Archive for category PERA
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.
This post was originally published on Watchdog Wire Colorado (“Gov. Hickenlooper Admits: Districts Can Use Amendment 66 Money For PERA“).
From the beginning, one of the key concerns surrounding Amendment 66 has been its prospective use to backfill the state’s public pension obligations, rather than aid Colorado students in the classrooms.
It’s a serious worry for Amendment 66 supporters- they even produced a video on this point, claiming that, “There is only one way to read Amendment 66 when it comes to where the new money goes” (visible at 1:38).
“Or, as the group pushing the ballot amendment states on its website, money that will be raised by Amendment 66, ‘is constitutionally and statutorily prohibited from ever being used directly to fund PERA.’”
But that one word, “directly,” is a loophole that even Governor Hickenlooper won’t climb through, and as a result, undercuts this entire claim by proponents.
A Revealing Question
As a result of my membership on the Jewish Community Relations Council of Colorado, I received an invitation to an event on October 8 in support of Amendment 66, hosted by Cherry Hills Village residents David and Laura Merage. The Merages are prominent entrepreneurs and founders of the David and Laura Merage Foundation, which counts education among its primary missions. Gov. John Hickenlooper was a featured speaker and gave some remarks regarding Amendment 66 to the crowd of about 40 people, followed by a question and answer session. I took this opportunity to ask the Governor for clarification on PERA funding. The following is an audio file and transcript of our exchange:
Gov. Hickenlooper: Anything else? What else?
Sharf: OK, so a question about the PERA. So, you had said that it can’t be used to backfill PERA, which is certainly true at the state level.
Gov. Hickenlooper: Yep
Sharf: Well, once the money gets to the districts…now, under SB1, which was supposed to be the fix for PERA, the districts were supposed to split – there was a lot more money going into PERA, there was some increases, some supplemental payments, that were going to go into PERA.
Gov. Hickenlooper: Right
Sharf: And, the districts were supposed to split that increase with the employees, with the unions.
Gov. Hickenlooper: Yep
Sharf: But with the exception maybe of Adams, they haven’t really. Overwhelmingly…
Gov. Hickenlooper: I’m not sure that that’s right -
Sharf: Well, Greg Smith -
Gov. Hickenlooper: They have not split it, they’ve just swallowed it.
Sharf: Right, that’s what I mean, is that they’ve basically just swallowed it.
Gov. Hickenlooper: Well, if you want to fix that, if that’s what’s happening, then we can’t legislate that. There’s a certain amount of money that goes into the districts, and that is the way our education system is structured. If you want to fix that, put it up on our website, how much of that money the district is spending on PERA. And I guarantee you the parents will go nuts.
Sharf: But do you need the tax increase to put it up on the website?
Gov. Hickenlooper: YES! I mean, to have a website like that, $18 million, $20 million, and then to operate it, yeah! You should see – you know what it’s going to cost – I just got the budget today – you know what it’s going to cost to finally have our drivers license system for the state of Colorado, to have a simple system where you go in and you get your driver’s license? And you can do it as you’re coming in, do all the prep work on your handheld device? You know what that’s going to cost? Eighty million dollars. Just so you’re clear; we’ve been working on that for two and a half years, they just told me that today in our budget meeting. That’s just what it is.
Under the terms of SB10-001, passed in 2010 and signed by then-Governor Bill Ritter, school districts are required to make additional payments into PERA in order to help stabilize the program. PERA’s Executive Director, Greg Smith, is on record as saying that the legislature’s intent was that they split the cost of those increased payments with their employees. Smith, in legislative testimony, noted that most school districts have failed to do so.
Sen. Michael Johnston, a prime sponsor of Amendment 66′s implementing legislation, SB13-213, and advocate for Amendment 66, also seemed to believe that SB10-001 required increased employee contributions, and seemed surprised in December of last year to find out that that wasn’t happening:
Question (at 1:21:05): The pushback that I got from our district, and quite honestly, there was no change in the contribution rate for the teachers, for the employees of the district. All the increase, at least in Jefferson County, picked up by the taxpayers and the district. They kept insisting that there was nothing they could do, so please go to the legislature and take care of that, there was nothing they could do about adjusting how much the contributions – the contributions go up really high on the taxpayer side but they haven’t moved for the teachers, at least in JeffCo. Perhaps in other districts…
Sen. Johnston: We should touch base after this, because the bill that I voted for did include increases on employee contributions, so we should talk about that.
