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Pensions & Politics

Managing "Generational Theft”


The Absence of Sound Public Policy Principles

Richard C. Dreyfuss
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.”
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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)
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Three Factors Drive the Political
Institution of Public Pensions

1. Poor Benchmarking

2. Poor Risk Management Practices

3. Politics

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#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.

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Towers Watson Survey
Average DC Employer Cost - 5.77%
http://www.towerswatson.com/united-states/research/2106

Fortune 100 Companies - Trends in Retirement Plans


100%

90%

80%

70%

60%

50%
Traditional DB Plans
40%
Hybrid DB Plans
30% DC Plans

20%

10%

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

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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

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#2 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.
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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

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#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

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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
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Politics
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

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“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)
35.00%

30.00%

25.00%

20.00%

Current Law
15.00% HB 2497

10.00%

5.00%

0.00%
2019

2028

2037
2011
2012
2013
2014
2015
2016
2017
2018

2020
2021
2022
2023
2024
2025
2026
2027

2029
2030
2031
2032
2033
2034
2035
2036

2038
2039
2040
2041
2042
2043
2044
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100%

50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024

Current Law
2025
2026
2027
2028

HB2497
2029
2030
2031
PSERS Projection of Funded Ratio

2032
2033
Senate Amended 2034
2035
2036
2037
2038
2039
PSERS Projection of Funded Ratios

2040
2041
2042
2043
2044
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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
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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)
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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”?

2. 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).

3. PA Municipal Pension Plans are a variation of this theme.

4. Retiree Medical Obligations are a parallel problem.

5. Given all this, what are the financial incentives to live, work, or invest
in Pennsylvania?

6. This debate is effectively one involving self-reliance while removing


politics from pensions, protecting the taxpayer and stopping
generational theft.
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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. “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.”
2. “They can implement various hedging strategies for the interest rate and
equity risk, which is costly and not a perfect solution.”
3. “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.”
4. “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.
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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 long-
term 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