibility. Of course, entering the workforce at 52 is not a typical scenario for most people and neither is staying at a job long enough to enjoy the comparative advantage of a defined benefit plan, as this analysis shows based on the retention rates.  

Conclusion 

The claim that a defined benefit plan is more efficient than a defined contribution plan, purely on a basis of cost, overlooks a larger and more meaningful perspective regarding benefit distribution. Most members of a DB plan do not stay at their jobs long enough to enjoy this “efficiency.”

Using the hypothetical PERS plan, fewer than 12% of employees make it to full retirement across all entry ages, yet the advantages of the DB retirement benefits seem to be tailored to this select group only. The vast majority of workers are better off with a defined contribution plan because the benefits they earn are not frozen when they leave for other employment. 

Additional notes on this analysis

Key Parameters 

1. Assumed Inflation – 2.25% 

2. Salary Growth Rate – 3.50% 

3. Vesting Period – 5 years 

4. Final Average Salary – 5 years 

5. Interest Credit – 6.5% 

6. Benefit Multiplier – 2.00% 

7. COLA – 0% 

8. Assumed Rate of Return – 7% for DB Plan, 6% for DC Plan 

9. Employee Contribution rate – 7% for DC and DB Plan 

10. Employer Contribution rate – 7% for DC and DB Plan 

Retirement Conditions 

1. Regular Retirement 

• Age 65 with 5 years of service 
• Age + years of service >= 90. Known as the rule of 90 

2. Early Retirement – Age 60 with 5 years of service 

This analysis assumes a 6% return for the defined contribution plan and a 7% return for the defined benefit plan. This is based on the NIRS assumption that the DB plan is managed by sophisticated fund managers and can therefore generate higher returns. This point was rebutted in the previous piece based on returns generated by pension funds vis-à-vis index funds to highlight the value of fund managers. This analysis focuses on benefit distribution, so the assumption of a higher DB return is used. 

The post Examining the populations best served by defined benefit and defined contribution plans appeared first on Reason Foundation.

A key issue with the National Institute on Retirement Security’s (NIRS) analysis is that it does not address a more overarching question about how the pension benefits of these plans are distributed. It has been well documented that most workers hired by the government do not stay in public employment long enough to receive a maximized pension. In Reason Foundation’s analysis of New Mexico’s Educational Retirement Board (ERB), the pension plan for teachers, only about 12% of newly hired employees make it to full retirement. This statistic means that the vast majority of workers in ERB are not reaping the full benefits of a defined benefit pension plan. The distribution of benefits among public workers in different plan designs (e.g., DC, DB, hybrid, etc.) is just as important, if not more important, than the cost efficiency argument. This article will primarily focus on the cost efficiency argument discussed in the NIRS report, and we will expand the conversation in a follow-up article later detailing the distribution of benefits between DC versus DB plans. 

Active Managers versus Individual Investors 

In its analysis, NIRS argues that because pension funds are managed by sophisticated fund investors, they are able to generate higher investment returns and avoid unnecessary fees due to their larger scale relative to an individual investor. Because defined benefit plans have pooled expenses, the argument goes, that these plans have economies of scale advantage and thereby lower management fees.  

The argument about advantages in managing the risk of runaway costs fails to hold up when examining outcomes of the last few decades. Institutional investors have struggled with managing this risk, leading to severe underfunding of pension plans across the country totaling roughly $650 billion, a sum that will likely increase again this year. This questions the very foundation of NIRS’ assertion that active institutional investors can manage risk better. Many pension systems clearly have not managed risk very well for many years, suggesting that hypothetical analyses should be taken with a grain of salt when they overlook the real world of existing unfunded liabilities. 

Regarding fees, NIRS bases their assumptions on a 2007 Center for American Progress Study arguing that hidden fees in 401(k) plans devalue total pension wealth by 20-30%. The fee differences outlined in the CAP study are the fee differences between retail and institutional shares for investing. Under this argument, DC plans only have access to retail shares and DB plans have access to institutional shares and thereby lower fees.  

Yet this argument does not reflect reality. DC plans (public or private) that are larger in size, such as Utah’s DC retirement system (URS), have access to institutional shares just like other DB plans, and therefore do not suffer the economies of scale problem when it comes to fees. The real comparison here should be between retirement plans of different sizes rather than the type of retirement plan design. 

It is true that there are people in some DC plans that have likely seen unnecessarily high fees, but that is also happening with pensions overall. There have been several reports in recent years pointing out how some public pension plans have seen excessive fees. Ohio’s State Teachers Retirement System, for example, reported paying $175 Million in fees to investment managers.  

In terms of advantages in overall investment results between active managers versus individual investors, recent history suggests otherwise. A study conducted by SPIVA found that active funds over the last decade have either underperformed or been on par with traditional index funds that passive investors use. The reasons vary, but in general, active investing has not had a clear advantage in returns.  

This conclusion even holds when examining alternative investments like private equity, which has increased in prominence among pension funds seeking higher returns going from 3.6% allocation in 2001 to 9.2% by 2019. A recent study by Reason examined the performance of private equity versus the S&P 500 over the last decade, finding that after adjusting for fees, private equity actually achieved results lower than the index.  

Balanced Portfolio 

NIRS also makes the argument that active institutional investors can manage market risk better with a more balanced portfolio. NIRS’ claim is not that the typical novice investor will create a risky DC portfolio, but rather they will choose lower return instruments such as bonds at the latter part of employment and in post-employment. This is a fair observation, as individual passive options like target-date funds adjust their investment strategies to reduce risks as they get closer to retirement. They argue that because of the lower returns, the DC plans will need to contribute more to the plan in order to generate the same benefit. According to NIRS’ calculations, the average contributions would need to be double (16% versus 32%) in a traditional DC plan than they would need to be in a DB plan to yield the same retirement savings. 

NIRS models hypothetical DC versus DB portfolios to compare returns over a person’s lifetime. The modeled asset allocation of the DC plan changes over time, while the DB’s allocation remains uniform throughout. They also split the DC plan into a regular DC plan and an “ideal” category based on similar efficiencies to a DB plan. The results show that at age 30—where the fixed income allocation is lowest—the DB return is around 6.7%. Meanwhile, the “ideal” DC return is slightly higher around 7%, with the regular DC return slightly higher than that at around 6.6%. At age 96—the final year for their model—the DB return holds because the asset allocation is the same, while the “ideal” DC and regular DC returns drop by 2.3% and 4% respectively.  

There are a couple of problems with this analysis. First, while they may lack the sophistication of pension insiders, individual investors do have access to direct tools and financial planners to better help with asset allocation, and well-designed public DC plans require the third-party administrator to offer some form of advice and counseling to participants. Institutional DB plans are not the only plans that have access to advisors or other tools to help with investing.  

Based on Vanguard’s lifepath fund for different age groups, the typical individual under 40 has an allocation for equities of around 90%. NIRS uses a 7% return for equities to benchmark, which is surprising since the average S&P 500 growth rate over the last 10 years was 12% according to SPIVA. With a 90% allocation toward equities, you would expect their return for that age group to be much higher than 6.8%. This warrants a closer examination of the assumptions used in the NIRS analysis. 

In terms of a balanced portfolio, real-world results do not support that DB plans are more risk-balanced through professional management than when managed by an individual in a DC plan. DB plans have been slow to lower their long-term investment return assumptions, which has created challenges for fund managers. Finding it more difficult to generate returns to match these increasingly unrealistic assumptions, many plans have assumed greater and greater risk in recent years, expanding shares in alternative investments like private equity and hedge funds thereby exposing portfolios to more volatility and risk.  

Risk Pooling Between Retirees 

NIRS makes the case that DB plans inherently have advantages in risk pooling among retirees. This insulates retirees from longevity risks—the risk that a person lives longer than their retirement benefits. NIRS argues that, in a DC plan, if a person has budgeted to save enough for retirement expecting to live to a certain age but ends up living longer, they are in trouble. In addition, if they live fewer years than expected and have surplus retirement savings, that excess is “wasted.” According to NIRS, about one in six dollars saved for a DC retirement plan does not go toward retirement. The NIRS argument obscures some critical points that undermine their overall position.  

When NIRS talks about the risk pooling between retirees in a DB, where the money comes from for longer longevity scenarios remains undiscussed. NIRS brings addresses this element when discussing DC plans (arguing that the workers have to figure out how to budget for how long they anticipate living). But in a DB plan, if benefits are projected for an assumed number of years and the actual experience ends up exceeding those assumptions, then the money will generally come from the government employer (or future taxpayers) via higher contributions. If NIRS views a retiree experiencing an excess of funds as an inefficiency, they should also recognize real-life unexpected costs commonly differ from the cost assumptions of DB plans. This also raises the question as to who is supposed to benefit from fund excesses. If the individual’s (or DC plan’s) excess funds are deemed inefficient compared to a pool of members in a DB plan, are not excess funds in a DB plan also inefficient to the individual? Recognizing only one side of excess funds is likely leading to an unbalanced conclusion. 

The NIRS study correctly identifies longevity risks associated with the traditional DC plan, but the risk of outliving one’s benefits can be eliminated entirely with the purchase of annuities such as what is offered by TIAA or in the UK with their Collective DC. More and more government employers are building these annuities into the DC products they offer. Essentially, an annuity option eliminates both “wasted” money and the insufficient fund issues NIRS raises. In fact, an annuity from a DC plan is actually more likely to serve an individual public worker when compared to a DB plan, seeing as DC plans vest immediately and many workers hired into government positions leave employment before the pension vesting period concludes, forfeiting the employer contributions made on their behalf.  

NIRS Analysis Benefit Efficiency 

This argument was not part of NIRS’s study but is crucial to address. Cost efficiency is just one lens through which to view a comparative retirement design, but there are others that are equally important. Even if a DB plan is more cost-efficient than a DC plan, what good is that if the worker doesn’t even stay until full retirement to collect the benefits in their intended entirety?  