On a per-pupil basis, this becomes clear. Statewide, the overall increase in PERA contributions (left axis) strongly parallels the increase per-student contribution to PERA from the districts, while the per-pupil contribution from the employees has barely budged (per-student on right axis):
Source: PERA CAFRs and Colorado Department of Education
District Versus State Rules
Because teachers are employees of the school districts and not the state, the overwhelming portion of the employer’s PERA contribution to the School Fund comes from the districts to begin with.
(One major exception is Denver teachers, whose retirement plan recently merged with PERA and has its own fund. Under the terms of the merger, DPS payments are currently offset by the interest payments on the debt DPS floated in 1997 and 2008 to fund their pension obligations.)
The governor’s candid admission that once the money leaves for the districts, the state has no real control over how it’s spent, severely undercuts one of Amendment 66′s supporters’ key claims about how much of the $1 billion in additional tax money is required to make it to the classroom, and how much will be diverted to the pension fund.
And the districts’ recent behavior gives taxpayers little cause for optimism, either.
Another month, another report showing the country’s pension problem to be worse than we thought, Colorado’s pension problem to be among the nation’s worst. This time, it’s a report from the non-partisan State Budget Solutions, “Promises Made, Promises Broken – The Betrayal of Pensioners and Taxpayers.”
In three significant measures, Colorado ranks in the bottom third of the nation’s public pensions: Its funded ratio is the 11th-lowest in the country, at 32.8%; the per capita unfunded liability is 15th-worst, at $16,158 per head; and as a percentage of the state’s GDP, Colorado is 16th-highest, at just over 31%. These dire rankings corroborate a recent Moody’s study that had Colorado’s unfunded pension liability in the bottom 10 as a percentage of state government revenues, another measure of the state’s ability to cover these debts.
They calculate the actual unfunded liability at just under $84 billion, nearly four times what PERA admits to, and $27 billion more than is estimated in an upcoming Independence Institute report. It should be noted, however, that the authors include five plans managed by the state’s Fire and Police Pension Association, much smaller plans which are not part of PERA.
The report takes issue with most public pensions’ investment return expectations, which usually vary between 7% and 9%, and the aggressive discounting oliabilities that most plans engage in. Instead of the optimistic – some would say wildly optimistic – return assumptions, the report’s authors use 3.225%, the 15-year Treasury rate. They also use that number to discount plans’ liabilities, arguing correctly that the discount rate should reflect a plan’s risk to its investors, not its returns on its investments. They argue that since these plans approach being risk-free investments, they should be discounted as such.
Personally, I think both the return assumption and the discount rate are too low. Even if 8% is unrealistic, and I’m not sure that it is, funds tend to have their money in diversified portfolios which will average returns higher than Treasuries. In addition, the plans are covered by state obligations, not federal ones. Investors have long recognized that state obligations carry more risk than do federal “risk-free” obligations, a fact reflected in the higher interest rates carried by state debt.
That said, the study makes two useful contributions to the debate. By making the return and discount assumptions it has, the report effectively sets an upper bound on the problem; surely no lower interest or discount rates could reasonably be chosen.
More concretely, by showing us to occupy the same neighborhood as such well-known pension basket cases as New Jersey and California, the report shows the foolishness of the approach of Amendment 66 – raising taxes, while appropriating all of the increased short-term revenue to ongoing operations.
Stapleton, a Republican, is a vociferous critic of the current PERA structure. The state treasurer is automatically a member of the 16-member PERA board. First elected in 2010, Stapleton in 2011 asked the board for access to individual records (without names) of the top 20 percent of PERA retirees, based on pension amounts.
High-dollar pensions have been something of a fixation for GOP critics of PERA, even though the average monthly benefit paid by the system is $3,020. Most PERA members aren’t eligible for Social Security. The PERA system covers all Colorado teachers and many higher education employees.
That last paragraph requires some rebuttal. High-dollar pensions are a fixation in large part because the rest of the PERA board decided to go to the mattresses to keep the information from being released. One might just as easily ask why keeping high-dollar pensions secret is something of an obsession for PERA.
That said, there are some excellent reasons for wanting to examine PERA’s high-dollar pensions.
