Employee Benefits

Managing the Public Trust

Unfunded pension liabilities continue to threaten city finances.
By: | October 1, 2013 • 10 min read

Detroit’s bankruptcy filing, many suggest, is more a symptom of Detroit’s overall economy rather than poor pension fund management.

Pension experts suggest two of Detroit’s pension systems may have been manipulated into appearing less sound than they are.

If that’s true, the political implications from what’s going on in Detroit will serve as fair warning for public pension managers in other cities.

Whether poor management or microeconomic factors or both are at stake, public pension risk is stepping into the spotlight nationally.

From a funding perspective, Detroit’s Police and Fire Retirement System (PFRS) and its General Retirement System (GRS) are in relatively good shape, according to Rachel Barkley, a municipal credit analyst at Morningstar in Chicago.

When the city filed for bankruptcy this past summer, Kevyn Orr, Detroit’s emergency manager, estimated the underfunding of the city’s two key pension funds at $3.5 billion.

But in an interview with Risk & Insurance®, Barkley said that the two systems are 90 percent funded on average. She said their combined 2011 unfunded liability was $644 million and that the two funds have an unfunded liability of $977 million estimated for 2012.

That is “still considerably less than Orr estimated,” said Barkley, and it leaves the funds in much better shape than most other state and local pension systems around the country.

Thanks in large part to a debt obligation assumed several years ago, “GRS was funded at 83 percent and PFRS at 99 percent as of June 2011,” — the latest date for which figures are available, said the Morningstar analyst, observing that the funds were propped up by a $1.45 billion pension certificate of participation borrowing in 2005 and 2006.

Orr has taken issue with the city pension managers’ calculations, questioning  assumptions of an 8 percent annual return on investment, a seven-year smoothing period (a common technique allowing investment gains and losses to even out over time), and a 30-year amortization schedule.

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For her part, Barkley said that while a five-year smoothing period is more the norm than a seven-year period, “The majority of these pension assumptions are within industry standards.”

Regardless of which side wins this argument, public sector risk managers have their work cut out for them in balancing the need to provide public services against responsible fiscal policy.

Why Detroit Matters

In August, an attorney representing hundreds of Detroit police and firefighters suggested that the Detroit conflict could set a legal precedent because pension issues there are so intrinsically connected to the bankruptcy case.

“Detroit is nationally significant because there is no precedent where the bankruptcy court has issued an opinion with respect to the authority of a municipality to reduce pension and retiree benefits for police and firefighters. Prior cases have reached negotiated settlements between the municipalities and the retirees,” said Strobl & Sharp attorney Lynn Brimer, legal counsel for the recently formed Retired Detroit Police Members Association. The association had attracted nearly 300 members as of August, according to press reports.

“The pension liability is highly contested and could have wide-reaching implications,” Barkley said during a recent Morningstar webcast.

“How these benefits are treated in the bankruptcy may set a precedent for how pensions are treated going forward, especially by distressed municipalities,” she said.

It could be many months before Detroit city retirees learn what’s in store for them. Yet all across the country, many state and municipal funds are facing insolvency.

The City of San Bernardino, Calif., was granted eligibility for bankruptcy protection in August. The city declared Chapter 9 bankruptcy last year.

According to an August story in the New York Times, San Bernardino plans to reduce its debt by cutting funds promised to the public pension system.

In California, Michigan and elsewhere, state and local plan sponsors have grappled to fund their liabilities, suspending or eliminating cost-of-living adjustments, cutting back on benefits for new employees, and in some cases raising employee contributions.

Despite a rising stock market, the rebound in tax revenues and increased employee contributions, the estimated aggregate ratio of assets to liabilities last year for a sample of 109 state-administered plans and 17 locally administered plans was 73 percent under current Governmental Accounting Standards Board (GASB) rules. Those figures are courtesy of a July 2013 report from the Center for Retirement Research at Boston College (CRR).

The report, co-authored by pensions expert Alicia Munnell — director of the CRR — found that the funded ratio in question is down slightly from 2011 and is considerably below funded ratios for public plans reported during the 1990s and early 2000s.

The key reason for the decline, the report stated, is the fact that liability growth, although having slowed recently, has still been outpacing asset growth.

“The growth in liabilities in 2012 was roughly 4.2 percent, considerably below the 6 percent growth in earlier years,” CRR explained.

Liability growth has slowed some because states and localities have responded to the economic crisis by reducing their workforce, freezing salaries and/or modifying the cost-of-living adjustments for current and future retirees.

And yet, the growth in the actuarial value of assets “was even slower, since the 2012 valuation for most plans pre-dated the 24 percent increase in the stock market that occurred between June 2012 and June 2013,” said the Boston College researchers.

In 2012, for example, employer contributions equaled 80 percent of the required payments. This decline resembles the pattern in the wake of the bursting of the dotcom bubble in 2000-2001, in which the percent of annual required contribution (ARC) paid fell from 100 percent in 2001 to 83 percent in 2006. Thereafter, the percent paid increased until the financial crisis of 2009.

“We’ve just been through an enormous financial crisis where mayors and governors are faced with a difficult choice as to how to spend their money,” Munnell said. Often, she noted, pensions took the hit.