According to the Bureau of Labor Statistics (BLS), the average worker changes jobs around 12 times during their career. The average tenure of someone at a job is typically between four to five years. This means that many workers are not staying long enough to receive a pension. In some cases, they are not even staying long enough to be vested in the pension system itself. In the example of New Mexico ERB, cited earlier, only about 12% of New Mexico teachers make it to full retirement and fewer than 30% of them even make it to the vesting period. This means that even if a DB plan is more efficient, it is only going to a fraction of the workers, suggesting that it is inefficient from a benefit access perspective.  

Probability of Members Remaining in New Mexico ERB 

In NIRS’ own study, they assume that the 1,000 workers used for their analysis all make it to full retirement with no turnover, death, or deferred benefits. NIRS does make an assumption about career breaks for parenting but still assumes no turnover or other disturbances. This is obviously not a realistic scenario.  

A more comprehensive perspective on the strengths and weaknesses of the two plan types would include a wide examination of different situations that are common for employees and the rates at which these situations occur. The concept of benefit efficiency, which is the idea of how widespread benefits are distributed in DC versus DB plans, will be fleshed out more in a follow-up piece. But for the sake of this explanation, whatever cost-efficiency NIRS has argued for in traditional DB pension plans comes at the expense of limiting access to the benefit for a very constrained population.  

The “Efficiency Gap” 

Putting all of the above together, NIRS makes a savings breakdown of DC versus DB plans in terms of cost and efficiency. NIRS notes the difference between an “ideal” DC versus a regular DC plan in that an “ideal” DC plan has the same fee structure as a DB plan. While this has been disputed in the points above, it is worth looking at the analysis’s final number of close to a 50% savings between a DB versus DC plan. While it is not possible to dispute the exact percentage, since the efficiency calculation is not provided, the idea that a DC plan is twice as expensive as a DB plan does not pass the basic litmus test.  

If DB plans were really more efficient than a DC plan to that degree, why have the companies that abandoned them in the 1980s and 1990s not gone back and adopted new DB pension plans, having learned the cost efficiency lesson of DC plans firsthand? Companies today are always trying to cut costs. Thus, a more efficient retirement system would likely be appealing to them. The fact that most private companies have chosen and remained in individualized retirement structures—in contrast to pensions—suggests an efficiency gap as large as NIRS has estimated is likely overstated. 

Conclusion 

There are clearly issues with both DC and DB plans that need to be worked out during plan design to ensure success, such as benefit structure, investment management, and funding policies. NIRS is right to focus on the importance of these issues but has relied on too narrow of a perspective, overlooking several key considerations that extend beyond just costs to the employer. 

NIRS assumes a near-perfect scenario for DB plans when assessing their viability – no change in workforce numbers, no underperformance in investment returns, and no unexpected fees. This scenario has not been the lived reality for most pension plans. 

In order to fully understand the strengths and weaknesses of each plan type, one must examine all aspects involved in the saving and distribution of retirement benefits, including careful consideration of plan recipients. The ultimate goal of a truly efficient retirement plan is to have as many workers as possible receive adequate benefits to provide for a healthy life after employment. Cost efficiency, while an important factor, is not a complete view of what a retirement plan is and what it is meant to achieve. 

The post NIRS’ assessment of the retirement efficiency gap leaves out some key details  appeared first on Reason Foundation.

2021 Pension Investment Returns

The S&P report revealed that the average investment return for public pension funds was 30% in the 2021 fiscal year. This resulted in the average reported funded status for pension plans increasing from 71% to 84%. The impressive jump in funded ratios has been followed by many public pension plans making actuarial adjustments, such as lowering their expected investment return rates to 7.0% on average. These assumed investment return rate reductions are likely to continue, bringing with them higher contributions from governments.

Pension funds seem to be well aware that the investment returns in 2020-2021 were an outlier, as pension boards have continued to lower their assumed rates of investment returns even after the investment results from the past year hit their books.

Many pension funds are still trying to explore high reward, but risky, alternative assets like private equity, hedge funds, and more recently, cryptocurrencies and special purpose acquisition companies (SPACs).

Since public pension benefits are guaranteed and usually backed by state law, pension funds would be better off continuing to downgrade investment return expectations, as they are now, while also pursuing a less volatile portfolio to build on the incredible momentum from 2021 rather than continuing to flirt with risky assets.

Inflation

Inflation rose to a 30-year high of 7% in December 2021 but according to the report, there are limited short-term implications for pension debt. However, S&P finds that if inflation persists, public pension costs could sharply increase for a couple of reasons.

First is that some pension plans provide a cost-of-living adjustment (COLA) that is attached to actual inflation metrics, meaning higher sustained inflation triggers a higher COLA amount than was planned for.

Second, salary increases will generally have to be higher to keep up with inflation, thereby increasing pension benefits which are typically based on a public worker’s highest three-to-five years of earnings. 

Prolonged inflation means that future pension benefits could increase on two fronts – higher base benefits due to higher salaries than were previously accounted for, and an increased benefit growth rate from increased cost-of-living adjustments.

The potential silver lining to prolonged higher inflation could be that discount rates could rise if inflation at these levels persisted, thereby increasing funded ratios. But given how much pension benefits would be increased, it is not yet clear whether this would be a net positive or negative for pension funds.

Pension Obligation Bonds

With interest rates remaining low, the issuances of pension obligation bonds (POB) have been increasing for the last few years in the United States. With inflation now a concern, the Federal Reserve is considering interest rate hikes in the near future that may make this option less appealing and slow the trend.

S&P Global published a report last year showing that POBs saw a massive spike during the COVID-19 pandemic, doubling to more than $6 billion in bonds issued in 2021. The driver of this was the increased spread between those bond yields and treasuries which S&P Global says is not free money while noting:  “[I]t indicates increased exposure to market volatility risk when proceeds are deposited in the pension trust.”

That being said, the S&P Global report also noted that POBs can be helpful as a part of larger pension reform but should also not be used as a short-term fix.

Demographic Impacts

Mortality rates, as one would expect, were unusually high the last few years due to the COVID-19 pandemic. The Centers for Disease Control and Prevention reported a drop in life expectancy of nearly two years in 2020, which was expected to continue through 2021. S&P says these trends could result in reduced liabilities for pension plans as expected lifetime benefits could end up being lower than expected.

Another aspect of the pandemic has been the rise in early retirements. Many people may opt to retire early if they feel the health exposure risk is not worth continued work. Early retirement is part of a larger phenomenon of the so-called ‘Great Resignation,’ which comprises all age groups and goes well beyond just early retirement. The impact of early retirements on public pension funds remains unclear since many plans do have penalties associated with early retirement and no one is sure how long this trend will continue. However, it is something pension funds should note and continue to watch.

Slower Payroll Growth

Finally, the S&P Global report discusses how employment and pay changes could impact pension funds in the short and long term. The National Association of State Retirement Administrators reports that since Feb. 2020, state and local governments shed nearly a million jobs, most of which they have not rehired for.

The slower payroll growth from state and local governments is crucial because they usually base their contribution rates on a certain percentage of payroll. If payroll growth slows and falls below actuarial expectations, contributions that they expected to be there in the future will not exist, potentially backloading significant levels of costs or unfunded liabilities. If payroll trends stay consistently lower than previously thought, then governments should lower their payroll assumptions and adjust contributions accordingly.

In short, S&P recognizes that most public pension funds had a spectacular 2021 and many have built on that momentum with key adjustments to their return rate assumptions. But many market experts are warning that factors such as inflation, rising interest rates, and slower payroll growth could derail public pension systems’ funding progress. These challenges can be mitigated, but policymakers should respond with needed pension policy reforms sooner rather than later.

The post S&P Global’s annual pension report projects an uncertain future for pension funds appeared first on Reason Foundation.

This fluidity means retirement plans that were once advantageous to these lifetime workers are now less attractive to a growing number of more mobile workers. To address this trend, many public employers have introduced defined contribution retirement plans to provide a more portable and optimal retirement benefit to workers who aren’t planning on sticking around at that job for multiple decades.

A defined contribution plan uses an individual retirement account, like private sector 401(k) accounts, to which regular contributions are made, eventually resulting in a lump sum that is accessible at the worker’s retirement. This type of retirement plan does not place retirement saving risk on the public employer and taxpayers. And it provides the employee with a chunk of money that can move with them from one employer to the next if they change jobs. It also affords the worker more personal control over investments and other disbursement options in retirement, like annuities.

Unlike defined benefit pension plans, defined contribution plans do not depend on actuarial predictions on the market or other demographic assumptions. The feature that most impacts a defined contribution plan is the total contributions flowing into the member’s account. For a defined contribution plan to provide an adequate retirement, the contributions that are paid into that personal account must be sufficient.

What is ‘sufficient’ depends on various factors, including the type of job being performed and the existence of other supplementary benefits like personal savings and social security. Figure 1 shows the various contribution rates that are used for the primary defined contribution plans run by state governments.

Figure 1: Contribution Rates for State-Run Primary Defined Contribution Retirement Plans

As the table above demonstrates, there is quite a bit of variance in contribution levels among state-run defined contribution plans. For example, public safety workers tend to have earlier retirement ages, so they need higher contributions to achieve a sufficient sum by the time they exit the workforce. Some government employers also decline participation in Social Security, which should be counteracted with higher defined contributions to make up for the loss of that income stream. This is visible in the above chart, with most of the top total contributions coming from either public safety plans or non-Social Security plans.

In general, most financial experts recommend that total contributions for a member participating in Social Security need to be 10% to 15% of their pretax earnings to ensure they have enough money for a secure retirement. For public workers not participating in Social Security or any other supplementary benefit, a higher 18% to 25% contribution rate is advised. 

Judging by the advice of experts, Florida—which is positioned dead last in the ranking of total contributions—needs to increase its contributions to ensure that its public workers will be retiring with enough in their defined-contribution accounts. In fact, policymakers in Florida are proposing just this, with Gov. Ron DeSantis including a 3% increase on state contributions in his proposed budget. More recently, the Florida state legislature introduced House Bill 5007, which would implement that increase.

As more government employers turn to defined contribution plans to better serve their evolving workforces, they must consider the various plan features needed to provide employees a secure retirement. The most important consideration is the level of contributions that go to the plan. It is useful to see how other states are handling this crucial aspect of retirement policy and useful for state employers to closely monitor where their contribution rates stand in this aspect.