First, at least some of those pensions come from teachers’ union reps, who are frequently no longer doing work for their school district, and instead are working exclusively for the union. The status of the Douglas County Federation of Teachers (DCFT) union rep became a major point of contention during open negotiations, mostly because she would have continued to accrue PERA benefits, even though the union offered to pay both her salary and her personal PERA contribution. With a $1 billion tax increase likely to be on the ballot this fall, and with much of the opposition to that tax increase based on the fact that about half of it would go to fund teachers pensions rather than classrooms, non-teaching union reps receiving outsized pension benefits would be embarrassing both for PERA and for tax increase supporters.
The other reason for concern over high-dollar pensions is the agency problem surrounding the PERA board itself. Most of the board are PERA members, and many receive high salaries, and so will be eligible for high-dollar pensions when they retire. With the PERA board having opposed recent attempts at reorganization, so that fewer board members are voting on their own benefits, the last thing they want is for attention to be focused on those benefits.
From a political point of view, it also makes sense for Treasurer Stapleton to try to split PERA beneficiaries between the average member and the high dollar recipient. While the PERA board and its allies have a history of resisting attempts to limit benefits overall, or to change the benefit calculation formula, a graphic demonstration of the actual distribution of benefits could lead many average PERA recipients to rebel against leadership, and accept limits at the high end of the scale. From the board’s point of view, that would be an ominous development.
While the Appeals Court has decided that Colorado taxpayers are not entitled to this information about their senior government employees, there is yet hope that the State Supreme Court will decide differently.
UPDATE: An earlier version of this post mistakenly attributed the ruling to the State Supreme Court.
One of the biggest problems with the way that pension plans report their solvency numbers is the assumption of constant returns over the life of the plan. By assuming constant returns, plans end up hiding the single biggest factor in why they’re likely to go bust: risk. This post will try, with a hugely (and unrealistically) simplified example, to illustrate the problem this poses when trying to figure out whether a plan has enough money to cover its liabilities.
For this first cut, the aspect I want to capture is that with mandatory annual outflows, a pension fund puts itself at risk of falling behind, and never being able to catch up.
Let’s take this example: a $1,000,000 liability, timed to last 30 years, with $250,000 annual payouts, and payments into the fund that are calculated based on the expected return on assets. Here’s what the fund balance will look like if we assume a constant 8% return on assets:
Payments into the fund each year are calculated to be a little over $161,000 a year in order to make this happen. Also note that all this is being conducted in real dollars; we’re ignoring inflation, which is going to drive some people up the wall, but 1) we can always make a calculation in real dollars, 2) there’s really no good way of predicting inflation over a 30-year span, and 3) this is a thought exercise.
Where can I get an 8% a year return for 30 years? Well, I could put it in bonds that return 8%, but those may not always exist. Right now, we have a low-interest rate environment, and even corporate bonds that are highly-rated don’t necessarily return 8%. Surely investment-grade municipal bonds don’t get me 8% at 30 years. And remember, I need to find a place to put each year’s inflow, so by the end of the 30 years, I’m unlikely to find a 1-year corporate or municipal bond that pays me 8%, absent a pretty severe inflationary environment.
One investment that is liquid, that also provides reliable 30-year returns over 8%, is the S&P 500 index of large-cap US stocks. The S&P has been around since 1926. So starting in 1955, we have 30-year return profiles for it. Here’s the distribution of annualized 30-year returns for the S&P 500, from 1955 – 2011:
The thing has never returned less than 8.5% over that time, and averages 11.76% (although the median is lower). This is a period of time that covers a World War, a Depression, inflation, the Korean and Vietnam Wars, the 2000 Tech Bubble Burst, and the 2008 Real Estate Bubble Burst. That’s a pretty good track record.
Here’s the rub. Here are the annual S&P 500 returns over that time:
Not so good. You have a pretty good chance of losing money; in 11 years out of 85 you’d be down 10% or more, and in 6 of those years, down 20% or more. In three of those years, you’d lose 35% or more of your total investment. You can see the problem: the risk of running one really bad year, or a couple of moderately bad years, early on, where you might have to spend your seed corn, is high enough to be worrisome, even if the total 30-year return is comfortably higher than your planning.
In order to see our imaginary fund’s chances of making to 30 years solvent, we need to put in not a constant 8% return, but a random variable that looks like the S&P 500 annual return. Surprisingly, there’s considerable debate over whether or not such a variable is even possible to construct. The returns are clearly not normally distributed, and adding more moments (skewness, how fat the tails are, etc.), doesn’t produce unique random variables. When you look at the returns, it also looks as though the year-to-year returns may not really be independent, either; that is, a losing year seems to follow another losing year.
