Posts Tagged PERA
PERA’s unfunded liability often comes into sharper after a year of low returns. Its detractors point to last year’s 1.5% return, for instance, as evidence that PERA’s expected rate of return is too optimistic (it is). Its defenders argue that a single year’s returns are less important than the long-term (they are). They then point to a time frame, say, the last 7 years, where PERA has averaged 9.7%.
But it’s not just average returns that matter. It’s cumulative returns, and there, even a couple of bad years can wreak havoc on a defined benefit plan.
Let’s look at PERA’s returns since 1990:
A few really bad years to start off the century, and we all remember 2008. But aside from that, mostly above expected, and a few years slightly below expected. If you had invested $100 in PERA Mutual Fund in 1990 and let it sit for a quarter century, you’d be about where you should be, based on each year’s expected rate of return. Most years, you’re even ahead of the game, before the dot-com burst and the housing bubble burst bring you back to earth.
But of course, you don’t put $100 in in 1990 and let it sit. You put $100 in every year. Instead of looking at this from the perspective of each year going forward, let’s choose the perspective of 2015 looking back at each year. That is, for each year where you’ve invested $100, let’s see how you end up in 2015.
For $100 invested in 1990, you’d expect to have about $800, and we already know that that’s what you’ve got. For $100 invested in 2000, though, you’d expect that to be worth $355 today, but it’s only appreciated to $228. That’s because in January 2000, you invested before the bad years of 2000-2002. So money invested in every year from 1995-2003 is worth less now than PERA’s expected return would project. In fact, there are only a few years where the cumulative return through 2015 is better than expected, because 2000-2002 and 2008 wipe out all the gains beyond expectations.
Not surprisingly, this means that your PERA Mutual Fund is short of expectations in 2015, by just over 9%. You’d expect to have just over $9000, but instead you’re just under $8200.
Naturally, PERA’s actual situation is much more complex than this. But the point remains – it’s not enough to do as well as you’d expect over a long period of time, even in the absence of required annual payouts. In order to keep the plan solvent, you need to do better than that.
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.
Another year, another school bond issue. This year, it’s Jefferson County where Referenda 3A & 3B will be on the ballot, asking property owners to increase the mill levy. 3A will fund operations, 3B capital investment.
The unions favoring the increase are using the usual scare tactics, of course. But this year, thanks to Sheila Atwell at Jeffco Students First (among others), they’re having to play defense on a number of issues, including the district’s PERA contributions.
The union claims, with some truth, that:
PERA contribution rates also cannot be changed through this November’s mill and bondelection. Money from 3A supports local schools and prevents further cuts to instruction; money from 3B goes to badly-needed maintenance and repair on the schools. Money from 3A and 3B does not go to PERA.
Currently, it is not possible for the Jeffco Board of Education to ask district employees to pay a higher percentage of their own PERA contributions to offset budget shortfalls. Senate Bill 11-074 was introduced in February 2011 and would have allowed school districts like Jeffco to raise the employee contribution rate and lower the employer rate, but that bill died in committee. No new legislation has been presented since 2011.
Because no new legislation has been introduced since 2011, changes made to PERA contribution rates can only made through legislation by the Colorado General Assembly at the state capitol.
Others have suggested that PERA is a union issue. It is not. Unions cannot change the state-mandated rates. PERA is a state issue and citizens who want to see it changed need to lobby their state representatives to do so.
Mixed in with the truth, however, is a healthy helping of disingenuousness. They are correct to this extent: The specifics of PERA are set by the legislature, and are not really negotiable at the local level.
That’s about where it ends. That PERA contributions are fixed, doesn’t mean that they don’t exist. They are a very real – and growing – part of the school budget. By taking that off the table for discussion, the CEA is asking homeowners – all taxpayers, really – to work harder and longer to fund union members’ retirements, while putting off their own.
The Democrats in the state legislature did indeed kill a bill, SB11-074, that would have permitted localities and school districts to shift some of the PERA contributions from employer to employee, as the state can do. A quick search of the Secretary of State’s site shows that among those instructing their lobbyists to oppose SB11-074 were PERA itself, the Colorado AFL-CIO, and the CEA.
To use the fact that the structure is set by the legislature as an excuse to persuade taxpayers to raise their own taxes for your benefit, advise them to seek redress at the Capitol if they don’t like it, and then actively work to frustrate that reform, is the kind of tactic that might have worked once, before the Age of Transparency, but no longer.
There was a 3% reduction in pay, but there’s no reason to attribute that specifically to PERA, to call it the teachers’ contribution to PERA solvency, as the union tries to do elsewhere on the page. What they want to do is to day that taxes aren’t going to PERA, while their pay decreases are. It’s the same sort of rhetorical shell game that unions often play.
The Bureau of Labor Statistics quarterly survey of wages shows that the average weekly JeffCO wage declined by 3.9% year-over-year in QA of 2011. So it’s all in the spirit of shared sacrifice.
UPDATE: Go to JeffCo Students First Action to see what you can do to stop this measure.
As PERA prepares to release its 2011 Comprehensive Annual Financial Report, keep an eye on 2011’s returns. Treasurer Walker Stapleton understatedly calls 2001’s anemic 1.8% return, a “serious warning sign.” I’d call it a big, red, flashing LED billboard.
“What’s the big deal? It’s only one year,” I hear you cry.
