Ted Ballantine | Pension360

Oregon PERS Reforms: The Supreme Court Will See You Now

Two major reform measures are finally ready for their day in the Oregon Supreme Court.

Public employees are challenging the 2013 reforms –which reduced the state’s unfunded pension liabilities by $5 billion by cutting COLAs and scaling back benefits – on the grounds that the measures broke contracts protected under the state’s constitution.

This week, both sides submitted their written briefings to the Supreme Court. Reported by the Oregonian:

Monday marked the deadline for written briefings to the Oregon Supreme Court, where public employees are challenging the legality of two pension reform bills enacted last year.

The laws reduced retirees’ annual cost of living increases and eliminated a benefit bump-up for out-of-state retirees that don’t pay taxes in Oregon. As such, they helped staunch the precipitous rise in required contributions to the system since the 2008 financial crisis decimated the fund’s investment portfolio and opened up a $16 billion funding gap.

Oral arguments will be held Oct. 14. Each side will have one hour. After that, public employers, the governor, lawmakers, employees and retirees can hold their collective breath, with a decision anticipated during expected in time for the 2015 Legislative session.

A quick breakdown of what we can expect each side to argue, from the Oregonian:

The Legislature referred any challenges to the bills directly to the Supreme Court to expedite the legal decision process. Public employees appealed the changes, arguing in briefs filed earlier this summer that the benefit changes violate the contract clauses of the Oregon and U.S. constitutions and amount to an illegal taking of private property without compensation.

The state and public employers maintain that the cost of living adjustments, contrary to previous decisions by the court, is not an immutable part of the contract. And even if it is, they maintain it can be changed, as the Legislature has done previously.

Likewise, they argue that the extra payments to cover beneficiaries’ state tax liabilities aren’t part of the contract and can be eliminated for out-of-state retirees who don’t pay Oregon taxes.

Legislators briefly weighed enacting another round of pension reforms this year, but they decided against it.

Vermont Fund May Become First To Hit Gas On Fossil Fuel Divestment

Vermont Gov. Peter Shumlin had previously been against the state’s pension fund divesting from fossil fuel companies.

Shumlin talked to the Associated Press about divestment last November:

“I believe that by keeping a seat at the table and by encouraging smart investments, we can make progress towards a cleaner, greener economy while still meeting our obligations to pay for the retirement of [state and municipal employees] in the most responsible way for taxpayers,” Shumlin told the Associated Press…

In other words: they can do more to effect change as a shareholder of fossil fuel companies. His argument against divestment echoes what we’ve heard from other pension funds around the country.

But Vermont’s view might be changing. Last week, Shumlin went so far as to call divestment from fossil fuels a “good idea”. Reported by Seven Days:

“I actually think it’s an intriguing idea,” Shumlin said. “And, you know, I think that, over time, we’ll find ways that we can be more active in that effort. I would like us to be. As you probably know, we have a fiduciary responsibility to the taxpayers to ensure that, you know, we’re getting a good return on our investments. So it’s going to take some time to make the transformation, but I think it’s a good idea.”

[…]

“I think it’s great,” [environmentalist and scholar Bill] McKibben told Seven Days by email, referring to Shumlin’s shift. “He’s been talking about climate change in powerful ways since [Tropical Storm] Irene, and this (assuming he actually follows through, and soon) is an obvious and easy move (Vt. led the way in divestment from apartheid, after all).”

“And it’s hardly revolutionary,” McKibben added, noting that the Rockefeller Brothers Fund, whose $860 million comes from Standard Oil money, committed to divestment on Sunday. “If the heirs to the world’s greatest oil fortune think it’s unwise and immoral to invest in fossil fuel, what the hell excuse do any of the rest of us have?”

More and more, pension funds are thinking about this issue. CalSTRS and other major institutional investors announced last week they are helping to fund a study on the effect climate change would have on markets.

Photo: Paul Falardeau via Flickr CC License

Can Insurance Companies Save Public Pensions?

Last week, Pension360 covered a question asked by the Washington Post’s Wonkblog:

Does it make sense for local governments to turn over the assets of their employee pension plans to insurance companies, who would in turn make monthly payments to retirees?

This week, Mary Pat Campbell (who runs the STUMP blog) has given an in-depth answer to the above question:

Here is the problem: for all of my posts about alternative assets in public pensions (though those are troubling when they are a huge portion of the portfolio), it’s not the financial risks per se, or even the longevity risk, that has been killing public pensions, though those do contribute.

It’s that governments are great at promising, but not so great at putting money by to pay for those promises.

[…]

Insurers are willing to write group annuities to back pension promises — they did this with GM and Verizon pensions — but you have to give them all the assets they require to back that business. A “fair price” would be less than what is statutorily required, probably, because statutory requirements tend to be very conservative in valuing the liabilities, in order to protect policyholders/annuitants. This is called surplus strain.