Given all this debate, I just figured that, with 57 separate 30-year runs available to us, the easiest thing to do would be to use those 30-year runs themselves. I.e, 1956 – 1985, 1957 – 1986, etc. Here’s a pretty typical return profile:
One really bad year, a couple of downers soon after, but positive almost all the time, and a number of eye-popping returns of over 40% to make up for it. Should work out, ok, right?
Not so much:
The actual balance in the account falls below the projection in Year 9, and never really is able to gain altitude again. By Year 20, the fund is bust, and has to either get bailed out or stop making payments.
What’s interesting is that it’s not the Year 6 Catastrophe that does the fund in. Given the good years that preceded it, the balance after Year 6 is right at the projected levels. A fund manager could easily persuade himself that everything’s going to be ok. What really causes the problem is the two bad-but-not-disastrous Years 9 and 10 consecutively. The S&P comes back in consecutive years with 20%, 25%, 20%, 35%, and it’s still not enough to put any real air between the balance and the ground. So by Year 15, when the S&P loses less than 10% – less than it had lost in any of the previous losing sessions – it’s effectively all over.
How often does this happen? Well, here are the failure rates for various return assumptions, starting with the average of 11.76% that the S&P actually returns, and going to 7%, for the ultra-conservative fund manager:
The manager who doesn’t leaving himself any breathing room cashes out over 60% of the time, which might be a little surprising. It’s not until we assume a 10% return (corresponding to annual pay-ins of $143,000), that we get to a 50-50- chance of seeing 30 years. Our 8% manager still fails over a quarter of the time, and it’s not until we get past a 7% assumed return (pay-ins of $169,000) – where we’re effectively giving up 40% of the actual S&P historical return in our planning, that we almost get to an 80% chance of solvency in Year 30.
Now, to be clear, you don’t end up in such bad shape most of the time that you don’t go bust. You’re often well in the black. For the fund manager who’s planning on 7%, he ends up over $10,000,000 in the black over a third of the time. So often, when you win, you win really big.
But in pensions as in baseball, you can’t spend those winnings from other timelines. The Cardinals beat the Reds 15-2 today, but tomorrow, it’s 0-0 when the pitcher takes the mound. My concern as a pensioner is being able to plan on a certain amount of money coming my way after I retire. If the plan goes bust when I’m 75, it’s too late for me to make other plans. And if the plan ends up with an extra $9,000,000 on-hand when I’m 80, there’s not much benefit in that, either. The cost of losing is very, very high; the unlikely rewards from extra winnings don’t make up for that, which is why I put my money into a “safe” pension plan in the first place.
Understand, as stated at the outset, this is a hugely simplified example, on about 100 different levels. Real pension plans don’t consist of a single individual. They generally don’t make payouts at the same time they’re collecting contributions. The lifetime of the plan for an individual is longer than 30 years. Their portfolio is more diversified than putting everything in US stocks. Inflation actually matters to pensions, possibly for benefits, certainly for wage calculations.
But the basic point – that the actuarial assumptions of flat returns, assumptions that fail to take into account risk as well as reward – are serious planning flaws that can ultimately lead to a plan’s demise.
My hope is, over time, to make these models more complex, remove some of the simplifications, give something approaching actual likelihoods of Colorado’s PERA going bust, and ultimately, create an online model where you, the reader, can enter your own assumptions and see what happens to PERA’s long-term prospects. That’s a big project, and it’s going to take a long time to complete. But there’s nothing in the finish product that isn’t here in the basic principles: returns move around all over the place, and the cost of providing ownership in a liability rather than an asset can be ruinous.
Over at the Denver Post, Vince Carroll details the price that PERA has been paying for its “fire-sale” of pension benefits from 2001-2005:
There are many PERA beneficiaries like Coffman who bought years of service — often at a very advantageous discount — and who now receive pension checks larger than you would expect based upon the span of their careers.
A large number of those transactions occurred over a three-year period a decade ago, when “PERA conducted what one executive called, in retrospect, a ‘fire sale’ on the service credit,” according to a 2005 analysis by the Rocky Mountain News.
The administration of Gov. Bill Owens, in a major blunder, lobbied for the fire sale as a shortsighted way to encourage early retirement and infuse new blood into the bureaucracy.
