Archive for category PERA
One of my fondest desires has been to produce a This American Life or RadioLab, only for free-market and conservative ideas. Thanks to Stacy Petty, I’ve actually been given a chance to do this.
In one of his own podcast interviews, Dan Carlin of Hardcore History fame says that his goal has been to produce, for radio, a long-form edition of what a newspaper column would look like. That’s kind of what I’m aiming for here, as well. Edited, polished, but also using the illustrative and mood-setting background sound that radio give you, but newspapers don’t.
It’s unclear exactly what the format will be going forward, but here’s the first attempt, discussing PERA, the forthcoming State Auditor’s report on an early warning system, and small planes. It runs 10:30, but I’m hoping to bring future editions in at exactly 10:00.
Even as Colorado’s state public pensions seek to add risk to their portfolio, California CalPERS is seeking to reduce risk and volatility in its own plan. In doing so, it sends up a flare for other pension plans. It also confirms one of the key assertions of defined benefit plan critics: the aggressive return assumptions, combined with permissive discount rate assertions, in US public pension plans incentivize those plans to chase those returns, and add risk in doing so.
In a piece I wrote back in March for Watchdog Arena, I noted that Colorado PERA’s Board of Trustees had voted to shift several percentage points of investment from stocks and bonds into riskier alternative assets and real estate. This portfolio isn’t necessarily out of line with the majority of US public pension asset allocations, but it does represent adding risk – and therefore volatility – in an attempt to increase returns.
Yesterday, Pensions and Investments reported that CalPERS is looking at reducing its expected 7.5% rate of return to as low as 6.5%. Doing so, the plan says, would allow it to shift its investments out of stocks and alternative assets into more predictable, less volatile bonds.
“It is essential that we do this,” said California Controller Betty T. Yee in an interview with P&I. Ms. Yee added that if CalPERS does not reduce volatility, it could jeopardize its ability to pay retirees in the future….
Ms. Eason said lowering the rate of return would also enable officials to build a portfolio less vulnerable to market swings. The current 7.5% rate of return has a 12% volatility rate. Reducing the rate to 7%, as one scenario does, would translate to a 10% volatility rate. A 6.5% rate of return would equate to a volatility level of 8.5%, she said.
In doing so, CalPERS doesn’t implicitly accept the critics’ assertions – it explicitly accepts them. They would lower the expected rate of return specifically so they could “safely” move assets into less risky (albeit less remunerative) investments. Public pension officials in the US have long denied a linkage between the two, so it will be interesting to see how they react to this admission.
By most measures, CalPERS is better funded that Colorado PERA, although not particularly well-funded. It admits to a funding level of 77%, compared to PERA’s claimed funding level of 62%. These claims both discount the pension liabilities at 7.5%, the assumed rate of return. Lowering CalPERS’s expected rate of return to 6.5% would, correspondingly, lower its funded level by lowering its discount rate. A study by State Budget Solutions, however, using the states’ cost of borrowing as the discount rate, placed the funding levels at 39% and 32%, respectively.
Colorado PERA released its 2014 Comprehensive Annual Financial Report on Tuesday, and there were no real surprises, which isn’t to say it was particularly good news for the state’s retirees, government employees, or taxpayers. For the most part, it showed more of what we already knew: a system in trouble, and unlikely to earn its way out of that trouble any time soon, if ever.
The rate of return on investment was 5.7%, which is 1.8% short of the expected rate of return of 7.5%. PERA will no doubt point to the fact that it met the benchmark return, but all that means is that the funds weren’t grossly mismanaged. The net result is that the unfunded liability, as acknowledged by PERA, climbed from $23.3 billion to $24.6 billion.
In reality, the future liability should be discounted not at the expected rate of return – an accounting gimmick that is only available to US public pensions – but by the borrowing cost of the governments involved. In this case, that would mean a discount rate of about 4.5%. Running that out 15 years, we end up with an eye-popping unfunded liability of $60 billion. A 30-year window raises it to an almost unimaginable $116 billion. That’s the unfunded liability – the promises made for which we have no money.