Government employers that fall close to or below recommended contribution rates should revisit their retirement contribution policies to ensure that they are providing a benefit that can be a valuable primary retirement vehicle capable of providing the type of income that workers need in retirement.

The post Comparing how much states contribute to public workers’ defined contribution retirement plans appeared first on Reason Foundation.

While the returns from non-traditional vehicles have the potential to be high, the risks are higher as well. Public pension funds like the Texas Teacher Retirement System (TRS) should be cautious as they venture into these areas and take risks with funds that retirees depend upon—and taxpayers are on the hook for.

What are SPACs?

SPACs are a vehicle for a company to go public with the goal of being acquired or merged with another company, making it different from a traditional initial public offering (IPO). The original company finds a sponsor who is tasked with taking the company public via the SPAC. The sponsor for the deal raises money via investors through traditional stocks as well as warrants, which are stocks that have guaranteed prices at a future date. This money is set aside in a trust. The sponsor then has 24 months to find a target company to acquire or merge with. If no target company is acquired, then the deal will fall through, and the investors will recover their investment. In the case of TRS, the pension fund is considered an investor and has put up $200 million for a sponsor to search for a target company.

What risks do SPACS pose for investors?

SPACs are often called “blank check companies” because the investors, in this case, the Texas TRS system, are putting all their faith in the sponsors to make the best possible decision with the money raised. The investor may be given a guarantee of a payout if there is no deal but there is no guarantee they will get their money back if there is a bad deal that falls apart further down the road. From the sponsor’s perspective, any deal is better than no deal simply because the sponsors do not own the company, they are only tasked with finding a buyer. In other words, the sponsor’s first goal is to get paid, and they can do so even if the deal will end up losing money for the company and investor. This leads to the second issue, which is the fees for the sponsors. Sponsors argue that their method is cheaper than paying an investment bank to go public. This is true on the surface, but if you consider that the sponsors often take a 20% ownership in the merged company, it’s more of a mixed bag. All in all, the quality of the sponsor is a make or break for a SPAC.

From the perspective of pension funds, this means that they could either be in the crosshairs of acquiring a bad company with no way out and/or they could be charged significant fees for the investment. Large investment fees are not new to the pension world. Transparency and the size of investment fees for alternative investment managers have long been a contentious topic.

Why the recent interest in SPACs?

SPACs are not new, they have been around since the 1990s. Historically, most investors steered clear of them because they were seen as opaque and unreliable, as investors are relying on a sponsor that may or may not have the same incentives to find a good deal. But recently the quality of sponsors and market impacts of the COVID-19 crisis has led to an uptick in SPACs.

First, notable hedge fund managers such as Bill Ackman and Chamath Palihapitiya became some of the biggest sponsors for SPACs via Pershing Capital (Ackman) and Social Capital (Palihapitiya). This fostered a cycle where more notable investors jumped into the fray and made the idea more mainstream.

Second, there has been a massive boom in SPACs during the pandemic-related market volatility. SPACs went from raising around $13.6 billion in 2019 to over $83 billion in 2020 to doubling it again to $160 billion in 2021. During the onset of the pandemic, valuations were extremely volatile, and many IPOs fell through. SPACs offer more certainty early on as well as greater upside to early investors. One of the main advantages of SPACs is that early investors can capture more of the early growth within a company before taking it public. For example, if a company had a traditional IPO at $40/share and after 2 years, the price jumped to $60/share, the early investors would capture a fraction of that gain. Since SPACs have not gone fully public yet in that 24 month period, the investors end up capturing most of the true value of the company.

All of this sounds great on the surface but unfortunately, SPACs have failed to meet their high return expectations in most cases. As of Mar. 2021, 60% of the SPACs lagged behind the S&P 500 and 40% of those SPACs sold below their initial price of around $10/share.

SPACs are a perfect example of a high-risk, high-reward investment. Risk and transparency issues associated with this type of investment have even motivated the creation of SPAC insurance. Companies like HubInternational sell this insurance to investors for each stage of the SPAC process, ensuring they come out whole. Public pension funds like Texas TRS could theoretically buy this type of insurance on their SPAC investments, thus reducing the risk of the investment. The problem is the cost of SPAC insurance is rising fast, and the return adjusted for these costs is dwindling.

The risks associated with SPACs should make public pension funds very weary. Rather than continuing to take on riskier strategies to achieve lofty investment return goals, policymakers and those managing the retirement investments of public workers should lower assumed rates of investment returns and make other funding reforms that secure the long-term stability of retirement systems.

The post The Texas teacher pension system makes investment in risky special purpose acquisition company appeared first on Reason Foundation.

Using these funds to pay down pension debt could reduce future pension costs for the state. Maryland is spending $1.8 billion a year in contributions to the pension plans, and $1.4 billion of this is going toward debt payments. Maryland could free up a portion of its budget each year by using the revenue generated from the airport lease to pay down part of this pension debt.

Leasing an airport involves a state or local government entering a long-term public-private partnership. The typical airport lease is 40-to-50 years. Most often, private airport companies provide the entire long-term lease payment upfront, but they can also choose to issue a down payment and provide scheduled payments over time, as was the case with the lease of the Luis Muñoz Marín International Airport in San Juan, Puerto Rico.

The revenue generated from an airport lease could be used for other purposes, such as updating or maintaining existing infrastructure — often referred to as infrastructure asset recycling — or paying down other government debt.

Throughout the world, privately managed airports are becoming the norm. Many large and medium airports in Europe are either fully or partially privatized and are generating revenue for public use, something governments in the United States are missing out on.

These long-term airport leases can be a win-win for governments and airport customers if they are properly designed. Ensuring that there is a transparent leasing process, enough competition between companies bidding on the assets and that there is buy-in from airlines are all key to designing successful airport lease agreements.

The idea of leasing BWI is not entirely new to Maryland policymakers. In 2010, the state considered full privatization of the airport in an attempt to shore up debt. However, the plan fell through when then-Gov. Martin O’Malley (D) felt that the deal offered was not reflective of the true value of the airport. In addition, he believed that the private company needed to act as a job creator and bring value beyond just cutting costs.

Whether an airport lease must meet every one of those requirements is subjective, but experience in other countries demonstrates that it is possible to address these concerns within the details of a lease agreement.

However, given the size of Maryland’s pension debt relative to the potential value of the airport, the state would need to consider additional policy reforms to fully fund retiree benefits and prevent the growth of future unfunded pension liabilities. These public pension reforms should include lowering investment return assumptions so they are more in line with market realities and creating a plan to fully pay off the pension plans’ debts within a realistic time frame.

If well-executed, long-term airport leases can improve the quality of airport services and provide additional revenue for government bodies. Maryland should strongly consider leveraging BWI to help the state at least partially address its serious public pension funding shortfalls.

A version of this column previously appeared in The Washington Post.

The post Maryland could pay down some state pension debt by leasing BWI Airport appeared first on Reason Foundation.

These investment return rate assumption adjustments come on the heels of a record investment performance of 27% in the fiscal year 2021, the best investment return performance the Maryland State Retirement Pension System (MSRPS) has had in 35 years. While this is an impressive return, future projections still show the fund’s long-term market forecast well below previous decades’ investment returns. Lowering the plan’s assumed rate of return will more accurately represent the true cost of the plan, which is a good first step in addressing larger challenges facing MSRPS.

Despite an excellent year, the market is still incredibly volatile. A 27% return is nearly impossible for a pension plan to achieve over a number of years. According to a recent report by Horizon, the near-term outlook for public pension funds is actually worse than it was just last year. In the Horizon report, investment advisors find the probability of achieving a 7% return over the next 20 years is now 38%. The previous year’s report said plans had a 45% chance to meet a 7% return. 

This is consistent with the Monte Carlo simulation analysis developed by the Pension Integrity Project, which is an iterative analysis of 10,000 market scenarios over 20 years considering expected returns, correlations, and volatilities to predict a pension plan’s probability of achieving certain return targets. Based on the correlation data provided by market analysts such as JP Morgan and BNY Mellon, along with our analysis, MSRPS’s probability of hitting a 7.4% return is between 30-40% in the near term.

The pension plan’s probability of hitting its new assumed rate of investment return of 6.8% ranges between 40-50%.  Plan administrators might counter this point with the fact that MSRPS consistently outperformed the 7.4% return target with an average return of 8.2% over the last 10 years. While this is true, over the last 20 years the plan returned only 4.7%. This illustrates how dramatically market conditions can change from decade to decade.  

Some experts believe that thanks to the record-setting returns being reported by many pension systems, the average funded status for public pension plans in the U.S. will jump by 10 percentage points, from being 71% funded to being 81% funded, on average. Rather than get complacent after a year of good investment returns, however, public pension plans like MSRPS should be motivated to make changes that will further improve their solvency.

MSRPS has taken good steps towards improving its funding by adopting an actuarially determined contribution rate (ADEC) in 2015, which was eventually implemented in 2017. Up until that point, MSRPS had consistently fallen short of making adequate pension contributions for more than 10 years. MSRPS still needs to make up for funding shortfalls from previous years though.

MSPRS should consider lowering its assumed rate of return even lower than 6.8% to align with market projections. This year New York state, for example, lowered its investment assumption to 5.9% from 6.8% after reporting an impressive return of 33% in the latest fiscal year.

Maryland policymakers should also seek ways to accelerate pension debt payments with shorter amortization periods. This would increase annual contributions but would also reduce long-term costs while simultaneously making the retirement system more resilient to future economic uncertainty. 

The last fiscal year provided great news via much-needed investment returns for public pension plans across the country. Many pension systems have struggled to rebound from the Great Recession (2007-2009) and were concerned they’d be further negatively impacted by the economic impacts of COVID-19. Despite this year’s excellent returns, pension reforms are still very necessary for most public pension systems. MSRPS is no exception. The reduction to the pension plan’s assumed rate of return is a welcomed change and will hopefully be the first step toward making Maryland’s public retirement system more secure and resilient.

The post Maryland State Retirement Pension System lowers investment return assumption, but more reforms are needed appeared first on Reason Foundation.

Figure 1 below highlights four pension plans in Canada that are fully funded or close to it. The large Ontario Teachers Plan falls just short of full funding at 95% but their excellent investment performance in 2020 may leave the plan with a surplus in 2021. 