But the thing is, even with the “fair price”, governments would have to pay amounts way beyond what they’re paying now, just to meet the pension promises made for past service, forget about any future service accruals.

The main problem is that not enough money has been put by. The risk is not so much that public pensions across the country have been investing too riskily or anything like that (but overly risky investing can make the bad situation worse.)

Now, not all pensions are underfunded as grossly as New Jersey or Illinois. But you don’t get to a 72% overall funded ratio just from those two states.

While insurers might be able to reduce the worry about longevity risk and financial risk for fully-funded plans, they cannot help politicians trying to lowball pension costs.

Her answer, in other words: “No”.

Photo by www.stockmonkeys.com

Public Pension Funds Drive Venture Capital Boom, But Performance Is An Issue

The venture capital industry is becoming a major force again, and pension funds are the major driver of the resurgence. From Businessweek:

Public pension funds—the state-run investment pools responsible for the retirement benefits of nearly 20 million Americans—have quietly been funding the recent boom in venture capital. The investment pools are made up of tax dollars and contributions from state employees. For the last few years, they have made up the biggest single source of funds flowing to venture capital, according to the most recent Dow Jones Private Equity Analyst Sources of Capital survey. In 2014, they contributed 20 percent of the sector’s overall haul, down slightly from a 25 percent contribution in 2013.

Indiana’s Public Retirement System allocates (PDF) 1.6 percent ($363 million) to venture capital, which is on the higher end as a percentage of assets; the California Public Employees’ Retirement System (CalPERS) allocates a more typical half percent of assets, although the fund is so big that this meager fraction totaled $1.8 billion in 2013. The amounts are small enough that if pension funds’ entire venture capital investments were to evaporate, pensioners would still be all right. In most states, pension obligations are guaranteed by state constitutions. If the investments—in venture capital or anything else—don’t pay off, taxpayers are on the hook for the shortfall.

But there’s a problem: some of the best venture capital funds don’t want to do business with public pension funds. From Businessweek:

Because public pensions must be transparent about their investments, which are subject to the Freedom of Information Act, many top-performing venture capital funds won’t accept pension money; they don’t want to publicly disclose their portfolios. This makes public pensions pick from other—often lesser-performing—funds.

Like hedge funds and other kinds of private equity, venture capital funds charge an annual management fee of 2 percent, plus 20 percent of profits. Performance is an open question. Many funds fail to perform (PDF) as well as an Standard & Poor’s 500-stock index fund. Diane Mulcahy,senior fellow at the Kaufmann Foundation, has observed that many venture capital funds aren’t profitable and that steady fee income diminishes the funds’ incentive to find profitable investments.

Other institutional investors are funding the VC resurgence, as well. Endowment funds provided the VC industry with 17 percent of its capital in 2014, according to the Dow Jones survey. Corporate pension funds accounted for 7 percent, while union pension funds accounted for 2 percent.

Photo by c_ambler via Flickr CC License

Linking Benefits to Investment Performance in US Pension Systems

Some countries, such as Norway, have incorporated a pension model called “risk-sharing”—a model where COLAs (and sometimes even benefit amounts) are contingent on investment performance. In other words, plan participants bear much more investment risk than participants in traditional DB plans.

What if that policy were extended to every public pension system in the United States? What effect would it have on liabilities?

Robert Novy-Marx and Joshua D. Rauh published a paper on the topic in the Journal of Public Economics last month.

From the paper:

Replacing COLAs across the US with PLAAs [performance-linked annuity adjustments] with a 5% hurdle and a guarantee that benefits would not fall below their initial level at retirement reduces the present value of legacy liabilities by $575 billion (or 12%) and the unfunded legacy liability by around 25%. Without minimum benefit guarantees, the legacy liability falls by $1.2 trillion (or 26%) and the unfunded legacy liability falls by 53%.

These reforms would also lower the annual required revenue increases to fund state plans within 30 years. These required increases stand at $1147 per household per year under current plan rules. They fall to $770 per household per year with PLAAs if benefits are not guaranteed to remain above a minimum level, but to only $1016 per year if benefits are guar-anteed not to fall below the initial level at retirement.

Of course, those numbers would come at a price for retirees: they’d bear extra risk during retirement under this policy. From the paper:

The PLAA arrangement leaves participants bearing risk only during retirement, not during the time they are working. Standard intuition from the lifecycle portfolio literature suggests that given a choice, individuals prefer to bear risk during the earlier years of their lives instead of the later years.

[…]

In a utility framework, we find that depending on the parameters, PLAAs with the hurdle rates and floors that we study in this paper can have either gains or losses relative to a COLA in terms of expected utility. Of course, the PLAAs we compare to COLAs here are generally substantially cheaper to provide, particularly with 5% hurdle rates and above. Even where expected utility is reduced, there are points of the distribution where the utility outcomes from the PLAAs surpass those of the COLAs, due to the benefits of equity exposure to CRRA utility agents with relatively modest degrees of risk aversion.

