public pension funding forum pension funding docs/ppff...public pension funding forum pension...

Public Pension Funding Forum

Pension Funding:

It’s Not a Math Problem

April 22, 2014

Presented by: Jim Link, CEBS

Framing the Problem

2 © 2014 The PFM Group

Total unfunded pension liabilities of

the 50 states: $833 billion (Bloomberg)

Total with more realistic discount rate

and reinvest assumptions: $1.875 trillion (Moody’s)

Starting in 2016, ten thousand baby

boomers will retire or reach age 65

each day for the next 17 years (Kiplinger)

Only 53% of individuals believe they

will be financially ready to retire (Mercer’s 2012 Workplace Survey)

By 2033, thirty million individuals will have

reached age 65 leaving both Medicare and

Social Security unable to pay their bills

from current revenue, with adjustments Today, retiree spending equals 5.3%

of our GNP and retirees hold 36% of

the nation’s invested capital

Consistent Funding Results in Greater Stability


“States that have the largest relative pension liabilities have at least one

thing in common: a history of contributing less to their pension plans

than the actuarially required contribution.” - Moody’s Investors Service

Annual Funding Levels Acting as Indicators…


2012 ARC Pmts

SOURCE: The Pew Center on the States, March 2014 Report

2012 ARC Funding %

Below 75%

75% or Above

ME 100%

NY 100%

PA 43%

VA 59%

WV 101%

NC 100%

SC 100%

GA 100%

FL 59%

AL 100%

MS 101%

TN 100%

KY 65%

OH 57% IN

88%

MI 80%

WI 100%

IL 76%

MN 81%

IA 97%

MO 96%

AR 95%

LA 96%

TX 69%

OK 104%

KS 67%

NE 91%

SD 100%

ND 53%

MT 69%

WY 89%

CO 85%

NM 83%

AZ 101%

UT 100%

ID 84%

NV 96%

CA 72%

OR 72%

WA 74%

AK 88%

HI 84%

PR 29%

NH

VT

MA

CT

RI

NJ

DE

MD

91%

118%

87%

100%

100%

39%

99%

87%

…To Overall Plan Funding


SOURCE: The Pew Center on the States, March 2014 Report

2012 State Funded Status

Below 50%

51% - 65%

66% - 75%

76% - 90%

91% or Above

ME 79%

NY 87%

PA 64%

VA 65%

WV 63%

NC 95%

SC 65%

GA 81%

FL 82%

AL 66%

MS 58%

TN 92%

KY 47%

OH 67% IN

61%

MI 72%

WI 100%

IL 40%

MN 75%

IA 80%

MO 78%

AR 71%

LA 56%

TX 82%

OK 65%

KS 56%

NE 79%

SD 93%

ND 63% MT

64%

WY 80%

CO 63%

NM 63%

AZ 72%

UT 76%

ID 84%

NV 71%

CA 77%

OR 91%

WA 95%

AK 55%

HI 59%

PR 8%

NH

VT

MA

CT

RI

NJ

DE

MD

56%

70%

61%

49%

58%

64%

88%

64%

• Unfunded Pension Liabilities create downward pressure on credit ratings

which makes borrowing for capital projects more expensive.

– Moody’s Investors Service Methodology for Calculating Pension Liabilities for

State and Local Governments:

• Unfunded state and local government pension liabilities increase from $766 billion

to $1.875 trillion

• Increased weight assigned to debt and pensions for ratings determination from

10% to 20%

Credit Ratings Under Pressure


Sources: Changes to pension liability calculations: Moody’s Investors Service, “Adjustments to US State and Local Government Reported Pension Data”, April 17, 2013

Proposed weighting of debt and pensions for local government ratings: Moody’s Investors Service, “US Local Government General Obligation Bond Methodology – Request for Comment”, August 14th, 2013

Fitch Ratings, State Pension Update, 2013; Fitch-adjusted figures assume and 11% increase in actuarial liabilities for every 1% variance between 7% and the plan’s investment return assumption

NET TAX-SUPPORTED DEBT AND ADJUSTED

PENSIONS AS A % OF PERSONAL INCOME

• Beginning in 2009, state plans have

instituted benefit reforms to improve

sustainability.

– Increased employee contributions

– Increased age or service

requirements for new hires

– Adjustments to post-retirement

COLAs

– Reduced benefit multipliers

– Options of hybrid DB/DC plan to

large groups of public employees

• While helpful, these reforms will only

attain their long-term objectives if

coupled with ongoing/increased

employer contributions.

Progress is Being Made, but is it Enough?


