The New Future of Public Retirement Systems

CSMFOFebruary 2009

Girard MillerSenior Strategist

PFM Group

Topics

Impact of Market Meltdown of 2008

GASB 45 implementation progress

Deferred compensation issues

Retirement benefits: sustainability

Benefits Bonds: POBs and OPEB-OBs

Impact of 2008 Market Meltdown After 5 decades of actuarial funding, public pension plans were

reasonably well funded, on average But some plans are grossly, chronically underfunded Recent market meltdown changed all that

Unfunded liabilities will skyrocket and ARC will increase

Unfortunately, the 2008 Market Meltdown changed all that Funding ratios typically declined 20-25 percent Resulting increase in employer costs: 2 to 4 percent of salaries The Public-Pension Straddle Option:

Heads employees win (when markets go up) and Tails taxpayers lose (when markets go down)

Impact on OPEB plans much less significant since most were unfunded or just starting up

Legacy of the Public-Pension Straddle Option:Skyrocketing employer pension costs

Employer costs have increased 40% and employee costs remained constant

Heads employees win, tails taxpayers lose

Chart source:NASRA public fundssurvey 2007

By 2012, employer costs may double from 2002 levels

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What hasn’t worked

Abuses in pension systems draw public ire Spiking Retroactive pension increases

Especially behind closed doors

Unrealistic discount rates: investment assumptions Ad hoc COLAs Further accounting reforms seem likely

Amortization of unfunded liabilitiesOften fails the “intergenerational equity” test

Need to better align with services provided

Otherwise, it’s an ‘un-voted tax’ on future generations

GASB accounting issues

Market Value? Issue now before the actuarial boards GASB will evaluate

Better and more disclosure of discount rate? Issue: comparability

GASB accounting issues

Market Value? Issue now before the actuarial boards GASB will evaluate

Better and more disclosure? Issue: comparability

Amortization policies Is 30 years with open amortization a proper limit? Are retroactive benefits better expensed immediately? COLAs: substance over form

What to do about ad hoc COLAs?

Girard’s suggestions to GASB

Prohibit amortization periods longer than remaining average service lives of employees and remaining lives of retirees Otherwise future taxpayers will be burdened with

costs of deceased workers who provided services to their grandparents

Require immediate expensing of retro pension and benefit increases

Calculate and disclose liabilities using national average investment assumption if plan uses a higher number

Deferred Compensation Plans Market meltdown impact on individuals

Horror, terror and fear Deferred retirement dates for those with major

dependence on 457 & 401 plans Fiduciary challenges for plan sponsors

Review investment menus Review fee structures Resist higher-fee products from vendors seeking

new revenues to replace asset-based fees Opportunities to re-bid plans

Hyper-competition has returned

Retirement investingThe long-term view This is clearly not a garden-variety recession Significant risk of double-dip or longer malaise Until housing and mortgage markets stabilize,

federal stimulus is probably insufficient Ultimately, long-term equity investments from the

lows in this terrible period will appear attractive But an entire generation will have lost confidence Good news: historical returns have returned to long-

term growth rate of 9.6%, so we have now “reverted to the mean”

Long-Wave Economics

We are here

Chart: http://www.kwaves.com/kond_overview.htm

These graphs depict wholesaleprice trends, not GDP

Long-wave cycles = 55 years on average

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Long-term investment outlook

See Girard Miller’s historical research on Governing.com

http://www.governing.com/articles/0807gmmw.htm

Equities outlook over 20 year and longer periods: historically favorable from these levels Suggests an equity-tilt strategy Will eventually open a ‘Benefits Bonds window’

The Business Cycle and the Benefit Bonds Window

Benefits Bond Window

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The New Benefits Bonds Paradigm: POBs and OPEB-OBs

Issue only during recessionary window, not any time Invest only in equities initially

Why sell bonds to buy bonds? Eventually migrate to balanced asset allocation

Requires a separate POB trust OPEB plans can set up new integrated OPEB trust

But not if a pooled investment is used Enables surplus equity returns to pay off debt Properly rewards taxpayers for the added risk they absorb

Prevents future earnings from funding another benefits increase that inevitably causes yet another deficit

See Girard’s New Benefits Bonds Paradigm athttp://www.governing.com/articles/0901gmillerc.htm

OPEB: (retiree medical)The “Other” retirement plan

Huge contrast with pension systems

Vast differences in approaches, history, and future outlook

GASB 45 and its aftermath Where the public sector stands today

Phase I, II and III governments Actuarial analysis vs. action planning and funding

Comparisons: Pensions vs OPEB

Pensions: 60-65% funded Primary retirement benefit Defined benefit model fits the

liabilities well Inflation caps for most plans Mature plans with large assets Governance well established;

statutes well codified Homogeneous or comparable

benefits structures

OPEB: Almost completely unfunded

($1.5 trillion) Secondary retirement benefit An “undefined benefit” Medical cost inflation risks Startup plans w/ zero assets Governance TBD Very diverse plan structures Pools don’t necessarily work:

variation in asset-liability profiles

Current Landscape for OPEB

Phase I & II work is done: larger plans know their liabilities

Few are actually funding their ARC “No Money”: Recession is the perfect storm When will rating agencies eventually take notice?

Few are doing strategic planning Few are doing sustainability analysis OPEB bonds window in 2009, maybe into 2010

Needed: OPEB Strategic Maps

Sustainability analysis Comprehensive OPEB strategic plan

Includes both strategies and implementation path Funding strategy & plan Benefits design strategy

This is where the evolution will take place Thoughtful leaders must also address sufficiency

Governance & trust structure Investment infrastructure: DB & DC hybrids?

Outlook in OPEB benefits plan design

Sustainability is key issue at plan sponsor and taxpayer level

Look for tiered benefits plans to emerge Employee contributions or increases Higher retiree/employee cost shares on co-pays,

deductibles, % of premium, etc. Dependent coverage Eligible retirement age Vesting schedules and “early retirement” reforms

Eventually will see more defined contribution plan features here Key issue here is sufficiency

Summary

Pension plans will require higher contributions Expect to pay an additional 2 to 4% of payroll

Pay attention to GASB accounting study Deferred compensation plans: Revisit and

review ‘Benefits Bonds Window’ expected later this year

Learn the 5 key principles of the New Benefits Bonds Paradigm

To achieve retirement finance sustainability, OPEB will be trimmed before pensions

Summary: OPEB OPEB will likely evolve more dramatically Key questions will be sustainability and

sufficiency Current benefits may be unsustainable Sustainability audit is worth considering

Plan re-design and cost mitigation are foreseeable in the OPEB sector

OPEB bonds expected to be feasible in 2H09 65% of AAL liability is the ‘new paradigm’ limit

See Girard’s New Benefits Bonds Paradigm athttp://www.governing.com/articles/0901gmillerc.htm

Girard Miller’s contact infoand Governing.com columns link

Phone 310.795.1354

Email: girardinmalibu@charter.net or: millerg@pfm.com

Governing.com: Column index link: http://www.governing.com/articles/gmiller.htm

QUESTIONS? Markets?

Defined benefit pension plans?

Deferred compensation plans?

OPEB?

GASB and Accounting?

Benefits Bonds: POBs and OPEB-OBs?