Top 12 Pension and Benefits Plan Issues for 2009: Executive Summary

New paradigms for a new year
by | January 22, 2009

This is a shortened summary version of a longer column. Read the full version: Part I and Part II.

The market meltdown of 2008 changed the way public pension and benefits plans will operate for years to come. Here are some of the most likely impacts, and other related trends expected to emerge in 2009. Readers who want more information should explore the full column with expanded discussion of each of these topics.

Part I :

1. Financial economics and MVL: rest in peace? The financial economists were half-right. Before the market meltdown, pension funds had over-estimated their ability to pay future liabilities. But using a risk-free Treasury bond yield as a discount rate would whip the horse after it's already limping from the market meltdown. There are better ways to put financial economics to use. See Topic #2 and Topic #6.

2. Pension funding after the meltdown: true cost of employees' straddle options. A straddle option is a call (up) option and a put (down) option. Pension funds gave both to public employees, for a price of zero. It's resulted in a $1 trillion pension deficit. Employer contributions must increase by 2 to 4 percent of payroll in order to pay off these deficits in our lifetimes.

3. Sustainability of retirement plans & OPEB ostriches. With pension plans destined to drain governmental budgets even more, at the same time newly recognized liabilities for retiree medical plans (OPEB) are hitting the books, many public employers will have to spend every new dollar of revenue they receive in the next decade on retirement benefits. Is that sustainable? If not, it's time to try different approaches.

4. Crocodile benefits "tiers" for new employees. A common strategy to reduce retirement benefits costs is to "tier" a plan so that new employees get reduced benefits. Sometimes it's necessary because of state laws or constitutions, but this column asks whether there might be better strategies to effect even greater savings and justice between generations of workers.

5. Pension obligation and OPEB obligation bonds: The new paradigm. A relatively rare market window may open later in 2009, allowing states and municipalities to borrow money in the bond market at lower rates than they invest their pension and OPEB assets. The old pension obligation bond (POB) model didn't work very well, and a new paradigm has emerged that suggests a better way to structure deals like this to protect taxpayers and investors. A companion column with full technical details is also available.

6. DB vs DC plans: A false dichotomy revealed. Pension advocates have suggested that defined contribution plans are inherently less efficient at investments. Their analysis was half-true, as it is not whether you define contributions vs. the benefits that makes a difference. And traditional DB plans embody a whopper of an investment inefficiency, as those who read the entire section of the expanded column will see.

Part II :

7. Collective defined contribution plans -- an intriguing new structure for OPEB. Although relatively rare, this "hybrid" plan design embodies some of the advantages of a pension plan (efficient, collective institutional investments and lifetime benefits) with the cost-control features that employers desire in a defined contribution plan.

8. GASB and pension accounting. GASB needs to put the Financial Economics issue to rest in 2009. Also we'd like to see closer attention to the amortization policies of pension funds, which presently are shifting costs to future generations of taxpayers to pay for benefits already awarded to employees who will die before their benefits are paid for. The abuses of retroactive pension benefits increases and ad hoc COLAs also deserve more rigorous accounting treatment.

9. OPEB legislation. States need to write better, clearer laws to govern the financial operations of "other post employment benefits" (OPEB) plans. Most states lack proper investment authority, almost all of them have failed to address the issuance of debt to pay for these bills, and many more need to provide for tax authority to pay for these obligations.

10. Pension funds to underwrite muni bonds? With the municipal bond market clogged up with the credit crisis, many private-sector bond insurers are cutting back on their business. Municipalities are paying through the nose to get private bond insurance. Could public pension funds enter the market with a win-win strategy that earns them some fair supplemental revenue and brings new competition to a one-sided market?

11. Pension contribution and COLA holidays. To balance their budgets, some big-name politicians are proposing pension contribution holidays. Bad idea. A better idea is to impose a holiday on ad hoc cost-of-living adjustments to pension funds with underwater investment portfolios. How can pension trustees and legislators give away benefits when the plans are in deep deficits?

12. Pension professionals' bonuses under attack: a better way to improve the optics. A prominent politician who hates public-sector bonuses also thinks that public pension professionals should get none. Here's why he's wrong: investment professionals should be paid when they outperform their markets, even when those markets are down. And the full article explains how a deferred compensation arrangement could move this issue out of the public radar.

BONUS TOPIC: Have active portfolio managers underperformed the market? Will they hereafter? The answer is that many, many active portfolio managers have failed to outperform their index benchmarks, even if they finished above their average competitor. Every pension fund in America needs to completely review and re-think its investment strategies, its portfolio positions, its investment managers and consultants.

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