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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
3 © 2014 The PFM Group
“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…
4 © 2014 The PFM Group
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
5 © 2014 The PFM Group
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
6 © 2014 The PFM Group
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?
7 © 2014 The PFM Group
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
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The Importance of Shared Sacrifice
9 © 2014 The PFM Group
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
10 © 2014 The PFM Group
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
11 © 2014 The PFM Group
– 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
12 © 2014 The PFM Group
• 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
13 © 2014 The PFM Group
• 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
16 © 2014 The PFM Group
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
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• Over a 20-year history, equity asset classes have regularly out-
performed fixed income classes, on a relative basis.
Asset Class Annual Returns
18 © 2014 The PFM Group
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
19 © 2014 The PFM Group
• 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
20 © 2014 The PFM Group
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
21 © 2014 The PFM Group
Sufficiency,
Affordability,
and Sustainability.
PFM Center for Retirement Finance
Additional Information
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Available at: https://pfm.com/financial-advisory/retirement/