STUMP » Articles » Why It's a Good Idea to Fully Fund Public Pensions » 22 March 2017, 07:58

I can’t believe I have to write this.

And yet, here we are.

I got started on this last month, when I learned of this paper: Funding Public Pensions: Is full pension funding a misguided goal?

Let me re-title it: “Funding Public Pensions: Is actually paying the promised benefits a misguided goal?”

There we go.

Anyway, let me pull out stuff from the paper.

ABSTRACT

Public pension systems across the United States are, and have been, in crisis. But, to a larger extent than is widely acknowledged, the crisis is the result of the accounting rules governing both these plans and the governments that sponsor them. These rules are designed to insure against risks that public pensions systems do not face, while simultaneously failing to insure against the risks they do face. The rules also encourage “reforms” that frequently do not improve the financial situation of a given pension system. This is not just deplorable, but a recipe for making a bad situation worse—precisely what we’ve seen over the past few decades. A hybrid accounting system could provide a more accurate picture of a system’s financial health while reducing the waste of overfunding. It could relieve unnecessary financial pressures on thousands of governments across the nation while still preserving the integrity of their pension systems.

Oh, they just want to change accounting standards.

Whatever.

I love the “waste of overfunding” bit. Talk about getting mired in theory, because it’s not like that’s a reality many pensions have to deal with right now.

THE DREADED 80 PERCENT FUNDING = FULL FUNDING

I swear, this paper should get a whole new category in the 80% Funding Hall of Shame.

But let me excerpt:

Actuarial: Full funding is not required to pay all pension debts

The drive to full funding cannot be justified actuarially, either. Though the details depend on
actuarial characteristics of the employee and retiree population, *many, if not most, defined-benefit
pension systems can operate forever at far less than full funding*. A retired teacher in Chicago
who passed away in 2014 after a long and happy retirement had every penny of her pension paid
by a system far below full funding, and yet all her pension checks cleared. A system at 70 percent
funding can likely pay all its obligations in a given year, and if at the end of that year it is at
70.1 percent, who is to say this cannot be repeated the following year if the actuarial facts on the
ground do not change significantly? Social Security operated at what amounted to a few percentage
points of full funding in its trust fund for two generations and only a very few pension plans
are funded at levels so low.31

To put it more rigorously, the normal cost to a pension plan accumulated within a calendar year
is the present value of the additional benefits accrued by all the employees in that year. If the
contributions to the fund (employer and employee contributions, as well as investment income)
are adequate to offset the normal cost and inflation, then the unfunded liability of a plan will
not change from one year to the next.32 If the unfunded liability does not change one year to the
next, the fund can operate indefinitely with that same unfunded liability.

A pension fund must pay 100 percent of its debts. But it need not pay them a moment before
they are actually due, and since a pension plan is constantly receiving new contributions, the
fund itself need not be the only source of payments. As a result, even if all the debts are paid, at
any one time, the fund itself may be at some level well below 100 percent funding.

He doesn’t even seem to understand why an underfunded plan may persist.

When the payroll is growing.

When it’s not….

But hey, let’s check his bad analogy! With a new target: 60%!

Recall the example above. Perhaps I took a $1,000 loan from you, promising in return to pay you
$19.72 per week for a year. If I have only $600 in the bank, then I have an unfunded liability of
$400. If I also have some source of income of just $7.96 per week, I will be able to pay 100 percent
of this debt, down to the penny, out of the combination of my income and my savings. Every step
of the way, my funding ratio—the ratio of my assets to the present value of my remaining debt—
will be 60 percent or less. (See figure on page 13.)

I’ve got a new analogy!

THIS IS TOTALLY THEORETICAL

You take out a $200K subprime loan on a house you can’t afford, in terms of either current savings or earnings. You make a minimal down payment and pay less than interest payments for 2 years because the mortgage terms allow you, and you figure either your earnings or the home’s value will increase over the two years (or both! score!)

Then 2007-2008 occurs.

Suddenly, you find your house can now sell at market prices at $150K, your mortgage balance is now $250K, and you can no longer make the minimum payments required!

So you’re out of a house, and have a debt that tracks you until you declare formal bankruptcy.

And you have credit card bills amassed because your were using those to pay your living expenses.

I think we all understand why the mortgage/loan analogy doesn’t work well at all — you can use that for an analogy for amortizing the unfunded liability, but not the liability as it is earned. And you get the unfunded liability mainly because you didn’t pay for your operating expenses (employee benefits are an operating, not capital expense) when incurred.

