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Pension Presentation - Emerald Investment Forum

Pension Presentation - Emerald Investment Forum

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Pennsylvania Pensions
Pennsylvania Pensions

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Published by: Commonwealth Foundation on Feb 02, 2011
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Pensions & Politics

The Absence of Sound Public Policy Principles
Richard C. Dreyfuss

Managing "Generational Theft”

Business Consultant and Actuary Senior Fellow - The Commonwealth Foundation Emerald Asset Management, Inc. Investment Forum February 2, 2011 – Philadelphia, PA

Managing Pension Liabilities
The Public Pension Crisis
August 18, 2006; Page A14

“… the fundamental problem is that public pensions are inherently political institutions.” “… the current public pension system simply isn't sustainable in the long run.”

Summary of the Problem
“In any collaboration between two groups who hold different basic principles, it is the more irrational one who wins.”  What good is an unprincipled bipartisan agreement? This helps explain the irrational pension legislation of
  

Act 9 (2001) – 25%/50% increase in pensions Act 38 (2002) – Retiree pension COLA Act 40 (2003) – Deferring unaffordable costs to 2012 and beyond Act 44 (2009) – City of Philadelphia & Municipal Pension Non-reform Act 120 (2010) – PSERS & SERS Non-reform (Generational Theft Bill)


Three Factors Drive the Political Institution of Public Pensions

1. Poor Benchmarking 2. Poor Risk Management Practices 3. Politics

#1 Poor Benchmarking

Pennsylvania public pay and benefits are typically benchmarked only against other public plans rather than the entire marketplace Affordability and market trends in the private sector are directly relevant to the public sector 2010 Hewitt Survey: only 11 of 33 major PA employers sponsor defined benefit plans

All sponsor 401(k) plans with an average employer match of 72 cents per dollar and an average matched employee contribution of 5.4 percent of pay.

Towers Watson Survey Average DC Employer Cost - 5.77%

Fortune 100 Companies - Trends in Retirement Plans
100% 90%
80% 70% 60% 50% Traditional DB Plans 40% 30% 20% 10% 0% 1998 67 7 26 1999 61 13 26 2000 60 14 26 2001 55 18 27 2002 48 24 28 2003 42 30 28 2004 40 30 30 2005 39 29 32 2006 36 25 39 2007 30 23 47 2008 22 26 52 2009 20 25 55 2010 17 26 58 Hybrid DB Plans DC Plans

Traditional DB Plans
Hybrid DB Plans DC Plans


Public Policy Principle #1

“Government has nothing to give anybody except what it first takes from somebody.”

Public sector financing is ultimately dependent upon private sector growth. Consider the significant pay and benefits differentials favoring the public sector.

Source: “Seven Principles of Sound Public Policy” Remarks before the Economic Club of Detroit by Lawrence W. Reed | Oct. 29, 2001



Poor Risk Management Practices

Few absolute metrics defining the affordability or reasonableness of pension costs given the “perpetual life of the government entity”. Entire defined-benefit (DB) funding system is based upon annual investment assumption in the 8% range. Little consistency in funding assumptions and funding methods making comparisons most difficult.

Private sector pension plans must fund their plans in accordance with The Pension Protection Act (PPA) of 2006 which requires lower interest rate assumptions and shorter amortization periods.

Public Policy Principle #2

“What belongs to you, you tend to take care of - what belongs to no one or everyone tends to fall into disrepair.”

Who ultimately owns the investment risk in the public pension system?

Source: “Seven Principles of Sound Public Policy” Remarks before the Economic Club of Detroit by Lawrence W. Reed | Oct. 29, 2001


#3 Politics
Pensions as political capital

Pension Fund Surplus = Benefit Improvements for Participants Pension Fund Deficits = Underfunding by Taxpayers Maintaining or Improving Benefits = High Political Rate of Return Reforming and Properly Funding Plans = Low Political Rate of Return

Public Policy Principle #3

“Sound public policy requires that we consider the long-run effects and all people, not simply short-run effects and a few people.”

We are 180 degrees out of phase

Source: “Seven Principles of Sound Public Policy” Remarks before the Economic Club of Detroit by Lawrence W. Reed | Oct. 29, 2001


Pensions are not well understood

Abundance of half-truths Benefit commitments can be over 50 years Funding is easily manipulated

Easy to (re)defer costs to the next generation

Local and city pension shortfalls are becoming political problems for the state

Philadelphia, Pittsburgh, Allentown, Erie and Reading


“Pension Magic” in Florida
(and elsewhere) Orlando Sentinel – July 7, 2010

"Warren Buffett would close down his shop and give his money to the city of Orlando" if it could get 8 percent, says Edward Siedle, a former federal securities lawyer and president of Benchmark Financial Services in South Florida.
Cities like Orlando have three choices, Siedle says. 1)"They can cut benefits, which is politically unacceptable”, 2)"They can increase contributions from the employer and employees, which is politically unacceptable.” 3)“The third choice is called magic. That's what public pension funds across the country are doing, coming up with magic.”