The latest data show that state pension plans in the U.S. had an average funded ratio of around 72% in 2019. While this year’s high investment returns may boost the U.S. average by a few percentage points, it will still be well below Canada’s average funded ratio.

Figure 1: A Snap Shot of Candian Public Pension Plans

Investment Return Assumptions

The biggest difference between Canadian and U.S. public pension planning is how the two nations approach setting investment return assumptions. The median assumed rate of return for state and local pension plans in the United States is roughly 7.25%. The average assumed return for the Canadian plans listed above is 4.7%. This means that American plans assume they will earn over 2.5% percent more on their investments each year. The Ontario Teachers’ Pension Plan has the lowest assumed rate of return of around 2.45% (which was recently lowered from 2.6%). 

This stark difference marks a major divergence in how the U.S. and Canada perceive and manage investment risks as they set funding policies and contributions rates. Canadian plans use more conservative return assumptions and they consistently perform above their assumed rate of return. In contrast, public pension plans in the United States often fall short of their overly optimistic investment return expectations and often fail to make up the difference with increased contributions. In fact, failing to meet investment return assumptions has been the largest contributor to unfunded pension liabilities for state and local plans in the U.S. in the last two decades.

Risk Appetite

The difference in return assumptions between U.S. and Canadian pensions also impacts investment strategies. In their 2021 Annual report, the Canadian Public Sector Investment Board set an asset allocation target of 12% for private equity assets. Similar allocation targets were set for the British Columbia and Ontario Teacher Pension Plan at 12% and 15% respectively. The lowest target was from the New Brunswick Pension Plan which had a private equity allocation of 4%. While alternatives assets like private equity have the potential for high investment returns, they also come with more volatility and a greater risk of loss.

Some U.S. public pension plans have much higher targets for alternative assets. The New Mexico Educational Retirement Board (ERB), for example, sets an allocation target of 45% for all alternatives (private equity, hedge funds, etc.). The plan, which serves New Mexico’s teachers, might be an extreme example but according to national data, the average allocation toward alternatives for state pension plans and the largest local plans was close to 20% in 2020. And U.S. plans are rapidly increasing their interest in these assets.

Canada’s more risk-averse strategy has paid off. A 2020 research paper, “The Canadian Pension Fund Model: A Quantitative Portrait,” found that U.S. pension funds would have performed better between 2004 and 2018 had they used Canadian investment strategies. The authors of the paper stated:

“We find that a central factor driving this success is the implementation of a three-pillar business model that consists of i) managing assets in-house to reduce costs, ii) redeploying resources to investment teams for each asset class, and iii) channeling capital toward growth assets that increase portfolio efficiency and hedge liability risks.”

Cost-Sharing By Employees and Employers 

Canadian pension plans also approach cost-sharing, which is how a pension plan divides contributions between the employee and employer, more conservatively than American pension plans.

In the U.S., employers typically contribute more towards a pension plan than employees. The most extreme example of this is the Louisiana State Employee Retirement System, which requires employees to contribute 8% of their paychecks towards pension savings but requires employers to contribute 40%. Due to growing unfunded liabilities, many U.S. plans are raising employer contribution rates more quickly than employees’ rates. Ultimately taxpayers are on the hook for these increased public pension costs.

Workers and employers in the Canadian Public Sector Plan both contribute around 9.5% to their plan. In Ontario, teachers and employers contribute 11%. Most Canadian pension plans follow this trend.

According to a report by Clive Lipshitz and Ingo Walter, this cost-sharing model is key to Canadian plans’ success. In their 2020 paper on “Lessons from Canada for the U.S.” they suggest that U.S. pension plans need to, “Understand pension funding within the framework of total compensation and if appropriate, consider a more equitable share of funding from plan members.”

The stark difference between Canada’s excellent public pension funding and the U.S.’s growing state and local pension debt proves that our nation’s policymakers and pension managers should consider emulating the Canadian approach to public retirement risk. Doing so would greatly reduce the risk of runaway costs for taxpayers and better secure the retirement funds of public workers. 

The post What U.S. pension plans can learn from Canadian pension funds appeared first on Reason Foundation.

Population declines generally result in lower tax revenues for state and local governments. Government expenditures such as payroll, government employer pension contributions, and pension debt payments typically come from state and local governments’ general tax revenue streams. If a state or local government’s tax revenues decline, they typically have to make up the difference either by raising taxes, cutting government employee benefits, or cutting government-provided services. But, as governments reduce services or increases taxes, residents may respond with their feet by moving to other areas, which can then exacerbate their financial challenges.

Population declines affect government payrolls and public pension plans because fewer citizens should mean less demand for new government employees, like police officers and teachers. Payroll growth is a huge factor in projecting pension plan solvency. Most public pension plans base their annual contributions on their payrolls, so higher payroll growth numbers mean that a plan can expect higher contributions to the fund in the future. If a pension plan falls short of its payroll growth targets, it will most likely end up contributing less to the fund than what is needed, which means higher unfunded liabilities—debt—later on. 

To remove the risk of underfunding their public pension systems, state and local pension plans should lower their payroll growth assumptions. Doing so would reveal a more accurate accounting of what their true unfunded liabilities are.

Public pension plans should also consider switching debt payments from a percentage of payroll (level percent) to a fixed dollar amount (level dollar), similar to what Michigan did for its teacher and state police pension plans in 2019. This fixed dollar contribution method not only removes any speculation about debt payment schedules but can also save government employers significant long-term costs. 

Population shifts can also make pension reform more or less palatable for policymakers.  A major part of many pension reform efforts involves finding funding to address growing public pension debt. Relying on a growing base of taxpayers to help foot the pension bill no longer works when a state’s population is declining. In this scenario, a state can increase the financial burden on remaining citizens, expand debt payment schedules, or enact reforms that could negatively affect existing workers. But states like Texas and Florida that have growing populations are in a highly advantageous position because they will likely have a growing tax base to give them a cushion to pay down their current pension debt. These states should take this opportunity right now to change pension plans’ overly optimistic investment return assumptions to more realistic levels and ensure they have strong systems in place for paying down existing pension debt. 

States with declining populations are in a tougher spot so it is important that they make changes to their pension plans sooner rather than later to avoid accruing even more public pension debt. Reforms should involve serious adjustments to payroll growth forecasts and investment return assumptions. They should also consider how they can tackle existing pension debt sooner rather than later, to reduce interest payments and avoid backloading costs on future taxpayers.

The post How Population Changes Impact Public Pension Funds appeared first on Reason Foundation.

This debt is putting a strain on schools and taxpayers in the state.

The latest analysis by the Pension Integrity Project at Reason Foundation, updated this month (February 2021), shows that deviations from the plan’s investment return assumptions have been the largest contributor to the unfunded liability, adding $897 million since 2002. The analysis also shows that failing to meet investment targets will likely be a problem for TRS going forward, as projections reveal the pension plan has roughly a 50 percent chance of meeting their 7.5 percent assumed rate of investment return in both the short and long term.

In recent years TRS has also made necessary adjustments to various actuarial assumptions, exposing over $400 million in previously unrecognized unfunded liabilities. The overall growth in unfunded liabilities has driven Montana’s pension benefit costs higher while crowding out other education spending priorities in the state, like classroom programming and teacher pay raises.

The chart below shows the increase in the Montana Teacher Retirement System’s debt since 2002:

Left unaddressed, the pension plan’s structural problems will continue to pull resources from other state priorities.

The full Montana TRS solvency analysis also offers stress-testing designed to highlight potentially latent financial risks the pension system is facing. Reason Foundation also highlights a number of policy opportunities that would address the declining solvency of the public pension plan. A new, updated analysis will be added to this page regularly to track the system’s performance and solvency.

Bringing stakeholders together around a central, non-partisan understanding of the challenges the Montana Teacher Retirement System and Montana Public Employee Retirement System are facing—complete with independent third-party actuarial analysis and expert technical assistance— is crucial to ensuring the state’s financial solvency in the long term. The Pension Integrity Project at Reason Foundation stands ready to help guide Montana policymakers and stakeholders in addressing the shifting fiscal landscape.

Makeup of Montana TRS Contributions

Montana law (MCA 19-20- 608 & 609) dictates that if the TRS funded ratio is below 90%, employer contributions should contribute an additional 1% of compensation, increasing by 0.1% each year up to 2% or the TRS funding ratio is above 90%.

The supplemental rate applicable to the university system (MUS-RP), is currently set at 4.72%.

What Drives Montana TRS Pension Debt?

1. Deviations from Investment Return Assumptions have been the largest contributor to the TRS unfunded liability, adding $897 million since 2002.
2. Changes to Actuarial Methods & Assumptions to better reflect current market and demographic trends have exposed over $400 million in previously unrecognized unfunded liability.
3. Deviations from Demographic Assumptions including deviations from withdrawal, retirement, disability, and mortality assumptions — added$332 million to the unfunded liability over the last 15 years.
4. Extended Amortization Timetables have resulted in interest on TRS debt exceeding the actual debt payments (negative amortization) since 2002, adding a net $39 million in the unfunded liabilities.

Challenge 1: Assumed Rate of Return

Investment Return History, 2001- 2020

Investment Returns Have Underperformed

TRS actuaries have historically used an 8% assumed rate of return to calculate member and employer contributions, slowly lowering the rate to 7.5% over the past two decades in response to significant market changes.

Average long-term portfolio returns have not matched long-term assumptions over different periods of time:

Note: Past performance is not the best measure of future performance, but it does help provide some context to the challenge created by having an excessively high assumed rate of return.

New Normal: Markets Have Recovered Since the Crisis—TRS Funded Ratio Has Not

The “new normal” for institutional investing suggests that achieving even a 6% average rate of return in the future is optimistic.

1. Over the past two decades there has been a steady change in the nature of institutional investment returns.
   • 30-year Treasury yields have fallen from near 8% in the 1990s to consistently less than 3%.
   • New phenomenon: negative interest rates, designates a collapse in global bond yields.
   • The U.S. just experienced the longest economic recovery in history, yet average growth rates in GDP and inflation are below expectations.
2. McKinsey & Co. forecast the returns on equities will be 20% to 50% lower over the next two decades compared to the previous three decades.
   • Using their forecasts, the best-case scenario for a 70/30 portfolio of equities and bonds is likely to earn around 5% return.
3. 3. The Montana TRS 5-year average return is around 6.6%, well below the assumed 7.5% return assumption.