My subprime mortgage analogy is the negative amortizing of the unfunded liability, while amassing new pension liability (on the credit cards).

And, unfortunately, there are too many plans like that right now.

THIS IS NOT THEORETICAL AT ALL

Okay, enough with the mental gymnastics (well, above was a cartwheel at best).

This is real, and this is happening right now.

Their pensions were cut by CalPERS. Now these San Gabriel Valley retirees worry about losing their homes.

Christell Standridge hasn’t been able to sleep much lately.

Two months ago, she received a letter from the California Public Employees’ Retirement System informing her the pension her late husband earned while working at the now-defunct East San Gabriel Valley Human Services Consortium could be reduced by as much as 63 percent.

The consortium, known as LA Works, had failed to make payments on retirees’ pensions for more than a year.

“I’m so stressed I can’t sleep, I can’t eat. It’s just terrible,” the 85-year-old Covina resident said Wednesday, hours after the CalPERS board voted to terminate its contract with the consortium and begin the process of slashing pensions for nearly 200 retirees of the job training agency.

“How could they do this?” she asked. “They promised that you’d have a good pension and then they don’t provide it.”

LA Works was formed as a joint powers authority in 1979 by the cities of West Covina, Azusa, Glendora and Covina. The agency laid off its employees and shut its doors in 2014 after Los Angeles County took away its funding amid a billing dispute.

In August 2015, the consortium stopped paying CalPERS its monthly contribution to fund members’ retirement benefits and accrued more than $400,000 in liabilities.

CalPERS officials say they were forced to declare the consortium in default and reduce its retirees’ pensions because neither the consortium nor the four cities that created it would pay.

…..
Consortium officials say they have no funds to pay and that the cities are not legally obligated to pay for the agency’s debts.

“They know we don’t have any money, so it’s not a surprise,” said Kevin Stapleton, chairman for LA Works board and mayor of Covina, who questioned why CalPERS would not use reserve funds from its Terminated Agency Pool to pay the full pensions for these employees. “What’s the point of the Terminated Agency Pool if it was not to deal exactly with this situation.”

CalPERS spokeswoman Amy Morgan said in an email that funding the full pensions of this group of retirees through the TAP fund may impact its “actuarial soundness.”

This is what happens when you keep underfunding, assuming the money will come in later.

It’s similar with what happened with subprime mortgages. People focus on the banks, but in this case, it’s not banks getting stiffed, but retirees.

Feeling so great about your lovely theory now?

This is the press release from Calpers on the decision to cut the pensions:

CalPERS Forced to Declare Southern California Agency in Default of Pension Obligations
March 15, 2017

East San Gabriel Valley Human Services consortium failed to fund pension benefits it promised its employees

SACRAMENTO, CA – The California Public Employees’ Retirement System Board of Administration today declared the East San Gabriel Valley Human Services consortium in default and terminated its contract after it failed to pay more than $400,000 to fund its pension plan.

Under the law, pension benefits will be reduced by approximately 63 percent for 191 members and 24 percent for six members hired after pension reform went into effect in 2013, effective July 1, 2017 if the consortium fails to pay.

“The Board was forced to make this painful decision after East San Gabriel Valley failed to stand by its contractual obligations despite repeated and numerous attempts by CalPERS to avoid this terrible situation,” said Rob Feckner, president of the CalPERS Board. “Cutting benefits to retirees is truly the last step we want to take, but our employers must uphold their obligations and keep the promises that they made to their employees. We have a fiduciary responsibility to protect the long-term future of all beneficiaries and the fund.”

East San Gabriel Valley is a Joint Powers Authority consortium formed in 1979 by the cities of West Covina, Covina, Azusa, and Glendora to primarily provide employment and training services to local residents and inmates incarcerated by the Los Angeles County Sheriff’s Department.

The consortium lost a major contract and closed its headquarters in 2014. Since August 2015 it has failed to pay its Unfunded Accrued Liability (UAL), now totaling $406,345. CalPERS made multiple attempts to collect the outstanding amount due, including:

Holding discussions with consortium officials in over 34 telephone calls
Sending multiple collection and demand notices to the consortium
Contacting all four of the cities that formed the consortium 38 years ago to request immediate payment

California Public Employees’ Retirement Law allows the Board to terminate an agency contract after it fails for 30 days to pay the full amount owed in contributions. The law also requires retirement benefits be reduced by the proportion of the amount due in accumulated employer and member contributions.

