Pension360

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Keith Ambachtsheer, Director Emeritus, International Center for Pension Management, Rotman School of Management, University of Toronto and author of The Future of Pension Management, wrote an op-ed for the Financial Times, Pension solution lies in long-term thinking:

If low investment returns are here to stay, those responsible for pension plans have a choice: wring their hands or fulfill their fiduciary duty by rethinking what it means for the design of their schemes.

Doing nothing is not an option. From 1871 to 2014 US equities produced an investment return, after inflation, of 6.7 per cent a year. Treasury bonds were good for 3 per cent.

In contrast, the Gordon Model — which calculates prospective returns from assumptions about growth and yields — suggests much lower returns are in prospect, a real equity return of 3.6 per cent and 0.6 per cent from Treasury bonds.

A recent Bank of England report, Secular Drivers of the Global Real Interest Rate , also supports this idea of the new normal. It shows the current low return regime correlates strongly with slowing economic growth, ageing populations, savings gluts in Saudi Arabia, China and other developing countries, declines in infrastructure investing, rising income and wealth inequality, and falling capital good prices.

Lower returns, meanwhile, make pensions more expensive. As rule of thumb, for every 1 per cent drop in annual returns contributions must rise 20 per cent. So how to squeeze higher long-term returns out of pension assets, while still providing retirees reasonable safety of payment?

Dutch economist and Nobel laureate Jan Tinbergen answered this question decades ago: achieving two economic goals requires two instruments, not one. For pension design this means separate instruments for achieving the higher long-term returns and the payment safety goals.

So the Tinbergen rule exposes a fundamental problem with traditional pension design, which attempts to meet both goals with one instrument. A confounding factor is the common practice of treating volatility in returns as a proxy for risk.

For most individuals, the dominant risk is the long-term rate of return will be too low. What is needed are sustainable long-term cash flows, such as dividends, which compound and grow over time.

Pension organisations that understand the need to distinguish between this long-term risk, and the danger of short-term fluctuations in asset prices, will split the assets in their care: into long-term return compounding and short-term payment-safety sub-pools.

Still, this is only the start of a solution. A big question remains about whether many pension managers truly understand pension economics.

The glass half-empty answer is that many organisations do not have the capability of finding long-term assets due to lack of scale, poor governance and improper staffing.

The glass half-full response is that there is a still small, but growing group of pension organisations with the requisite capabilities and the scale to exploit them. They have what Peter Drucker, the inventor of modern management, described as the dictates of organisational effectiveness: mission clarity, strong governance and the ability to attract talent.

Arguably, the reorganisation of Ontario Teachers’ Pension Plan in 1990 started this Drucker movement, from where it spread to other large Canadian funds and, more recently, around the world.

Today, these “Drucker funds” are poised to deliver an extra 2 or even 3 per cent per annual investment return on their long-term return compounding assets.

The rethink also made the old new again, recalling John Maynard Keynes 1936 attack on the destructive effective of short-termism when investing. Then managing the Cambridge university endowment fund, he wrote in his General Theory the behaviour of long-term investors will seem “eccentric, unconventional and rash in the eyes of average opinion”.

The logic is not hard to follow. Hire skilled and motivated investment professionals, and tell them to focus on acquiring and nurturing sustainable long-term cash-flows in the forms of interest, dividends, rents and tolls in a cost-effective manner.

Indeed, eight decades later long-termism is again showing it can generate above-market returns. Keynes outperformed the market by 8 per cent a year between 1921 and 1946. On a much larger scale, Ontario Teachers’ outperformed it by 2.2 per cent from 1990 to 2015.

Such crucial additional active returns will continue to be available as long as average opinion continues to think long-term investing is “eccentric, unconventional, and rash”.

When it comes to pensions, I like reading Keith Ambachtsheer’s thoughts as he is widely regarded as an expert in the field. You can subscribe to the Ambachtsheer Letter at KPA Advisory services here and read more of his comments tailored to institutional investors.

You can also order Keith’s book, The Future of Pension Management, on Amazon.ca or Amazon.com. I have not ordered this book yet but along with Jim Leech and Jacquie McNish’s book, The Third Rail, I’m sure it’s well worth reading if you want to understand the challenges confronting pensions on a deeper level.

(As an aside, in our phone conversation yesterday, Brian Romanchuck of the Bond Economics blog told me he is in the process of writing his third book. You can order all of Brian’s books on Amazon here and trust me, they’re definitely worth reading and a real bargain.)

Now, I don’t always agree with Keith Ambachtsheer and have openly questioned some of his views on my blog but this op-ed is a great, albeit abbreviated, introduction to what is plaguing many pension plans today.

Alluding to Tinbergen and Keynes, two well-known titans in the field of economics (you should read about their famous debate on econometrics here and here), Keith cleverly highlights the problem with traditional pension design and how pensions which have the right (ie., Ontario Teachers, now Canadian) governance can use their internal expertise, scale and very long investment horizon to their advantage to generate above-market returns over a long period.

(By the way, retail investors reading this comment can also learn about the importance of dividends, diversification and long term investing. In my comment on building on CPPIB’s success, I mentioned books like William Bernstein’s The Four Pillars of Investing and The Intelligent Asset Allocator and Marc Litchenfeld’s Get Rich With Dividends to help you understand how to manage and build your nest egg over the long run.)

I can’t really add much to what Keith is arguing in his op-ed except to point you to my recent comment on why US public pensions are crumbling where I stated the following key points:

• Global deflation isn’t dead; far from it and anyone who doesn’t take the bond market’s ominous warning seriously is doomed (I would also add there is no bubble in bonds).