Expanding Risk in Search for Yield

Probability Analysis: Measuring the Likelihood of TRS Achieving Various Rates of Return

Probability Analysis: Measuring the Likelihood of TRS Achieving Various Rates of Return

TRS Assumptions & Experience

• A probability analysis of TRS historical returns over the past 20 years (2000-2020) indicates only a modest chance (26%) of hitting the plan’s 7.5% assumed return.
• Horizon’s long-term capital assumptions adopted by TRS project a 47% chance of achieving their current investment return target.

Short-Term Market Forecast

• Returns over the short to medium term can have significant negative effects on funding outcomes for mature pension plans with large negative cash flows like TRS.
• Analysis of capital market assumptions publicly reported by the leading financial firms (BlackRock, JP Morgan, BNY Mellon, and Research Affiliates) suggests that over a 10-15 year period, TRS returns are likely to fall short of their assumption.

Long-Term Market Forecast

• Longer-term projections typically assume TRS investment returns will revert back to historical averages.
  • The “reversion to mean” assumption should be viewed with caution given historical changes in interest rates and a variety of other market conditions that increase uncertainty over longer projection periods, relative to shorter ones.
• Forecasts showing long-term returns near 7.5% being likely also show a significant chance that the actual longterm average return will fall far shorter than expected.
  • For example, according to the BlackRock’s 20-year forecast, while the probability of achieving an average return of 7.5% or higher is about 49%, the probability of earning a rate of return below 5% is about 21%.

Important Funding Concepts

Employer Contribution Rates

• Statutory Contributions: TRS employers make annual payments based on a rate set in Montana state statute, meaning contributions remain static until changed by legislation.
• Actuarially Determined Employer Contribution (ADEC): Unlike statutory contributions, ADEC is the annual required amount TRS’s consulting actuary has determined is needed to be contributed each year to avoid growth in pension UAL and keep TRS solvent.
• Variable Contribution Rate: Not as rigid as statutory contributions but not as responsive as actuarially determined contributions, Montana’s current tradition of legislating contribution increases only after years of poor performance requires political action in times of volatility, with rate increases requested only when forecasts show that the period to fully amortize the current legacy unfunded liability exceeds 30 years.

All-In Employer Cost

• The true cost of a pension is not only in the annual contributions, but also in whatever unfunded liabilities remain. The ”All-in Employer Cost” combines the total amount paid in employer contributions and adds what unfunded liabilities remain at the end of the forecasting window.

Quick Note: With actuarial experiences of public pension plans varying from one year to the next, and potential rounding and methodological differences between actuaries, projected values shown onwards are not meant for budget planning purposes. For trend and policy discussions only.

Baseline Rates

• The variable contribution rate used as the baseline funding policy in the following analysis responds to changes in market conditions in lieu of the slower-paced statutory rate increases anticipated under current state law.
• The variable baseline rate factors in statutorily required appropriation from the state of a fixed amount of $25 million for the fiscal year beginning July 1, 2013 which is used to calculate the amortization period and subsequent variable rate. The variable baseline rate does not include conditional decreases tied to the TRS funding period.

Risk Management

Stress Testing TRS Using Crisis Simulations

Stress on the Economy:

• Market watchers expect dwindling consumption and incomes to severely impact near-term tax collections – applying more pressure on state and local budgets.
• Revenue declines are likely to undermine employers’ ability to make full pension contributions, especially for those relying on more volatile tax sources (e.g., sales taxes) and those with low rainyday fund balances.
• Many experts expect continued market volatility, and the Federal Reserve is expected to keep interest rates near 0% for years and only increase rates in response to longer-term inflation trends.

Methodology:

• Adapting the Dodd-Frank stress testing methodology for banks and Moody’s Investors Service recession preparedness analysis, the following scenarios assume one year of -24.0% returns in 2020, followed by three years of 11% average returns.
• Recognizing expert consensus regarding a diminishing capital market outlook, scenarios assume a 6% fixed annual return between crisis scenarios.
• Given the increased exposure to volatile global markets and rising frequency of Black Swan economic events, we include a scenario incorporating a second Black Swan crisis event in 2035.

Scenario Comparison of Employer Costs

How a Crisis Increases TRS Cost

• Discount Rate: 7.5%
• Assumed Return: 7.5%
• Actual Return: Varying
• Amo. Period: Current

Unfunded Liabilities Under Crisis Scenarios

• Discount Rate: 7.5%
• Assumed Return: 7.5%
• Actual Return: Varying
• Amo. Period: Current

TRS Solvency Under Crisis Scenarios

• Discount Rate: 7.5%
• Assumed Return: 7.5%
• Actual Return: Varying
• Amo. Period: Current

All Paths to a 7.5% Average Return Are Not Equal

Long-Term Average Returns of 7.5%

Sensitivity Analysis: Normal Cost Comparison Under Alternative Assumed Rates of Return

Amounts to be Paid in 2020-21 Contribution Fiscal Year, % of projected payroll

Challenge 2: Deviations and Changes to Actuarial Assumptions and Methods

Failure to meet actuarial assumptions, and delay in updating those assumptions, has led to an underestimation of the total pension liability.

Adopting more prudent actuarial assumptions and methods necessitates the recognition of additional unfunded liabilities.

Actuarial Assumption and Methods

TRS unfunded liabilities have increased by a combined $400 million between 2002-2020 due to prudent updates to actuarial assumptions and methods such as lowering the assumed rate of return.

Salary Increase Assumptions

TRS employers have not raised salaries as fast as expected, resulting in lower payrolls and thus lower earned pension benefits – a common case for many state-level pension plans. This reduced unfunded liabilities by $266 million from 2002-2020.

Withdrawal Rate, Service Retirement, and Mortality Assumptions

Due to misaligned demographic assumptions, TRS unfunded liabilities have increased by a combined $332 million between 2002-2020.

This likely stems from a combination of one or more of the following factors:

Actual withdrawal rates before members have reached either a reduced or normal retirement threshold have been lower than anticipated.

TRS members have been retiring earlier than expected, receiving more pension checks.

Overestimated Payroll Growth

Overestimating payroll growth may create a long-term problem for TRS in combination with the level-percentage of payroll amortization method used by the plans.

This method backloads pension debt payments by assuming that future payrolls will be larger than today (a reasonable assumption).

While in and of itself, a growing payroll is a reasonable assumption, if payroll does not grow as fast as assumed, employer contributions must rise as a percentage of payroll.

This means the amortization method combined with the inaccurate assumption is delaying debt payments.

Challenge 3: Insufficient Contributions & Debt Management Policies

Over the past two decades employer contributions to TRS have fallen short of the amount plan actuaries determined would be needed to reach 100% funding in 30 years.

State contributions towards paying off pension debt are less than the interest accruing on the pension debt.

Challenge 4: Discount Rate and Undervaluing Debt

The discount rate undervalues the total amount of existing pension obligations.

1. The “discount rate” for a public pension plan should reflect the risk inherent in the pension plan’s liabilities:

• Most public sector pension plans — including Montana TRS — use the assumed rate of return and discount rate interchangeably, even though each serve a different purpose.
• The Assumed Rate of Return (ARR) adopted by Montana TRS estimates what the plan will return on average in the long run and is used to calculate contributions needed each year to fund the plans.
• The Discount Rate (DR), on the other hand, is used to determine the net present value of all of the already promised pension benefits and supposed to reflect the risk of the plan sponsor not being able to pay the promised pensions.

2. Setting a discount rate too high will lead to undervaluing the amount of pension benefits actually promised:

• If a pension plan is choosing to target a high rate of return with its portfolio of assets, and that high assumed return is then used to calculate/discount the value of existing promised benefits, the result will likely be that the actuarially recognized amount of accrued liabilities is undervalued.

3. It is reasonable to conclude that there is almost no risk that Montana would pay out less than 100% of promised retirement income benefits to members and retirees.

• The Contract Clause in the Montana Constitution is similar to the U.S. Constitution’s Contract Clause. There is little basis to conclude Montana TRS has the kind of liability risks implied by a high discount rate.

4. The discount rate used to account for this minimal risk should be appropriately low.

• The higher the discount rate used by a pension plan, the higher the implied assumption of risk for the pension obligations.

Sensitivity Analysis: Pension Debt Comparison Under Alternative Discount Rates

Changes in the Risk Free Rate Compared to TRS Discount Rate (2000-2020)

Change in the Risk Free Rate Compared to TRS Discount Rate (2000-2020)

Challenge 5: The Existing Benefit Design Does Not Work for Everyone

• More than 70% of TRS members do not work long enough to earn a full pension
• The turnover rate for Montana teachers suggests that the current retirement benefit design is not effective at encouraging retention in the near-term, and may be pushing out employees at the end of their careers.
• 59% of new teachers leave before 5 years
• TRS members need to work for 5 years before their benefits become vested.
• Another 9% of new teachers who are still working after 5 years will leave before 10 years of service
• 23% of all members hired will still be working after 30 years, long enough to qualify for full, unreduced pension benefits

Recruiting a 21st Century Workforce:

• There is little evidence that retirement plans—DB, DC, or other design—are a major factor in whether an individual wants to enter public employment.
• The most likely incentive to increase recruiting to the public workforce is increased salary.

Retaining Employees:

• If worker retention is a goal of the TRS system, it is clearly not working, as nearly 70% of employees leave within 5 years.
• After 15 to 25 years of service there is some retention effect, but the same incentives serve to push out workers in a sharp drop off after 30 years of service or reaching the “Rule of 80” threshold.