HB 2497 Projection of PSERS Taxpayer Contribution as Percentage of Payroll
(in FYE 2011, 1% pay =~$135M)



20.00% Current Law


HB 2497








































50% 2011 2012










2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
HB2497 Current Law

PSERS Projection of Funded Ratio

2032 2033 2034 2035 2036 2037 2038 2039 2040 2041 2042 2043 2044

PSERS Projection of Funded Ratios

Senate Amended


Negative Implications of HB 2497
Unacceptable Risks, Generational Theft, Non-Reform During the next 30 years all this will be made worse if we: 1. Fail to earn the 8% annual assumed rate-of-return on the assets 2. Revise the investment assumptions to reflect lower expectations. 3. Once again defer scheduled contributions to “save” money 4. Once again “fresh start” or re-amortize the unfunded liability 5. Grant retirees an ad-hoc COLA, implement an early retirement incentive or otherwise enhance current or future pension benefits


True Pension Reform Must Satisfy Three Basic Principles – Using Realistic Funding Assumptions

1. Funding must be current.
  

Benefits should be funded as they are earned and “paid-up” in the aggregate at retirement Achieving a 100% funded ratio Significant private sector pension funding reforms occurred in 2006.

2. Costs must be predictable. 3. Costs must be affordable.

4-7% of payroll (net of employee contributions)

Five Step Pension Reform Plan
1. Establish a Unified Defined Contribution plan for new state and local government workers, school employees, judges, and legislators – Curtails open-ended liabilities; Eliminates long-term commitments on behalf of taxpayers – Removes politics from pensions 2. Prohibit pension obligation bonds or other post-employment benefit (OPEB) bonds – Prevents “generational theft” – deferment of liabilities 3. Mandate pension and OPEB liability management reforms for current and any newly created liabilities. – Achieve an annual employer cost of 4% to 7% of payroll with standardized actuarial assumptions, shorter amortization periods, all generally similar to PPA of 2006. Prohibit “fresh-starting”. – Prohibit benefit improvements if this would result in a funded ratio below 90%.

Five Step Pension Reform Plan
4. Consider modifying unearned pension benefits (if legal and feasible) – Reduced formula; Redefinition of eligible earnings; Increasing the normal retirement age; Curtailing early retirement subsidies; Eliminating COLAs and Deferred Retirement Option Programs (DROPs) 5. Consider funding reforms only after prior steps are achieved – Challenge is to do this without increasing taxes or through new borrowing

Omitting steps 1,2,3,4 ≠ pension reform

Thoughts for Sound Public Policy
1. Deferring unsustainable pension liabilities does not make future liabilities sustainable. Why is contributing less into already underfunded plans considered “reform”? We have over-leveraged our pension system. The challenge is to finally restore proper funding while offsetting these increased costs elsewhere within the state and local budgets without increasing overall spending (or borrowing). PA Municipal Pension Plans are a variation of this theme. Retiree Medical Obligations are a parallel problem. Given all this, what are the financial incentives to live, work, or invest in Pennsylvania? This debate is effectively one involving self-reliance while removing politics from pensions, protecting the taxpayer and stopping generational theft.


3. 4. 5. 6.

Thoughts for Pension Asset Managers

Pensions Struggle With 'New Normal' Yields October 14, 2010 “While options for closing the funding gap abound, none are palatable.” 1. 2. “They can de-risk by better matching existing bond holdings to the duration of their liabilities, but this would lock in their underfunded status to the point they may need to make additional contributions.” “They can implement various hedging strategies for the interest rate and equity risk, which is costly and not a perfect solution.” “They can step up their investments into high yield bonds or alternatives such as hedge funds and private equity, which would involve more risk-taking.” “Or, if they don't have cash on hand, they might be forced to revisit payouts.”


Milliman's annual pensions study shows the average equity allocation has fallen more than 15% over the past three years.


Thoughts for Pension Asset Managers
1. How are future investment returns to be achieved given the need to finance growing government deficits? The US dollar is/will be under pressure. Inflation will undermine any future returns. 2. Likely result is a “crowd-out” of private-sector capital investment needed to achieve productivity increases. Are your asset returns dependent upon assumed/continued government subsidies? 3. Growing difficulties in determining proper pension asset allocations and efficient frontiers to satisfy long-term asset return targets. Lower longterm investment expectations will need to be acknowledged. 4. DB pension plans will face liquidity challenges as politicians are faced with a combination of raising taxes, enacting reforms or further deferring costs while triangulating the politics – bankruptcies likely to occur. 5. Historically, private sector pensions generally reflected market discipline thereby differentiating themselves from public sector plans. However, government bailouts and subsidies are replacing bankruptcies and market forces. 22

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