Thursday, October 24, 2013

Hidden Actors in Boosting Public Pension Benefits

Hidden Actors in Boosting Public Pension Benefits

The trustees and public unions in Detroit are being excoriated for increasing the pension benefits afforded to municipal workers.     Mary Williams Walsh, a reporter for The New York Times, lays this out in an article entitled “Case in Detroit Highlights Costs of ‘Extra’ Pension Payments.”[1]  In her article, Ms. Walsh points out that enhanced benefits were doled out by many public pension plans, and that those increased liabilities are coming back to haunt beneficiaries and taxpayers.  We’re left with a picture of politicians, unions, and pension trustees manipulating retirement schemes.
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This picture is far from complete.  While Ms. Walsh draws the role of the actuary into her story, she does not properly capture the forces that pushed pension trustees to increase benefits.  In order to get the complete picture, you have to be a bit of market historian.

From 1980 to 2000, stocks and bonds appreciated 15% to 20% per annum.  Even if a public pension plan’s active managers underperformed the market, the assets were growing far faster than the plan’s investment assumptions of 8.5% or 9%. As a result, the pension plans appeared to produce surpluses year after year.  And if benefits weren’t tweaked, the surplus appeared to grow larger as the years went by.

While trustees were responsible for making the decision to enhance benefits, and the unions and politicians pushed for increases, experts supported their decisions.  As Ms. Walsh's article points out, actuaries participated by offering up these surpluses to the trustees without applying any significant warnings.  Today actuaries, the folks who estimate the asset and liabilities, are distancing themselves from their involvement in enhancing benefits.  However, ten and fifteen years ago, actuaries were advising pension trustees on how to spend the surplus.  If the actuaries had viewed benefit enhancements as imprudent back in the 1990s and early 2000s, they should have resigned.  Instead, they went on collecting their fees.

There was another critical actor involved in pushing up benefits and thereby undermining the long-term health of public pension plans: money managers.  This is a part of the story that Ms. Walsh doesn't mention.  Money managers furnished the pension trustees with glowing forecasts of expected returns for stocks and bonds.  The magic of the market was going to allow the trustees to provide supplemental benefits and keep the pension plans fully funded.  In fact, the forecasts were so rosy that many states and municipalities didn’t have to make contributions to the pension plans. 

Of course, the magic began to run out when the bubble burst, but the damage took awhile to surface.  As the new millennium dawned, the stock market tumbled, and the surpluses began to vanish.  When the market recovered, the extraordinary returns of the 1980s and 1990s failed to reappear.    The extra liabilities had been baked into the pensions, the surpluses were gone, and the growth of the assets couldn’t fill the gap.

My knowledge of this story comes from my own experience.  As a money manager in the 1990s, I supplied those rosy forecasts to my pension clients.  I made it easy for trustees to believe that the surpluses reported by their actuaries were free to be spent.  While every money manager was well acquainted with the long-term history of financial markets, we created rationalizations to support the case that markets would always appreciate by double digits.  My forecasts weren’t outliers.  If money managers wanted to maintain their relationship with their clients, they needed to feed them bullish assumptions.  The bullish assumptions in the first part of our presentations also helped to distract our clients from the fact that the second part showed that we had underperformed the rising market.

By the time I became CIO for the North Carolina public pension plan about ten years ago, I’d reformed my ways.  Nonetheless, I watched as the last bits of the 1990s surplus were doled out even after the awful markets in 2000 and 2001.[2]  Although I counseled caution, the increased benefits had become an annual rite, and the politicians, actuary, and money managers weren't about to upset the trustees or the retirees.[3] There was a surplus in 2001, and it was going to be spent.

In the end, the actuaries got their fees, the money managers got rich, and the pension beneficiaries and taxpayers were hung out to dry.  Sadly, public pension beneficiaries and taxpayers are at war over who should shoulder the burden of the shortfall.  Ironically, the people who aided and abetted the trustees, unions, and politicians are the ones stirring up taxpayers.  Money managers and actuaries were the biggest beneficiaries of the system they are now attacking.

[2] Stocks fell about 9% and 12% in 2000 and 2001, which wiped out the market’s 21% return in 1999.  Because the market had been up so strongly in the late 1990s, the pension surplus remained even in 2002.  As I recall, we still had a surplus in 2002 after the market fell 22%.
[3] In North Carolina, the State Treasurer is sole fiduciary over the investment of the pension assets.  However, trustees oversee the retirement plans with the Treasurer serving as chairman.

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