The three top themes for benefits managers this year are OPEB, fees and sustainability. Here's what's happening:
OPEB solutions -- at last! 2007 was the year of OPEB awareness. For those of us who've followed this issue for a decade, it's somewhat anticlimactic. But now the cards are finally on the table. The Governmental Accounting Standards Board's statement 45 requires governmental employers to record their "other post-employment benefits" (OPEB) obligations, such as retiree medical benefits, just like pensions. Most governmental units have now obtained an actuarial report of their accrued liabilities and necessary annual contribution levels. National estimates range from $1 to $1.5 trillion of unfunded accrued liabilities, and the Governmental Accountability Office estimates that public agencies must contribute an additional 3 percent of payroll over what they presently contribute to properly fund their OPEB promises.
If last year was devoted to obtaining information and informing key decision-makers, this year must emerge as the year for strategy and action. To procrastinate further is simply an invitation to deeper debt. The problem with OPEB is that medical-cost inflation outstrips general prices and especially tax revenues. The liability just snowballs the longer officials wait.
Many city, school, county and state managers have studied the problem enough to know that they need to do something and have started to search for solutions. Vendors in the defined contribution (DC) industry are licking their chops. They hope that states and localities will cut the cord with new hires and start enrolling them in "sidecar" defined contribution plans. These plans leverage the companies' recordkeeping systems that are already used in payroll savings plans. The problem is that nobody has offered much in the way of solutions for the existing "defined benefit" promises to existing retirees and graying Baby Boomers who are too old now to shift over to a viable DC solution.
Thus, 2008 will be a banner year for OPEB consultants. Public managers often lack expertise and need professional advice to help them solve the OPEB riddle. For employees and policymakers, it's a comfort to have independent recommendations. Unfortunately, those who only use actuaries are doomed to solve the problem with another problem: an endless commitment to fund an "undefined benefit" with a traditional, defined-benefit funding model that doesn't really fit the fact set. ("To a man with only a hammer, every problem looks like a nail.")
Policymakers need objective, unbiased, independent strategies from experts who understand the problem and don't have a favored solution that leads the public agency to a specific investment product that enriches the "adviser." The trouble is that few firms actually provide unbiased yet comprehensive consulting services. So I expect to see new entrants in this business in 2008 who can fill a void in the consulting marketplace. The challenge will be in finding good ones who can objectively present both defined benefit and defined contribution solutions plus viable hybrids.
One transitional strategy I would encourage this year is the "1-percent-a-year" approach to ramping-up employer contributions for OPEB. Instead of jumping immediately to full funding levels, which would force layoffs in many revenue-starved states and municipalities, budget officers might consider a phased-in approach for both DC and DB plans. Just as employees can raise their personal savings rate over several years to achieve a sustainable long-term rate without making unaffordable cutbacks in their personal budgets, many governments need to tiptoe into full funding. Accounting standards will show this as a funding shortfall in the year-end financial report, but if the footnotes display management's and elected officials' intent to attain full funding, then pro-active managers can show the bond rating agencies and taxpayers that leaders got the message. That will buy enough time to install viable permanent solutions.
OPEB bonding: Don't jump the gun! If interest rates continue declining, municipal bond advisors will soon come out of the woodwork to pitch OPEB bonds as the expedient solution to the funding conundrum. I'm still leery of OPEB bonds at this time in the business cycle (see my previous column on this topic) unless we endure a full-fledged recession with markets correcting 25 percent from their peaks. That kind of "average bear market" would take the Dow Industrials below 11,000 and the S&P 500 below 1,200. Optimal OPEB and pension bond issues would be sold near the recession bottom with stock and bond yields fully depressed. We're not there yet.
Don't forget that in 1998, financial advisers and underwriters talked several states into issuing untimely pension obligation bonds following the Long Term Capital Management credit crisis. Public pension officials and state treasurers saw the stock market rise for a short period and then plunge 40 percent -- putting their investments underwater and leaving them with a mess on their hands. I certainly wouldn't rule out a final up-leg in this stock market, but unless the Dow Industrials can then climb all the way to 17,500 before the next recession ensues, odds of successful OPEB bonds at this time are still questionable, as my previous column suggested.
