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An advocate of a new bonds-based strategy to stabilize troubled public pension funds says the change would be costly and take years.
The CalSTRS board last week heard what one panelist called a “raging debate” in professional circles: Do public pension funds need to be radically restructured to survive.
The issue was “liability-driven investing,” a return with a modern twist to bond-based investing abandoned by most public pension funds several decades ago. Seeking higher yields, the funds shifted to riskier stocks and alternatives such as private equity.
The increased investment earnings during good times ballooned to two-thirds or more of pension fund revenue, dwarfing employer-employee contributions. The earnings were expected to cover higher earnings for employees.
But a historic stock market crash and deep economic recession punched a big hole in public pension funds. Now state and local governments, the “plan sponsors,” face soaring annual pension payment to cover the investment losses.
Critics are calling it a “pension crisis” and warning that the pension benefits are “unsustainable.” A PPIC poll in January said 67 percent of voters favor switching new public employees to 401(K)-style investment plans, common in the private sector.
An advocate of the new bonds-based strategy, M. Barton Waring, retired Barclays chief investment officer, told the California State Teachers Retirement System board that public pensions need big change that will cause emotional, political and financial pain.
“One thing I want to exhort you to is do what has to be done, especially those that represent the teachers’ interest,” said Waring. “Do what has to be done to save a defined benefit (pension) plan in some form, because the worst defined benefit plan is better than the best defined contribution (401(k)- style) plan.”
Waring said the median amount in the tax-deferred 401(k)-style individual investment plans of persons age 60 to 65 is $75,000, not enough savings for an adequate retirement.
Liability-driven investing shifts the focus from seeking returns with riskier investments such as stocks to covering the future obligations with nearly risk-free bonds, bolstered by inflation adjustments or financial instruments called “derivatives.”
“If done completely, it would prevent surpluses and deficits from forming,” Waring said.
Among the problems, he said, is a potential shortage of federal inflation-adjusted bonds, the difficulty in getting lawmakers to boost contributions to the pension funds, and setting the level of pension benefits.
“It’s a journey,” Waring said. “It’s not something you would try to do in a year. It’s something that would take time.”
CalSTRS already is estimating that it may need to double current contributions, totaling about 20 percent of pay, to reach full funding Teachers contribute 8 percent of pay, school districts 8 percent, and the state 4 percent.
Unlike most public retirement systems in California, CalSTRS cannot set its own contribution rates, needing legislation instead. As state lawmakers struggle to close a $19 billion deficit, CalSTRS is expected to wait until next year to seek more money.
In the debate over public pension investment strategy, the view of financial economists, held by Waring, tends to conflict with the tradition of actuaries such as the other panelist, Dimitry Mindlin, CDI Advisors president.
“LDI (liability-driven investing) is a relatively new buzz word, even though the ideas have been around for quite some time,” Mindlin told the CalSTRS board.
He said it’s probably “more of a marketing campaign to sell these (LDI) investment products than anything else.” For those who think interest rates are a prime risk, he said, “you should certainly consider LDI products.”
But among the problems in adopting an LDI strategy, he said, is that pension commitments can change with pay and other variables, making cash-flow matches with bonds difficult. He said minimizing risk would require “massive” contribution increases.
“The cost would be so high, and the level of benefits would be so low,” said Mindlin, “many participants would decide your defined benefit (pension) plan is not a good thing: ‘It gives me safety but at huge cost.’ You may lose support for your system.”
Waring said shifting to a bonds-based strategy would require changing the way pension fund assets are valued, which could dramatically increase the estimated cost of paying pensions in the future.
CalSTRS currently assumes that investments will earn an average of 8 percent a year in the decades ahead. The new strategy would assume that investments would earn a much lower “risk-free” government bond rate.
A study released by Stanford graduate students in April, based on data before the market crash in the fall of 2008, said that if a risk-free bond rate, 4.1 percent, is used the CalSTRS shortfall or “unfunded liabilities” zooms from $16.2 billion to $157 billion.
Waring said that using earning estimates based on stocks and other risky investments is an “outdated” method developed a century ago by actuaries, but now used only by public pensions and some parts of the insurance industry.
“There is no place in the real world of financial economics where prospective return on assets is used as a basis for financing,” he said.
The governor’s pension advisor, David Crane, reportedly was removed from the CalSTRS board by the state Senate four years ago because he contended that a huge debt owed for future pensions was being hidden from the public.
Crane and one of the economics professors who agree with the methodology of the Stanford study, Josh Rauh of Northwestern University in Chicago, were among the speakers at a roundtable on pensions held last week by Gov. Arnold Schwarzenegger.
Last month, the Governmental Accounting Standards Board asked for comment on a proposal directing public pensions to use the risk-free earnings rate, but only for debt not covered by their assets.
The change would increase a pension fund’s estimated shortfall or “unfunded liabilities,” presumably a prod toward increasing employer-employee contributions to properly fund future obligations.
In a preliminary report, Jack Ehnes, the CalSTRS chief executive, told the board last week that the proposed accounting change only applies to the reporting of debt, not how pension plans are actually funded.
But, Ehnes said, what if a lower risk-free rate did lead to higher contributions, and earnings turned out to be nearer the current 8 percent target? The plan would have surpluses and the current generation would pay more than its share of costs.
The CalSTRS board, like the board of the California Public Employees Retirement System, is considering lowering its assumed earnings rate, possibly from 8 to 7.5 percent a year.
Several board members requested a briefing on the earnings rate from impartial experts in September, more preparation for a tentatively scheduled decision in November. Some points of view on the complex issue were mentioned at the meeting last week.
Allan Emkin of Pension Consulting Alliance told the board that “it’s going to be harder to make money in the next 25 years than it was in the previous 25 years.”
He said investment asset classes are no longer as favorable. For example, 10-year bonds yielding 16 percent in the early 1980s now yield 3 percent, and stock price-earning ratios that were 8 percent are now 16 to 17 percent.
“We collectively are going to have to be more innovative, more creative because the tools that worked, which were basically to be fully invested at all times, will probably not be the best strategy for the next 25 years,” Emkin said.
Asked for a breakdown of the assumed 8 percent earnings rate, Chris Ailman, the CalSTRS chief investment officer, said 3 percent is inflation and 5 percent is real growth, reduced further by the nearly 2 percent usually received from stock dividends.
“I would argue, and I have, with people who said it’s going to be 6 (percent) or lower that they are basically saying the United States is going to go in the drain in the next 100 years,” said Ailman. “I’m not willing to go there.”
Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at calpensions.com