by David Robertson, CFA
November 2016
Just over a century ago, Upton Sinclair wrote The Jungle. While the novel was intended to highlight the horrible conditions of many immigrant workers, it gained traction with the public by way of its "exposure of health violations and unsanitary practices in the American meatpacking industry" [here]. Combined with the prevailing winds of Progressive Era politics, Sinclair's muckraking efforts led to the creation of the Meat Inspection Act and ultimately to the Food and Drug Administration (FDA). The fact that we normally take food safety for granted is a testament to the great success of these measures.
Despite having a robust system of programs and regulations that ensures the safety of the food we consume, the same cannot be said of our public retirement plans. Many are chock full of high risk investments in a desperate attempt to boost returns and many give a false sense of security that promised benefits will be delivered without significant new funding. Worse, these inadequacies threaten the financial health of us all.
Fortunately we aren't starting from ground zero in these matters. An important precedent was set in 1974 when the Employee Retirement Income Security Act became law in response to widespread mismanagement of private pensions in the 1950s and 1960s. In a similar vein to some of the food laws in the early twentieth century, ERISA was intended to protect the interests of employees by way of "establishing standards of conduct for plan fiduciaries" [here].
What ERISA did not do, however, is apply these quality assurance standards to public pension plans - and this is an important distinction. Public pension plans, in contrast to private ones, generally provide much stronger guarantees. As a result, when private plans go bust retirees lose their benefits, but when public plans go bust they normally have to tap taxpayers to make up the difference. That makes the underfunded status of public plans an investment problem for everyone who lives in their jurisdictions.
Given this debt-like burden that must be borne by society, one might assume that an industry effort to facilitate greater transparency and more efficient management with the goal of better serving public interests would be uncontroversial. One would be wrong.
Indeed just this past summer, the working paper, Financial Economics Principles Applied to Public Pension Plans ("pension report") [here], was due to be published by the American Academy of Actuaries and the Society of Actuaries (SOA). Shortly before its expected publication, however, both organizations aborted these plans stating that "producing a final paper could not be achieved to the satisfaction of the Academy and the SOA," and the group tasked with producing the paper was disbanded. A few weeks later the SOA changed course again deciding to "make the draft paper available at this time."
The pension report comes across as a fresh application of ideas and principles from the realms of economics, financial economics, public finance, investments, and financial reporting that conjures up a sense of thoughtfulness much more than controversy. The logical and lucid conclusions are intended to guide better reporting and better decision making among public pension plans and are characterized by some key tenets that address important issues:
The most important implications of the pension report were illustrated nicely by Andrew G. Biggs [here]. One serious issue is that the value of liabilities in public pension plans is severely understated. Biggs explains that "Under current practice, a state or local government employee retirement plan 'discounts' its benefit liabilities using the assumed return on the investments held by the plan." He continues by describing that, "Most state and local pensions hold about 75 percent of their investments in risky assets such as stocks, private equity or hedge funds and they assume annual investment returns of about 7.6 percent." As a result, "Based on this method, state and local plans today are about 74 percent funded and have unfunded liabilities of about $1.4 trillion."
In the context of current market conditions, however, these return expectations are wildly optimistic. In order to provide some perspective on market expectations for returns, the Financial Times reported on research from Norway's big oil fund, the largest sovereign wealth fund in the world, a couple of weeks ago [here]: "The [government-commissioned] report estimated that the fund's real rate of return was expected to be 2.3 per cent over the next 30 years." Similarly weak returns are also expected by John Hussman [here], among others: "We currently estimate that the total return on a conventional portfolio mix of stocks, bonds and Treasury bills is likely to average scarcely 1.5% annually over the coming decade."
Discounting public plan liabilities by the more realistic return expectations of these market participants would suggest a much higher value of those liabilities than is currently reported. The pension report suggests even this is not enough though. Since the benefits of public pensions are essentially guaranteed, they should be discounted by a risk free rate. Biggs reports that "using the Treasury yield these plans are about 39 percent funded with unfunded liabilities of about $5.2 trillion."
Another serious problem highlighted in the report is that of intergenerational equity. The authors directly confront the reality that there are consequences to allowing public pension plans to become underfunded and the greatest harm falls on younger generations. Indeed the report explicitly states that "Managing a defined benefit public pension plan in an economically efficient manner, without violating intergenerational equity, requires keeping the pension plan fully funded on a solvency liability basis." Otherwise, "Future taxpayers will be obligated to pay for services previously rendered." Forcing costs onto people who do not receive the benefits is an important economic and ethical issue.
