Lessons From California Public Pensions

Over the last few days, the print media (at least we used to call it print media) has hit hard on public pensions in the State of California. The New York Times hit hard on the differences between the "actuarial approach" and the "market approach." The Los Angeles Times took on a pension deal from the late 90s. Both of these are symptomatic of the issues that all of taxpayers, legislators, workers, and actuaries face in the public pension world.

Let's take a step back. Some of the most generous of all public pensions are those available to public safety officers primarily police and fire. I could give you lots of reasons why this approach is correct and why it's not. You might disagree with my analysis on all of them, but that's not what's important here.

Historically, people who have chosen careers in police and fire have thought of their careers differently than people in most other professions. Those careers are very risky and they are physically demanding. Many in those professions would tell you and me that lasting more than 30 years or so is just not practical. And, if we take that as a correct statement (I do), then it is reasonable that such public safety officers be eligible to retire from that career earlier than we would expect in most other careers. After all, if you were trapped in a burning building, would you be happy if the people trying to save you were just trying to hang on until normal retirement age at 65, but weren't really physically capable of handling such a demanding task?

Over time, states, cities, towns, and other governmental organizations found the answer. Provide those public safety officers with a significant incentive to retire early (compared to other careers) and if you do that, you don't have to pay them all that much. So, what that has historically achieved is that costs for current public safety employees have been relatively lower and costs have been deferred into their retirements.

That's a problem. It doesn't need to occur. The correct answer for a governmental employer, or other employer, is to realize that deferred compensation (that's what a pension is) is earned during a employee's working lifetime. Therefore, it should be paid for during that working lifetime. After all, once an individual in any profession retires, they no longer provide a benefit to the organization that they previously worked for. Further, the burden to pay for those pensions should not be passed on to future generations of taxpayers.

In the past, I have commented about various actuarial cost methods. An actuarial cost method is a technique for allocating costs to the past, the present, and the future. Looking at things as any of a taxpayer, legislator, employer, or employee (I happen to not be all of those, but even so, I can put myself in the shoes of those that I am not), the correct answer has the following characteristics:

• An employee's pension is paid for (funded) over their working lifetime. Once they retire, the cost of providing their benefit is over. (Understand that actuarial gains and losses make this an inexact science, but we should be close.)
• The cost of providing that employee's pension should be level. That is, it should either be a constant percentage of their pay or a constant dollar amount. As an employer, I can budget for that. 

Let's consider an example of that second bullet. Suppose I pay a public safety officer $60,000 per year (I know -- in some jurisdictions that seems high and in others it seems low) in salary. Further suppose that their deferred compensation costs me 10% of pay annually. Then when I am budgeting for that person, I know how to budget every year. If their pay goes up by 5%, so does the cost of their pension, roughly. This year, I budget $66,000 for current plus deferred compensation. Next year, with that 5% budgeted increase, I budget $69,300 for current plus deferred compensation.

There is an actuarial cost method that does exactly this. It's called Entry Age Normal (EAN). When I entered the actuarial profession back during the days when we used green accounting paper rather than spreadsheets, in my experience, EAN was the actuarial cost method of choice. But, it had its downsides. 

• Neither the accounting profession nor the federal legislators accepted it as the method of choice.
• Employers were advised that their current cash cost would be lower using a different actuarial cost method. It's easy to say you will fix that problem later on.
• Observers understand a method where you pay for benefits as they accrue, but nor one in which you pay for benefits as they are allocated by actuaries.

So, now we have come to a crossroads. Many of the largest public pension plans are horribly underfunded regardless of how you determine funding levels (some have been funded responsibly; others have not). Getting them well funded requires cash which can only come from increasing taxes or from taking money from elsewhere in the budget (dream on). Legislators want to get re-elected which means you don't raise taxes. 

Hmm, I see a problem here.

The problem extends to private pensions as well, but there are  good solutions there. Since EAN is not available as an actuarial cost method anymore (we could choose to have our valuation done using the legally prescribed Unit Credit actuarial cost method, but fund not less than the EAN cost although that is very rarely done), we need to look in other places. 

Plan design is an excellent lever in this regard. Suppose we had a plan design  that even under a Unit Credit cost method allowed us to achieve exactly what we are talking about here. And, suppose that design allowed for all the benefits of defined benefit plans (DB) including market-priced with no built-in profits annuity options, professional investing, no leakage, portability, and virtually no cost volatility. Wouldn't that be an ideal world?

That design exists. And, you can have it now.

Funded Status of Corporate Pensions Improves Due to Increased Funding

Each month, Mercer does an analysis of the funded status of pension plans sponsored by S&P 1500 companies. Based on the Mercer study, the aggregate funding deficit as of March 31, 2011 was about $213 billion, down from $256 billion a month earlier. Mercer said that one of the primary reasons for this smaller deficit is that pension plan sponsors continue to make significant contributions to the plans. This is especially true for corporations with high quality debt where the current extremely low cost of borrowing for these companies has caused many to choose to borrow to fund up those plans. Also notable in the Mercer study is that the aggregate funded status for the same plans increased from 81% to 87% during the 3-month period ended March 31, 2011.

What's going on here? While I haven't had the opportunity to discuss this issue with all of the finance heads, many of whom are presumably the ones who are making this decision, let's consider a very plausible rationale. Suppose you sponsor a pension plan that is underfunded by $100 million. In simple terms, this leaves you with a $100 million liability on the balance sheet. Now, if you turn around and borrow that same $100 million (or some piece of it) at today's very low rates, you 'move' the liability on the balance sheet from the pension plan to more standard corporate debt, and you do it a low rate.

Why might this be good? In and of itself, it might not be, but suppose you use that new level of funding to help de-risk the pension plan. You are now taking what many consider to be a risky, highly volatile (this has been addressed over and over again here and in many other places) liability and replacing it with a stable, less risky liability. In today's world, where risk is bad and risk management is king, this is highly desirable. My employer has been at the forefront of such risk management efforts in pension plans since our inception.

Frankly, it's not just funding that has decreased deficits and increased funded statuses. Equity investments have generally performed well year-to-date and underlying discount rates have remained relatively stable.

I haven't seen the gory details of the Mercer study, but I must wonder to what extent the Pension Protection Act (PPA) funding rules have been behind these contributions as well. With plans being as poorly funded as they have been recently, and CFOs having the knowledge that PPA does require particularly rapid (7-year) funding of the underfunded, might they not be simply opting to throw cash at the plans when the cost of cash is low? Better, perhaps to do it this way, than to fund only when it is required when their borrowing costs may be higher.

So, the large corporate world seems to be getting this under control. If only sponsors of public pension plans could fix their underfunding as easily.

DB Pension Finance Year to Date

Here's an article focusing on year-to-date US DB pension funded status written by my friend and former colleague, Brian Donohue. Note that for the typical plan, without regard to contributions, funded status has probably declined slightly.

You can read it here: http://tinyurl.com/28hv7td