Topic Index: 2009's Top 12 Issues Part I: 1. Financial Economics and MVL: rest in peace? 2. Pension funding after the meltdown: true cost of employees' straddle options 3. Sustainability of retirement plans and OPEB ostriches 4. Crocodile benefits "tiers" for new employees 5. Pension obligation and OPEB obligation bonds: the new paradigm 6. DB vs DC plans: a false dichotomy revealed Part II: 7. Collective defined contribution plans -- an intriguing new structure for OPEB 8. GASB and pension accounting 9. OPEB legislation 10. Pension funds to underwrite muni bonds? 11. Pension contribution and COLA holidays 12. Pension professionals' bonuses under attack: a better way to improve the optics BONUS TOPIC: Have active portfolio managers underperformed the market? Will they hereafter? Executive Summary of Parts I and II
7. Collective defined contribution trusts. Having recently devoted some serious time to study these uncommon creatures, I appreciate them the more I see them, especially for retiree medical benefits (OPEB) plans. They are less likely to supplant pension funds, however. In light of constitutional protections to pension fund retirees, the only way that a collective DC plan makes sense in the primary retirement plan world would be as a new benefits tier offered to new employees. For example, an employer unable to continue current DB benefits levels on a sustainable basis could establish a new collective DC plan for new employees with employer and employee contributions bargained collectively, and perhaps also give new, young and mobile professional employees the option to self-direct some of their contributions in a conventional qualified 401 plan or a retirement health savings plan.
The collective DC plan model seems very well suited to retiree medical (OPEB) plans, where the future costs of medical inflation are highly uncertain, and the benefit is secondary to the pension plan. There, it makes great sense for the employer to make a fixed contribution for future employee benefits, to be supplemented by employee contributions, and leave the determination of the benefits to the plan trustees to equitably allocate based on future investment and actuarial results. Such plans can still qualify for pre-tax benefits which makes them more tax efficient than a qualified 401-type DC plan. If the employer is bearing all actuarial risks in the primary pension plan, it makes all the more sense to require new and even incumbent employees to bear the risks collectively in a DC plan for OPEB benefits.
One detraction inherent in these plans is the uncertainty and variability of benefits and the need to communicate with employees and retirees much more effectively than either traditional DB plans or individual DC plans.
Another remaining problem for collective DC trusts is that the Governmental Accounting Standards Board (GASB) needs to provide greater clarity about their classification and accounting. Clearly, these are defined contribution plans, but typically the employer establishes a governmental trust (often a so-called Section 115 trust). If that trust is not formulated as a Voluntary Employee Beneficiary Association (VEBA), and thereby spun off from the plan sponsor, then there is a question in some minds about how the plan would be classified under GASB 45 -- which could affect the discount rate and the actuarial valuations significantly. I think they should simply be classified as DC plans and the actuaries should apply the same standards for discount rates as they would in a DB plan, but it would be nice to see this addressed formally by the accounting authorities.
In response to last month's column, I received a note from an actuary who claims that this country's only example of a collective DC trust is the federal Social Security System. Before that idea goes too far out there, I'd like to make sure that readers know that (1) there really are viable collective DC trusts already operative in the municipal sector and (2) the Social Security system hardly fits this model because Congress refuses to downsize the benefits promise to fit the resources available, which is the fiduciary responsibility of a CDC trustee. If Social Security were subject to ERISA, the trustees and the Congress would all be in jail now or in personal bankruptcy court -- along with their actuaries.
A future, detailed follow-up column will also address governance and operational issues, as I delve deeper into collective defined contribution plans in another management letter.
8. GASB and pension accounting. While I've got GASB on my mind, it should be noted that the board and staff have initiated a major study of pension and post-retirement accounting issues. One of the key issues to be addressed is how pension and OPEB plans amortize their unfunded liabilities. Current accounting standards permit unfunded liabilities to be amortized for as long as 30 years. The rules also permit "open amortization" which is like an interest-only mortgage that allows the plan to amortize over 30 years this year, and 30 years next year, and 30 years the year following, and so on. Needless to say, that will never result in the ultimate repayment of an unfunded pension or OPEB liability. Worse yet, the average service lives of most public employees, and particularly public safety workers, is less than 30 years. For retirees, we know actuarially that the average 65 year old will likely die within 18 years. So the accounting clearly does not match the reality, and this shifts a cost burden onto the next generation of taxpayers. Would you buy home appliances with a 30 year interest-only home equity loan, and name your grandchildren co-borrowers without their signature?