Overall, the funding levels fell to 64.2% from 65.2%, but the two biggest funds are much worse off than that. The State Fund’s funding level slipped to 59.8%, the School Fund to 62.8%. These calculations are done using the market value of the assets, rather than the smoothed actuarial value, as they have in the past. That actually makes the funding levels look better, as the investments age out the miserable 2011 investment year, but it gets the direction right, and funds can only spend and invest actual dollars, not smoothed ones.
The amortization periods – how long it would take to get to full funding – also ballooned to 45 years for the State Fund, and 48 years for the School fund, after accounting for the future increases in the AED and SAED supplemental payments. PERA rightly points out that these numbers don’t account for the decrease in benefits for future hires, which probably shorten the amortization periods by a few years.
I’ll have a lot more to say about this, but the short version is that there’s nothing to be cheerful about here. PERA will claim that everything is still on track to be fully-funded decades hence, but then, PERA always thinks nothing’s wrong right up until the point that they come to the legislature for more money.
Photo Credit: Todd Shepherd & Complete Colorado
When the PERA Pension Obligation Bond story was in its death throes, the Denver Post was writing a story about the political, rather than the financial angle, of the bill and its failure in committee. Treasurer Walker Stapleton had testified in favor of the bill in the House Finance Committee, although most of his testimony was of a technical nature.
At the time Post reporter John Frank called me, I had not yet heard Stapleton’s comments on the Mike Rosen Show, where he appeared to try to walk back his support for the bill. There’s no reason to rehash the controversy here, and that’s not the point of the post.
The point is this: Franks paraphrased what Stapleton had said, and asked me to comment on his on-air statements. I asked him to quote them to me. He quoted to me a couple of sentences, and I was brought up short. But this was a radio talk show, and Mike Rosen is one of the best interviewers around. The actual on-air back-and-forth was much longer than that.
So I paused, said that, even though I had just asked him to quote Stapleton to me, I really would need to hear the whole thing before I could comment. And I went on to say something Franks probably already knew – that there were legislators without pension funding expertise who had probably been swayed by Walker’s support, and by the fact that the Republican Treasurer, Democrat Governor, and “impartial” PERA Board were all in favor of the deal.
Later, after thinking about it, I came back with what I expressed as a possible interpretation of what Frank had quoted me, didn’t offer an opinion on it, and suggested he go back and listen to the whole interview with that idea in mind.
Reporters often count on people liking to talk, and liking to talk to reporters specifically, because they may get to see their names in print. But you don’t have to answer a question if you don’t want to, and you don’t have to offer an opinion when the only information you’re getting is from the reporter.
I doubt Frank was purposely trying to do a hatchet job on Walker, but there was no reason to fall into the trap of trying to offer an opinion based on an interpretation of one small piece of the story.
This is an extended version of the OpEd that appeared in the Greeley Tribune.
Last week, Colorado legislators considered – and rejected – a plan of dubious legality to shore up the state’s public pensions.
The result of a difficult three-way negotiation among Governor Hickenlooper, Treasurer Stapleton, and PERA, the plan would have circumvented the state Constitution’s limits against issuing general obligation debt without a vote of the people, for gains that would have been largely illusory.
Worse, the changes could have encouraged future legislatures to repeat mistakes that put teachers’ and state employees’ retirements at risk in the first place, while making real reforms more difficult.
HB15-1388 would have authorized the State Treasurer to direct the Colorado Housing and Finance Authority (CHFA) to issue up to $10 billion in bonds on the state’s credit. The proceeds would have been deposited into PERA’s State and School funds, and invested with the rest of PERA’s assets. The investment returns theoretically would shorten PERA’s time to full funding.