 

• If deflation does end up coming to America — aided and abated by the Fed who is still following an übergradual rate hike path, acutely aware global deflation presents the mother of all systemic risks — then this means ultra low rates and possibly even the new negative normal are here to stay.
• Even if global deflation doesn’t hit America, the bond market is warning every investor to prepare for lower returns ahead, something I’ve been warning of for years.
• Low returns are already taking a toll on US public pensions, which is why they’re increasingly looking at alternative investments like private equity, ignoring the risks, to shore up their pension deficits (CalPERS has cited macroeconomic challenges in private equity returns but I’ve already warned you of private equity’s diminishing returns).
• But assets are only one part of a pension plan’s balance sheet, the other part is LIABILITIES. Declining or negative rates will effectively mean soaring pension liabilities. And in a world of record low yields, this is the primary driver of pension deficits. Why? Because the duration of pension liabilities (which typically go out 75+ years) is much bigger than the duration of pension assets so any decline in rates will disproportionately and negatively impact pension deficits no matter what is going on with risk assets like stocks, corporate bonds and private equity.
• Faced with this grim reality, pensions are increasingly looking to invest in infrastructure which are assets with an extremely long investment lifespan. But even that’s no panacea, especially in a debt deflation world where unemployment is soaring (infrastructure assets in Greece are yielding far less than projected following that country’s debt crisis. Now the vultures are circling in Greece looking to pick up infrastructure, real estate and non performing bank loans on the cheap).
• The key point is pensions need to prepare for much lower returns and stop relying on rosy investment assumptions to get them out of a deep hole. Stop focusing on assets and focus on growing liabilities in a deflationary world where people are living longer and introduce risk-sharing and better governance at your public pensions.

 

In his comment above, Keith rightly notes that as a rule of thumb, for every 1 per cent drop in annual returns contributions must rise 20 per cent. That is a big reason why US public pensions are so hesitant to lower their discount rate, namely, because if they do lower it, contributions will go up and employees and the state governments will need to pay more to shore up their public pensions.

However, in my comment on the big bad Caisse, I explained why with the passage of Bill 15 which forces plan sponsors in Quebec to share the risk of their plan, it was in the best interests of Quebec City’s public sector workers to transfer their pension assets out of their city pension plan to the Caisse where they can collect better risk-adjusted returns at a fraction of the cost.

In my opinion, the solution to the global pension crisis is to follow Canada’s radical pensions and adopt the governance model that has allowed them to thrive over the very long run.

That brings me to another giant in the field of economics, the great Paul Samuelson who once fretted the day everyone starts following Burton Malkiel’s advice in A Random Walk on Wall Street.

I too fret the day every public pension and sovereign wealth fund in the world adopts the Canadian pension model because it will necessarily mean more competition and less future returns for our large Canadian pension plans.

Luckily, we’re a long way off that point and as the pension Titanic sinks, some public pensions will sink a lot deeper than others and never come back to fully-funded or even adequately-funded status. But I guarantee you Canada’s large, well-governed defined-benefit pensions will weather the storm ahead and lead the way forward, always focusing on the long term.

Credit rating agency Moody’s said on Wednesday it positively viewed the Illinois Teachers’ Retirement System’s decision to lower its assumed rate of return from 7.5 percent to 7 percent.

The lower rate will be tough for the state to stomach in the near-term as it raises annual contributions by hundreds of millions of dollars. But it also forces the state to pay up, and makes the System less reliant on out-sized investment returns.

From the Chicago Tribune:

A key ratings agency said the decision by the Illinois Teachers’ Retirement System to lower its expected rate of return was “a positive,” even though it means the cash-strapped state will have to find hundreds of millions of dollars more to pay into the pension program for teachers who live outside of Chicago.

The decision by the system’s board to alter the rate of return on investments from 7.5 percent to 7 percent was made despite opposition from Gov. Bruce Rauner, who characterized it as a rushed decision that puts taxpayers on the hook. It was an odd position for the Republican governor, who has long criticized state and city government for kicking the can down the road on financial issues.

But Moody’s Investors Service said the change was “a positive” despite increasing financial pressure on the state in the near term, saying the move would “lower exposure to volatile investment performance.” Moody’s estimated that if the new, lower rate had been in effect for the budget year that began July 1, the state’s required employer contribution would have been $4.3 billion, roughly $421 million more than if the assumed rate of return stayed at 7.5 percent.

Still, Moody’s said even under the lower rate the state remains roughly $1.5 billion below their “tread water indicator,” meaning the system’s unfunded liabilities will continue to grow.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

Nicole Bullock of the Financial Times reports, The crumbling assumptions of US public pension plans:

The governor’s office for Illinois, a state with notoriously weak finances, this week issued a stark warning about what might happen if it reduced the assumed rate of return for its Teachers’ Retirement System.

“If the board were to approve a lower assumed rate of return taxpayers will be automatically and immediately on the hook for potentially hundreds of millions of dollars in higher taxes or reduced services,” the state’s senior adviser for revenue and pensions wrote in a memo.

Unlike corporate pensions, US public pensions discount their liabilities using the rate of return they expect to generate on their investments. Some experts complain that these rates have been set unrealistically high. Lower return expectations would push up the cost of liabilities on their balance sheet, and force Illinois to make higher contributions. If costs to the pension were to increase by $250m it would nearly equal an entire year’s appropriation for six universities.

In spite of the warning, the board on Friday reduced the retirement system’s assumed rate of return to 7 per cent from 7.5 per cent.

Illinois highlights one of the most hotly debated issues facing state and local governments in the US: how to value pension liabilities and, in turn, what is the true nature of the deficits they face. As governments are already cash-strapped, these questions are now highly politicised.

Raising taxes and scaling back pension benefits are painful and difficult measures. It leads to a third issue: to justify these high expected rates of return plans are taking on more risk with money they are obliged to pay out.

”The attractiveness of assuming a high discount rate is that you tell the taxpayers, unions and the public that the liabilities are lower, but the only way to maintain that kind of discount rate is to have risky assets” says Don Boyd, a fellow at the Nelson A Rockefeller Institute of Government.

He estimates that extent to which high rates of return keep contributions lower is well over $100bn a year in the US (click on image).

On average US pension plans are assuming 7.6 per cent rates of return, according to the National Association of State Retirement Administrators. That is down from 8 per cent before the financial crisis, but many observers argue that it is still way too high given the persistently low level of interest rates and the outlook for investment returns.

In effect, the fear is that the maths mean plans are saying something costs $1 when it really costs $2 or $3. Corporate pensions value liabilities using a rate drawn from bond yields, which are far lower.

Joshua Rauh, a finance professor at Stanford University, has led the call for public pensions to use different discount rates. He argues for US Treasuries (currently yielding less than 2 per cent) since there is no guarantee that a plan will achieve the expected rate of return while the pension is a guaranteed promise. What is more, in the few municipal bankruptcies that have occurred to date pensioners have headed the queue even before bondholders.

Based on that he estimates that unfunded liabilities are $5tn-$6tn, including the latest downdraft in market rates post-Brexit vote, compared with the $1tn-$2tn figure based on the plans’ targeted rates of return.