Likewise, the accounting standards are too lenient now when politicians and short-term senior administrators cut a back-room deal with unions to grant retroactive pension benefits and sidestep the costs during their tenure. They should be compelled to account for the increased unfunded liability immediately as a cost in the current contract year, and not deferred to future taxpayers. Both of these paradigm-shifts are overdue. As a pragmatist, however, I would suggest implementation of the amortization rules after 2011 to give governments sufficient time to step up to the cost implications in light of their other imminent fiscal burdens. The last thing they need right now is a pension cost increase on top of their OPEB costs which most are unable to fund properly, even with 30 year amortization schedules. The retro-pension rules should take immediate effect, however.
GASB also has been studying the "financial economics" arguments for calculating or disclosing liabilities using risk-free discount rates. As I explained last month in Topic #1, my views have shifted on this issue. Where I once saw potential informational value in requiring a risk-free MVL disclosure in the notes to pension fund statements, this past year's historic flight to quality has shown us all how such a number becomes meaningless at market extremes. Technically, the municipal investment community would be far better off with a required disclosure of plan liabilities using the variable-to-fixed swap-equivalent method I introduced in Topic #6 last month. The actuarial standards boards could easily provide guidance to actuaries on how to construct that valuation model using available financial tools such as Black-Scholes formulas. That said, I won't hold my breath waiting for something this esoteric to become the actuarial or accounting standard.
This is one battle where I think the public pension community will win their case for the status quo, because the alternatives presented by their critics have failed to achieve decision-usefulness. Professional investors can find other ways to estimate the true value of a public employer's benefits liabilities. My one practical suggestion in this regard is that plans which assume a rate of return above the national average should be required to disclose what their liabilities would be if they used the national average -- which would make people think twice about over-aggressive assumptions. That seems to me to be an actuarial standard and not an accounting standard, however, although public disclosure in the financials would be far preferable to opaque actuarial reports that just sit on the staff's shelves.
9. OPEB legislation. Only a handful of states have enacted investment, bonding, tax and labor laws sufficient to provide for proper management and financing of retiree medical benefits (OPEB) plans. As noted in my previous column on this topic, state professional associations need to press hard in 2009 to obtain needed legislation to clarify the investment authority of OPEB trusts (to resemble that of pension funds), enable policy-makers to properly fund previously committed obligations with appropriate taxing authority (if allowed by constitution of course) and to employ the tools of bond finance during market periods when such strategies are fruitful and prudent, as attested by responsible professionals and fiduciaries.
In states where this is now a problem, the OPEB legislation should also direct arbitrators to consider local private-sector retirement benefits as a key "comparable" factor in their decisions, to eliminate the unions' ongoing game of comparing public employees' benefits only with other public employees' benefits -- which is a recipe for taxpayer backlash at the polls someday as voters bristle against what appears to them to be lavish compensation arrangements.
In the next management letter, I will present model legislation for OPEB plan financing, investing and trust fund operations.
10. Pensions to underwrite munis? The National League of Cities and the National Association of Counties have just released a Blue Ribbon Commission report on enhancing the municipal credit markets. One of its suggestions is the possibility of public pension plans entering the municipal credit guarantee market on a sustaining basis, as some have done in the past on an ad hoc basis. Although there are many details to be ironed out, and numerous fiduciary and risk concerns must be addressed, the potential for public pension plans to provide competition to private-sector bond insurers can only help the municipal bond market achieve better and fairer pricing. And if the taxpayers can save some money on both ends of the deal by receiving supplemental income in the pension fund while reducing borrowing costs for their governments' debts, that could be a win-win. My related column on this topic addressed some of the fiduciary protections and risk controls that obviously need to be considered in this debate.
11. Pension holidays. As noted in a related column, some politicians are looking for easy ways out of their fiscal challenges in this recession year, and pension contribution holidays are back in vogue. With the private sector also succumbing to this idea as a way to conserve cash and keep employees on the payroll, it is hard to fight back on these attacks on proper funding. But in the public sector, the odds strongly suggest that the money will never be there in the future to restore proper funding, so a sustainability audit would be an excellent technique to employ before allowing public employers to take the easy path now, while simply deferring the inevitable downsizing of either the workforce or the benefits plans themselves.
The only pension holiday that makes any sense to me this year is a sustained "COLA holiday" for plans that are deeply underfunded. In recent years, the practice of awarding ad hoc cost of living increases to retirees has become almost reflexive, despite funding conditions. With plans now deeply underfunded, this practice needs to stop. Once pension funding ratios exceed 110 percent it would again be reasonable to discuss ad hoc COLAs, but that will take years if not decades. Those who want to build COLAs into their actuarial assumptions should do so formally as part of the benefits formula, and ante up the employee contributions required to pay for them.