State Retirement Systems

2012 ARC Payment %

20 Largest US Cities’ Retirement Systems

2012 ARC Payment %

Below 50% 51% - 65% 66% - 80% 81% or Above

SOURCE: Loop Capital 2013 Annual Public Pension Funding Review; Annual Financial Reports

• A funding policy must be established with specific objectives. Lay out a plan to fund pensions

Provide guidance in making annual budget decisions

Demonstrate affordable financial management practices to taxpayers

Reassure bond rating agencies

Assure employees how pensions will be funded

• Sustainability through policy implementation. Have a pension funding policy that is based on an actuarially determined

contribution

Build funding discipline into the policy to ensure that promised benefits can be paid

Maintain intergenerational equity so that the cost of employee benefits is paid by the generation of taxpayers who receive services

Make employer cost a consistent percentage of its current and projected payroll

Require clear reporting to show how and when pension plans will be fully funded

Funding Policy Concepts & Objectives


The Importance of Shared Sacrifice


Prevailing Solutions

• Holistic view of total compensation

• Higher employee contribution

• Required ARC funding

• Caps on benefits

• Funding underfunded systems

• Fixed retirement age

• Elimination of retroactive increases

• Development of hybrid systems

• Create contribution certainty and risk parity

• Monitor with vigilance and engage

employees

Solutions that Might Fit the

Context Mel Aaronson has

Defined Today

• Benefits bonds

• Asset monetization

• To be effective and sustainable, a pension funding strategy

must be considered across three primary areas.

The Three Prongs of Pension Funding


PENSION FUNDING CONSIDERATIONS

Benefits

• Benefit Structure

• Demographics

• Labor Negotiations

Budgetary / Financial

• Budget Flexibility

• Solution Options

• Credit Impact

• GASB Changes

Investments

• Return Assumptions / Projections

• Asset Allocation

• Liquidity Needs

• Issuers of Pension Obligation Bonds (“POBs”) issue debt in the taxable

fixed rate markets and deposit the proceeds into their pension system.

• POBs are a risk-bearing arbitrage strategy between the cost of financing

and the return on investment.

Pension Obligation Bond Mechanics


– Investment rates that

are greater than

borrowing costs will

achieve net savings to

the pension obligation.

– POB proceeds should

be invested in asset

classes that provide

the best risk/return

trade-off (i.e. Equities).

• POBs replace a ‘soft

liability’ with a ‘hard

liability’.

• The Government Finance Officers Association (“GFOA”) advocates a

thorough review and the use of caution before issuing Pension Obligation

Bonds.

GFOA Best Practices for POBs


• Pension Obligation Bonds, if used, should be utilized in conjunction with, and not in place of, sensible funding and investment policies.

POBs as part of a larger strategy

• Stakeholders should be aware that pension liabilities with debt service payments can limit budgetary flexibility, and may not eliminate unfunded liabilities in perpetuity.

Broader budgetary impacts must be considered

• Pension Obligation Bond debt should not extend the unfunded actuarial accrued liability.

Avoid extension of UAAL

• Issuers should be mindful of the impacts on debt capacity, and the reporting implications of the hard debt liability.

Creation of ‘hard liability’; impact on debt capacity

• Employers participating in multiple-employer systems should pay additional attention to the actuarial and cost implications of those plans.

Impact on multiple-employer systems

POB Considerations


• There are numerous factors that must be evaluated and weighed when

considering a POB that directly impacts the funding strategy.

– Conversion of a soft liability to a hard liability

– Issuance timing

– Issuer debt load and capacity

– Ratings impact

– Covenant risk mitigation

strategies while debt is

outstanding (to the extent

legally enforceable)

• Create separate trust

structure within retirement

system to facilitate a POB

investment strategy that is

different than system-wide

asset allocation

• Limit ability to provide benefit enhancements while POB debt is outstanding

• Consider a rate stabilization fund from POB excess returns once funded ratio

exceeds 90%

• The timing of when an issuer enters the market can significantly affect

the performance of POBs.

• Stock prices fluctuate, and the risk of loss in the first recession after a

POB sale must be evaluated carefully.

Pension Obligation Bond Timing

14

• A ‘Pension Obligation

Bond Window’ is the

period of time an issuer

can invest these bond

proceeds in the stock

market with a reduced

probability of

experiencing lower

stock prices in the

subsequent economic

recession.

© 2014 The PFM Group

• The period of time an issuer of benefits bonds can most reasonably expect to

invest bond proceeds in the stock market without witnessing lower stock prices

in the subsequent economic recession.

What is the Pension Obligation Bond Window?

15

– Measured from the

bottom of the stock

market (which typically

corresponds to the

trough of an economic

business cycle) until the

stock market ‘breakeven’

level with the subsequent

stock market bottom.

– Theoretically, the period

in which the risk of

subsequent cycle loss is

< 50%.

– Quantifiable only in

hindsight.

– No one can ever predict

in real-time when there is

a bottom.