Critics of the current accounting worry about “a day of reckoning” when US public pensions run out of money or their cost becomes so great that it cannibalises the money for public services and prompts tax increases to the extent that people leave the most troubled spots.

Others say concerns are vastly overblown except perhaps in the most extreme of cases. Troubled pensions played a role in Detroit’s bankruptcy and the debt crisis in Puerto Rico, two of the biggest blow-ups in US public finance in recent years. Chicago is another area that is grappling with particularly severe pension woes.

Keith Brainard, Nasra’s research director, says the rationale for using expected long-term rates of return to value pensions comes from the concept of “intergenerational equity” — each generation pays for the cost of services it receives — and that linking to current interest rates increases the chance of separating the cost of the service from the generation receiving that service.

And while the recent performance of public pension funds in the aggregate has been bleak — just 0.5 per cent for the year ended June 30, according to Callan Investments Institute, a research group — the idea is to reflect a long-term outcome (click on image).

“All those day of reckoning stories report unfunded liabilities assuming the plans will receive no benefit or reward from taking investment risk. That type of reporting can be misleading and make pension costs look a lot bigger than expected. That reporting, by itself, is not informative,” says Matt Smith, Washington state’s actuary. “On the flip side, if you only report the expected cost of a pension system assuming a long-term rate of return, that does not tell the entire story of the cost and risk of running a pension system. The truth is probably between those two points of view.”

Either way, the high return assumptions have prompted plans to move into riskier assets over the years with allocations to hedge funds, private equity and real estate.

“As they get into these potentially very volatile risk investments, they may get lucky, but it may just get a lot worse,” says Mr Boyd. “If we get a 20 per cent down year, with $3.6tn under investment, if they lose 20 per cent that is almost three quarters of a trillion dollars.”

Some plans are beginning to consider lower return expectations and the risk associated with alternative types of investing.

Calpers, the largest US pension fund, a few years ago decided to stop investing in hedge funds as part of a long-term plan to lower the risk, cost and complexity of the investment portfolio. More recently, it also embarked on a 30-year plan to reduce the discount rate from 7.5 per cent to 6.5 per cent.

The idea has traction elsewhere. Just this week, Connecticut’s treasurer, Denise Nappier, argued for lower investment return assumptions.

“Markets have largely recovered from the troughs seen in the Great Recession, but are susceptible to downside surprises stemming from changes to the global economic outlook,” she said. “If return assumptions are set at levels unlikely to be attained, it will be difficult to achieve them without pursuing high risk investment strategies. It is far more prudent to structure the portfolio based on what is achievable, rather than what is desirable.”

But any such changes will come with a cost, too.

This is a great article from Nicole Bullock of the Financial Times, one of the few serious newspapers left in the world.

Connecticut’s treasurer, Denise Nappier, who is rightly arguing for lower investment return assumptions, knows what she’s talking about. I wrote a comment from May 2015 on delusional US public pensions where I noted the following:

This is another excellent comment discussing the pension rate-of-return fantasy. Unfortunately, NASRA is still smoking hopium and nobody wants to talk about the elephant in the room. I fear the worst for pensions as global deflation sets in, decimating them and forcing them to come to grips with the fact that 8% will turn out to be more like 0% or lower in coming decade(s).

Nonetheless, the talking heads on Wall Street are talking up global reflation and U.S. public pension funds are increasingly shifting assets into high fee private equity, real estate and hedge funds to make that 8% bogey. Unfortunately for them, they will fall well short of their target, but they will succeed in enriching a bunch of overpaid hedge fund and alternatives managers that are preparing for war.

In my humble opinion, U.S. public pensions should heed the wise advice of the Oracle of Omaha as well as that of the king of hedge funds and steer clear of this space (because most don’t have a clue of what they’re doing).

They should also pay close attention to Ron Mock, the President and CEO of the Ontario Teachers’ Pension Plan, who recently sounded the alarm on alternatives. It’s worth noting that unlike U.S. public pension funds, the Oracle of Ontario uses one of the lowest discount rates in the world to discount their future liabilities and they monitor all risks very closely as they try to match assets with liabilities.

In fact, Neil Petroff, the soon to be retired CIO of Ontario Teachers once told me flat out: “If U.S. public pension funds used our discount rate (now below 5%), they’d be insolvent.”

I’ve been sounding the alarm on deflation and the pension Titanic sinking for as long as I can remember. Unfortunately, just like in the case of Harry Markopolos, no one was listening!!

But unlike the Madoff scam, when US public pensions crumble, it will have far more devastating and widespread effects and hurt the economy for decades.

Now, it is true that Ontario Teacher’s Pension Plan uses the lowest discount rate among public plans. There are several reasons for this including a well-known fact that teachers tend to live longer than the rest of the population (most likely because they are highly educated, live healthy lifestyles and unlike financial parasites, they have socially useful jobs).

Ontario Teachers’ is also a mature plan which means it has to manage its assets and liabilities a lot tighter than other plans because the ratio of active working Ontario teachers relative to retired teachers is declining rapidly, placing more pressure on the plan to manage is assets and liabilities more carefully.

Despite these challenges, Ontario Teachers’ has managed to deliver excellent long term results and is now fully funded. It is widely heralded as being one of the best pension plans in the world, and I concur, it is definitely a force to be reckoned with as is the Healthcare of Ontario Pension Plan (HOOPP), the super funded plan everyone wishes they had.

What do Ontario Teachers’, HOOPP and the rest of Canada’s radical pensions have in common that US public pensions are missing? World class governance that separates politics from the investment decision making and in the case of OTPP, HOOPP and other Ontario public pension plans, they have adopted a risk-sharing model that means plan sponsors share the risk of the plan equally.

In effect, this means when there’s a deficit, plans sponsors don’t assume investment returns alone will bail out their pension plan, they look into cutting benefits too (typically this is done by partially of fully reducing inflation protection).

Now, I’d like you to pause here and soak all this in because there’s a lot of stuff I discuss on my blog that is second nature to me but for the novice, it’s like trying to learn a foreign language.

