How to Run a Pension Fund -- Without Running It Into the Ground

Government finance officers tell it like it is. Will politicians finally listen?
by | November 4, 2010

By now, most everybody in America has seen and read media exposés describing the financial problems of our state and local pension funds. Dire deficits in pension funds as calculated by academic economists are raising the visibility of the fiscal challenges that lie ahead. What nobody has done until now, however, is to provide the kind of "tough love" remedial advice that politicians don't want to hear but need to heed.

That's why it's refreshing to see a respected public-sector professional association publish a new "Advisory" on pitfalls to avoid in financing public retirement plans.

The Government Finance Officers of the U.S. and Canada (GFOA) recently posted some sound professional guidance that public managers and elected officials need to take seriously, and soon. Although cynics might gripe that they are chasing the horse now that it's already out of the barn, I would counter that we have to start somewhere to get that horse on the path to reform and back inside the barn. GFOA's advice will not be easy tonic for most public employers to swallow. The implications are that unsustainable plans must be reformed and funded. That probably means a decade of austerity and possibly hiring freezes until we "new-normalize." In some cases, public services will be reduced to pay for pension benefits of workers already retired.

GFOA's Advisory on Pension Pitfalls is posted on their website, and you can read it there in full.

I can't and don't purport to speak for them. Rather, I'll offer my own independent viewpoints on a few key topics in the report:

1. Full funding: Don't cut corners. GFOA's financial experts point out that the fastest way to destroy a pension fund is to fail to make the actuarially required annual contributions. Pension "holidays" declared by disingenuous politicians have almost always resulted in subsequent financial problems. Yet 95 percent of today's retiree medical plans are entirely underfunded today, with public employers not even trying to make their actuarial contributions. That just digs a deeper hole. State laws must be amended to require timely payments of full actuarial contributions. If that requires a four-year phase-in so that the budgets can squeak out the necessary funding, I can live with that. But we have to start now, before the next recession in a future business cycle suppresses the funding ratios once again.

2. Stop spiking. One of the most visible and controversial shortcomings of a defined benefit pension plan is its vulnerability to abuse by savvy and cynical employees who gin-up their pensions by "spiking" their final compensation with overtime, accrued sick and vacation pay, bonuses and other non-recurring compensation. It's not fair, and the taxpayers almost always come out on the short side of the stick.

3. Adjust retirement ages for longevity. Americans are living five years longer than they did 50 years ago, yet public pension funds have often reduced the retirement age. This shortens the funding period and extends the payout period, which is an actuarial nightmare. Early retirement ages for public employees have become a flashpoint with the media and taxpayer-dissident groups. To make retirement plans sustainable, the eligibility ages must be increased to rational levels.

4. Stop retroactive benefits increases. When employees are awarded benefit increases retroactively for prior service, the plan incurs an immediate unfunded liability. For vested employees, the retro benefit is a pure windfall with no value in terms of retention.

5. Drop DROPs or at least reformulate them. Most (but not all) deferred retirement option plans are ill-designed efforts to keep employees working because their low retirement ages flunk the test of recommendation #3 above. Why else would we pay employees to keep working unless the system is defective? GFOA provides useful guidance for reform in a separate publication that it cross-references.

6. Avoid unfunded COLAs. Cost of living allowances and inflation increases can be built into the plan design with proper actuarial principles. This essentially reduces the expected (real) rate of investment return or requires higher contributions by employers and employees. Granting a COLA without funding is financially equivalent to a retroactive benefits increase for incumbents.

7. Get real about investment assumptions. Some plans have tried to suppress their required contributions by artificially inflating their expected investment returns. See my prior column on Public Pensions Investing for Less, which describes why prudent pension plans are now scaling back their investment projections.

8. Require fair shares from employees. Most pension plans already require an employee contribution, but many employers are now requiring those contributions to be increased to help defray the spiraling costs of these benefits. GFOA also discourages "non-contributory" plans, such as retiree medical benefits plans, in which employees make no contribution. Remember Miller's Rule #2*: When the price is zero, the demand is infinite. We've learned from experience in the field that public employees are more responsible when they share in the costs. My personal view is that it should all be 50-50, but that is just me speaking.

9. Prior service must be fairly priced. Many pension plans allow employees to buy service credits for various reasons: military service, prior service at another government, or to transfer in assets from their supplemental savings plans (like 457 plans). Unfortunately, experience has shown that most pension plans have under-priced that conversion feature. To avoid give-aways, plans need to use accurate and contemporary actuarial pricing.

Public managers and elected officials will be wise to circulate GFOA's document regularly and encourage educational-discussion sessions with policymakers, pension trustees and labor leaders. When opportunists promote unsound funding practices, staff members need objective guidance from respected professional experts to help beat back the grave-robbers. I applaud the GFOA committee on retirement and benefits administration for its important technical work here, and the association for its courage to stand up for what's right. Its work will help lay the groundwork for sensible and durable reforms of public retirement plans. These admonitions and first-principles must be remembered in both good times and bad, because there is a pension fund plunderer waiting for every phase of the economic cycle.

This is the GFOA's second "home run" in the pension ballpark this year. Their best practices for retirement system governance were spotlighted in my earlier column: A Gold Standard for Pension Rule Books.

*What's Miller's Rule #1? "Hope is not a strategy."


Disclosure: Girard Miller is an advisor to the GFOA committee on retirement administration and other professional organizations. His opinions published here are entirely his own and do not represent the views or policies of any organization with which he is or was affiliated.

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