As Carroll notes, this problem was known as early as 2005, when David Milstead of the late, lamented Rocky wrote about it:
But the deal got sweeter. Gov. Bill Owens, then in the early part of his first term, wanted to streamline government and bring new employees into the state work force. In 2000, with his encouragement – some say pressure – PERA cut the already-low price of purchasing extra years by 14 percent, to 15.5 percent of salary.
Owens said he doesn’t recall the specifics of what was said to PERA, but “I thought it was valuable to have the flexibility to get new employees into some of the positions in the state bureaucracy.”
Service-credit purchases kicked up by 38 percent in 2001, topping $100 million.
PERA decided to raise the price back to 18.1 percent of salary for members under 50 and increase it to 22.1 percent for older members. But they told employees it wouldn’t happen until November 2003.
Given that window, thousands of employees raced to the sale.
It also calls to mind an excellent article by Josh Barro in National Affairs, “Dodging the Pension Disaster,” where he suggests a way (perhaps) to actually reduce the unfunded liability after a defined benefit-to-defined contribution transition:
A working paper by Maria Fitzpatrick, a fellow at the Stanford Institute for Economic Policy Research, attempts to determine just how highly some public employees value their pension benefits. She examined Illinois teachers’ choices when, in 1998, they were offered a chance to make a one-time payment up front in exchange for more generous benefits in retirement. The terms of the purchase varied significantly depending on a teacher’s salary and years of service. Using reasonable discount rates, the up-front purchase cost was lower than the present value of benefits for nearly all teachers — 99% could expect at least a 7% annual return on investment, with no risk so long as the state did not default. But the deal was sweeter for some teachers than for others, a variation that made it possible to estimate the subjective present value that teachers placed on future benefits.
Fitzpatrick’s finding is, in a way, depressing: On average, teachers were willing to pay only 17 cents on the dollar to obtain a pension-benefit increase. This suggests that defined-benefit pensions are a highly inefficient form of compensation, costing taxpayers far more than they are worth to public employees.
But it also suggests an appealing policy solution: Governments can offer to buy back promised pension benefits at a discount, and employees may be inclined to take the deal. Admittedly, the proposal presents a political problem to lawmakers, in that it requires them to produce an immense sum of cash up front in order to eliminate a long-term liability. To alleviate some of that pain, however, governments could responsibly issue bonds to raise the money — since this would mean simply substituting explicit debt for a larger amount of implicit pension debt. Governments would incur an obligation to pay interest on the bonds, but in most cases that amount would be more than offset by the reduction in required employer pension contributions.
In Colorado’s case, the price was about 15.5 cents on the dollar, but there was huge interest, so a fair price may be considerably higher than that. Add to that the fact that people are often less willing to let go of a perceived cash benefit than they are to buy it in the first place, and there’s reason to think we can’t possibly buy it back for 15.5%. Still, having a limited-time “open season” market, or Dutch auction, with a declining price, might be a way of disposing of some of the liability.
PERA’s the price for purchasing service credit has since returned to reasonable levels, we’ll be living with the cost of selling long-term debts cheaply for a long time to come. At this point, it’s almost impossible to tell how much of PERA’s long-term debt obligation comes from this sale; I can’t find aggregate numbers in the CAFR, and the charts above show only the price paid, not the goods sold, but it certainly warrants further investigation.
This morning, the Denver Post carried a story about PERA’s “celebration” over a 12.9% return on its investments in 2012, and how it allegedly puts to the lie to State Treasurer Walker Stapleton’s concerns over the solvency of the pension plan.
Would that it were so, but PERA is, as usual, spiking the football on this one too early.
First, let’s start with the return itself. 12.9% is good, but it’s not exceptional, as PERA returns go. It’s above the 8% that they assume over the next 60(!) years, in order to get the funds to be solvent over that time, to be sure. And it’s only possible because a higher return means a higher volatility. As we’ve said before, PERA only needs to have a couple of bad years to fall so much further behind that it can’t catch up. This year’s modest gains in its funded levels could easily be wiped out by even a couple of average years that see positive returns in the 5% range.
As an aside, we should also note that PERA’s returns follow the returns of the much larger California pension system, CalPERS, almost exactly:
The 12.9% is below PERA’s self-imposed benchmark of 13.4% – with Alternative Investments doing the worst relative to its benchmark. It’s right at BNY Mellon’s Median Public Fund average return of 13.0%. And it’s right in line with what you’d expect, given CalPERS’s 13.3% this past year. If PERA is willing to declare victory for missing its own benchmarks, and doing just about as well as everyone else, we should perhsaps be asking what we’re actually getting for all that money management staff we’re paying.
