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BENEFITS BEAT
The Pension COLA Conundrum
Making adjustments for inflation will be painful — if not impossible.
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With signs abundant that inflation is heating up, retirees in public pension plans are making more noise than ever about cost-of-living increases (COLAs) in their pension payments. With gas prices hitting $4 a gallon and cereal costs doubling, it's hard for retirees on a fixed income. But in today's economy, most public pension plans are not financially able to give retirees what they want.
In South Carolina, the governor has vetoed a bill that would have raised the COLA allowance for retirees from 1 percent to 2 percent, on grounds of cost. In Massachusetts, municipal leaders are opposing a state legislator's proposal to grant a cost-of-living increase to retirees in local plans. They point out that their plans are already underfunded and that another increase in benefits will simply push them closer to the brink of financial distress.
Public pension plans handle the cost-of-living issue in a variety of ways. In some jurisdictions, the public pension plan itself provides for automatic COLAs, usually with a cap or ceiling of a few percentage points. These plans build the inflation expectation into their actuarial assumptions and calculate their contribution rates accordingly — unless they give out a supplemental COLA as was proposed in South Carolina. In other states and in many municipalities, there is no explicit COLA in the pension plan. It's up to the trustees or the employer to grant an "ad hoc" COLA whenever the mood strikes them (or the pressure gets intense). These plans generally don't build the inflation increases into their actuarial numbers, so every time they grant an increase in benefits, they add liabilities that are unfunded. From an actuarial standpoint, they are "COLA ostriches."
The huge problem facing public pension plans now is that we have entered a period of stagflation in which investment returns are unlikely to pay for COLAs. The "free lunch" of strong investment returns — in the 1990s and the middle of this past decade — is no longer there to pay for benefits increases. If anything, many pension plans will suffer declining funding ratios as their investments fail to meet actuarial assumptions.
Politicians, of course, are prone to favor COLAs. They win votes from retirees, and anybody who opposes them gets blackballed by retiree organizations. Of course, they almost always punt the costs to future taxpayers, looking no further than their own term in office. When was the last time a politician included an appropriation of money from the current budget to pay for a new COLA?
Baby Boomers now considering retirement are just beginning to catch on to the inflation problem. If public pension funds are unable to afford COLAs in the future because of insufficient investment returns, that means they need to work longer to defer retirement and build up a higher final average salary on which to base their pensions. Even that behavior will work against the pension plan actuarially, but at least the system will collect the employees' contributions.
Despite the best efforts and "jawboning" by the U.S. treasury secretary and the chair of the Federal Reserve, the dollar has plunged in value and will eventually lose even more, which invites inflation. Oil prices are denominated in dollars, and when the dollar declines in foreign exchange markets, oil prices must increase. The "disinflation" of the 1990s has now been replaced by easy-money inflation in this decade, as the Fed was forced by financial crises to push interest rates below the inflation rate and to expand the money supply above sustainable growth levels. Although we're not at the same level of inflation risk as the 1970s, this stagflation scenario is a junior version of the same monster. Only this time we have a horde of Baby Boomers about to retire and expecting to receive COLAs, whereas they were putting money into pension systems in the 1970s.
Solutions? Unfortunately there are no easy answers for pension trustees. One obvious policy recommendation is that ad hoc COLAs are a matter of form over substance, and if they are regularly granted, then the actuarial assumptions need to take them into account. A stronger policy response is to provide improved COLA benefits to workers who elect to work beyond age 65, and to deny COLAs to early retirees. Another approach mentioned in a prior column would grant COLAs only if the plan is fully funded. Finally, pension funds need to include some inflation-protection assets in their portfolios (see this month's related column on oil for observations on that strategy).
At a minimum, every pension board should include the topic of long-term sustainable COLA policies in its annual strategic planning agenda. The worst is yet to come, I suspect, as the official CPI numbers have masked the extent of real inflation already creeping into the system. Once that becomes obvious — when the public-employee labor unions figure out how to win full-inflation pay increases and retirees succeed in playing to the heartstrings of politicians — the actuarial balance of many pension systems will begin to unravel. Those who get ahead of the problem will fare much better than those who play ostrich.
Girard Miller, an analyst of benefits and investments with 30 years of experience in the public, private and nonprofit sectors, can be reached at Girardinmalibu@charter.net. His general market observations and institutional investment strategies are his own and should not be construed as investment advice or recommendations concerning specific securities. More biographical information.