A third big problem revealed in the report is that current reporting norms for public plans are inadequate. The pension report emphasizes that, "Public employee pensions – and the lawmakers who oversee them, the taxpayers who fund them and the employees and retirees who depend upon them – need to know how much the plans have promised and how much investment risk the plans are taking in hopes of meeting those promises." Without this basic information it is virtually impossible to manage the plans efficiently.
The pension report should awaken concerns among investors every bit as much as the muckrakers' enlivened concerns among consumers because the implications are every bit as serious and pervasive.
In both cases, poor transparency allowed bad practices to persist for far too long. In the case of public pensions, disclosure rules that mask the true degree of underfunding conceal the ultimate liabilities from clear view. Conceptually, this is essentially the same exercise as maintaining off balance sheet liabilities. Indeed it is the same basic exercise that took down Enron (and others) in the early 2000s.
Unlike with Enron, however, which took liberties with established accounting rules, current standards for public pension plans actually encourage obfuscation of funding levels by suggesting an overly conservative discount rate. This has the effect of institutionalizing bad practices and perpetuating the difficulty of resolving funding shortfalls. There is simply no good policy reason for this. As Biggs points out, "But here’s a fact that should tell you something: almost no other pension plans in the world are allowed to use the kind of accounting that U.S. state and local plans can."
Also unlike with Enron, shortfalls at public pension plans have the potential to affect everyone. When Enron failed, only Enron investors and pension beneficiaries were affected. But because public pensions generally have much stronger guarantees than private plans, the underfunded liabilities are also harder to extinguish. Sooner or later the benefits of public plans will have to be paid for and that will most likely come through taxes of some sort. As a result, these shortfalls become an issue of public financial health.
In addition, since the underfunding of public pensions is not evenly distributed, future tax burdens will not be evenly distributed either. Some states such as Illinois, Connecticut, Kentucky, and New Jersey all have pensions that are severely underfunded and therefore pose the greatest risk for higher future taxes. Increasingly, choosing a place to live will become an investment decision and it will exacerbate inequality because those who can move to friendlier tax jurisdictions will do so.
Further, geographic inequality is likely to be accompanied by generational inequality. The longer underfunding of public pensions continues, the more the ultimate costs will get pushed onto young and unborn (and therefore, non-voting) taxpayers. Over time, this will most likely impair both the ability and incentive for future generations to be productive economic participants. In other words, consuming pension benefits today at the expense of economic growth tomorrow amounts to something like economic cannibalism. While this presents an important ethical issue for society, it also represents a clear economic risk for investors.
This highlights an interesting political conundrum. On one hand, retirees of state and local governments certainly have a right to expect that their pension promises be honored. Yet on the other hand, the pension benefits are bad promises and come at an extraordinary cost to younger generations and therefore to society as a whole. Most people would do almost anything to help their kids out. Yet, by placidly accepting the status quo for public pensions and failing to demand full funding, they are at very least complicit in handicapping their kids' futures. This truly is a case where doing nothing can cause a great deal of harm.
A recent article by John Authers in the Financial Times [here] hints at a way forward. In an analysis of corporate governance he highlights the advantages of engagement as opposed to activism:
Elroy Dimson, financial historian and head of the advisory committee of the Norwegian sovereign wealth fund, puts the argument this way: “The argument in favour of intervening with companies is that if you can persuade a company to behave in a way that is more appealing to investors then the price will go up. Those who engage with companies have an opportunity for superior returns. Those who ignore companies and veto them will be too late to the party.”
In other words, there is empirical evidence that investors working with company executives, as opposed to fomenting activism against them, can deliver superior results. By analogy, it suggests that conflicts over underfunded pensions could also be resolved more effectively through collective problem solving than through confrontation. It is true that retirees were promised their benefits but it is also true that it is unfair and economically damaging to younger generations.
Finally, while public pension plans rarely hit the radar of important issues, investors would be well served to pay more attention. Not only are the underfunding levels onerous, but the costs are likely to impair economic growth and increase inequality. Although there are a number of obvious political challenges to fully resolving public pension shortfalls, it is not hard to start the process. Embracing the principles of the pension report is an excellent start. The trivial degree of concern we exhibit today in regards to food safety is a testament to the success of muckrakers like Upton Sinclair and the food inspection programs they inspired. Wouldn't it be nice if we could feel as secure about retirement too?