12. Bonuses and compensation for pension staff. I saved this one for last, to salute those hard-working souls who are genuine and proven performers in the public pension community. Despite the deadwood, there are talented people in many of the key positions, and they deserve a fair shake. They take a lot of flack with little appreciation. My final "Top 12" issue for 2009 is bonus compensation for pension plan professionals. It's become so popular to attack bonuses that even President Obama has joined the chorus. At least one prominent public official has attacked the concept of bonus payments to any public employee, including public pension professionals. After a horrid recessionary year like 2008, many people think that knowledge workers on Wall Street and in the pension world should get coal in their stockings. Some think that when the market is down, there should be no bonuses. In Ohio, the retirement board suspended bonuses on the basis of that kind of thinking. Others just think that bonuses are wrong for public-sector professionals in the first place.
Well, I'm here to say that incentive compensation and variable compensation do indeed belong in the public pension internal pay system. First, it's appropriate to reward achievement in complex financial markets through variable compensation, and that requires a bonus structure -- which must be tightly managed. Certainly, if the pension plan has underperformed it benchmarks, bonuses should be cut dramatically or even eliminated. But if the investment portfolio and plan performance have fairly exceeded their bogey, then incentive compensation is fairly due to the employees whose work products outperform the market averages -- even in a recessionary bear market.
Secondly, bonus compensation is necessary to attract and retain highly qualified professionals. I recently got a kick out of watching the conservative-libertarian TV commentator Larry Kudlow on CNBC taking the unexpected position that executives in the banking and auto industries now getting taxpayer bailouts still need to be eligible for bonuses if we are to get performance above the level of a G-15 federal bureaucrat, and he's dead right about that. His logic and insight applies to public pension professionals just as well.
In the public pension sector, I have one constructive suggestion from past experience to offer -- which might help with the controversial optics of paying cash bonuses in down-market years. Include a top-hat deferred compensation plan in the structure, so that the professional employees' compensation for losses averted (by portfolio out-performance on a relative basis in a money-losing year) can be awarded, but not vested and distributed until markets have recovered. That arrangement provides some retention features as well, and should be viewed by all parties concerned as a fair compromise. Bonus deferrals can muffle the attacks by self-promoting politicians or other critics who don't get the concept that this is actually a business enterprise that you're running here and not just a bureaucracy. We used a similar strategy for senior executives when I worked at Janus Capital during their dark days of regulatory investigation, and it placated hostile shareholders and media curmudgeons -- while retaining honest key professionals who were equally sensitive to the appearances of cash bonuses in terrible times.
BONUS TOPIC: Have active portfolio managers earned their fees, and will they in the future? There has always been a debate in public pension circles about whether large portfolios can actually outperform the market benchmarks. Many large state systems invest a significant amount of money in core equity index portfolios, sometimes using internal staff to reduce costs. The theory has always been that active management adds value through information (research) advantages, behavioral discipline, timing and analysis. But in large plans, the problem for active managers is that they must invest huge amounts of money in their finite ideas, thus impacting the market when they buy and sell, and thereby dilute the effectiveness of their own work. The larger the mandate, the more their returns have tended to revert to the mean.
In the aftermath of 2008's market carnage, there is another factor to consider: Many equity managers in particular have significantly underperformed their benchmarks. Most of them failed to raise cash before the down-market, which was one of the long-standing arguments favoring active management: Active managers were supposed to trim portfolios when valuations are excessive, but that did not happen in many cases. In other instances, the mathematical models and investment strategies that worked for the past ten years blew up completely during the market meltdown and have erased all their "alpha" (active management returns). Of course, some active managers will be able to sport portfolio returns that exceed their peer groups -- simply by the law of averages, half of them should accomplish that. But I suspect a majority will fail the acid test of outperforming their objective market-index bogeys.
Will trustees and consultants revisit indexing and passive management strategies in 2009? I will not be surprised to see some public plans decide that lower fees and less "tracking error" will be the path of least resistance and greater efficiency.
After publishing my "executive summary" of these issues two weeks ago, which contained a preview of this coming attraction, I received an e-mail from a state watchdog group reminding me that many active money managers use "easy to clear" hurdles when they design "custom indexes" that are rather self-serving. (That's how they calibrate their fees -- duh!) If ever there were a time for an independent audit of whether value has actually been added by hiring outside money managers, this would be it.
One of the key tasks for pension trustees in 2009 will be to ask hard questions of money managers. Many of them have lost their bearings, and some have abandoned the disciplines for which they were hired. And here's a perverse thought to haunt CIOs and trustees, looking forward: Those who outperformed during the recent megabear market may actually not be the right horses to ride once this economic malaise has ended. What worked in the past may not ever work as well again in the future. Almost nobody can rest on their laurels in this new world of investment markets. In well-governed plans, 2009 should see a lot of soul-searching and deeper thinking about basic assumptions and processes. Give some thought to that audit of active management: You may discover you have been spending a lot of money in management fees for naught.