A Framework for Policy Reform

Objectives

• Keeping Promises: Ensure the ability to pay 100% of the benefits earned and accrued by active workers and retirees
• Retirement Security: Provide retirement security for all current and future employees
• Predictability: Stabilize contribution rates for the long-term
• Risk Reduction: Reduce pension system exposure to financial risk and market volatility
• Affordability: Reduce long-term costs for employers/taxpayers and employees
• Attractive Benefits: Ensure the ability to recruit 21st Century employees
• Good Governance: Adopt best practices for board organization, investment management, and financial reporting

Pension Resiliency Strategies

1. Establish a plan to pay off the unfunded liability as quickly as possible. The Society of Actuaries Blue Ribbon Panel recommends amortization schedules be no longer than 15 to 20 years.
2. Adopt better funding policy, risk assessment, and actuarial assumptions. These changes should aim at minimizing risk and contribution rate volatility for employers and employees.
3. Create a path to retirement security for all participants. Consider offering members that won’t accrue a full pension benefit access to other plan design options (e.g., cash balance, DC, hybrid, etc.)

Potential Solutions

1. Establish a Plan to Pay Off the Unfunded Liability as Quickly as Possible

Current amortization policy for TRS targets time horizons that are too long:

• TRS targets a 30-year window to pay off unfunded liabilities.
• The longer the unfunded liability amortization period, the greater chance that market risk drives unfunded liabilities higher.
• The Society of Actuaries Blue Ribbon Panel recommends amortization schedules be no longer than 15 to 20 years.

Rethink amortization in two steps:

Step 1: Address the Current Unfunded Liability

• Segmenting accrued unfunded liabilities from any gains or losses in future years can allow policymakers to set the past debt on a direct and fiscally realistic course to being fully funded.
• Prevents the need to revisit the issue in subsequent sessions.

Step 2: Develop a Plan to Tackle Future Debt

• Adopting “layered” amortization for future unfunded liabilities. would ensure that any new pension debt accrued in a given year is paid off much faster—preferably 10 years or less—than the current 30+ year period.
• Covering future pension losses with consistent annual payments over a decade or less would align TRS amortization policy with actuarial best practice.

2. Adopt Better Funding Policy, Investment Policy, Risk Assessments and Actuarial Assumptions

Current funding policy has created negative amortization and exposes the plan to significant risk of additional unfunded liabilities.

• Establishing TRS contribution rates in statute, and requiring political intervention with uncertain outcomes, makes it difficult in practice to respond quickly to changing economic circumstances.
• This policy is in contrast with the more common funding method based on normal cost and the amortization cost that pays down unfunded liabilities over a predetermined, closed period.
• Given the volatility of their amortization policy, it will likely take more than 30 years to amortize current unfunded liabilities, exposing TRS to major financial risks over that period.
• Options to consider include:
  • Requiring employers and future employees that accrue defined benefits to make contributions on a pre-defined cost sharing basis (such as a 50-50 split) as actuarially determined
  • Using short (10-year or less) periods to pay off any new, annual unfunded liabilities that might accrue

Improve risk assessment and actuarial assumptions.

• Look to lower the assumed return such that it aligns with more realistic probability of success.
• Adjust the portfolio to reduce high risk assets no longer needed with lower assumed return target.
• Work to reduce fees and costs of active management.
• Consider adopting an even more conservative assumption for a new hire defined benefit plan.
• Require regular stress testing for contribution rates, funded ratios, and cash flows with look-forward forecasts for a range of scenarios.
• While pension plans can, and some do, implement a limited risk assessment under current financial reporting, an independent risk assessment/stress test review using a range of pre-built stress scenarios is the ideal approach.

3. Create a Path to Retirement Security for All Participants of TRS

Montana TRS is not providing a path to retirement income security for all educators

• For example, only 23% of teachers make it to the 30 years necessary for a full, unreduced pension. This means the majority of teachers could be better served by having the choice of an alternative, more portable plan design—such as a cash balance, hybrid or defined contribution retirement plan.

Employees should have options when selecting a retirement plan design that fits their career and lifestyle goals

• Cash balance plans can be designed to provide a steady accrual rate, offer portability, and ensure a path to retirement security.
• Montana has a long history of managing cash balance plans through municipality, county, and district systems.
• Defined contribution plans can be designed to auto-enroll members into professionally managed accounts with low fees that target specified retirement income and offer access to annuities.

Montana Teacher Retirement System (TRS) Pension Solvency Analysis

The post Montana Teacher Retirement System (TRS) Pension Solvency Analysis appeared first on Reason Foundation.

Grayscale Investors, the world’s largest digital asset manager, told Bloomberg that they expect pension funds and endowments to fuel their future growth. Grayscale owns 3 percent of all shares of Bitcoin, and most of their $2 billion to $25 billion asset growth over the last year has been from Bitcoin.

Recently, the California Public Employee Retirement System (CalPERS), the nation’s largest public pension system, disclosed that it increased its investment in RIOT Blockchain Inc., a bitcoin mining company, from $49,000 in 2017 to $1.6 million in 2020.

Pension funds like CalPERS typically search for higher investment yields by investing in private equity. But in recent years, returns from private equity have underperformed in comparison to the S&P 500. Analysis of private equity returns (net of fees) has essentially matched the performance of the S&P since 2009.

The reasons for this decline are varied, but this trend can largely be attributed to the fact that private equity is a relatively mature industry in where attractive investments at low cost are hard to come by. The term “alpha” in investing refers to the amount of excess returns generated by excess risk—in essence measuring the value add of an external fund manager. In the case of private equity, alpha during the last decade was close to zero percent,  compared to hedge funds which saw an alpha of negative 1 percent.

As a result of these market trends, institutional investors have been showing an interest in even riskier assets that may produce higher yields. This search has lead public pension systems like Virginia’s Fairfax County Employees and Police Officers Retirement Systems as well as the University of Michigan’s pension plan to invest in Bitcoin and other cryptocurrencies.

While the growth in cryptocurrencies has been stratospheric in recent months, these assets have also seen massive volatility apart from the most recent price drop, with one of the largest price drops in 2018. Bitcoin had its first major peak at $20,000 per share during the end of 2017 but then plunged 75 percent in less than a year. This peak-to-trough decline is comparable to the dot-com bust, which dropped 78 percent from its peak.

The jury is still out on whether Bitcoin can hold water in the long run. Even if Bitcoin isn’t a bubble, it is likely to see a correction in the future with the flood of investors pouring in and prices will likely continue to fluctuate.

In any case, it’s not wise for public pension funds and taxpayers to be exposed to such financial risk. Public pension benefits are constitutionally protected and taxpayers—who would be asked to make up for pension shortfalls—should not be subject to the risks of such volatile investments.

Although current pension investment allocations towards Bitcoin and other crypto assets are small, California’s large increase in crypto shares could spark interest in other states. Pension funds and other asset managers may believe they can time the market and jump in on Bitcoin at the perfect time, but with something like cryptocurrencies, that is much easier said than done.

While the goal of public pension funds trying to improve yields and make up for lost growth in 2020 is admirable, Bitcoin is just too volatile at this point and the significant risks to public pension systems, retirees, and taxpayers far outweigh the benefits. A much better goal for public pension funds would be to lower their investment return assumptions and adjust other expectations to lower market yields.

Update 5/17/2021: CalPERS’s 2020 cryptocurrency investments were made through a passive index fund rather than an active investment. While this does not change the fact that cryptocurrencies are risky investments for pension funds, an investment made through a passive index fund should not be seen as a commitment to a certain asset or asset class. 

The post Should Public Pension Funds Be Investing In Cryptocurrency? appeared first on Reason Foundation.

The Montana Public Employee Retirement System (MPERS) has seen a significant increase in public pension debt in the last two decades. In the year 2001, the public pension plan, which serves state workers, was overfunded by almost a half of a billion dollars and had almost 120 percent of the assets they needed on hand to pay promised benefits.

Today, the pension plan is only 74 percent funded and has $2.1 billion in debt.

The latest analysis by the Pension Integrity Project at Reason Foundation, updated this month (February 2021), shows that deviations from the plan’s investment return assumptions have been the largest contributor to MPERS’ unfunded liability, adding $1.3 billion since 2001. The analysis also shows that failing to meet investment targets will likely be a problem for MPERS going forward as projections reveal the pension plan has roughly a 50 percent chance of meeting their 7.65 percent assumed rate of investment return in both the short and long term.

Negative amortization has also added $587 in unfunded liabilities to the plan since 2002. Negative amortization is experienced when interest on debt exceeds actual debt payments in any given year.

The overall growth in unfunded liabilities has driven Montana’s pension benefit costs higher while crowding out other taxpayer priorities and programs in the state.

The chart below, from the full solvency analysis, shows the increase in the Montana Public Employee Retirement System’s debt since 2001:

This underfunding not only puts taxpayers on the hook for growing debt but could jeopardize the retirement security of Montana’s state employees. Left unaddressed, the pension plan’s structural problems will continue to pull resources from other state priorities.

The full Montana PERS solvency analysis also offers stress-testing designed to highlight potentially latent financial risks the pension system is facing. Reason Foundation also highlights a number of policy opportunities that would address the declining solvency of the public pension plan. A new, updated analysis will be added to this page regularly to track the system’s performance and solvency.

Bringing stakeholders together around a central, non-partisan understanding of the challenges the Montana Public Employee Retirement System is facing—complete with independent third-party actuarial analysis and expert technical assistance—the Pension Integrity Project at Reason Foundation stands ready to help guide Montana policymakers and stakeholders in addressing the shifting fiscal landscape.

Montana Public Employee Retirement System (MPERS) Pension Solvency Analysis

Reason Foundation’s previous solvency analysis of the Montana Public Employee Retirement System is available below:

• January 2021 Montana Public Employee Retirement System Pension Solvency Analysis

The post Montana Public Employee Retirement System (MPERS) Pension Solvency Analysis appeared first on Reason Foundation.

In the United States, public pension funds, which have an average investment return target of 7.25 percent, will likely struggle to meet those investment targets and could be severely impacted by plummeting interest rates. Without changes to pension plans’ assumed rates of return, many public pension systems will see an increase in debt.

Unfortunately, many public pension plan managers are not interested in adjusting their investment return targets to realistic levels at this time. Instead, they are seeking riskier, potentially higher-yielding investments in an effort to make up for depressed interest rates and hit their targets.

Fixed-income investments, like government and corporate bonds, have been a part of pension fund portfolios for decades. And, for several pension funds, fixed-income investments hover around 25 percent of their entire investment portfolios.