The key points I want to make here are the following:

• Global deflation isn’t dead; far from it and anyone who doesn’t take the bond market’s ominous warning seriously is doomed.
• If deflation does end up coming to America — aided and abated by the Fed who is still following an übergradual rate hike path, acutely aware global deflation presents the mother of all systemic risks — then this means ultra low rates and possibly even the new negative normal are here to stay.
• Even if global deflation doesn’t hit America, the bond market is warning every investor to prepare for lower returns ahead, something I’ve been warning of for years.
• Low returns are already taking a toll on US public pensions, which is why they’re increasingly looking at alternative investments like private equity, ignoring the risks, to shore up their pension deficits (CalPERS has cited macroeconomic challenges in private equity returns but I’ve already warned you of private equity’s diminishing returns).
• But assets are only one part of a pension plan’s balance sheet, the other part is LIABILITIES. Declining or negative rates will effectively mean soaring pension liabilities. And in a world of record low yields, this is the primary driver of pension deficits. Why? Because the duration of pension liabilities (which typically go out 75+ years) is much bigger than the duration of pension assets so any decline in rates will disproportionately and negatively impact pension deficits no matter what is going on with risk assets like stocks, corporate bonds and private equity.
• Faced with this grim reality, pensions are increasingly looking to invest in infrastructure which are assets with an extremely long investment lifespan. But even that’s no panacea, especially in a debt deflation world where unemployment is soaring (infrastructure assets in Greece are yielding far less than projected following that country’s debt crisis. Now the vultures are circling in Greece looking to pick up infrastructure, real estate and non performing bank loans on the cheap).
• The key point is pensions need to prepare for much lower returns and stop relying on rosy investment assumptions to get them out of a deep hole. Stop focusing on assets and focus on growing liabilities in a deflationary world where people are living longer and introduce risk-sharing and better governance at your public pensions.

Of course, it’s business as usual at US public pensions which is why we’re now hearing of disaster striking the Dallas Police and Fire Pension and “crippling tax hikes” to shore up the Illinois Teachers’ Retirement System (TRS), the state’s largest pension fund which is only 41.5% funded.

I’ve warned all of you living in the United States, Chicago’s pitchforks and torches are coming to a city and state near you.

The sad part is it doesn’t have to be this way. Public defined-benefit plans aren’t the problem. On the contrary, they’re part of the solution to America’s retirement crisis if only they can get the governance and risk-sharing right.

What else do they need to get right? Well, they can start by being more honest about the true extent of pension liabilities. Somewhere between the $6 trillion pension cover-up and trillion dollar state pension funding gap lies the truth but make no mistake, the US pension Titanic is sinking and the solutions being offered, like switching from a DB to DC plan, are absolutely terrible decisions from a public policy perspective because they will only exacerbate pension poverty in America.

On this last point, my brother sent me the Financial Times John Authers’ latest Long View, There is still time to alter the script of the pension crisis:

If we have done our job properly, you should by now be scared out of your wits. The FT has spent the last week examining a serious problem for all of us — that lower bond yields mean higher strain for pensions.

(The reason, for those who have not been reading, is that lower yields make it more expensive to buy a guaranteed stream of income from bonds. Thus companies and governments who have promised their employees a fixed pension, or so-called “defined benefit” plans, face a growing shortfall which must somehow be filled. And it means savers in modern “defined contribution” plans, who have no guarantees and have mostly failed to save enough so far, risk an impoverished old age).

The scale of the problem is dizzying. It is exacerbated by the fact that future returns on US stocks, the world’s most popular asset class, are likely to be weaker because they are so expensive. And yet they look cheaper than bonds.

Now, it is incumbent on me to come up with some solutions. As this is the long view, I will concentrate on defined contribution plans. In the short term, many employers face a serious problem plugging pension deficits. But most of us face a tougher future where the risks of retirement financing will lie squarely with us, and not with our employers.

While a technical actuarial problem carries a real risk of a social crisis, there are opportunities. Disaster is avoidable.

First, the problem is partly caused by the good news that we are living and maintaining our health for longer. It is not the worst hardship to expect to work a few years longer than our parents did. That increases our nest egg and reduces the time over which it has to be spread.

Second, compound interest is our friend. Small increases in the amount we save make a difference when compounded over a working lifetime. So we need to save more.

Third, the underlying driver of low yields is low inflation. If (big if) this continues, then our savings will hold their value more than they used to do.

Fourth, there is the matter of how we save. We need to get more bang for our buck. That means cutting down on fees wherever possible. It also means timing the market sensibly. It is never a good idea to take the risk of being out of the stock market altogether (even during the 2008 disaster this would have risked missing the dramatic bounce back in the spring of 2009). But it does make sense, within bands, to maximise allocations to investments that look cheap (as emerging markets do now), and minimise allocations to those that look expensive (such as US stocks).

It also requires exploiting pension plans’ greatest advantage; that they have time on their side. Globally, there is a need for better infrastructure, and a lack of funds from straitened governments to pay for it.

The most successful public defined benefits pensions — such as those in Canada — hold infrastructure. They are pools of patient capital to aid public investment. Defined contribution plans do not. The reason for this brings us to the most important point — the design of DC plans needs to be rethought, totally.

DB plans were well designed for a world of shorter life expectancy, high yields, high returns and long careers spent with the same company. They are now obsolete. But DC plans in many countries are not plans at all — they are a tax incentive to buy mutual funds. They have some of mutual funds’ advantages that a pension fund does not need — like the ability to buy, sell or switch between funds at any time — but lack advantages that pension funds should enjoy, such as the ability to buy illiquid assets.

This must be fixed. There is no reason why young investors’ long-term savings should not go into funding infrastructure, or clean energy, or other beneficial investments for the future. The funds to do this will be less liquid than a mutual fund, and that does not matter.

A second critical issue, beyond investing and accumulating assets, is to manage the “decumulation” phase, when savers start drawing their income. That can no longer be about buying bonds, thanks to low yields. It will have, increasingly, to be about selling stocks and other long-term investments. The plans need to be structured so that savers have clear guidance on how much of their fund it is safe to draw down each year. A large statement on retirement with a “target” or “maximum” annual withdrawal might be a good idea (as would earlier strong guidance, or even compulsion, towards saving more).

The recent British reform to allow savers to take more of a lump sum at retirement is a confident and irresponsible step in exactly the wrong direction.

One final point. Reading the mass of feedback we have received, it grows clear that the issue of pensions divides us, particularly along generational lines. Many view it in moral terms. This is all wrong. We are all in this together, whether we are generationally lucky or not. We can wait for a social disaster of widespread poverty for the elderly — or we can adapt, design a new system for a new economy, and treat a long-lived, low-inflation world as a blessing.