Well, it turns out that if you’re projecting returns over a long period, the early returns have a disproportionate effect on whether or not you’ll make your targets. And while PERA projects an overly-optimistic 8% annual return, even meeting that as an average cumulative return is no guarantee of solvency to the end.
Returns aren’t smooth, they vary over time, and while the exact distribution is a matter of dispute, that fact isn’t. While the actuarial outlays are relatively smooth, returns can bounce around all over the place, and poor early returns can mean that you’re eating into your principal, and won’t be able to make it up on the back end, even if the returns rise to meet your project cumulative average.
Take three sets of return profiles, one constant, one with slightly higher-than-expected returns the first two years, and one where the fund loses 5% a year for the first two years, but settles in at a higher rate.
All of them converge to the save Cumulative average at the end of the 20-year run:
But because they have to take money out each year, the end of year balances tell a starkly different story for the three funds:
One fund slowly declines from $1 million balance to $800K. The one with higher early returns also declines, but ends up above its starting balance. And the one with poor early returns never recovers.
In fact, 20 data points is a very small sample, and even a distribution of returns that averages 8% could easily produce, over 20 samples, returns far higher or, more likely, far lower. The graph below shows the average returns and final balances from a 10,000-run Monte Carlo simulation:
Below about 10%, there’s a virtual guarantee that some of the funds will go bankrupt. Let me emphasize that this is a very simplified model, for display purposes only. Do not try this at home. (Actually, go ahead and try this at home. You’ll probably be as depressed and I was.)
What this shows, though, is that even using a lower rate of return doesn’t necessarily guarantee the fund’s soundness, and certainly doesn’t model the fund’s future. The only way to do that is through a Monte Carlo simulation, using the historical returns of the assets in which the fund is invested.
While more complex to do, and very hard to model on a spreadsheet, there is precedent for incorporating Monte Carlo modeling into financial planning, pension solvency analysis, and even into accounting. The Black-Scholes method, for instance, is used to calculate the value of stock options granted to employees and expensed on corporate financial statements. And allowances for bad debt are routinely audited for fidelity to previous customer defaults. There’s no reason that we couldn’t require pensions to do the same.
At the very least, it would perhaps keep today’s 1.8% return announcements from being such a surprise, and from taking such a toll on PERA’s solvency estimates.
Along with all my other exciting duties, I’ve taken on the role as the manager of the PERA Project for the Independence Institute’s Fiscal Policy Center. It’s an astonishing amount of material to become acquainted with, but I’m starting with the most recent Comprehensive Annual Financial Report, from 2010 (the 2011 report won’t be ready until July, for some reason).
Most funds try to achieve some level of diversification within their target investments. This is true even for narrow, industry-specific funds, but is clearly true for larger, broad-based funds like a retirement fund, whose primary goal needs to be capital preservation and conservative growth.
In PERA’s case, they divide their investments into five asset classes: stocks, bonds, real estate, commodities, and alternative investments. While there’s some correlation among these, they are true asset classes, meaning that they really do respond to different economic conditions and stimuli. While a generalized, panicky flight for the exits would affect them all, for the most part, these investments don’t move in tandem.
However, the benchmarks against which PERA measures its performance are another matter, and may be setting the fund up for diminished returns.
The benchmarks themselves are not only highly correlated, in several cases, they’re just the same as each other:
|DJ US Total Stock Market Index|
|MSCI ACWI ex-US Index|
|Fixed Income Custom Benchmark|
|Barclays Capital Universal Bond Index|
|Barclays Capital Long Gov’t Credit Index|
|Alternative Custom Benchmark|
|DJ US Total Stock Market Index + 3%|
|Real Estate Custom Benchmark|
|NCREIF Open-end Core Fund Index + 1%|
|DJ US Total Stock Market Index|
|MSCI ACWI ex-US Index|
|Fixed Income Custom Benchmark|
There are some questions here. First, the “Opportunity Fund” is currently invested in timber and raw materials. Surely there must be commodity indexes that would be more reflective of the fund’s style. A mixture of equities and fixed income indices doesn’t seem to bear any relationship to the fund’s investments.
Second, fund managers are judged in part by how well they track or beat these benchmarks, PERA is potentially setting up incentives to invest in assets that are reflected in those indices, throwing away the benefits of diversification. The Opportunity Fund, for instance, is being judged on what amounts to a combination of the Global and Fixed Income Benchmarks. It may be in commodities or timber now, but it could well end up migrating to investments that track those other two funds.
The Alternative Investment Fund is the most problematic; in essence, it’s just being held to the US stock market plus 3%. But look at its portfolio: private equity, venture capital, and distressed debt. Those investments don’t necessarily peak at the same point in the business cycle as vanilla equities. The difficulties and dangers of benchmarking alternative investments, which are often illiquid and lacking in direct peers, have been noted before. But there are any number of hedge fund indexes available for them to use. Surely some basket of those would be more reflective of the fund’s actual and intended holdings.
I’ve only just noticed this, and to be fair, I don’t have any evidence that it’s actually affecting investment decisions. Moreover, it’s a second-order effect. Obviously, this isn’t as bad as if the asset classes themselves were highly-correlated. But it’s possible that PERA is creating investing incentives that could come back to bite them in bad years, and cost them valuable basis points in normal years.