New Mexico’s Educational Retirement Board (ERB), which serves the state’s teachers, is one such plan that dedicates roughly a quarter of its portfolio to fixed-income assets. Within New Mexico ERB’s fixed income-investment allocation, 7 percent of funds go to emerging market debt, which is essentially sovereign bonds issued by countries classified by the World Bank as lower-to-middle-income to upper-middle-income. This includes countries such as Brazil, India, and Nigeria.

Even though emerging market debt carries much higher yields that are attractive to pension funds, those benefits can be outweighed by enormous risks since several of these countries have defaulted on their debt in the past. Due to this risk, public pension investment allocations to emerging market debt have historically been used sparingly in pension fund portfolios. However, in recent months, pension fund managers have signaled a growing appetite for allocating more assets to this asset class. The reasons for this change could be:

1. Smaller Contraction and Sharper Rebound – According to the International Monetary Fund (IMF), the developed world’s economy will, on average, contract about 5.8 percent in 2020 and rebound about 3.9 percent in 2021. Those numbers are almost reversed for the emerging markets where the economic contraction is expected to be about 3.3 percent in 2020 with a rebound of 6 percent in 2021. This means that on average, the emerging markets are forecast to be a key driver of economic growth post-pandemic.
2. Search for Yield – With the downward pressure on interest rates in the US, Europe, China, and elsewhere, the search for higher yields will be paramount for pension funds seeking to hit their investment return targets without lowering investment return assumptions.
3. Backstop from IMF – Given the risk of debt defaults as discussed earlier, emerging market investment was always severely limited in pension funds. With the coronavirus pandemic continuing, the IMF has provided partial guarantees to several emerging markets in debt relief. This response has made this debt much more attractive.

There are still a lot of risks associated with emerging market debt. For starters, each of the economic forecasts and scenarios above may not materialize fully. For example, the economic rebound may not be as strong as expected, or the IMF may not guarantee as much debt as investors expect. Each of these scenarios would be a blow to the attractiveness of emerging market debt.

On top of that, these emerging market countries have significant currency risks that could be made worse through recent trends in declining exports. In other words, many public pension funds are still taking significant financial gambles by investing in emerging market debt.

As long as public pension funds across the country continue to maintain unrealistically high annual return targets of around 7.25 percent, and as long interest rates in developed economies continue to plummet to zero—and below zero, we can expect emerging market debt to continue to gain traction with plans willing to take significant risks in 2021 and beyond.

The post With Interest Rates Low, US Pension Funds Make Risky Investments In Emerging Market Debt appeared first on Reason Foundation.

During an August Investments and Pensions Oversight Committee (IPOC) meeting, the Educational Retirement Board’s administrative leadership spoke to state legislators about the long-term funding prospects of the plan and laid out three options they believe could get ERB back on track to being fully funded by 2050.

These suggestions were to increase employer contribution rates, transfer the pension plan’s reported $9 billion in unfunded liabilities to the state’s general ledger through a bond offering, or decrease retirement benefits offered to ERB members.

Legislators and ERB seem to have come to an agreement on a plan to increase employer contributions and ERB has already drafted legislation to do so.

The bill is set to be introduced by State Sen. Mimi Stewart (D-Albuquerque) in the 2021 legislative session. The proposed bill increases the annual statutorily-set ERB employer contribution rate from 14.15 percent to 18.15 percent, increasing one percent a year over four years.

In its latest presentation to IPOC on December 10, the New Mexico Educational Retirement Board’s administrators used the plan’s latest valuation report to walk policymakers through its current $9 billion shortfalls and 60 percent funded status by way of highlighting the fact that there is currently no path for ERB to fully fund retirement benefits. Plan administrators warned that, historically, ERB has had the ability to pay benefits in perpetuity, but for the first time in its history, ERB is expected to exhaust that ability soon absent changes to current funding policy.

The employer contribution rate is the amount of funding that the state is required to contribute to the plan each year. This funding increase recommendation is the latest legislative attempt by ERB to ensure the retirement benefits of state-employed educators are fully funded and available to retirees over the long-term.

Previous well-intentioned efforts to increase retirement eligibility requirements, increase member contributions, and tie retirees’ cost-of-living-adjustments (COLAs) to ERB’s funded ratio (all of which focused on the member’s influence on the funding formula) have made a small impact on the resiliency and long-term solvency of ERB.

Figure 1 below displays the funding history of the plan.

Figure 1: History of the New Mexico Educational Retirement Board’s Solvency

Actuarial analysis of ERB’s latest proposal suggests that the increased employer contribution rate, while a positive step, would only make a difference in the plan’s long-term sustainability if all actuarial assumptions are met over the next 30 years.

The Pension Integrity Project at Reason Foundation modeled the proposal and found that if implemented, ERB’s 2050-projected unfunded liability would decrease by nearly 40 percent, decreasing from $34.2 billion in debt to $20 billion. The ERB proposal, however, would still ultimately result in the plan’s accrued benefits being only 66 percent funded in 2050.

In short, the proposed changes could be a good, small reform and the plan’s funded status would marginally improve if all actuarial assumptions are met over the next 30 years, but ERB would still have significant structural problems and remain far short of full funding.

From a solvency perspective, the impact of increased contributions on ERB is clear: the more contributions the better. However, our analysis also finds that when accounting for potential future market underperformance, absent addressing the systemic issues driving the growth of unfunded benefits, ERB’s funding issues are bound to worsen.

To be sure, increasing contributions to address growing unfunded liabilities is a good policy step for many public pension plans, but often more changes are necessary to fully address the fiscal stress pension debt puts on employees, retirees and taxpayers.

Figure 2 illustrates this important finding by comparing the current state of ERB, where all actuarial assumptions governing the plan—including ERB’s current 7 percent investment return rate assumption—are accurate each year, to a less optimistic forecast that shows the condition of ERB after 30 years of more conservative investment returns and two recessionary periods.

Figure 2: The Effect of a 4 Percent Employer Contribution Increase on ERB’s Funded Ratio

In the event that all of the plan’s assumptions are consistently accurate over the next 30 years, additional state funding would improve ERB solvency. But the proposal to increase contributions does nothing to address the current unfunded liabilities or the system’s exposure to market volatility.

Additionally, ERB funding improvement relies on the theory that the system’s investment return rate assumption of 7 percent, among others, will either be met or exceeded in the near-term, which ERB administrators and consultants say they believe is a reasonable assumption.

When assumptions are missed, especially the plan’s investment return rate assumptions that serve as the only other funding source outside of members and taxpayers, ERB’s unfunded liabilities would grow despite increased contributions from the state. Thus, in the overall picture, the proposed contribution increases wouldn’t prevent the further accrual of unfunded retirement benefits by public educators, who, for their part, have honor the obligation their side of the agreement entered in when first hired.

Figure 3 shows the projected increase of ERB unfunded liabilities under various economic and investment return scenarios.

Figure 3: The Effect of a 4 Percent Employer Contribution Increase on ERB Unfunded Liabilities Under Lower Investment Return Rates

A less lucrative investment portfolio and recurring recessions over the next 30 years, which most economists expect, would likely result in significant drops in ERB’s funding regardless of the proposed employer contribution increase.

Increasing the contribution rate is a good idea but without also addressing the volatility inherent in the ERB investment portfolio and adjusting how the state is paying off its debt and unfunded liabilities, ERB will remain less and less resilient to economic and stock market shifts over time and will continue to accrue ever higher unfunded liabilities.

The proposed contribution increase would certainly be beneficial from a solvency perspective, but ERB’s situation requires far more substantive adjustments to how unfunded liabilities are tackled and how the plan reacts to underperforming investment results if it is going to ensure retirement benefits for New Mexico’s teachers and educators are sustainable and financially resilient to market shocks over the long-term.

During New Mexico’s recent PERA reform effort, state policymakers simultaneously increased employer contributions while also addressing systemic design flaws like the guaranteed cost-of-living adjustments that were untethered to actual inflation and reducing PERA’s long-term exposure to market risk by lowering investment return assumptions.

Elsewhere, in 2018, the state of Colorado not only increased employer and employee contributions to its main public pension system but also established an automatic adjustment feature— automatically increasing annual pension contributions and lowering the pension plan’s cost-of-living adjustments if certain funding thresholds are not met. The city of Fort Worth soon followed suit, enacting a similar automatic adjustment policy for its public workers’ pension system.

Adding an automatic adjustment policy to increased contribution proposals would not only improve the trajectory of ERB funding but could also insulate the system from unpredictable market returns in the future. Such a policy would allow annual contributions to respond more freely to changing conditions and ensure that if any future investment returns come in below expectations, they do not derail the public pension system’s trajectory towards full funding.

The best way for New Mexico lawmakers to address the problem of contributions not adjusting to market volatility and performance would be for the legislature to contribute annually to ERB at an actuarially determined employer contribution (ADEC) rate.

Every year, ERB’s actuaries calculate the amount of funding the pension plan needs from all sources to avoid any growth in unfunded pension liabilities. Currently, the state does not rely on this ADEC value to determine its annual contributions, as many pension plans across the country do. Instead, ERB relies on a fixed percentage of payroll set by law at the discretion of legislators. The result of this policy has been chronic underpayments, adding to the system’s long-term solvency concerns.

Figure 4 illustrates this problem, showing that state contributions into the fund have been below actuarially required amounts for nearly 20 years.

Figure 4: Actual vs Required ERB Contributions

ERB would benefit from adjusting its funding policy to match the many other states that rely on the actuarially-determined amount to set annual contributions. This change in policy, like the proposed automatic adjustment feature, would protect the post-employment security of New Mexico educators from the unpredictable future of the market.

Figures 2 and 3 above also include scenarios modeling an ADEC-based policy, which shows ERB’s funded ratio rising to nearly 100 percent and its unfunded liabilities being nearly eliminated in 30 years.

The ERB-backed state funding increase proposal represents a commitment to securing the retirement of New Mexico educators.

However, despite the contributions increases moving ERB off the path of insolvency, the proposal’s success relies heavily on the ability of ERB to achieve expected returns. Because of this, the retirement security of the 12 percent of New Mexico educators who serve their communities long enough to earn an unreduced ERB retirement benefit, will continue to be exposed to a great deal of risk and ERB will still need additional adjustments in the future.