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“Everyone would like employers to pay the full [ARC] amount while they’re trying to do 1,000 things at once,” such as “keeping schools open and revenues up, and I dare say pensions got shortchanged,” Munnell observed.

“Hopefully that trend will reverse itself,” she added. As budgets recover and unfunded liabilities stabilize as a result of stock market gains, “hopefully the percent of ARC paid will once again increase,” she said.

Some experts said the problems are tied to a flawed public pensions system that needs fundamental change.

Hank Kim, executive director and counsel for the National Conference on Public Employee Retirement Systems (NCPERS) in Washington, said that public employers “usually are not bound by their state law” to make all of their required contributions to state and municipal funds.

“State law generally only creates a pension plan. It is largely silent about required contributions. Courts have said that pensioners have a right to the promised benefit but do not have a right to force contributions to ensure those benefits,” he said.

Look at Illinois

One fund that does things differently, he said, is the Illinois Municipal Retirement Fund (IMRF), the state’s second largest pension system.

Louis Kosiba, executive director of the IMRF in Oak Brook, Ill., said the fund is a statewide system representing 2,900 units of local government, and roughly 25 percent of the state’s active government employees.

In the Illinois system, each participating employer pays a unique contribution rate to help fund benefits for participants. IMRF calculates this rate each year, and when contributions are not properly paid, the fund has three tools to collect the correct amounts:

* Employers may be sued in circuit court;

* Where participating entities collect real estate taxes, those taxes can be intercepted for pension contributions; or

* Where participating employers receive funds from the state, those payments can be garnished to meet pension obligations.

“IMRF is structured very differently from the state-funded public pensions in Illinois,” explained IMRF spokesman John Krupa.

“The five state-funded retirement systems [The Teachers’ Retirement System of the State of Illinois; State Universities Retirement System; State Employees’ Retirement System; Judges’ Retirement System and the General Assembly Retirement System] all depend on the state legislature to annually appropriate the actuarially required contribution to help fund the systems.

“IMRF has the statutory authority to enforce payment by each participating employer each month,” said Krupa.

“Article 7 of the Illinois Pension Code allows participating employers to levy a tax to fund their actuarially required contribution to IMRF. Employers who fall under a tax cap [and non-taxing bodies] can pay IMRF using income they derive from other sources, e.g., fees for services,” he explained.

In June, the IMRF reported it was roughly 86 percent funded on a market value basis, up from 80 percent at the end of 2011.

In contrast, Morningstar reports that at the end of fiscal 2011, the aggregate funded ratio for the five state-funded Illinois pension systems Krupa cited was at 43 percent.

Last June, Moody’s downgraded $27 billion of general obligation bonds in Illinois to A3 from A2 and stated that the state’s “severe pension liabilities” across the five state funds represent the state’s greatest credit challenge.

Meanwhile, more and more public fund officials are going about restructuring their liabilities of late. One option involves adopting so-called “risk parity” programs and other ways of reallocating assets.

“It’s important to understand that corporate plans are not in better shape than public plans because they were smarter investors,” said Jay Kloepfer, an executive vice president and the director of Capital Market and Alternatives Research at investment consultant Callan Associates in San Francisco.

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“The Pensions Protection Act of 2006 made corporate plans contribute more to such plans and shortened the time horizon to calculate how long it takes to get funded,” Kloepfer said, but “none of this applies to public funds.”

Many public funds have made insufficient contributions, so they’ve had little choice but to invest aggressively, so “de-risking” is an entirely different thing for them than for corporations, he said.

Instead of allocating assets in a traditional fashion, with equities making up the bulk of the portfolio and the bulk of the risk, risk parity weights each asset in a portfolio such that it contributes equally to the total risk of the portfolio.

Diversification is another de-risking tool, said Kloepfer, who has seen more public funds look to private equity, real estate, timber, agriculture and hedge funds of late as a way to hedge against market risk.

From a regulatory perspective, there may be some changes down the road as new GASB rules begin to go into effect next year.

Among other things, these new rules will require that seriously underfunded plans use more conservative discount rates to calculate their liabilities.

Boston College’s Munnell has another suggestion, based on a new approach to defined benefits recently adopted by the Canadian Province of New Brunswick.

This program guarantees pensioners specific base benefits, but only grants ancillary benefits if a plan is healthy enough.

According to a Boston College report in August outlining the plan, “Ancillary benefits not granted in bad years can be expected to be fully restored in good years. In fact, pensioners will receive checks in good years that will compensate for [cost of living increases] missed in bad years.”

The center at Boston College is not the only one advocating such a program for U.S. states and cities.

In early August, the New York Times did the same in an editorial.

“All states and cities — and not just those facing imminent crisis — would do well to examine a promising approach to pension management recently adopted by the Canadian province of New Brunswick with the support of the province’s labor unions,” the newspaper said.

Under the program, “If a fund’s investments fall too much, the government kicks in more money and retirees do not get some of the ancillary benefits,” the Times stated.

“If it does better than expected, employers recoup some of their earlier contributions and workers get bigger monthly pension checks.”

Janet Aschkenasy is a freelance financial writer based in New York. She can be reached at [email protected]

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The R&I Editorial Team can be reached at [email protected]