Mr. Authers raises many excellent points but he misses the biggest point of all as he glazes over the brutal truth on defined-contribution plans and under-appreciates the long term benefits of well-governed defined-benefit plans like the ones we have here in Canada.

He does praise Canada’s large DB pensions for investing directly in infrastructure but then he goes on to say to say DB pensions are “obsolete”. Excusez moi? This is total rubbish and the proof is that Canada’s radical pensions are thriving even in a deflationary world (because they got the governance and risk-sharing right).

Also, anyone can invest in infrastructure stocks like Brookfield Infrastructure Partners (BIP) in their personal savings or retirement account, but when it comes to secure public pension savings, I’d much rather have what the members of Ontario Teachers, the big bad Caisse, PSP, CPPIB, OMERS and most of Canada’s Top Ten have in terms of direct infrastructure investments.

All this to say John Authers needs to talk to Jim Keohane, Ron Mock, Mark Wiseman, Mark Machin, Leo de Bever, and other pension experts here in Canada, including yours truly, to “fine-tune” his solutions to the global pension crisis to put well-governed DB plans front and center.

At least John Authers and Nicole Bullock of the Financial Times are discussing the pension crisis in an open and constructive way. The silence from the financial media on this critically important issue is deafening.

A new commentary from Fitch Ratings lambasts states for their pension funding practices.

Even as contributions rise, Fitch writes, the sustainability of pension systems is not improving.

Fitch acknowledges that states are paying more in recent years:

Actual pension contributions have risen rapidly in recent years as governments have attempted to stem the erosion of their systems’ funded ratios and catch up with rising ARCs, the contribution benchmark calculated by actuaries as necessary to eliminate the unfunded pension liability over time. The average actual contribution in fiscal 2014 is roughly 89% greater than in 2008, the year the global financial crisis began, while the ARC has risen an average of 72% since then.

But, the credit rating agency contends, it’s not enough:

Actual contributions remain inadequate relative to the ARC. Based on Fitch’s last state pension update, a little more than half of major state-wide systems received an annual contribution in fiscal 2014 at or above their ARC. The remaining systems received lower contributions. A shortfall in actual contributions, relative to the ARC, deprives a system of investable resources, increases its unfunded liability and elevates the future ARC that will be calculated at subsequent funding valuations.

In many cases, a system’s ARC itself is a poor benchmark of contribution adequacy.

[…]

Under a 30-year rolling amortization, the ARC is an inadequate measure of contribution sufficiency because at each successive annual funding valuation the ARC is recalculated based on a new 30-year open period, much like refinancing a home mortgage loan year after year. The resulting ARC is likely to provide a higher degree of contribution stability at a lower cost than if it were calculated based on more conservative, alternative methods, such as a consistently fixed, closed-period amortization, various layered amortization approaches, or even a shorter rolling period, such as over 20-years.

For systems using a 30-year rolling amortization, the resulting ARC may too low to cover the cost of new benefits each year plus the accrued interest on the pre-existing unfunded liability — hence the unfunded liability can rise each year, even when the full ARC is paid and other assumptions are achieved. Many governments using 30-year rolling amortization while consistently paying their full ARC each year have still seen their funded ratios languish well below prerecession levels.

Leo Kolivakis is a blogger, trader and independent senior pension and investment analyst. This post was originally published at Pension Pulse.

John W. Schoen of CNBC reports, States face pension fund gap approaching $1 trillion:

After years of not setting aside enough money, state pension funds are looking at a $1 trillion shortfall in what they owe workers in benefits, according to to a new analysis from The Pew Charitable Trusts.

State retirement systems caught a break with strong investment returns in fiscal 2014, but the gap is expected to top $1 trillion in fiscal 2015, the last fiscal year with full results (click on image).

“The lesson here is that state and local policymakers cannot count solely on investment returns to close the pension funding gap over the long term,” the report said.

While many states have cut benefits for new workers and frozen plans for current staff, they cannot cut benefits that have already been earned by public employees. That means they have to find money to make up the shortfall by cutting other programs, raising taxes or both.

The report is based on the most recent data from all 50 states, which are typically reported as much as a year after each fiscal year ends.

States were to make up $35 billion of their unfunded liabilities in fiscal 2014, leaving a shortfall of $934 billion. That’s because of unusually strong returns averaging 17 percent in 2014, according to the study. But average returns fell sharply in 2015, it said, to just 3 percent.

The numbers for fiscal 2016, which ended on June 30 for most states, won’t be reported for some time. But investment gains are expected to work against them. Pew reports that public pension funds had negative average returns during the first three quarters of the latest fiscal year.

Those lower returns mean states with badly underfunded retirement plans will have to set aside more tax dollars to fill the shortfall.

States with the biggest funding gaps include Illinois and Kentucky, the two worst-funded systems, with just 41 percent of what’s needed to pay the benefits promised to public employees. New Jersey has set aside just 42 percent (click on image):

Only three states have set aside enough money to fully pay retirement benefits owed to current and futures retirees: South Dakota (107 percent of liabilities), Oregon (104 percent) and Wisconsin (103 percent).

State pension fund debts have been growing since 2000, after falling in the preceding decades. The last time they were fully funded was the late 1990s, when a stock market boom generated returns that left them with a surplus of funds to pay benefits (click on image).

Let’s have a closer look at The Pew Charitable Trusts’s analysis on state pension deficits, The State Pension Funding Gap: 2014:

The nation’s state-run retirement systems had a $934 billion gap in fiscal year 2014 between the pension benefits that governments have promised their workers and the funding available to meet those obligations. That represents a $35 billion decrease from the shortfall reported for fiscal 2013. The reduction in pension debt was driven primarily by strong investment results, with public plans in fiscal 2014 averaging a 17 percent rate of return.

This brief focuses on the most recent comprehensive data from all 50 states and does not reflect the impact of weaker investment performance in fiscal 2015, which averaged 3 percent. Performance has been even weaker in the first three quarters of fiscal 2016, with negative average returns. Preliminary data from fiscal 2015 point to increases in unfunded liabilities for the majority of states. Total pension debt is expected to be over $1 trillion for state plans, an increase of more than 10 percent from fiscal 2014.

When combined with the shortfalls in local pension systems, this estimate reaches more than $1.5 trillion for fiscal 2015 and will likely remain close to historically high levels as a percentage of U.S. gross domestic product (GDP). The lesson here is that state and local policymakers cannot count solely on investment returns to close the pension funding gap over the long term; they also need to follow funding policies that put them on track to pay down pension debt.