The rest of the paper can be read here.

Oregon’s Governor Speaks On Future of Pension Reforms

The Oregonian is running an interesting column in the weeks leading up to the Nov. 4 election for state governor. The column is called “Tough Questions”, and it gives readers a chance to ask questions to the two candidates, incumbent Gov. Kitzhaber and his challenger, Republican Rep. Dennis Richardson.

Today, a reader asked the governor a question related to the pension reforms enacted by the state last year.

Here’s the exchange, from the Oregonian:

Reader: The court decision on the 2013 PERS changes is expected by the 2015 Legislature. You’ve said that you’re done with PERS reforms. Does that mean that if the Court strikes down all or some of the PERS changes, you will not revisit the changes that were rejected previously? If so, then what budget items do you plan on cutting to make up for the extra PERS costs.

Gov. Kitzhaber: The 2013 PERS reform, along with pension fund earnings, reduced the system’s unfunded liability from $16.3 billion at the end of 2011 to $8.1 billion at the end of 2013. As a result of these changes we are already succeeding in controlling costs and today public employers are investing more in programs and services and school districts have begun hiring back teachers, reducing class size and restoring a full school year.

The reforms adopted are fair, progressive and legally defensible. We believe the State will prevail in court. With PERS off the table, we need to harness the same bipartisan support to make targeted investments in third grade reading, science and technology education and other key programs.

In a poll on the Oregonian website, 72 percent of readers said they though Kitzhaber dodged the question with his answer. But 28 percent of readers thought he answered the question fully.

Director Stole $739,000 From Small Massachusetts Pension Fund

The pension fund run by Maynard, a small town 20 miles outside of Boston, isn’t very big. It has $29 million in assets and serves about 270 total members.

But the fund is making headlines today for an unfortunate reason: it’s been revealed that the fund’s director, Timothy McDaid, had stolen $739,000 from the fund since 2007.

What’s more, his scheme would have continued if it weren’t for an anonymous tipster who informed the fund of the theft. From the Boston Globe:

McDaid, who oversaw Maynard’s $29 million retirement fund, was attending a 2012 conference of public pension officials. Such events are usually predictable affairs, but this one took a dramatic turn.

Three colleagues from the Maynard pension board pulled McDaid into a meeting room to confront him with troubling information. Through an anonymous fax, they had just learned that McDaid had a drug problem and that six months earlier he was convicted of stealing $165,000 from a charity where he had kept the books.

“Did you hurt us too, Tim?” one of them asked.

His long-running ruse exposed, McDaid broke down in tears, according to board members. He admitted writing himself $739,000 in checks from the town’s pension fund. The news was shocking. But it shouldn’t have been.

[…]

McDaid, now 48, joined Maynard’s retirement system in July 2007 with an impressive resume. He had been chief auditor for the Public Employee Retirement Administration Commission, known as PERAC, the group that regulates Massachusetts city and town pension systems. But Maynard’s pension directors did not realize that McDaid had been asked to resign from his $80,000-a-year job there. And they did not call to check his references.

For months, McDaid cut checks to himself from a small office in Maynard’s Town Hall, where he was paid to administer a fund with 98 retirees and 186 active workers. Heavy turnover in the town’s financial staff meant there was no second set of eyes on the books, according to court records and interviews. McDaid told officials he was happy to help out by writing the checks and reconciling the bank records.

McDaid had pilfered $739,000 from the pension fund. And he might have continued to drain money from the system if it hadn’t been for the mysterious fax that arrived in PERAC’s office the Friday before the Hyannis conference.

It was a copy of the court case from the Asperger’s foundation theft. There was no cover sheet, no traceable fax number.

There’s much more to the story, including how auditors failed to uncover McDaid’s prior conviction of stealing from a charity organization. You can read the full story here.

Report: Maryland Fund’s Below-Median Returns Coincide With Shift to Alternatives

The Maryland State Retirement and Pension System experienced a 14 percent return in the 2013-14 fiscal year. The fund’s then-Chief Investment Officer, Melissa Moye, touted the returns as “strong” – but a new report suggests not only that those returns were below-median level, but also that they were driven by a shift in investment strategy that put more money in alternative investments.

From David Sirota at the International Business Times:

According to [report authors] Walters and Hooke, a former Lehman Brothers executive, that shift [of assets to Wall Street] coincided with below-median returns for Maryland’s public pension system.

“Ironically, as the fund’s relative performance has declined, its Wall Street money management fees have risen,” the report says. “In fiscal year 2014 alone, the Maryland state pension fund paid out roughly $300 million in fees to Wall Street money managers. Over the past 10 years, these money management fees amounted to over $1.5 billion, according to the fund’s annual financial reports. Nevertheless this high-priced advice resulted in 10-year returns that were $3.22 billion (net of fees) below the median.”