Worst, though, is that PERA’s situation really hasn’t improved all that much, and remains far worse than they’re willing to admit. PERA discounts its liabilities using the expected rate of return on its investments, per the Government Accounting Standards Board (GASB) rules. There are a number of problems with doing this, first and foremost being that it encourages funds to take on more risk in order to appear better-funded. It’s also unsound financial economics. Every other pension rule in the world requires the fund to use its parent entity’s long-term cost of borrowing. In this case, that would be best approximated by Colorado Certificates of Participation, currently trading at 5.3% yield. PERA provides a sensitivity analysis of various discount rates, and it’s not too hard to extend it back to a rate of 5.3%. (There’s also a very slight change in the actuarial value of the assets; I’ve included that just for completeness).
So basically, properly calculated, instead of having the unfunded liability of just over $24 billion that PERA admits to, it’s actually in the hole for about $47 billion, or about $23,500 per household. A more accurate number could be gotten with a more detailed analysis, but this is probably within a billion or two dollars, which suddenly doesn’t seem like all that much money.
PERA likes to claim that the actual unfunded liability doesn’t really matter all that much, since it can’t ever be called in tomorrow, but must wait until it’s actually due. Like so much else PERA says when it comes to its unfunded liability, this fundamentally misunderstands the nature of present value. The point isn’t whether or not a liability can be collected tomorrow. Present Value is just a means of comparing a future liability and present assets in today’s dollars, a way of asking how much you would pay today for the promise of the amount of the liability tomorrow (or whenever it’s due). It has nothing to do with whether or not such an immediate transaction is possible.
However, we can calculate how much the unfunded liability will mean to Colorado families when they have to make it up. Right now, a $23,500 debt, paid at PERA’s assumed return of 8% over 30 years, is about $2,000 per family, per year.
Save the champagne.
As relates to another story – PERA’s baleful effects on school budgets, the release of the CAFR gives us a chance to update our school spending charts. There’s some improvement in the growth rates, even as they continue to far outpace inflation. And in the School Division, the increase is coming entirely from the taxpayers.
Last week, former PERA Executive Director Miller Hudson penned an op-ed for the Denver Post, arguing that PERA’s situation has improved to the point where we need not worry about it, and that no further tinkering with it is necessary (“There is no need for panicky ‘fixes’ to PERA“). Unfortunately for the taxpayers of Colorado, Mr. Hudson’s comforting conclusions are belied by some uncomfortable facts.
Let’s begin with where Mr. Hudson places the blame for the current funding problems. He identifies one of them correctly – overly generous benefits that amount to promises that cannot be kept, except at great expense. He is also correct that the dot-com bubble was fool’s gold for the legislature, which led it to create the overly-generous benefits.
But PERA’s portfolio managers (who predate Mr. Hudson’s tenure as Executive Director), allowed the fund’s investments to become dangerously overweight in volatile stocks, in effect letting their winning bets ride. When the dot-com bubble burst, so did PERA’s funded ratio, and it continued to decline throughout the decade, recovering only slightly in the mid-00s:
This chart also shows the folly of relying on long-term returns to determine a fund’s solvency. If a plan is underfunded, adding additional return may look like the way to catch up. But along with that additional reward comes additional risk and volatility. When the portfolio has a bad year, as in 2000, 2001, and 2008, it doesn’t have the option of drastically reducing its payout that year, as you or I would with our own retirement accounts. The need to pay benefits regardless of the fund’s annual return can put it in a hole that it can never recover from. PERA’s estimate of 8% may indeed be a realistic return over 30 or 40 years. But benefits need to be paid when they need to be paid, and the results of this thinking are all too obvious in the above chart.