These data follow new standards from the Governmental Accounting Standards Board (GASB), the independent organization recognized by governments, the accounting industry, and capital markets as the official source of generally accepted accounting principles for state and local governments. As of June 15, 2014, GASB required governments to report pension debt as a net pension liability (NPL) on their annual balance sheets and to disclose more details on the cost of new pension benefits earned by current workers. In addition, some poorly funded plans must now use more conservative assumptions when calculating pension liabilities for reporting purposes.

Under the new rules, reporting on pensions is more closely tied to general accounting standards, rather than to plans’ individual funding policies. In particular, plans are no longer required to report the actuarial required contribution, known as the ARC, which had been the most common metric for assessing contribution adequacy. Although most plans have continued to include the ARC as a supplemental disclosure—or produced a similar metric known under the new GASB standards as the actuarially determined contribution (ADC)—these measures are based on each plan’s own assumptions and do not always signal true fiscal health. The Pew Charitable Trusts did not include those calculations in this brief because the ARC is not consistently available and the ADC does not have to meet minimum standards. Neither metric on its own provides sufficient information to evaluate the policies that states are following to fund their pension promises.

The analysis also looks at net amortization, a new 50-state metric that can help state and local governments understand whether their funding policies are adequate to reduce pension debt. Net amortization serves as a benchmark to assess contribution policies and helps gauge whether payments to a pension plan are sufficient, both to pay for the cost of new benefits and to make progress on shrinking unfunded liabilities. The calculation is based on the assumptions that plans use to determine liability and estimate long-term investment returns; it also accounts for employee contributions, given that workers in most states contribute to pensions.

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What Is Net Amortization?

Net amortization measures whether total contributions to a public retirement system would have been sufficient to reduce unfunded liabilities if all expectations had been met for that year. The calculation uses the plan’s own reported numbers as well as assumptions about investment returns. Plans that consistently fall short of this benchmark can expect to see the gap between the liability for promised benefits and available funds grow over time.

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Under this new metric, states that follow contribution policies that are sufficient to pay down pension debt if plan assumptions are met are achieving positive amortization. States where contributions allow the funding gap to continue to grow are facing negative amortization. The analysis in this brief shows that 15 states currently follow policies that meet the positive amortization benchmark—exceeding 100 percent of needed funding—and can be expected to reduce pension debt in the near term. The remaining 35 states fell short; those performing the worst on this measure typically had the largest unfunded pension liabilities.

While 40 states reported decreased unfunded liabilities in 2014, only a small number met the positive amortization benchmark because the calculation is based on the long-term assumptions that plans use to set funding policy, including expectations for the rate of return on investments. In the short term, states experienced stronger-than-expected investment returns, which helped reduce reported pension debt. However, investment returns vary widely over time, and most governments that sponsor pension plans made contributions that were not large enough to reduce debt based on expected long-term rates of return.

New accounting standards spotlight poorly funded plans

The new disclosure rules require that state balance sheets now include the net pension liability, which is the difference between pension plan assets, reported as plan net position, and total pension liability. Net pension liability is essentially the pension debt, or unfunded liability, for that plan. All plans now calculate assets based on the market value of investments on the reporting date, rather than smoothing investment gains and losses over time, which had previously been allowed. This means that the 2014 results fully reflect the impact of strong market gains. Going forward, reported asset values will be more volatile from year to year. For example, funded levels are projected to decline for fiscal 2015 because the average returns of 3 percent were well below plans’ long-term return targets.

In addition, the new standards now require certain plans with low funded ratios to report pension liabilities using more conservative investment return assumptions. (See Appendix B for a more detailed explanation.) So far, this new requirement has had an impact on only eight of the 100 largest state-sponsored pension plans. Looking at restated 2013 results, this accounts for about $72 billion in increased reported pension liabilities and pension debt in total. Plans in Illinois and New Jersey, along with the Kentucky Teachers’ Retirement System and the Texas Employees Retirement System, account for over 90 percent of this amount.

The new rules also require that all public pension plans use the same methodology to calculate liabilities. Previously, state pension plans could choose from multiple approaches, though most had been using the approach that is now required.

Primarily because of market gains, the state pension funding gap dropped in 2014, the first decline in reported pension debt since 2000. Lower investment returns in 2015, however, indicate that pension debt will increase when valuations for that year are complete.

The volatility in investment returns between 2014 and 2015 demonstrates that states cannot rely on higher-than-expected returns to eliminate unfunded liabilities. Pew’s net amortization analysis provides a benchmark for measuring the sufficiency of contributions based on long-term investment return assumptions. This analysis shows that states in aggregate fell short of the net amortization benchmark by $29 billion in 2014.

Figure 2 shows the impact that changes in accounting standards had on total reported pension debt in 2013 as well as the effects of investment gains and other factors in 2014.

Figure 2 (click on image)

While these new standards are required for all plans, most continue to report information using the previous standards as well. The prior rules allowed plans to report assets smoothed over multiple years and did not require the use of more conservative assumptions to report liabilities, as described above. In this analysis and going forward, Pew will use data reported under the most recent set of GASB standards because they provide a standardized point of comparison across plans and reflect the most up-to-date industry standards, consistent with our past work and the most recent government accounting guidelines.

Figure 3 shows trends in aggregate assets and liabilities since 1997. Fiscal 2014 data reflect the new reporting standards, which use the market value of assets and a different method for calculating liabilities. Figure 4 shows total state and local pension debt as a share of GDP.

Figures 3 and 4 (click on images)

New data provide for better measures of plan health

The new disclosure requirements under GASB allow for improved analysis of plan contribution policies compared with previously available data. Before the change, most researchers, including Pew, had to rely on the ARC as a means of comparison. But meeting contribution targets based on this reporting standard never ensured that states and cities were actually paying down their pension debts.

The new data included in public pension financial statements allow for measurement of whether an employer’s contribution policy achieves net amortization. That is the level at which employers’ annual contributions to a plan are sufficient to pay for the cost of new benefits in that year as well as offset any projected growth in pension debt after netting out employee contributions.

