9 December 2009, AdvisorPerspectives

In Tom Stoppard’s screenplay Shakespeare in Love, Geoffrey Rush’s character, when asked repeatedly how the seemingly impossible gets done, he repeatedly answers, “I don’t know, it’s a mystery.” These days that’s how one might view the ability of local and state governments to meet their growing pension liabilities.

Opinions on the matter range from measured optimism, as expressed by the Keith Brainard, research director of the National Association of State Retirement Administrators, to outright pessimism expressed by bond fund guru, Bill Gross of PIMCO.

Brainard oversees the most comprehensive national database that captures approximately 85 percent of the entire state and local government retirement system. NASRA’s operations are funded in part by small fees paid by these governments and by money managers who attend its conferences. He acknowledges the hit that public pensions will experience from the 2008 market crash has been only minimally captured in his FY 2008 annual report.¹ The reason: investment losses [and gains] over any particular year are not immediately felt because government valuation convention seeks to smooth away volatility by spreading annual performance over the proceeding five years. This allows government to sidestep the need to raise taxes to meet temporary shortfalls. It also inhibits knee-jerk reactions by managers to falling valuations, when holding is often a prudent choice.

Last year’s figures reveal a gap between liabilities and assets of nearly 15 percent. Even if this year’s market gains hold, the gap will likely worsen. This would reinforce a negative trend that started after 2001 when government pension plans were actually running a slight surplus of nearly 2 percent. This deficit, that’s been expanding over the last seven years, suggests that pension funding sources are not keeping up with liabilities, and that investment returns across a full market cycle have not been sufficient to make up the difference.

It’s important to note that while the current gap is significant, it has been worse in recent years. In 1990, it was 21 percent. We could indeed be heading back to these levels as last year’s losses reverberate into future year returns. There is also the prospect of a weak economy unable to provide significant relief in the form of greater tax revenues over the coming years.

At the same time, state and local governments are being confronted with growing needs of the unemployed and to finance economic stimulus. After the huge $787 billion federal stimulus package is exhausted, there will likely be limits on future federal transfers to aid state and local government. And if Wall Street stumbles in the wake of slow economic growth, the public pension deficit is likely to fall under greater strain.

However, Brainard believes that overall, government officials have a decent long-term investment record in effectively responding to budgetary stresses. Most important, he says that “there is no reason to believe that the 8 percent assumption on asset growth is unreasonable over the long run.”

Mark Ruloff, director of asset allocation at the global advisory Watson Wyatt Investment Consulting [which advises on $2 trillion of private and public pensions worldwide], believes that this assumed rate of asset growth is a serious problem because it is also applied to the rate in which liabilities are discounted. He counters by saying “instead of offering pensions based on a rate of return that’s unpredictable, future obligations should be based on a risk-free rate of return, such as 10-year Treasury yields, which is currently under 4 percent.” That’s less than half the current assumed growth rate.

Linking pension liabilities to a projected long-term rate of return, rather than an actual one, is a systemic problem in the way public plans are managed, according to Ruloff. “It leads to more aggressively positioned portfolios that introduces more risk than should be in a retirement system,” he says.

Bill Gross is more severe. He thinks many public plans are in deep trouble because “states are typically ostriches with their heads in the sand, hoping their problems go away.” And some recent data seems to support Gross’ contention. The Illinois Teacher Fund offers an extreme example of the problem. Bloomberg News recently reported that assets as of the end of FY 2008, which ended in June, had declined from $38.4 to $28 billion over the past year while liabilities had increased to $73 billion.

Bloomberg also cited a US Census Bureau report that said public retirement accounts lost 21 percent or $600 billion through June 2009. And that assets in the 100 largest public pension plans, which account for nearly 90 percent of all government retirement monies, fell to $2.2 trillion.

Orin Kramer, the chairman of the New Jersey State Investment Council, which formulates policies affecting the state’s $68 billion investment funds, paints an even bleaker picture. He believes that state and local pension underfunding nationwide is currently running at $1 trillion. This figure is many times larger than what industry studies have revealed, and represents nearly half of public pension assets.

Still, Kramer fears that underfunding will eventually make it very difficult for governments to tap the bond markets and that federal intervention—involving implied or explicit guarantees—may be necessary to fund future debt.

Whether or not public pension liabilities are going to swamp state and local budgets comes down to several core issues.

• First, is the basic way governments fund pensions sustainable?
• Two, are the assumptions about underlying investment returns reasonable?
• Three, if our expanding national debt leads to much higher borrowing costs and inflation, how will pension officials deal with this nasty one-two punch?

A survey of reports and interviews with industry observers provides a basic incite.

