Pension Aftershocks
from the Market-Quake

Oct. 15, 2008 By GIRARD MILLER

The landscape for retirement plans is shifting beneath our feet.

Girard Miller
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The past month has been a miserable period for pension-fund trustees, retirement-plan administrators, and individual retirement investors. Collapsing stock markets wiped out hundreds of billions of long-term savings and pension fund assets that may not quickly recover, as all signs point to a recession that could further erode investment portfolios. The media is having a field day with questions like "How much have you lost?" Retirees are nervous about the safety of their pension funds — and the prospect that COLAs will become the dodo birds of public finance because there is no money to pay for them. Public employers have only begun to contemplate the increased costs they will face in the future as a result of the market's devaluation of pension portfolios. Class-action attorneys are circling the public pension plans to find "lead clients" to file suits against bankrupt Wall Street firms.

Some of the potential fallout from this bear market was first outlined in my January outlook for 2008, which discussed the likely impact on funding ratios and the actuarial debate around Financial Economics. With the market plunging even deeper than the historical averages I cited at that time, it's now necessary to think through the likely impacts on retirement-plan strategy and operations. Markets could recover from last week's lowest levels, even in the face of a recession, but enough damage has now been done that it is time to assess the impact and likely consequences. And if the economy sours and feeds the bear in this market again, then the trends outlined here will become even more pronounced.

Here's a snapshot based on present market conditions following the newly announced orchestrated global moves by governments to stabilize the banking industry and the financial sector:

Plunging pension-plan funding ratios. In little more than a month's time, the stock market has undone an entire generation's worth of systematic actuarial funding in public pension plans. The results will become painfully visible with the 2009 round of actuarial reports which would show the average public pension plan's funding ratio dropping from 85 percent to somewhere closer to 65 percent before "actuarial smoothing." Unless stock prices recover significantly before then, the average plan's unfunded actuarial accrued liabilities will more than double, and taxpayers will be presented with sharply increased costs to maintain the pension plans.

Here's the ugly aftershock math: The average public pension plan was roughly 85 percent funded before this bear market in stocks got underway last October. Since then, equity market indexes have declined almost 35 percent on average through Monday's 900-point Dow rally. Stocks and other related forms of equity represented over 60 percent of most larger plans' asset allocations, so if the other asset classes offset each other (bond gains offsetting recent commodity declines, for example), the average decline in total investment value is probably 20 to 25 percent of the overall portfolio. In addition, the major public pension funds had assumed that investment returns would average 8 percent rather than actually losing money, so the actuarial shortfall is probably closer to 28 to 33 percent of the investment portfolio. Given that plans were 85 percent funded, this represents a roughly 25 percent decline in the average plan's funding ratio to a new level around 65 percent, marked to market. Many plans will show better numbers, others worse — and this is just a ballpark/bar-napkin estimate, not an actuarially precise calculation or survey.

These declines in the funding ratios will show up in the next actuarial report as an increase in the plan's unfunded accrued liabilities, which will then be amortized by the actuary (generally over 20-30 years) to recalculate the required employers' contribution rate going forward. If plans were 15 percent underfunded before, and now are 35 percent underfunded, the employer's annual costs for unfunded liabilities will more than double. Depending on the plan, this could represent a cost increase of roughly two percent of payroll for many state and local governments. If the actuaries were to amortize these new deficits over periods that actually reflect the remaining service lives of employees rather than the longer periods used by many plans, the required new contribution rates would be even scarier. The vast increase in unfunded liabilities may draw heightened attention to controversial amortization practices, as explained in my previous column on this topic.

The "Perfect storm" of retirement finance. These increased pension costs will hit municipal budgets at the same time that most public employers must start funding their retiree medical plans known as OPEB (for "other post-employment benefit") plans. The combined effect in many public agencies will be more than 5 percent of payroll (and considerably more in some cases) — a huge cost increase that could impair the ability of these employers to grant salary increases in the next year or two. This double whammy of added retirement plan expenses will potentially make most governments' overall retirement systems unsustainable for the long term. The necessary revenues simply are not there to fulfill these increased contribution requirements.

Something has to give, and I suspect it will be the following:

• Employers will be compelled to pass along part of the increased costs of these unfunded liabilities to employees through increased employee contributions to pension and OPEB plans.

• Many OPEB plans must be redesigned to reduce their actuarial costs to sustainable levels.

• Cost-of-living allowances in some pension funds will be reduced or eliminated.

• Increased use of pension obligation bonds and OPEB bonds to fill the actuarial gaps once the municipal bond market stabilizes and the recession has appeared to bottom, as discussed in my prior column on that topic. In the coming month, I will discuss this strategy in greater detail in light of emerging market developments. (Click here for a free subscription to the Governing Management Letter, which will carry that forthcoming column.)

Trustees will take heat on investments and some will point fingers at "greedy" companies and "inept" money managers. The quarterly reviews of pension fund investment performance now underway for September 30 will be ugly and testy. Trustees will feel compelled to "do something" to demonstrate and document their fiduciary responsibility, even if their options are limited. With losses running into the millions and even billions of dollars at the plan level and hundreds of billions of dollars nationally, pension trustees will feel obligated as fiduciaries to grill and second-guess their investment advisors, and it is inevitable that certain individual trustees will point fingers and say "I told you so" about investment risk.