The National Association of State Retirement Administrators (NASRA) accurately notes that using net amortization may not always recognize funding policies that are sustainable and that could reduce pension debt over the long term. However, for states following policies expected to address unfunded liabilities, the net amortization benchmark can help pension plan sponsors measure progress. In addition, Moody’s Investors Service’s latest analysis of contribution policies follows a very similar approach in terms of measuring whether states reduced unfunded pension liabilities in the current budget year. The Society of Actuaries Blue Ribbon Panel also noted the importance of contribution polices that pay down pension debt over a fixed time period.

Plan administrators also point out that the numbers disclosed under GASB rules will often differ from those that drive contribution policies. Most notably, GASB requires plans to report assets on a market basis, but plans’ funding policies typically calculate contributions using asset smoothing to recognize gains and losses over time. Other differences can affect liabilities, but these are expected to be limited. For instance, the discount rate requirements under the new GASB rules affect only a select number of troubled plans. Additionally, most plans were already calculating their liabilities using an entry age actuarial method—which takes into account workers’ likely pay increases in calculating pension costs—as required for new GASB disclosures.

Any credible approach to achieving full funding of pension promises needs to pay down pension debt over a reasonable time frame. Prior to this year, GASB standards provided state pension plans with significant leeway in calculating the ARC, which allowed for contribution policies that fell short of this goal. For example, these standards allowed states to reset the maximum 30-year payoff schedule annually. This approach may provide near-term budget relief, but it allows pension debt to grow and costs more in the long run. Because of its limitations, the ARC proved to be a minimum reporting standard rather than a model approach for pension funding.

The net amortization measure assesses the results of contribution policies without taking into account unexpected gains and losses. If plan assumptions are correct, plans receiving contributions meeting the net amortization benchmark will have their unfunded liabilities shrink. Pew’s analysis shows that most state pension plans didn’t receive sufficient contributions to meet this benchmark in 2014.

It is important to note that the net amortization calculation does not use the same discount rate for all plans—it relies on plans’ own individually chosen assumptions. Plans with higher assumed rates of return will have lower estimated costs of benefits, and that will lower the benchmark for positive amortization.

There is still no single measure of plan fiscal health, but effective contribution policies eventually achieve positive amortization. Along with funded ratios and supplemental disclosures on funding policy—including ARC calculations—net amortization provides an important benchmark for states and cities to consider.

Figure 5 shows each state’s net amortization as a share of covered payroll, the total salaries paid to current employees.

Figure 5 (click on image)

Net amortization provides fuller picture of contribution policy

Net amortization provides policymakers a clear picture of the effectiveness of a state’s contribution policy in terms of paying down pension debt in the near term. The data show that many states are not contributing enough to their pension funds to reduce unfunded liabilities—including some states that have paid the full ARC. The new net amortization benchmark provides a better assessment of contribution policies than prior measures did.

Under the new metric, Kentucky, New Jersey, Illinois, and Pennsylvania experienced the largest negative amortization, when adjusted by covered payroll. Plans in these states face significant challenges and have low funded ratios. And without the strong overall investment returns in 2014, net amortization shows that these states would have lost further ground. All four also fell short of paying what would have been the full ARC in 2014. Pennsylvania, however, has committed to large and steady increases in contributions, and is projected to reach positive amortization by 2018.

Of the 10 states with the strongest results on positive amortization, seven have historically paid about 95 percent of ARC. But this group includes three states—Nebraska, Oklahoma and Louisiana—that reported paying less than full ARC payments in recent years. Still, the three continued making progress in reducing pension debt.

Oklahoma’s performance reflects a 2011 change to cost of living adjustments (COLAs). After that policy change, the state’s current contribution policy was adequate to pay down the remaining pension debt. Louisiana sets higher standards than typical state pension plans in calculating its actuarial contribution. As a result, even though the state fell short of full ARC funding in 2012 and 2013, its contributions were enough to make progress on paying for pension debt in 2014. Nebraska’s numbers were driven by contribution timing as well as changes to the state’s contribution policy in 2013. Pew’s research indicates that most states with contribution policies sufficient to pay down pension debt used more conservative approaches targeted at reducing unfunded liabilities compared with states that failed to meet net amortization.

In other cases, states and participating local governments made full ARC payments but still fell short of reducing their pension debt because they followed 30-year payment plans that were refinanced annually. Alabama and Arizona, for example, have historically set actuarial contribution rates based on approaches that would not make progress on paying down pension debt. As a result, while both states paid every dollar that plan actuaries asked for, their unfunded liabilities increased and their funding rank relative to other states declined. Both states’ pension plans have recently changed contribution policies, with a goal of hitting positive amortization over time.

Low funding levels make it harder for states to make progress. Those with larger unfunded pension liabilities require substantially higher contributions to pay down debt because they generate less in the way of investment earnings. Connecticut is only 50 percent funded, but the state’s current contribution policies, which include a fixed amortization period to pay off the unfunded liability, are anticipated to start reducing debt in fiscal 2017. The state has made progress by increasing payments every year; in 2014, it made the highest contributions relative to payroll of all but three states.

Connecticut’s pension funds assume relatively high 8 percent returns, which means that the current policy is sustainable only under risky assumptions. This example shows the difficulties that face a fiscally challenged state trying to pay down pension debt, as well as how a state can improve funding policies over time.

Elsewhere, Virginia shows how states that recently adopted more responsible funding policies might not pay down pension debt immediately, though they will close their funding gaps over time. In 2013, the Virginia Retirement System (VRS) board adopted a stronger funding policy to pay off the unfunded liabilities over a fixed time period, a method known as a closed amortization schedule. State policymakers also enacted legislation to make full actuarial contributions by 2018.

West Virginia stands apart as having made the most progress on pension funding, increasing its funded ratio from 40 percent to 78 percent from 2003 to 2014. West Virginia has averaged payments equal to 95 percent of the ARC or higher for a decade, as have 21 other states, but it has followed a more aggressive funding policy than many of its peers. Tracking net amortization highlights the importance of analyzing how actuarial contributions are set.

Looking at net amortization allows policymakers to better compare contribution policies by measuring outcomes rather than inputs, using a consistent formula for liabilities and using the market value of assets. However, plans still use a range of investment return assumptions under which higher assumed rates of return lead to the reporting of lower liabilities and costs.

Looking forward: Measuring and managing cost uncertainty

Net amortization assesses what happens under current policy if everything goes as expected. However,in providing a fixed benefit, public employers take on a variety of risks—in particular, investment risk. In calculating the fiscal sustainability of a pension plan, looking at different scenarios in what is called sensitivity analysis or stress testing gives a more complete picture of future pension costs and projected pension debt.