That said, states should begin preparing now to set up the legislative and legal infrastructure needed to run a statewide optional OPEB financing agency for both the debt and the resultant investment portfolios. State financial experts can usually best provide expertise, the lowest rates and the best investment returns possible for municipalities that lack capacity. Absent timely state action, municipalities should start planning now for their own OPEB bond issues if the markets and the economy slide downward from here in coming months.
Ultimately, a full-fledged recession would present a timely opportunity to bond-out and pre-fund many governments' retiree medical obligations. But this is not a panacea. It's much more important to mitigate the long-term costs and build a sustainable benefit structure first. That way, both taxpayers and potential bond-buyers can know that OPEB bond issuers have brains and have put a ceiling on the benefits liability. Again, public managers should hire OPEB benefits strategy consultants before they start listening to self-interested bond advisors and underwriters: Get your horse in front of the cart.
Buyer's market for DC plans. Despite the recent market corrections and worries, the defined contribution business is booming. Plan administrators and the mutual funds they represent made record profits in 2007, with average account balances at all-time highs in many plans. The DC industry has reached full maturity in the public sector. Few traditional 457 deferred-compensation plans are being created, and the ballyhooed defined-contribution gold rush from defined benefit systems never really materialized. Thus, there are now too many competitors and too many institutional salespeople, so price wars are inevitable -- if the public sector seizes the opportunity to drive fees lower. All it takes is a request for proposal.
There are few deferred-compensation plans that couldn't lower the fees paid over the next five years if they simply put their plan out to bid, using a professional. Even those who do a "price check" by running their own RFP may extract lower fees. But the smartest public managers will be those who move quickly to put their plans out to bid. They will exploit the high average account balances they currently have by leveraging their buying power through a paid, independent plan consultant.
This offers managers and oversight boards an opportunity to streamline and redesign the investment menu for the next decade, re-educate workers as retirement investors, and think through the objectives and service needs of employees. Opportunities are ripest for municipalities with open-ended contracts that have, thanks to inertia, relied on the same vendor for years. But even those working on "contract extensions" cleverly granted under previous fixed-term engagements should consider marketing their plans this year. In today's hypercompetitive market, nothing will be gained by waiting.
Sustainable plan designs and portfolios. If retirement-plan administrators do nothing else this year, they should conduct a strategic session with their trustees on the issue of sustainability. Are your actuarial assumptions realistic? Are benefit structures realistic or even necessary, in light of your evolving workforce and future tax base? Is your investment portfolio positioned for the next decade or it is a ticking time bomb? When was your last asset allocation study?
A corollary of this theme relates to your investment return assumptions. Many public pension plans have ratcheted up their long-term actuarial assumptions for their investment returns to levels that may not be sustainable. As mentioned in my companion column on markets and investments in 2008, there are several investment consultants who privately doubt whether public agencies will achieve their long-term targets in the intermediate term. For those who've pushed the edge of the actuarial envelope and were right in the recent boom years for equities and alternatives, this might be a prudent time to trim back the long-term assumptions at least enough to maintain credibility with your constituencies.
If a recession or growth slowdown ushers in a period of substandard investment returns, there could be two consequences: First, the plans' real-time funding ratios could slip lower and deepen the unfunded liabilities, which in turn will increase the actuarially required contribution for employers (taxpayers). Second, there could be a credibility crisis in the accounting world. The private sector has moved to using Treasury bond yields as the discount rate, while the public sector continues to rely more aggressively on actuarial assumptions because bankruptcy and mergers are rare in government. However, if the business media, taxpayer advocates or employer organizations begin to suspect that public pension funds are using unrealistic numbers in their actuarial assumptions, pressure could mount on GASB to push municipalities toward private-sector accounting conventions -- which ironically could force even higher employer contribution rates in the short run.
The national pension organizations should seriously consider some "best practices" guidance on this topic. Inflated assumptions could come back to haunt everybody in the next decade if markets fail to match trustees' official capital markets expectations.
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