The terminated contract will take effect in 60 days. Once the contract is terminated, the consortium is liable to pay the full amount of its termination liability of approximately $19.3 million, which would fully fund current and future payments of retirement benefits to its members. If the consortium fails to pay the termination liability, then CalPERS will send a notice to current and former employees of the consortium outlining the decision to reduce retirement benefits, beginning July 1, 2017.

CalPERS first notified employees and retirees in January 2017 that the consortium had failed to pay the amount due and that retirement benefit reductions could follow. The reduction applies only to the portion of benefits a member earned while working at the consortium.

“Our financial oversight of public agencies will continue to further reduce the risks to members, employers, and the CalPERS Fund,” said Richard Costigan, chair of the CalPERS Finance & Administration Committee. “We’re committed to being a reliable partner to our participating employers and helping them fully understand the costs of the pension benefits they offer.”

One of the consortium’s four founding cities contends that it cannot pay the pension contributions because doing so would constitute a “gift of public funds.” CalPERS General Counsel Matthew Jacobs disagreed, and said that public entities have a legal right to appropriate funds as they see fit, as long as it’s for a public purpose, such as paying public pension contributions.

Last November, CalPERS declared the city of Loyalton in default of its obligations to CalPERS after failing to pay what it owes to fund its pension plan, and reduced benefits for four Loyalton retirees.

For more information, see the agenda item (PDF) and presentation (PDF) outlining this issue.

Here’s the agenda item.

Here’s the presentation.

And here is a video:

FWIW, I knew this was coming (one of the reasons I waited on posting my response to the paper).

The Loyalton cuts were only the first. In the presentation, you see the timeline started in 2015 for this particular group.

CURRENT COMMENTARY

Ed Mendel at Calpensions does a good job covering the debate:

UC paper argues full pension funding not needed
A paper issued by Stanford graduates seven years ago helped shift public focus to what critics call a “hidden” pension debt. Now a paper issued by UC Berkeley’s Haas Institute last month argues that full pension funding is not needed and may even be harmful.

The Stanford paper came after record losses in crucial investment funds expected to pay two-thirds of future pension costs. Whether investment earnings forecasts used to offset or “discount” future pension debt are too optimistic became a key part of pension debate.

It’s not clear at this point, needless to say, that the UC paper will mark another turning point in the debate. But pension funding has not recovered from the huge investment losses nearly a decade ago, despite a lengthy bull market that has nearly tripled the Dow index.

The California Public Employees Retirement System, only 63 percent funded last month, fears investment losses in another big market downturn could be crippling. Even a prolonged stagnant or slumping market could erode the management outlook.

It seems possible (who knows how likely) that in the years ahead there may be a growing movement, out of necessity, to accept or rationalize low pension funding as normal, reducing the pressure for employer rate increases that are already at an all-time high.

Seven years ago, the Stanford graduate student paper contending that California’s three big public pension funds had a shortfall of $500 billion, not the reported $55.4 billion, drew national media attention.

A New York Times story called it a “hidden shortfall.” A Washington Post editorial said it’s “more evidence that state governments are not leveling with their citizens about the costs of pensions for public employees.”

The Stanford study, using the principles of financial economics, discounted future pension obligations using risk-free bonds, not government accounting rules that allow pension funds to use earnings forecasts for stocks and other higher-yielding investments.

……
The UC paper said accounting rules “have been a convenient club to wield against public employee unions,” enabling claims that poor pension funding shows “the public has been duped into obligations it cannot afford.”

The author argues that many union leaders have weakened their own position by demanding full funding of pensions and viewing suggested cost-cutting reforms as an attack on benefits.

The paper quotes a source of support mentioned by other skeptics of the need for fully funding pensions, a report by the Congressional Government Accountability Office in 2008.

“Many experts and officials to whom we spoke consider a funded ratio of 80 percent to be sufficient for public plans for a couple of reasons,” said the GAO report.

“First, it is unlikely that public entities will go out of business or cease operations as can happen with private sector employers, and state and local governments can spread the costs of unfunded liabilities over a period of up to 30 years under current GASB standards.”

Girard Miller, debunking 12 pension myths, said in a 2012 Governing magazine column the view that 80 percent funding is healthy comes from anonymous GAO and Pew sources and a federal requirement that private pensions take action when funding falls below 80 percent.

Miller said pension funds should be 125 percent funded at the market peak. Based on equity losses in 14 recessions since 1926, a pension plan 100 percent funded at the end of a business expansion is likely to lose 20 percentof its value during an average recession.