The new GASB rules include some sensitivity analysis: Plans are required to estimate liabilities based on projected returns 1 percentage point above or below their assumed rate of return. The Society of Actuaries commissioned a Blue Ribbon Panel to issue recommendations on pension funding and governance, which included a more detailed stress testing approach. Finally, states such as California and Washington have taken the lead by publishing sensitivity analyses on their public pension plans to assess their fiscal sustainability under multiple investment scenarios. Given the importance of risk in understanding pension plans’ fiscal condition, Pew will be working to incorporate stress testing and sensitivity analysis into future reports on state pension funding levels.

Conclusion

The gap between the pension benefits that state governments have promised workers and the funding to pay for them remains significant. Many states have enacted reforms in recent years to help shrink that divide, but they also have benefited from strong investment returns.

Over the long term, however, these returns are uncertain. In addition, many states have not made contributions that would reduce plan debt under expected returns. New tools, such as net amortization, stress testing, and sensitivity analysis, provide policymakers with additional information to better evaluate the effectiveness of their policies and ensure that plans can achieve full funding over time—and that pension promises can be kept.

You can read the full Pew report on state pension funding gaps as of 2014 by clicking here. The report contains end notes and appendices. You can also download an Excel spreadsheet with state by state data from the report here.

Also, as shown below, the funded ratios increased in most states in FY 2014 (click on image):

Of course, as mentioned in the report, returns have come down over the last fiscal year and more importantly, interest rates have also declined and that is the primary driver of pension deficits.

The report is very useful and basically offers hope to many states struggling to address the problem of chronically underfunded public pensions. In this report, states like Kentucky, Illinois, New Jersey and Pennsylvania should look at the success of the Virginia Retirement System and try to adopt better funding policies (ie. no contribution holidays, keep topping up your state pensions!).

However, the Pew report leaves out a lot of information. For example, it singles out “West Virginia as standing apart, having made the most progress on pension funding, increasing its funded ratio from 40 percent to 78 percent from 2003 to 2014.”

All this is true but there is no mention of a recent report by the National Institute of Retirement Security (click here to read it) which shows that West Virginia and other states that switched from a DB to DC plan did not help their existing underfunding problem and in fact increased pension costs (again, click here for more information)

All this to say you have to be extremely careful reading these reports because there is a lot of stuff left out, important things like switching from a DB to DC plan which is an absolutely terrible decision from a public policy perspective.

Importantly, switching to a DC pension plan won’t stop the pension Titanic from sinking, it will only accelerate widespread pension poverty and increase social welfare costs (and the national debt).

None of these important policy questions are discussed in The Pew Charitable Trusts’s report. Sure, it’s a useful report that gives us a snapshot of state pension funding gaps using the net amortization measure (and even that is deficient because they use their own assumed discount rates), but if offers little in terms of insights and policies that will improve retirement security in the United States.

Also, the trillion dollar gap has been contested. In the $6 trillion pension cover-up, I discussed why some experts think the figures being reported on state pension funding gaps by the Society of Actuaries vastly understate the real extent of the US public pension gaps. I’m not suggesting they’re right but we need a more fruitful, honest and transparent debate on all these important public policy issues or else succumb to Chicago’s pitchforks and torches.

What else do US state pensions need to do? They desperately need to adopt the governance that has allowed Canada’s radical pensions to forge ahead and become global leaders in terms of managing pension assets and liabilities.

In other words, there is a gross misconception that if you improve the funding policy, you will magically fix state pension deficits. Sure, this will no doubt help a lot but unless you fix the governance at these state pensions, you won’t make real long-lasting change to secure their long-term sustainability.

Instead of fixing their governance so they can manage more assets internally, it’s business as usual for US public pensions which are shifting more assets into private equity, ignoring the risks and forking over huge fees for mediocre returns. That’s a subject for another day but it’s not a winning strategy.

Lastly, I want to share with you an email I received earlier today from someone who thinks I don’t know what I’m talking about when discussing why the pension Titanic is sinking:

You’re missing the boat. Returns, including returns on pension funds, are ALWAYS spreads, not absolute numbers.

It does not matter how much pension funds return as an absolute number. What matters is how much they return with respect to inflation or deflation (the spread). What matters is purchasing power, not the absolute return number!

In a world that is deflating at 3% a year, a 1% return will do just fine!

I replied back:

I think you are missing the point, pensions are all based on a promise that they will have enough money to cover future liabilities. In a deflationary world, rates will remain ultra low or negative for years, which means low returns and more importantly soaring liabilities. The only spread that counts is the one between assets and liabilities and since the duration of liabilities is much bigger than the duration of assets, deflation will kill pensions, especially poorly governed, chronically underfunded US pensions.

On that note, enjoy your weekend, and try not to worry too much about Janet Yellen and Stanley Fisher’s remarks. I still maintain that the Fed would be very foolish to raise rates in a world struggling with strong deflationary headwinds.

And while some like Morgan Stanley’s Jonathan Garner see emerging markets turning the corner, I would caution all of you to be very careful with emerging markets, energy and commodity shares going forward, regardless of what the Fed decides to do (read my market insights here and here).

The Government Pension Investment Fund lost $52 billion (or, -4 percent) in the 2^nd quarter of 2016.

This week, GPIF’s President talked about the two factors he believes contributed most to the market conditions leading to the loss.

From the Financial Times via CNBC:

Norihiro Takahashi, the GPIF’s president, said that markets during the quarter had seen the dollar-yen exchange rate “developing without a clear sense of direction”. In June, he said, two main factors produced especially high market volatility that strengthened the yen and caused stocks to tumble.

One of these, he said, was the fact that the result of the British referendum on the EU had been different from market expectations — a shock that saw the yen soar against all major international currencies as investors turned to it as a safe haven.

The surging yen, whose rate against the dollar is correlated with the Japanese stock market, produced a 7 percent plunge in the Topix Index on the session immediately after the June 23 referendum results emerged.

The GPIF president also cited US May employment data, which came in lower than market forecasts, as a source of uncertainty during the quarter.

Takahashi sought to head-off a public backlash over the most recent results, saying in a statement: “Even if market prices fluctuate in the short term, it will not harm the pension beneficiaries…we invest from a long-term viewpoint.”