November 2016
Just over a century ago, Upton Sinclair wrote The Jungle. While the novel was intended to highlight the horrible conditions of many immigrant workers, it gained traction with the public by way of its "exposure of health violations and unsanitary practices in the American meatpacking industry" [here]. Combined with the prevailing winds of Progressive Era politics, Sinclair's muckraking efforts led to the creation of the Meat Inspection Act and ultimately to the Food and Drug Administration (FDA). The fact that we normally take food safety for granted is a testament to the great success of these measures.
Despite having a robust system of programs and regulations that ensures the safety of the food we consume, the same cannot be said of our public retirement plans. Many are chock full of high risk investments in a desperate attempt to boost returns and many give a false sense of security that promised benefits will be delivered without significant new funding. Worse, these inadequacies threaten the financial health of us all.
Fortunately we aren't starting from ground zero in these matters. An important precedent was set in 1974 when the Employee Retirement Income Security Act became law in response to widespread mismanagement of private pensions in the 1950s and 1960s. In a similar vein to some of the food laws in the early twentieth century, ERISA was intended to protect the interests of employees by way of "establishing standards of conduct for plan fiduciaries" [here].
What ERISA did not do, however, is apply these quality assurance standards to public pension plans - and this is an important distinction. Public pension plans, in contrast to private ones, generally provide much stronger guarantees. As a result, when private plans go bust retirees lose their benefits, but when public plans go bust they normally have to tap taxpayers to make up the difference. That makes the underfunded status of public plans an investment problem for everyone who lives in their jurisdictions.
Given this debt-like burden that must be borne by society, one might assume that an industry effort to facilitate greater transparency and more efficient management with the goal of better serving public interests would be uncontroversial. One would be wrong.
Indeed just this past summer, the working paper, Financial Economics Principles Applied to Public Pension Plans ("pension report") [here], was due to be published by the American Academy of Actuaries and the Society of Actuaries (SOA). Shortly before its expected publication, however, both organizations aborted these plans stating that "producing a final paper could not be achieved to the satisfaction of the Academy and the SOA," and the group tasked with producing the paper was disbanded. A few weeks later the SOA changed course again deciding to "make the draft paper available at this time."
The pension report comes across as a fresh application of ideas and principles from the realms of economics, financial economics, public finance, investments, and financial reporting that conjures up a sense of thoughtfulness much more than controversy. The logical and lucid conclusions are intended to guide better reporting and better decision making among public pension plans and are characterized by some key tenets that address important issues:
- The cost of benefits and the value of liabilities depend on the benefits offered, not upon the assets expected to finance those benefits.
- Satisfying intergenerational equity, an economic term of art, requires each generation of taxpayers to pay contemporaneously the costs (including compensation and benefits) of the services it receives.
- Public financial reporting must take into account the market value of costs and liabilities in order to hold officials accountable, to be decision useful, and to assess interperiod equity.
The most important implications of the pension report were illustrated nicely by Andrew G. Biggs [here]. One serious issue is that the value of liabilities in public pension plans is severely understated. Biggs explains that "Under current practice, a state or local government employee retirement plan 'discounts' its benefit liabilities using the assumed return on the investments held by the plan." He continues by describing that, "Most state and local pensions hold about 75 percent of their investments in risky assets such as stocks, private equity or hedge funds and they assume annual investment returns of about 7.6 percent." As a result, "Based on this method, state and local plans today are about 74 percent funded and have unfunded liabilities of about $1.4 trillion."
In the context of current market conditions, however, these return expectations are wildly optimistic. In order to provide some perspective on market expectations for returns, the Financial Times reported on research from Norway's big oil fund, the largest sovereign wealth fund in the world, a couple of weeks ago [here]: "The [government-commissioned] report estimated that the fund's real rate of return was expected to be 2.3 per cent over the next 30 years." Similarly weak returns are also expected by John Hussman [here], among others: "We currently estimate that the total return on a conventional portfolio mix of stocks, bonds and Treasury bills is likely to average scarcely 1.5% annually over the coming decade."
Discounting public plan liabilities by the more realistic return expectations of these market participants would suggest a much higher value of those liabilities than is currently reported. The pension report suggests even this is not enough though. Since the benefits of public pensions are essentially guaranteed, they should be discounted by a risk free rate. Biggs reports that "using the Treasury yield these plans are about 39 percent funded with unfunded liabilities of about $5.2 trillion."
Another serious problem highlighted in the report is that of intergenerational equity. The authors directly confront the reality that there are consequences to allowing public pension plans to become underfunded and the greatest harm falls on younger generations. Indeed the report explicitly states that "Managing a defined benefit public pension plan in an economically efficient manner, without violating intergenerational equity, requires keeping the pension plan fully funded on a solvency liability basis." Otherwise, "Future taxpayers will be obligated to pay for services previously rendered." Forcing costs onto people who do not receive the benefits is an important economic and ethical issue.