And while the legislature rarely met its Annual Required Contribution (a contribution set by Government Accounting Standards Board, and designed to ensure actuarial soundness), this shortfall was only a relatively minor factor in the fund’s increasing unfundedness. According to the chart below, had the legislature made the ARC every year from 2000 on, the State and School Divisions, which comprise the overwhelming part of PERA, would only have been about $4 billion better-off last year. PERA admits to a $23 billion unfunded liability, although there is reason to believe it is much larger:
Mr. Hudson also argues that, because overall, PERA contributions account for less than 3% of public spending, the burden is light. This ignores that for many entities – school districts, in particular – PERA spending is eating up an increasing portion of their operating expenses:
This is a result of the very supplemental payments (SAEDs) that are designed to save the system from ruin. PERA is correct that the supplemental payments were envisioned as being shared between the districts and their teachers. But with many, if not most, school boards under the thumb of the teachers’ unions, they have decided to have their districts absorb the entire supplemental payments. This means that as of 2011, for four major Denver-area school districts, roughly 11% of their operating expenses were going to teacher pension plans, money that could have gone into the classroom.
Mr. Hudson tries, implicitly, to discredit those who are concerned about PERA’s fiscal condition by claiming that it is only “in recent decades” that concern has grown up around the unfunded liability. While it is true that in the past, PERA has been significantly under-funded, two conditions make that of greater concern now. First, the PERA unfunded liability is much larger now as a percentage of the state GDP, meaning that should a fix become necessary, the pain to the state’s taxpayers will be considerable greater than it has been in the past. In the 1980s and early 90s, the unfunded liability hovered around an unthreatening 2% of state GDP. That has since grown to 9%:
Second, since PERA has an unfunded liability, it means that some of its current expenses are paid for by current employees. (A fully-funded program would, by definition, have all current expenses in the bank.) The ratio of current employees to retirees has been falling for decades, as well, meaning that any increases in contributions will fall more heavily on future employees and future taxpayers:
As part of his rhetoric, Mr. Hudson contrasts the concrete – and real – improvements from SB10-001 with unnamed and undescribed “fixes” proposed by those who worry about PERA’s financial condition. This leaves the reader to imagine all sorts of horribles. Let’s look at some of the “panicky” fixes proposed in the state legislature over the last several years:
- HB13-1040: Would have calculated benefits on the basis of seven, rather than three years’ pay, making “spiking” more difficult to achieve
- SB13-055: Would have applied the same liability discount rate rules to PERA as apply to US private pensions and European public pensions
- HB12-1142: Would have given all PERA members the option to join PERA’s own defined contribution plan
- HB12-1179: Would have broadened the composition of PERA’s board to reduce conflicts of interest and increase accountability
- SB12-016: Would have given local governments the same option the state government has to make plan members pick up more of their benefit contributions in times of fiscal distress
- HB12-1250: Would have calculated health care benefits on the basis of costs, rather than employees’ salaries
- SB12-082: Would have set the PERA retirement age to that of Social Security for non-public safety members, a matter of basic fairness
- SB12-119: Would have forced PERA make adjustments until its plans could meet a 30-year amortization window, the standard for pensions
- SB12-136: Would have included PERA benefits in the state’s Biennial Compensation Report
All of these changes are designed to increase transparency, increase accountability, and decrease conflicts of interest. All of them are designed to increase fairness, and increase the likelihood that PERA retirees will be able to rely on promises made to them.
It is telling that each of these changes – every last one – has been opposed by PERA and its allies in the public employees unions here in Colorado.
And it’s enough to make you wonder who’s really panicking.
Defenders of PERA often argue that while the liabilities have been under-funded in the past, it is only now that PERA’s critics have begun to worry about the matter. The implied message is that the complaints are political, rather than financial. Here’s why this isn’t the case:
Yes, Colorado’s economy has grown, but the PERA liability has grown faster. While through the 80s and most of the 90s, the unfunded liability hovered around 2% of the state’s GDP, since 2000, it has grown to 9%. Of course, during the good economic years, it declined somewhat, and it may well decline a little again this year, as PERA’s returns are expected to be around 12% on its portfolio. But sooner or later, we will hit a cyclical recession, and even as the economy shrinks, PERA’s unfunded promises will continue to accumulate.
Did you recognize the faulty presumptions in PERA’s spirited defense of defined benefit plans?
You have been given a false choice about why defined benefits plans are better than defined contribution plans.
In a recent EdNews Colorado Voices column, Colorado PERA Executive Director Greg Smith avers that PERA’s existing defined benefit structure best serves both the teachers and the taxpayers of Colorado. He was responding to a report by the National Council on Teacher Quality that leads the reader to support reforms to move away from the existing scheme and toward a defined contribution plan. Smith’s claims are wrong about the advantages of defined benefit plans in general, and PERA’s actuarial soundness in particular.