“A plan funded at 80 percent going into a recession will likely find itself funded at 65 percent at the cyclical trough — and that’s a toxic recipe calling for huge increases in employer contributions to thereafter pay off the unfunded liabilities,” Miller said.

Now CalPERS is about 65 percent funded and phasing in the fourth in a decade-long series of rate increases ending in 2024. Getting back to 80 percent funding has been mentioned at the last two monthly CalPERS board meetings.

As a five-year strategic plan was adopted in February, board member Dana Hollinger suggested that a goal of 75 to 80 percent funding in five years would be more “attainable” and “realistic” than the goal that was aproved: 100 percent with acceptable risk, beyond five years.

Last week, Al Darby of the Retired Public Employees Association urged the board to reverse a short-term shift last September to lower-yielding investments expected to reduce the risk of funding dropping below 50 percent, another of the goals adopted in February.

“Restoring public equity allocation to pre-2016 levels would contribute a lot to reaching the 80 percent funding status that we are all hoping to restore,” Darby said.

What you’re really hoping to restore is over 100% funding, as Girard Miller indicates. We’ve had multiple years of bull runs, and while sometimes the returns have been anemic, we haven’t had a big recession/correction for almost a decade now.

Not saying we’re due, but….

….if you’re not even at 80% after that many years of good returns, something is wrong.

And stop blaming 2008 results.

PRIOR ARGUMENTS FROM ME

I have written about this before, unsurprisingly, and a lot of it has to do with the idiotic 80% funding myth.

From June 2014: Public Pensions Primer: Why Do We Pre-fund Pensions?

The main reason: Governments fail

…..

Now, Detroit had a bunch of public workers it made pensions promises to. If these promises are not fully pre-funded by those making the promises, they have little chance of being made whole when the operation goes belly-up, as we see in Detroit. Supposedly, the Detroit pensions were in good funded status, but we shall see in this series (starting with this one), why this is misleading.

You pre-fund pensions to protect the promise. Ask the retirees of Detroit how great they feel having their income being cut while they’re retired.

And that was for a pension plan that was supposedly well-funded.

From two years ago: Are Public Pensions Actually in a Crisis? Or Is It Just a “Mathematical Issue”?

Let me address this in pieces:

Pension liabilities don’t come due all at once,

No, but supposedly they will come due. Each year you have benefits to pay in addition to whatever new benefits are accrued by employees.

Pension plan contributions are supposed to cover the benefits accrued by work that year. If you don’t make those contributions in that year, you have to make up for it — and the assumed lost fund earnings — in subsequent years.

The specific cash flows don’t come all at once. Indeed, you were supposed to be paying for them all along.

…..
“Considering that the 2008-09 market decline reduced public pension asset values by one-fourth, and the funds have distributed benefits continuously since, the fact that asset values are above their precrash level is actually something to applaud.”

I have no idea whether to applaud it or not. It’s not only that cash has gone out the door, but additional liabilities were taken on. For most of the pension plans I’ve seen (except very small, closed ones), the total liability has increased over that period, and the assets have grown, but not enough to be fully-funded.

One appropriate measuring stick (by obviously not the only one) is how much assets are on hand to cover the promises already made – not future promises, not some of the earned benefits – but what should you have on hand now. They already measure this – you should be familiar with it from my 80 Percent Funding Hall of Shame.

For crying out loud, being 80% funded sucks if you’ve had multiple years of double-digit returns. Have you not been putting in money?

Increasing by 1% in bulk, when the liabilities have grown even more… no, I’m not going to applaud that.

We’ve had a great stock return ride since 2011 — so many point to it as some kind of Obama magic. And now Trump magic.

I am very nervous myself, but I’m an actual long-term investor, and I haven’t made much in the way of big promises to others.

But after over five years of great returns, public pensions are much less funded than they were in 2001.

Why might that be?

Public Pension Watch: The Fragility of “Can’t Fail” Thinking

What actually threatens the actuarial soundness of public pension plans is behavior like the following:

Not making full contributions.

Investing in insane assets so that you can try to reach target yield. Or even sane assets that have high volatility to try to get high return, forgetting that there are some low volatility liabilities that need to be met.

Boosting benefits when the fund is flush, and always ratcheting benefits upward.

Calpers should be extremely familiar with that sort of behavior.

Here is the problem: all sorts of entities directly involved in public pensions have thought that the pensions can’t fail. Because of stuff like: constitutional protections of benefits (so paying pensions would take precedent over other spending needs, like paying for current services), “government doesn’t go out of business”, the supposedly infinite taxation power of the government, and so forth.