A third big problem revealed in the report is that current reporting norms for public plans are inadequate. The pension report emphasizes that, "Public employee pensions – and the lawmakers who oversee them, the taxpayers who fund them and the employees and retirees who depend upon them – need to know how much the plans have promised and how much investment risk the plans are taking in hopes of meeting those promises." Without this basic information it is virtually impossible to manage the plans efficiently.
The pension report should awaken concerns among investors every bit as much as the muckrakers' enlivened concerns among consumers because the implications are every bit as serious and pervasive.
In both cases, poor transparency allowed bad practices to persist for far too long. In the case of public pensions, disclosure rules that mask the true degree of underfunding conceal the ultimate liabilities from clear view. Conceptually, this is essentially the same exercise as maintaining off balance sheet liabilities. Indeed it is the same basic exercise that took down Enron (and others) in the early 2000s.
Unlike with Enron, however, which took liberties with established accounting rules, current standards for public pension plans actually encourage obfuscation of funding levels by suggesting an overly conservative discount rate. This has the effect of institutionalizing bad practices and perpetuating the difficulty of resolving funding shortfalls. There is simply no good policy reason for this. As Biggs points out, "But here’s a fact that should tell you something: almost no other pension plans in the world are allowed to use the kind of accounting that U.S. state and local plans can."
Also unlike with Enron, shortfalls at public pension plans have the potential to affect everyone. When Enron failed, only Enron investors and pension beneficiaries were affected. But because public pensions generally have much stronger guarantees than private plans, the underfunded liabilities are also harder to extinguish. Sooner or later the benefits of public plans will have to be paid for and that will most likely come through taxes of some sort. As a result, these shortfalls become an issue of public financial health.
In addition, since the underfunding of public pensions is not evenly distributed, future tax burdens will not be evenly distributed either. Some states such as Illinois, Connecticut, Kentucky, and New Jersey all have pensions that are severely underfunded and therefore pose the greatest risk for higher future taxes. Increasingly, choosing a place to live will become an investment decision and it will exacerbate inequality because those who can move to friendlier tax jurisdictions will do so.
Further, geographic inequality is likely to be accompanied by generational inequality. The longer underfunding of public pensions continues, the more the ultimate costs will get pushed onto young and unborn (and therefore, non-voting) taxpayers. Over time, this will most likely impair both the ability and incentive for future generations to be productive economic participants. In other words, consuming pension benefits today at the expense of economic growth tomorrow amounts to something like economic cannibalism. While this presents an important ethical issue for society, it also represents a clear economic risk for investors.
This highlights an interesting political conundrum. On one hand, retirees of state and local governments certainly have a right to expect that their pension promises be honored. Yet on the other hand, the pension benefits are bad promises and come at an extraordinary cost to younger generations and therefore to society as a whole. Most people would do almost anything to help their kids out. Yet, by placidly accepting the status quo for public pensions and failing to demand full funding, they are at very least complicit in handicapping their kids' futures. This truly is a case where doing nothing can cause a great deal of harm.
A recent article by John Authers in the Financial Times [here] hints at a way forward. In an analysis of corporate governance he highlights the advantages of engagement as opposed to activism:
Elroy Dimson, financial historian and head of the advisory committee of the Norwegian sovereign wealth fund, puts the argument this way: “The argument in favour of intervening with companies is that if you can persuade a company to behave in a way that is more appealing to investors then the price will go up. Those who engage with companies have an opportunity for superior returns. Those who ignore companies and veto them will be too late to the party.”
In other words, there is empirical evidence that investors working with company executives, as opposed to fomenting activism against them, can deliver superior results. By analogy, it suggests that conflicts over underfunded pensions could also be resolved more effectively through collective problem solving than through confrontation. It is true that retirees were promised their benefits but it is also true that it is unfair and economically damaging to younger generations.
Finally, while public pension plans rarely hit the radar of important issues, investors would be well served to pay more attention. Not only are the underfunding levels onerous, but the costs are likely to impair economic growth and increase inequality. Although there are a number of obvious political challenges to fully resolving public pension shortfalls, it is not hard to start the process. Embracing the principles of the pension report is an excellent start. The trivial degree of concern we exhibit today in regards to food safety is a testament to the success of muckrakers like Upton Sinclair and the food inspection programs they inspired. Wouldn't it be nice if we could feel as secure about retirement too?
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