Smith cites a National Institute on Retirement Security (NIRS) report that claims three advantages for defined benefit plans over defined contribution plans:
- Less error in the amount saved for retirement,
- Less need to rebalance and re-allocate assets over time, and
- Better returns, largely as a result of lower transaction costs.
Each advantage turns out not to be dependent on having a defined benefit plan, but on having a professionally-managed, aggregated plan. The same advantages would accrue to a similar defined contribution plan that was also aggregated and professionally-managed.
PERA already has such an option, PERA Plus. It’s organized as a three-part 457(b) / 401(k) / Defined Contribution option. Like any set of diversified retirement offerings, it includes a variety of funds with different investment goals. For our discussion, the most relevant set of funds are those with target retirement dates. PERA has nine of these, with target dates every five years from 2015 to 2055, and an Income Fund designed to provide current income for current retirees.
Over time, as the target date for each fund approaches, that individual fund reallocates its assets into more conservative investments, before maturing and merging into the Income Fund. While each individual fund “ages,” all the funds collectively are maintaining a proper average. Taken together, they continue to represent the aggregate ages and target retirement dates of the entire set of members, the very source of the first two alleged advantages. The third, that of lower transaction costs, is completely independent of how liabilities are calculated.
There is no inherent reason why the assets of a DB plan should earn a higher return than those of an identically-invested DC plan. The only mandatory difference is that the defined benefit plan beneficiary has a share only in the specific benefits to be paid – the fund’s liabilities. By comparison, the owner of a defined contribution plan has a property right in the assets. Therefore, while a defined contribution plan is, by definition, always fully-funded, a defined benefit plan may have to seek additional funding, or trim back on its promises, in order to remain so.
The danger of unrealistic promises
It is therefore imperative that the promises being made to future retirees be realistic. All the more so if the promised benefits are being used to attract and retain qualified or exceptional teachers. Unfortunately, it is far from certain that PERA can afford the promises it is making, given its current funding levels. Recent legislative reforms (Senate Bill 10-001 in particular), while welcome and substantial, simply do not close the gap.
By PERA’s most recent published calculations, its unfunded liabilities remain at a staggering $26 billion, and its overall funded level is well below 60 percent, on a par with the chronically ill Illinois public pensions. In fact, a recent study by Barry Poulson suggests that PERA could be in the worst shape of any statewide plan in the country.
Let’s give credit where credit is due. PERA’s adoption of a 401(k)-like portability is indeed commendable. But if it’s designed to mimic the properties of a 401(k), it can hardly then provide an advantage over one.
While PERA is no longer “letting it ride,” as it did with its stock market investments of the late 90s, the 8 percent returns needed for a return to solvency come with risk. Even better-than-average returns during regular years won’t make up for prior losses in bad years, because funds must then catch up, while payments can’t be deferred.
What success SB1 does offer is predicated on both benefit reductions and payment increases. However, a court challenge to the limitation of COLAs to 2 percent has been upheld by a State Court of Appeals, and its future is uncertain at best. Should the lower courts find that limitation not to be justified, most of the immediate reduction in PERA’s unfunded liability will be wiped out.
On the contribution side, PERA plans to require supplemental increases, rising incrementally from 2 percent to 5.5 percent until 2018. School districts have been picking up the tab for these increases, rather than passing them on to the teachers themselves, as they are allowed to do. As a result, PERA now absorbs upwards of 15 percent of annual operating expenses in many large school districts, a number that is expected to rise to 20 percent as the existing plan increases for make-up contributions.
Disclosure of ties to lobbying group needed
It is also worth noting that the institute that issued the favorable DB article (NIRS) is the lobbying and public policy arm of the defined benefit public pensions, with a particularly close relationship with Colorado PERA. Smith sits on the board of directors of NIRS, as does Meredith Williams, PERA’s former executive director. Colorado PERA is both a charter member and in NIRS’s Visionary Circle, along with such other public plans as CalPERS and the Illinois Municipal Retirement Fund.
Inasmuch as NIRS is not an independent think tank, but instead is a creation of interested parties to the debate over public pensions, this relationship ought to have been disclosed.
While there is no doubt that total compensation is an important part of attracting and retaining effective teachers, those promises must be grounded in reality. Until realistic arguments are used, PERA will continue to fail not only its member teachers, but also the schools and parents it is intended to serve.
This article originally appeared in EdNewsColorado.