According to NASRA’s Keith Brainard, one-third of public pensions are funded by workers, two-thirds by government. When supported by a healthy economy and governments not overladden with deficits and debt, that arrangement may work. But under today’s stressful conditions, this arrangement is likely to exacerbate matters where the numbers aren’t adding up. Brainard thinks that while this funding approach works for a number of plans, others that are broken will need to alter the contribution ratio, as well as benefits. He is confident that troubled plans will make the necessary adjustments.

A sound assessment of the matter is dependent on the reliability of the underlying quality of the pension numbers being reported. Brainard believes that Government Accounting Standards Board [the public equivalent to the Financial Accounting Standards Board or FASB], which guides the pension number crunching and assumptions, is sound and transparent. He has faith in the figures making up his annual assessment of public pensions. And his findings have been largely corroborated by Wilshire Consulting. While Wilshire’s annual study is more narrowly focused on state retirement systems, it provides a meaningful look at how public pension plans invest. [See attachment.]

Wilshire breaks down the collective asset allocation of pension plans to determine forward returns and risk assumptions. It found that between 2003 and 2008, state pension plans were taking on a bit more risk in exchange for minimally more returns that were 50 basis points below the 8 percent assumed returns that NASRA reports. [Note: NASRA includes local pension plans, which are not a part of the Wilshire study.]

Over this five-year period, Wilshire found that investment portfolios were boosting foreign equity exposure in exchange for less domestic exposure, the latter still dominating overall weighting [38.1 percent versus 18.8 percent for international stocks]. Real estate climbed by nearly 2 percentage points to 5.9 percent. Private Equity also increased by 1.4 percentage points to 5.6 percent.

The largest source of this new exposure came from bonds, which fell by 9 percentage points to 27.6% of the portfolio. According to Wilshire, with bonds having ostensibly lower risk and with equity, private equity, and real estate coming with much higher risk, the overall risk profile of state pension portfolios has increased from 10.3 to 10.9 percent.

This shift in risk probably increased the hits state pension plans experienced during the recent bear market. And one cannot presume this higher beta portfolio has delivered greater upside as the market rallied in 2009 because, like many investors, administrators had likely ratcheted back on risk after the market broke. This won’t be known until Wilshire completes its next study in spring 2010.

There’s no consensus on whether assumed rates of returns are reasonable. Historical data may suggest they are. But if we entering a period of a so-called New Normal, these projections may need to be altered to avert a crisis.

Leo Kolivakis, who was a senior investment analyst at two of Canada’s largest pension funds and who currently maintains his own website called pensionpulse.blogspot.com, thinks that given an allocation of 50 percent equities, 35 percent fixed income, and 15 percent alternative investments, plan administrators should be projecting a long-term annual rate of return of 5 percent. He bases this determination on the belief that over the next ten years, he thinks we will be in a period of low growth and low inflation, with deflationary worries being a major concern. He also worries that the Federal Reserve is fueling asset inflation through cheap money to help repair banks’, households’ and pension fund portfolios. “There’s a risk of values decoupling from fundamentals,” fears Kolivakis, which could send stocks tumbling.

Economic growth may not be significant enough to drive inflation. But record debt levels could. If it becomes more difficult to sell local, state, and national debt because the perceived risk premium has increased, not only due to the country’s troubled fundamentals but also due to the risk associated with foreigners holding dollar-based assets, we may see a significant rise in interest rates to sustain demand. If that occurs, it could very well lead to higher costs in both production and prices.

According to NASRA’s FY 2008 study, “most plans [currently] use an inflation assumption between 3.0 percent and 3.5 percent. For the 25-year period ended in 2008, the average rate of inflation, based on the most recognized inflation indicator published by the U.S. Bureau of Labor Statistics, was 3.0 percent.”

Mark Ruloff isn’t overly concerned about the impact of rising borrowing costs and inflation on public pension plans. “They basically net out,” he explains, as rising inflation-adjusted liabilities are offset by higher yields on debt. If wage growth tracks higher inflation, it would also increase contributions to pension plans. Runaway inflation, however, would likely be another story.

So what does all this mean about the state of the country’s public pension plans?

Leo Kolivakis thinks the public pension system is not in good shape and requires fundamental changes. These could include raising the retirement age, increasing employee contributions and lowering future benefits for new employees. Though it may not affect the public sector as directly as the private sector, Kolivakis fears the country’s demographic trends–fewer and fewer workers will be supporting more and more retirees.

NASRA’s Brainard thinks that “absent dramatic improvements in investment markets, public pension funding levels will be lower in FY 09 and [for] the ensuing three to five years, and costs for most plans will be higher. Employee contributions will play a role, to some degree, in blunting higher required costs, and the delay between the market declines and the implementation of higher costs gives plan sponsors an opportunity to prepare. Strong growth in global equity markets to-date in 2009 will help to offset a portion of the 2008 declines.”

Whoever is right, public pensions have the potential of becoming a subprime-like bombshell. Like housing lenders and borrowers, government officials and workers must seriously address this issue before it overwhelms budgets that are already under severe strain.