Because they thought that pensions could not fail in reality, that gave them incentives to do all sorts of things that actually made the pensions more likely to fail. Because, after all, the taxpayer could always be soaked to make up any losses from insane behavior.

Stupidity Round-Up: Funded Ratios and Racial Proportions

WHAT DOES THE FUNDED RATIO ACTUALLY MEAN?

This is a particular lie I’ve seen creeping in more and more to try to downplay the seriousness of public pension underfunding.

This is the latest example:

For members who have been paying into KPERS, that money cannot legally be touched; that 67 percent just means that if everyone in the system retired today, the state would only have two-thirds of the money it has promised to employees.

At the Actuarial Outpost I had the gut reaction THAT’S NOT WHAT THAT MEANS DAMMIT and somebody laughed.

It’s not funny.

So what does the funded ratio mean?

It’s a particular measure comparing the assets you have on hand with the accrued liabilities at a particular point in time. It’s a simple fraction, assets over liabilities.

One of the AO users described it as “the ratio of current assets to the portion of future benefits attributed to past service”.

Here is what the Public Employee Retirement Administration Commission in Massachusetts says:

The funded ratio of a system represents the actuarial value of plan assets divided by the actuarial accrued liability. When the funded ratio reaches 100%, a system is said to be “fully funded.”

In no actuarial method that I know of do we assume that everybody is going to retire tomorrow in setting the value of that liability. There is a set of assumptions, one of which is the distribution of ages at which people will retire.

Now, those assumptions can be wrong, but nobody uses the “everybody retires tomorrow” assumption unless something really bizarre is happening.

It’s not quite the same, but it would be equivalent to “everybody dies tomorrow” assumption for an actuary valuing life insurance reserves or “everybody is in a car accident tomorrow” for an actuary setting personal auto reserves. It’s absurd… and would make the funded ratio look much, much worse.

Sorry to drag people into the weeds, but if the argument is going to be based on the technicalities of accounting standards, and interpreting what they mean, I’ve got to go there.

LOOSENING UP ACCOUNTING STANDARDS WON’T FIX MATTERS

Now, I don’t necessarily have a problem with the theory behind the Haas paper: I can understand using different valuations for different purposes.

After all, it’s done in insurance: there’s statutory accounting & GAAP/IFRS accounting.

GAAP/IFRS is the reporting you send to investors, so they can understand how business is performing. It tends to have looser reserving standards than STAT, and allows the recognition of certain intangibles and allows you to capitalize acquisition costs over the expected life of a block of insurance business. It’s your regular old standarding accounting principles.

Here’s the point of STAT (statutory accounting & reporting): to make sure that the promises, as expected (plus a margin for comfort), are covered. STAT wants reality and it wants security.

If public pensions had something like that, I would have no issue.

But they don’t.

The current public pension accounting standards are a little bit more conservative than what they recently replaced, but it’s nowhere near STAT accounting for fixed annuities, for example.

And retirees don’t find out how loose that accounting was until, like with the orphaned plans at Calpers, there’s no money forthcoming. So they have to make do with whatever assets are left. They can’t pretend there will be future contributions making up for any losses.

So lovely theory you have in that paper, but it’s nowhere near helpful in current respects.

From the conclusion:

Ultimately the best argument against the current rules is that following these rules is not necessary
to keep the checks from bouncing. “Full” funding of any pension system requires spending
more money than necessary to meet the government’s obligations. Is that not the very definition
of waste? The remaining question is whether our nation will drive thousands of municipalities
into bankruptcy, deprive millions of public employees of pension benefits they have earned, and
discredit one of the great financial advances of the last century—all in order to preserve this waste.
To date, the answer is not comforting.

You are putting extra aside, in terms of risk capital, to ensure that promises are fulfilled. I do not see how paying for the promise, the promise which was made, is wasteful overspending.

You need some stronger proof that the contributions set aside is wasteful overspending as plans go into asset death spirals.

THE GOAL: FULFILLING PROMISES

100% funding is the target.

Actually paying promises is the target.

Not 80%.

Not 60%

Not cutting pensions by almost 2/3 when the governments wither away and there are no contributors left.

People talk about protecting taxpayers (who can disappear) and bondholders (who always know there’s a risk), but my primary concern is protecting retirees.

And those retirees of Loyalton, Detroit, Prichard, and now East San Gabriel Valley weren’t protected.