Adopting more risk-averse investment return assumptions and funding policies to prevent the further growth of unfunded benefits, while establishing a plan to pay off the plan’s existing unfunded liability as quickly as possible would directly address the systemic underfunding that has created the challenges facing ERB today.

The post Contribution Increases Could Help New Mexico’s Teacher Pension Plan, But More Changes Are Necessary appeared first on Reason Foundation.

In fact, the average investment return rate of the 84 state-managed public pension plans that have reported their fiscal year 2019-2020 returns so far is just 3 percent. Despite the stock market having a strong year, Reason Foundation’s analysis shows that the nation’s 10 largest public pension systems averaged just a 2.6 percent rate of investment return, which is significantly short of what the plans were expecting. The shortfalls of these 10 public pension plans account for $68 billion of the estimated $200 billion expected to be added to the nation’s total public pension debt.

Although 3 percent is well above the negative return rate that some experts feared pension plans might see after the pandemic hit, any time that a pension plan’s investment returns fall short of its set assumed rate of return debt is added to the retirement system.

The average assumed rate of return for state-managed public pension plans in 2019 was 7.25 percent. Falling short of that goal by more than 4 percentage points at the aggregate level should be concerning to public employees, plan administrators, and taxpayers alike.

Figure 1 below shows the growth of pension liabilities (promised benefits) vs the growth in pension assets since 2001. The difference between the two, highlighted in gray, is accumulated unfunded liabilities, or pension debt.

Figure 1: Total State-Managed Public Pension Unfunded Liabilities And 2020 Projection 

Source: Pension Integrity Project at Reason Foundation analysis of U.S. public pension actuarial valuation reports and Comprehensive Annual Financial Reports (CAFRs). 

One bad year of market returns can significantly impact near-term pension funding. For example, we estimate the New York State and Local Employees Retirement System’s negative 2.7 percent return this year could increase its debt burden by more than $17 billion (based on the market value of assets, see methodology section in the app for more details).

A smaller plan, like the New Mexico Educational Retirement Board, which earned a negative 0.6 percent return, could see a $1 billion increase in unfunded pension liabilities.

While investment performance in any single year may have a relatively limited impact on long-term pension solvency, our analyses demonstrate that consistent investment underperformance relative to the investment return assumptions made by pension systems have been the biggest culprit behind the growth of public pension debt across the nation. Even during a period of strong stock market performance, including the longest bull market in history, public pension plans failed to make significant funding progress as their pension investment results repeatedly failed to match expectations throughout the last decade.

According to Reason Foundation’s analysis, most fiscal year 19-20 investment returns fell within a positive return range of  1.3 percent to 4.0 percent.

Figure 2 below shows that 75 percent of reported returns were under 4.0 percent, 50 percent were below 3 percent and 25 percent were below 1.3 percent.

Figure 2: 2020 Investment Return Distribution 

Source: Pension Integrity Project at Reason Foundation analysis of publicly reported FY20 investment returns,

The worst return so far reported has been the Louisiana State Employees Retirement System, which saw a negative 3.8 percent rate for its fiscal year.

At the other end of the spectrum is the Delaware State Employees’ Pension System, which finished its fiscal year with an impressive 10 percent yield. At the time of this publishing, of the 84 pension systems that have posted complete fiscal year results, only the Delaware State Employees’ Pension System has met its assumed rate of return in FY 19-20.

It’s also worth mentioning that return results for systems with fiscal years ending on Sept. 30 and Dec. 31 will likely look better than the results for pension plans that have fiscal years that ended on June 30, 2020. Markets continued improving in the second half of calendar 2020 after the early stages of the COVID-19 pandemic and recession so those plans had more time to recover from the pandemic’s initial impact on markets.

Although COVID-19 and the recession’s impact on markets and the economy were less disastrous than many experts had forecasted in the spring of 2020, public pension systems continue to face significant challenges in the years ahead.

In its latest World Economic Outlook, the International Monetary Fund projects that real gross domestic product (GDP) in the world’s advanced economies will settle at around negative 5.8 percent for 2020 (with the U.S. expected to post a final figure of around negative 3.6 percent) and average 2.2 percent growth rates in the 2022-25 period. The low economic growth forecasts at a minimum portend lower returns on equity investments (e.g. corporate stocks).

Figure 3: Real Gross Domestic Product Growth Projections

Source: International Monetary Fund, “World Economic Outlook October 2020”.

Even before this year’s COVID-19 related market volatility, experts were forecasting a new normal low-yield environment for institutional investors like pension funds over the next 10-15 years. If pension plans and policymakers do not adjust their investment return assumptions to these forecasts, more public pension debt will be added to most systems. As pension assets get more and more depleted, it also becomes more difficult to depend on market returns as a method to climb back to full funding.

The 2020 investment return results add to concerns that public pension plans will continue to struggle with investment return realities that are below the return rates they are counting on, which could have long-lasting negative effects on taxpayers. Long-term underfunding could potentially:

• Increase the risk of pension plans not being able to pay out promised benefits.
• Trigger benefit cuts or much lower benefit accrual formulas for new hires.
• Require future taxpayers to cover high costs for current and past public employees, whose services they will receive no benefit from.
• Pull public funds away from other priorities like K-12 education and public safety.
• Put public pension systems into a “point of no return” where assets are so depleted that it becomes almost impossible to invest their way to full funding, even with double-digit yields later (recent examples include the Puerto Rico, Illinois, and Kentucky pension systems in the last decade).

The first vaccines have arrived but the coronavirus pandemic is not over yet, and states will feel the effects of the COVID-19 recession in their budgets for quite some time.  Policymakers should take this unique moment to revise investment return assumptions and other expectations for public pension funds in order to fully-fund pension promises that have been made to workers.

The post Pension Debt Grows as Public Pension Systems Post Low Investment Returns for 2020 appeared first on Reason Foundation.

In an August presentation to the New Mexico Investments and Pensions Oversight Committee, the state’s Educational Retirement Board (ERB) administrators warned that without significant employer contribution increases, there may need to be benefit reductions for the pension plan’s active and new members. They said these cuts would help the plan, which serves all of the state’s K-12 educators and some higher education employees, reach full funding in a 30-year period.

Reason Foundation’s latest analysis shows that New Mexico Educational Retirement Board had $8 billion in unfunded liabilities in 2019, up from only $650 million in unfunded liabilities in 2001. The majority of this growth in unfunded liabilities stems from investment returns that fell below investment return rate assumptions and insufficient contributions on the part of the state.

At this time, it will take the New Mexico Educational Retirement Board 47 years to pay off its accumulated debt. According to the Society of Actuaries (SOA), the recommended payoff period for public pension debt is 15-to-20 years.

These numbers do not take into account the fact that ERB reported a negative .97 percent return for its last fiscal year. Estimates show that this negative return could add an additional $1 billion of debt to the pension system.

The director of ERB discussed a variety of ways these pension cuts could play out, including a reduction of the benefit accrual rate for future service, which would mean workers receive fewer retirement benefits for the same employee contributions. Also discussed was a 0.5 percent cap on cost-of-living adjustments (COLAs) until the plan is projected to reach 100 percent funding within 30 years.

While it is good that ERB is highlighting the urgency of the pension plan’s financial troubles, cutting benefits without addressing structural and funding policy issues undermining the sustainability of the pension plan would be an inadequate approach to solving a nuanced problem.

Rather than jump to benefit cuts, the state legislature could explore more substantive reforms that could put ERB on a realistic debt payoff period, just as the legislature did last year when it passed reforms to the New Mexico Public Employee Retirement Association (PERA), the state’s other major public pension system.

PERA has consistently maintained a higher funded ratio than ERB while also paying out higher benefits, but last year unpromising financial forecasts prompted the legislature to enact plan changes to help improve the system’s solvency. These changes included a shift to a flexible COLA that adjusts based on fiscal conditions and a “shared sacrifice” of an equal employer and employee contribution rate increase.

According to PERA’s own projections, these changes will raise the plan’s chances of reaching full funding by 2043 from 38 percent to 47 percent and will save the state from accruing an estimated additional $15 billion in unfunded liabilities during that period. These changes increase retirement security for employees and retirees, and ERB should look to implement similar reforms.

ERB has not been completely inactive in trying to ward off insolvency. In April 2020, the plan reduced its assumed rate of return on investments from 7.25 percent to 7 percent. This change will limit the opportunity for new debt to accrue as a result of investment shortfalls.

In the last 20 years, ERB has averaged a 5 percent investment return and their return for this last fiscal year was negative .97 percent. And, well before the COVID-19 pandemic and recession arrive, financial experts were saying a lower yield investment environment would plague public pension plans for the foreseeable future. The below chart compares ERB’s assumed rate of return to actual investment returns since 1995.

Figure 1 – New Mexico ERB Returns vs Assumptions

Source: Pension Integrity Project Database with data compiled from New Mexico ERB Valuation Reports

State law has also contributed to ballooning unfunded liabilities as annual pension contribution calculations for ERB are set in state statute rather than by plan actuaries who calculate the actual amount required to fully fund benefits each year. Over the last 20 years, actual contributions have shorted ERB of $1.4 billion in payments.

This is funding that will eventually need to be recouped via either higher contributions or higher than expected investment returns. It would behoove state policymakers and taxpayers to make pension reforms sooner rather than later. Every year that passes without this money in the pension fund means more lost investment revenue, making the retirement plan more expensive for employers, members, and ultimately taxpayers.

The chart below displays the gap between the actuarially determined contributions and the actual contributions made by the state each year since 2001.

Figure 2 – New Mexico ERB Employer Contribution Shortfall

Source: Pension Integrity Project Database with data compiled from New Mexico ERB Valuation Reports

These structural problems are the main contributors to ERB’s growing debt and the increasing likelihood that pension benefits will be reduced.

State policymakers should begin to address these challenges with meaningful and lasting pension reforms based on informed analysis, just as they have done for New Mexico’s Public Employees’ Retirement Association. If meaningful action is taken quickly, the pension benefit cuts the plan is currently warning about and considering could be avoided.

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