The bonds’ interest was to be funded by the supplemental payments that the state and school districts pay into PERA (the AED and SAED), with PERA paying back the principal when the bonds matured. The AED and SAED payments are taxpayer contributions established in 2004 and 2006 to stabilize PERA’s finances. They are escalating percentages of employee salaries.
The complex web of relationships was needed to avoid state constitutional limits on issuing debt. The bill’s language laid out the legal arguments for why the restrictions didn’t apply. Supporters claimed they were revenue bonds that would not obligate general tax dollars, and purported that CHFA is not a state agency.
Passing the buck to the courts, HB 1388 would have required a binding judicial ruling certifying the scheme’s legality before the bonds could have been issued.
Make no mistake: The debt would have been on the state’s credit, and shown up on the state’s balance sheet. These are not revenue bonds; they would have been funded only by general tax revenue.
Whether or not the game of hide-the-pea satisfied the courts, it violated the spirit and purpose of constitutional provisions designed to prevent the legislature from indebting citizens into a long-term fiscal bind. The many state bankruptcies of the 1840s were still fresh in the people’s minds in 1876, when the Constitution was drafted. Those concerns are no less valid now.
The bonds wouldn’t have shown up in PERA’s financial report, except in the footnotes. With no single, authoritative document laying out the full financial picture associated with funding the state’s public pensions, PERA would look better-funded than it was.
Risk-averse legislators could have justified avoiding the difficult decisions needed to provide real retirement security for Colorado’s teachers and state employees. Future legislatures might have been tempted to repeat the mistakes that put that security at risk in the first place. While a full legal analysis awaits, tying the AED and the SAED explicitly to a bonded debt might have complicated any attempts at more sustainable reform.
A comprehensive study by the Center for Retirement Research found that the misuse and mistiming of pension obligation bonds have punished numerous states and municipalities over the last 20 years. The Government Finance Officers Association recommends against their use.
To their credit, the bill’s architects studied past failures and tried to mitigate the risks to Colorado and its schools. The annual interest on the bonds could have been no larger than two-thirds of each year’s anticipated AED and SAED, with a minimum 2 percent spread between the bond interest rate and PERA’s anticipated rate of return. Statutory contributions to PERA – inadequate though they are – would have remained intact, and bond proceeds would have been unavailable for diversion to other spending.
Still, the deal entailed significant risk. Proponents misleadingly argued that it refinanced 7.5 percent debt at 4.5 percent. In an actual refinance, the original obligation is paid off. Here, the pension obligation would have remained, with Colorado taking on additional debt.
Even PERA’s claim that its current debt should be discounted at 7.5 percent is based on an accounting gimmick only available to US public pensions – and no other pensions in the world. (Not coincidentally, without the discipline of correct accounting, US public pensions are also the worst-funded public pensions in the world.)
As contractual promises, they should be discounted at the same interest rate as the bonds. PERA would just be adding 4.5 percent debt to the true 4.5 percent debt of its current contractual obligations, improving its situation only marginally.
The proposal’s safeguards would not have changed the fact that proponents were seeking to close the funding gap by taking on additional debt and risk.
While the governor and the treasurer are to be credited for taking PERA’s underfunding seriously, HB 1388 was the wrong answer to the problem.
Late last week, the redoubtable Andrew Biggs of the American Enterprise Institute published a state-by-state comparison of full-career public pension retirement benefits, in that organization’s monthly Economic Perspectives. While news of PERA’s long-term fiscal problems won’t be a surprise to anyone reading this blog, it may come as a surprise to learn that Colorado ranks among the most generous states when it comes to that measure.
In nominal dollars, Colorado ranks fourth in the country, at just over $60,000 for an employee who spends his entire career in the state civil service. The $60,420 per annum figure ranks just behind California and Alaska, and considerably behind Nevada’s $64,000. When adjusted for the states’ relative cost of living, as calculated by the Council for Community and Economic Research, Colorado jumps well past both California and Alaska, into 2nd place.
