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.

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:

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.