© 2013 PFM Asset Management LLC

• It is important that POB issuers commit to taking a long-term view on the

results of the strategy.

– History shows that over a long-term period (30-year), equities predominantly

outperform POB funding costs; whereas shorter term views (5-year) provide

more erratic performance results and greater risks.

Evaluating POB Strategy Outcomes


Data source: Ibbotson Associates, Inc.

Update, resize

• Proceeds of a POB issuance

should be invested differently

than the balance of the

retirement system assets.

– Typical pension plan investment

strategies have asset allocation

targets that include equities,

fixed income, and other asset

classes.

– Plan sponsors should not issue

bonds to buy bonds.

– POB proceeds should primarily

be invested in equity asset

classes.

Investment of POB Proceeds


• Over a 20-year history, equity asset classes have regularly out-

performed fixed income classes, on a relative basis.

Asset Class Annual Returns


Source: Callan Associates

Annual Returns by Asset Class (1994 – 2013)

Barclays Corp High

Yield -1.03%

Barclays Corp High

Yield 19.18%

Barclays Corp High

Yield 12.78%

Barclays Corp High

Yield 1.87%

Barclays Corp High

Yield 11.36%

Barclays Corp High

Yield 2.38%

Barclays Corp High

Yield 5.88%

Barclays Corp High

Yield 5.28%

Barclays Corp High

Yield -1.41%

Barclays Corp High

Yield 28.97%

Barclays Corp High

Yield 11.13%

Barclays Corp High

Yield 2.74%

Barclays Corp High

Yield 11.86%

Barclays Corp High

Yield 1.87%

Barclays Corp High

Yield -28.16%

Barclays Corp High

Yield 58.21%

Barclays Corp High

Yield 15.12%

Barclays Corp High

Yield 4.88%

Barclays Corp High

Yield 15.81%

Barclays Corp High

Yield 7.44%

Barclays Agg

-2.02%

Barclays Agg

4.21%

Barclays Agg

6.54%

Barclays Agg

5.93%

Barclays Agg

7.84%

Barclays Agg

5.24%

Barclays Agg

6.97%

Barclays Agg

4.33%

Barclays Agg

2.43%

Barclays Agg

4.34%

Barclays Agg

4.10%

Barclays Agg

10.28%

Barclays Agg

8.43%

Barclays Agg

11.63%

Barclays Agg

-0.82%

Barclays Agg

9.64%

Barclays Agg

8.70%

Barclays Agg

3.64%

Barclays Agg

18.46%

Barclays Agg

-2.92%

The New Paradigm View of

Benefit Bond Decisions


• Based on stage in business cycle

• Optimal recessionary sizing (80 to 85% for POBs; 65% for OPEB-OBs, preferably split in two issues)

Issuance Sizing

• Primary driver of issuance – equity market risk/reward characteristics based on stage in business cycle

• Dynamic reinvestment scenario analysis

Financial Analysis

• Equity-only initially, no arbitrage in selling bonds to buy bonds

• Time-based migration to normal asset allocation

Investment Management

• Restrictive covenants to preclude benefits “give-aways”

• Excess returns available to pay down debt

• Protective POB trusts

Overfunding Risk

Mitigation

• Many governments own significant assets that provide a stable and long-

term source of cash-flows.

– Governments may sell or lease these assets to match long-term cash-flows

with the long-term liabilities associated with retirement systems.

Asset Monetization as a Funding Strategy


Pittsburgh, PA rejected a bid of $453 million for a 50-year lease on

parking revenues to fund its pension deficit. Instead, it sought to

accomplish the same purpose by transferring the yearly parking

revenue directly to the pension system. While the economics of this

were similar, no changes were made to the pension system’s benefits,

and the funded ratio is falling.

Allentown, PA leased its water utility for 50 years to a public authority

in return for $211.3 million, of which $160 million was used to reduce

the unfunded pension liability. Future rate increases were limited and

there was no initial cost to taxpayers. As a result, Standard & Poor’s

revised Allentown’s ratings outlook from stable to positive.

Chicago, IL monetized its on-street parking enterprise for $1 billion, but

used the proceeds to fund a current operating deficit. Critics contend

the City was undercompensated in the transaction and neglected to

provide protection against steep increases in future parking rates.

• Any strategies implemented with the goal of strengthening a public

retirement system must be part of a long-term plan that spreads the

impact of changes across employers, employees, and taxpayers.

• These stakeholders’ interests must be balanced to create…

Conclusion


Sufficiency,

Affordability,

and Sustainability.

PFM Center for Retirement Finance

Additional Information


Available at: https://pfm.com/financial-advisory/retirement/

public pension funding forum pension funding docs/ppff...public pension funding forum pension...

Documents