Biggs also noted that the present value of these benefits can create “pension millionaires,” whose benefits exceed $1 million in today’s money. When Colorado’s benefit is compounded at the maximum 2.0% COLA, and then discounted using a 3.5% risk-free discount rate, the total comes in at $1.25 million in 2014 dollars, assuming the beneficiary retires at 60 and lives to 82.5 years of age.
As Biggs points out, the need to stay for an entire career in order to collect benefits, at the same time that they forego Social Security benefits for those years, is a serious disincentive to retaining qualified and motivated public employees. Those who leave – or arrive – in the middle of their career get shortchanged the most, since vesting and benefits are not proportional to the years served.
The problem here isn’t that workers are greedy, or that these benefits themselves are unsustainable. It’s that the results are unfair to the majority of workers, who find their own benefits shortchanged in order to fund the retirements of full-career public servants. A conversion to a defined contribution plan, where workers are always fully vested in their own contributions would help to solve this problem, and be much fairer to the majority of workers who do not spend their entire careers with the government.
My introductory at-bat in the Independence Institute’s lineup at the Greeley Tribune:
The assumption of a 7.5 percent return masks considerable risk and volatility. Although catastrophic market years such as 2008 have historically been rare, smaller routine losses are to be expected. Those losses can force an already-underfunded system to eat its seed corn by paying benefits out of assets that should be earning returns.
As a result, considerable risk exists that in the future, the state will still need to cut benefits to those who are already retired, to raise taxes, to cut services, or all three.
There is a way out.
I suggest three reforms that would help solve the problem. We’re no longer in a budget crisis. The Democrats’ passion for spending every last dime that comes in on new programs that will cry poor in the next recession may fix that. In the meantime, though, now would be a good time to fix this.
Today at PERA’s testimony in front of the Colorado legislature’s Joint Budget Committee, the subject of the revisions of GASB’s public pension accounting rules came up. While PERA produced the usual song and dance about discount rates, one portion of the discussion was illuminating.
It turns out that each district that participates in PERA will have to show a pro-rated portion of that fund’s liability on its own balance sheet. PERA makes a couple of comments about this; first, that this is an unusual liability that can’t be brought forward, and second, that there’s nothing that the district can do to reduce it. The first comment is the usual stuff that public pensions always use to justify their higher discount rate. The second requires a little explanation.
You need to remember that the unfunded liability is PERA’s, and it’s only being distributed for accounting reasons to the various districts. The PERA funds are managed by PERA on behalf of the individual members, not on behalf of the districts. The districts have an annual required contribution based on the salaries of the individual PERA members working there, but that’s it. Their contributions go into the appropriate PERA fund, and become the property of PERA. There’s no “JeffCo School Account” at PERA, or “Mesa County Employees” account.
Which means that there’s also no way for the individual district to discharge it own portion of PERA’s unfunded liability, even if PERA were permitted to take additional contributions from employers, which it’s not.
Suppose the School Fund has an unfunded liability of $10 billion. Suppose 5%, or $500 million of that, is attributable to JeffCo School. And suppose JeffCo, in a Herculean effort, raises $500 million in taxes to pay it off, and ensure that they never have to worry about their portion of PERA’s unfunded liability again. JeffCo School cuts a check to PERA for $500 million. And that money goes into the Big Barrel called, “PERA School Fund,” reducing its unfunded liability by 5%, to $9.5 billion. And the next year, JeffCo’s Schools gets a Thank You Note, along with a notice from PERA that they are responsible for 5% of PERA’s School Fund unfunded liability, or $475 million. That’s what PERA means when it says that this is a unique liability for districts – they can’t really do anything about it on their own, but there it sits, on their balance sheets, screwing up their ratios.