If the fund had matched medianreturns for public pension systems across the country, “the state could have awarded 80,000 poor children with $40,000 four-year college scholarships,” Hooke and Walters wrote.

Maryland’s shift into alternative investments happened while the securities and investment industries made more than $292,000 worth of campaign contributions to Democratic Gov. Martin O’Malley, who appoints some members of the Maryland pension system’s board of trustees. Vice News has reported that the Private Equity Growth Capital Group is a financial backer of a 501(c)4 group co-founded by O’Malley. In May, Pensions and Investments magazine reported that the Maryland governor appointed a managing director of an alternative investment firm called The Rock Creek Group to head a state task force on retirement policy.

Meanwhile, the chief investment officer of Maryland’s pension system was recently appointed to a senior position in the U.S. Treasury Department overseeing public pension policy.

“Eliminating active managers, selling alternative investments, and adopting indexing for 90 percent of the state’s portfolio would ensure median performance,” his report concludes. “These actions would also save the state huge amounts in money management fees.”

Hooke has testified in front of lawmakers advocating the increased use of index funds in pension investments – a strategy that would have worked well the last 4 or 5 years, but one that offers little protection against market contractions.

Since 2008, Maryland has more than doubled its investments in private equity, real estate and hedge funds. Those asset classes made up 29 percent of its portfolio in 2013.

Fitch Downgrades Pennsylvania; “Weakened” Pension System Drives Demotion

Credit rating agency Fitch has downgraded Pennsylvania’s general obligation bonds one notch, from AA to AA-.

What’s more, Fitch changed the state’s outlook from “stable” to “negative” – meaning another downgrade could be coming if Pennsylvania doesn’t address the structural problems that led to this recent demotion.

The structural problems in question are largely linked with the state’s pension system. From the Fitch report:

CONTINUED FISCAL IMBALANCE DRIVES DOWNGRADE: The downgrade to ‘AA-‘ reflects the commonwealth’s continued inability to address its fiscal challenges with structural and recurring measures. After an unexpected revenue shortfall in fiscal 2014, the current year budget includes a substantial amount of one-time revenue and expense items to achieve balance and continues the deferral of statutory requirements to replenish reserves which were utilized during the recession. The commonwealth’s rapid growth in fixed costs, particularly the escalating pension burden, poses a key ongoing challenge, although Fitch expects budgetary planning and management to mitigate these pressures in a manner consistent with the ‘AA-‘ rating.

PENSION FUNDING DEMANDS: The funding levels of the commonwealth’s pension systems have materially weakened as a result of annual contribution levels that have been well below actuarially determined annual required contribution (ARC) levels. Under current law, contributions are projected to reach the ARC for the two primary pension systems by as soon as fiscal 2017, but the budgetary burden will increase, crowding out other funding priorities.

INCREASING BUT STILL MODERATE LONG-TERM LIABILITIES: The commonwealth’s debt ratios are in line with the median for U.S. states. However, the commonwealth’s combined debt plus Fitch-adjusted pension liabilities is above-average, and will likely continue growing given the current statutory schedule of pension underfunding for at least the next few years. Fitch views Pennsylvania’s long-term liability burden as manageable at the ‘AA-‘ rating so long as the commonwealth adheres to its funding schedule, or enacts reforms that do not materially increase liability or annual funding pressure.

[…]

Without structural expense reform, or broad revenue increases, pension costs will consume a larger share of state resources and limit the commonwealth’s overall fiscal flexibility. In fiscal 2015, commonwealth contributions will increase over $600 million from the prior year to $2.7 billion on a $30 billion general fund budget (9.1%). Based on the statutory framework and the pension systems’ historical data and actuarial projections for contributions, Fitch anticipates increases for fiscal 2016 and 2017 will be similar though somewhat lower. While substantial, Fitch views the anticipated increases in annual contributions and unfunded liabilities laid out in the current statutory framework as within the commonwealth’s capacity to absorb at the ‘AA-‘ rating level.

Moody’s downgraded Pennsylvania in July.

Video: Challenges Facing Public Pensions

The 2014 CSG National Conference was held last month, but videos of the presentations have just begun to surface in the past few weeks.

This presentation touches on the history of public pension plans in the United States, the challenges those plans face today, and the retirement “insecurity” faced by private sector workers.

The talk, titled “Public Pensions”, was given by Hank Kim, executive director and counsel for the National Conference on Public Employee Retirement Systems. His bio:

Hank Kim is executive director and counsel for the National Conference on Public Employee Retirement Systems, the largest public pension trade association in the United States. His responsibilities include strategic planning for NCPERS, promoting retirement security for all workers through access to defined benefit pension plans, and the expansion of NCPERS’ role in the continuing debate on health care.

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