Coming soon: class action lawsuits by pension funds. One predictable trend will be a movement by public pension funds to join in class-action suits against Wall Street companies that went bankrupt or lost their share values. The litigators who brought us tobacco lawsuits before and mutual fund litigation in 2003 have now found a new host on which to feed. They love pension funds as clients because the largest investor is usually named as lead plaintiff and that guarantees the litigators a lot of billable hours regardless of the outcome and the actual recovery of assets — which in these cases will be from insurance companies that underwrote the general liability and directors' and officers' policies. Some trustees will feel obligated and gratified if they can point fingers at allegedly crooked or stupid CEOs and boards of directors by suing to recover pennies on their lost dollars, and they will feel that they are fulfilling their fiduciary obligations in doing so.

"Take 'em out and hang 'em": Lynching the portfolio managers? Another predictable trend will be a cycle of money-manager dismissals for underperformance. Public pension trustees are notorious for hiring money managers at the top of their game and firing them at the bottom. It's been called the "Steinbrenner Syndrome" by financial analysts who liken the phenomenon to the New York Yankees owner who hired pitchers at the top of their performance curve and let them go after they slumped. In the money-management sweepstakes, I pity the poor portfolio managers who were meeting their benchmarks before the bottom fell out of the market and have since underperformed. Instead of going onto a "watch list" or "probation," which would be the normal process under stable market conditions, I suspect we will see many plans simply taking their money managers out and shooting them on the spot. They need to show their constituents that "it was the investment managers who were stupid" and not they. They will resemble presidential candidates who tell voters that they are "fighting for you." Of course, the result of their actions generally will be to "lock in the losses" whenever the market cycle turns, but in this heated environment the investment industry can expect to see some heavy turnover among portfolio managers. Likewise, the investment consultants who recommended more-aggressive asset allocations may take more heat than usual.

Will pension trustees adopt more-conservative portfolios and actuarial assumptions? What remains to be seen is whether pension trustees also will scale back their expectations of investment returns going forward. If they reduce the expected returns on portfolios by reducing their exposure to the stock market, for example, the side-effect will be a reduction of the discount rate used in their actuarial calculation, and hence a higher unfunded liability and a larger required employer contribution. It's a vicious cycle here.

The DB-DC wars are now over — for pensions but not OPEB. As I have noted previously, the advocates of defined-contribution (DC) plans to replace defined-benefit (DB) pensions in the public sector have crept back into the woodwork. Baby Boomers had already figured it out, as they could not accumulate sufficient assets to retire via a new replacement DC plan, even before the recent market meltdown. Public policy sentiment in favor of DC plans had eroded seriously after the Internet bubble collapsed in 2001 and the 2001-03 bear market wiped out many individuals' portfolios. With the 2008 bear market now fresh on their minds, policymakers will be loathe to start up a DC plan (even though some could argue that now would be the smartest time for a new employee to enter the financial markets).

On the other hand, sponsors of OPEB plans will likely see renewed interest in starting up a DC feature, option or hybrid for new and possibly also younger employees as one of the cost-controlling reforms needed to make their retiree health plans financially sustainable. Unlike pensions, OPEB plans are a secondary retirement benefit and are not well suited for the defined-benefit model anyway because of the unpredictability of future medical costs.

Financial Economists can now say "I told you so." To their credit, we have not heard any gloating yet, but the actuaries who have been advocating use of a "risk-free" rate of return assumption for pension funds have seen their arguments ring prophetic in this market meltdown. Their assertion that trustees and administrators have underestimated the inherent risks of investing in stocks, and that future taxpayers have been burdened by artificially high assumptions of investment income, has arguably now been supported by marketplace evidence. The increases in unfunded liabilities explained above are exactly what the Financial Economics school claimed would inevitably result. It is too soon to tell whether the market meltdown compels the actuarial community to require alternative calculations using a risk-free discount rate, but the case for providing such information as part of the plan's disclosure documents may have been strengthened by recent market developments.

Let level heads prevail. If history has taught us anything in the world of public-sector retirement-plan management, it is that time works on our side. I cannot predict the bottom of this bear market nor the end of this recession. What I can do is remind readers that rash reactions almost always cause more trouble than the problems they seek to solve. This market meltdown is very much like the "horse out of the barn," and closing the door now won't do much good. The reforms of public pension plans mentioned above will likely be accelerated by the shrunken values of investment portfolios, but they will not occur overnight. That said, however, plan redesign will be needed in many jurisdictions. Sustainability must become a central concept in public retirement finance as the dreams of a prior generation of pension-plan participants have been shaken and the best-laid plans of trustees and administrators have been set back by at least a decade by the market's repricing of equity risks in the 2008 Bear Market.

Markets are likely to remain volatile through the remainder of this recession, so the data provided above is likely to change for the better and the worse several times before policymakers take detailed actions. But for the strategies and trends outlined here, the direction is what is most important, and those are unlikely to be changed by secondary moves in the markets.

In the upcoming Governing Management Letter, Girard Miller will provide some thoughts and tips for employees wondering whether and when they can afford to retire and for retirees who fear they now need to go back to work because their nest eggs have been devastated by this bear market. Watch for that column to appear on October 22, and subscribe now to the free Governing Management Letter by clicking here.

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.
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