Yes, ratios. It turns out that the Colorado Department of Education does a Fiscal Health Analysis on the various school districts, and a key part of that analysis is certain ratios, three of which (Asset Sufficiency, Operating Reserve, and Change in Fund Balance) depend on the districts’ General Fund Balance. CDE hasn’t disclosed yet how they’ll deal with this change, but if it were up to me, I’d more or less ignore it in that analysis. The liability really belongs to PERA, not to the district, and since the legislature will ultimately fix (or not) the problem, it’s almost impossible to know how it relates to any district’s current demographics, employment, or finances.
Last Thursday, Colorado PERA Executive Director Greg Smith gave his annual SMART Act testimony to the Joint Finance Committee of the Colorado General Assembly. Since 2012, all departments of the Colorado state government have been required to testify during the interim concerning their operations, their efficiency, and the degree to which they are fulfilling their mission.
PERA recently changed its assumed long-term rate of return from 8% to 7.5%. In light of that change, its amortization period – the time when PERA will have no unfunded liability, assuming a constant rate of return – has grown from 30 years, probably to something near 40 years.
During the Q&A session, State Rep. Lori Saine (R-Dacono) asked Smith about using a Monte Carlo simulation to test PERA’s long-term soundness. As described in more detail here, averaging a given return over a period of time isn’t the same thing as getting that rate of return every year. PERA’s portfolio might well average 7.5% over 40 years, and still go bust because its returns in the next few years are below average, leaving to try to make up the difference from a lower balance. Rep. Saine was asking if PERA did or could run a simulated 40-year set of returns, and see how often the fund went bust and how often it stayed solvent at the end of that 40-year window.
Mr. Smith replied that yes, they do Monte Carlo simulations, and then proceeded to describe not those, but instead a sensitivity analysis available in the Comprehensive Annual Financial Report (CAFR). The sensitivity analysis is something else altogether. It looks as what happens to PERA if the returns over 40 years are 6.5%, 7.5%, 8%, up to 9.5%, but it still assumes a constant rate of return. This is a completely different analysis, one that admits the possibility of lower-than-expected long-term returns, but ignores the danger in a few years of very low short-term returns, or even a couple of years of severe losses.
Monte Carlo simulations model the year-to-year variability in return that is an inherent function of risk. As a result, even funds that appear to be well-funded, or that appear to have a long-term path to being fully-funded, can show low likelihoods of staying solvent through their amortization periods. Doing such an analysis helps to prevent unpleasant surprises, and is to be preferred to a simple sensitivity analysis such as the type PERA performs and publishes.
Regardless of one’s preference, the two shouldn’t be confused for each other.
You can hear the entire exchange here:
Friday, the PERA Board decided to make two significant changes to their actuarial assumptions. First, they lowered their expected return on their portfolio from 8% to a more realistic 7.5%. Second, they lowered their inflation expectation from 3.5% to 2.8%.
This is being advertised as a more realistic set of assumptions, in effect, an admission against interest that outside players such as Treasurer Walker Stapleton have been agitating for for some time. The lower rate of return will, according to the Denver Post report, raise the unfunded liability from $23 billion to $29 billion.
It’s true that the 7,5% rate is more conservative than 8%, and closer to the average rate of return being assumed by most public pension funds around the country. On that basis, the change is to be welcomed. But for a long time, I’ve felt that the rate of return was very much out of line.
In fact, the lower rate of return should have no effect on the unfunded liability. The only reason that the unfunded liability will grow is that PERA will use the lower rate of return as the new discount rate. Of course, as we’ve discussed before, the discount rate should be independent of the rate of return; it should be the state’s long-term cost of borrowing, or even the risk-free rate of return, the 30-year US Treasury rate.
In addition, many of the benefits of the lower rate of return are more than offset by the lower inflation rate. Before, the real rate of return was 8 – 3.5, or 4.5%; now it’s 7.5 – 2.8, or 4.7%. PERA is decreasing the increase in future liabilities here, by lowering the expected future increase in salaries. This means that the net effect of both changes is to increase the real rate of return.
Unfortunately, we won’t know exactly how this plays out until PERA releases its next CAFR – next July, 8 months from now.