Mismatched Incentives: Are Trustees to Blame for Pension Underfunding?

Public pension boards are tasked with supervising the investment of the funds raised from the contributions from state employers and employees. But the way the pension boards are staffed discourages a focus on the long term health of public pension plans.

Manhattan Institute Fellow Daniel DiSalvo elaborates on the Pension Board Problem in this excerpt from Governing:

The problem is that both the political appointees and the elected representatives have incentives to ignore the long-term health of the funds. Political appointees are responsive to constituencies, such as the governor who appointed them or local businesses, (which) distract them from managing the fund strictly in its beneficiaries’ long-term interest. Meanwhile, public employees and their union representatives are tempted to trade pension savings tomorrow for higher salaries today.

How do these incentives play out? To hold down short-run costs, political appointees are likely to favor high assumed rates of investment returns, which keep employer contributions lower and avoid throwing a wrench in the governor’s budget. Political appointees also tend to favor investing in local industries — whether or not they are actually profitable. Two Texas funds were heavily invested in Enron before it went bankrupt, for instance. And in 1990, Connecticut’s state-employee fund lost $25 million investing in Colt’s, the firearms manufacturer, to preserve local jobs.

Likewise, public employee representatives respond to workers’ demand for higher salaries today by keeping the assumed rate of investment returns high. In a recent study, political scientists Sarah Anzia and Terry Moe found that elected representatives of public employees did not seek to impose more realistic — that is, lower — assumed rates of investment returns. Rather, they found, more worker representation on boards and stronger public unions led to more fiscally irresponsible decisions.

The larger consequence of the misaligned incentives of pension boards is that they don’t protect employees and taxpayers from major financial risks. Poorly managed pension systems are now consuming the politics – and much of the budgets — of Connecticut, Illinois, New Jersey and other states.

Michigan Installs New Board to Oversee $70 Billion Public Retirement Fund

A newly-created State of Michigan Investment Board will now exercise supervisory functions over the state’s $70 billion investment fund. The Board will hold open meetings four times a year to make investment decisions, evaluate the fund’s performance ,and set funding goals.

Here is part of the AP report in Crain’s Detroit Business:

State Treasurer Nick Khouri was previously the sole fiduciary of the investment, with the help of an advisory committee, but he told the Lansing State Journal that such arrangements are increasing a thing of the past. “This idea of having a single person responsible for the investments has really gone out the window in the last few decades,” Khouri said.

He will be the chair of the new five-member investment board, which also includes the state budget director and three gubernatorial appointees. The executive order that created the board specifies that the unpaid board members will serve four-year terms.

(Michigan Governor Rick )Snyder recently announced that the appointees are Dina Richard, senior vice president of treasury and chief investment officer for Trinity Health; James Nicholson of Detroit, chairman of PVS Chemicals Inc.; and Reginald Sanders of Portage, director of investments for the W.K. Kellogg Foundation.

Illinois judge halts reforms until constitutionality determined


When Illinois lawmakers passed their landmark pension reform law in December, they marked their calendars for June 1, 2014.

That’s the date the law was supposed to go into effect, but lawmakers, unions and most citizens knew better—a myriad of legal challenges would surely push back the implementation of the reforms and pave the law’s path to the state Supreme Court.

Today, an Illinois judge confirmed that sentiment when he ordered a temporary restraining order on the law that will prevent it from taking effect on June 1. The ruling ensures that the law won’t go into effect until the legal battles over the law’s constitutionality are resolved.

The decision is a major victory for the group whose challenge catalyzed today’s judgment: We Are One Illinois, a coalition of retiree groups and unions.

From the Chicago Tribune:

The groups argued the law is unconstitutional because it scales back benefits and raises retirement ages. Under the Illinois Constitution, public employee pensions are a “contractual relationship” with benefits that cannot be “diminished or impaired.”

“This is an important first step in our efforts to overturn this unfair, unconstitutional law and to protect retirement security for working and retired Illinois families,” said Michael T. Carrigan, president of the Illinois AFL-CIO, the point man for the union coalition.

Judge John Belz recognized the retirees and others in the pension systems could suffer “irreparable harm” if the law is allowed to go forward while the constitutionality issues is still being fought out in the courts, according to his order. The case is expected to wind up in the Illinois Supreme Court.

The decision won’t affect Illinois’ budget; lawmakers anticipated the legal challenges against the reform law, and didn’t incorporate its projected effect into the budgets for fiscal year 2013 or fiscal year 2014, which begins July 1.


Photo Credit: SalFalko via Flickr Creative Commons License

Report: Kentucky reforms benefit most workers—but hurt some, too


It’s early yet, but a new analysis of Kentucky’s recent pension overhaul says that the reforms are working—at least for some.

The study, released by the Urban Institute today, shows that the state’s reform measures will result in more benefits for most workers, although the most experienced workers in Kentucky’s system are not likely to benefit at all.

From the Courier-Journal:

Researchers concluded that the shift will provide at least as much lifetime benefit to 55 percent of vested employees and that most workers with up to 24 years of service will fare better compared to the traditional plan.

But, the report notes, most workers with more than 25 years of service, or those hired later in life, would benefit more from the traditional plan. And employees with 30 years or more will receive about $180,000 less under the change, it said.

The reform measures, signed into law last year, switch public employees from a defined-benefit plan to a hybrid cash-balance plan.

A recap of the new plan:

The state’s traditional retirement plan determined pension benefits based on an employee’s salary. The cash balance approach guarantees a 4 percent return while basing additional benefits on investment performance at Kentucky Retirement Systems. But the change only applies to employees hired after Jan. 1.

Proponents argue that it will help spread out investment risks between government and workers and save the state money during economic downturns.

Draine said the report shows 90 percent of the benefits went to only a quarter of employees under the old system, while that number drops to 66 percent with the reforms.

But critics contend that it makes retirement income less predictable for public employees.

Kentucky is also required under the law to make its full Actuarially Required Contribution, which it frequently skipped out on over the past decade. That comes at a cost of about $100 million annually, which was paid for by eliminating COLAs and increasing the state’s personal income tax.

As of 2011, Kentucky’s retirement system has the 7th highest unfunded pension liability in the country. The Kentucky Employees Retirement System is only 50.5% funded.


Photo Credit: OZinOH via Flickr Creative Commons License

Judge: Challenges to Rhode Island pension overhaul will move forward


Rhode Island’s 2011 pension overhaul—considered to be the most sweeping pension reform law in the country—has had its fair share of legal challenges.

A number of public sector unions and retiree groups currently have suits pending against the law, and their arguments, as with similar cases in other state, center on provisions in the state constitution that protect pensions as contracts.

Rhode Island was hoping that those arguments wouldn’t hold water and requested to have the cases thrown out. But Superior Court Associate Justice Sarah Taft-Carter ruled today that the unions’ arguments are too strong to simply dismiss.

From the Washington Times:

Unions and retirees have argued that their pension benefits constituted an implied contract, while the state disputes that. Taft-Carter notes in her decision that unlike some other states, Rhode Island’s constitution and law do not explicitly state that public employees have a contractual right to their pension benefits.

But she writes that other factors support it being a contract, such as the fact that workers have served the public for a required number of years and contributed a required percentage of their salaries to the pension system in return for pension benefits.

“A valid contract exists between plaintiffs and the state, entitling plaintiffs to their pension benefits,” she wrote.

Taft-Carter notes that her standard for reviewing the state’s motion to dismiss was not whether the lawsuit is likely to succeed, but rather to assume the allegations are true, and examine the facts in a light favorable to the unions and retirees.

Rhode Island Gov. Lincoln Chafee and Treasurer Gina Raimondo said in a joint statement that they expected the judge’s decision and are now preparing for trial.


Photo Credit: Governor Chafee via Flickr Creative Commons License

Curbing the Incentive for Pension Padding: Correcting the Employer Contribution Mismatch

ABSTRACT: An often overlooked issue in the debate over New York‘s runaway pension costs is the practice of pension―padding or spiking, whereby a public employee works overtime during his final years of employment, inflating his total compensation during his peak earning years and, more significantly, distorting his pension calculation.

Oklahoma moves forward with bill aiming to eliminate traditional pensions for state workers


Oklahoma’s landscape is dotted with abandoned frontier forts, Civil War battle sites and other relics of history.

Now you might be able to add another relic to that list: state sponsored defined-benefit pension plans, which could soon become a remnant of the past in Oklahoma.

The state’s House of Representatives passed a bill today that would shift newly hired state workers from the current defined-benefit system into a 401(k)-style defined-contribution plan.

Under the plan, employees would allocate at least 3% of their paychecks to the retirement plan, and the state would match those contributions up to 7%.

The bill doesn’t apply to teachers, firefighters or police officers, and would only cover state workers who are hired after November 1, 2015.

The Associated Press has more details:

The state worker salary bill would set aside 3 percent of the previous fiscal year’s payroll costs for salary adjustments each year and give the Office of Management Enterprise Services authority to set pay structures and determine if targeted adjustments are needed.

Its author, Rep. Leslie Osborn, R-Mustang, said it will provide initial raises to the state’s lowest-paid workers, including corrections, human services and public safety workers, at a cost of about $40 million.

State worker salaries are about 20 percent below comparable jobs in the competitive labor market. The measure would boost salaries to 90 percent of private-sector pay over four years.

Opponents of the measure are concerned that it shifts too much risk onto workers. The payout of a 401(k) plan is determined by the performance of its underlying investments, which means an economic downturn would severely decrease the value of retirees’ nest eggs.

The bill now moves to the Senate, where it is expected to pass.


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