Report: Look at Certain Factors When Analyzing the Health of Pension Plan

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WASHINGTON — Market participants should look at contribution levels, plan assumptions, and other factors when analyzing the health of a pension system and governments should employ best practices to avoid underfunding, an analyst at Wells Fargo Securities wrote in a report issued this week.

The commentary piece from Natalie Cohen, managing director of municipal securities research for Wells Fargo, comes in the wake of recent settlements in the Detroit bankruptcy case that have raised the issue of whether underfunded pension and other retiree benefits could affect bond repayments or lead to rating downgrades. The settlements only lightly impair retirees, but three insurers that insure most of Detroit's unlimited-tax general obligation debt would only recover 74% on their claims.

The issue of how pension problems could affect bond repayments is primarily a concern for financially distressed governments. But investors, analysts and advisors should apply the same discipline to analyzing pensions as they do to analyzing general financial conditions, the report said. However, disclosure is hard to find and assumptions vary widely across plans.

Market participants should analyze whether the state or local government is paying into the fund at a level recommended by actuaries, the report said.

"Not doing so is effectively a commitment to consume the resources of future taxpayers without offering them a corresponding benefit," Cohen wrote. "That is, resources will need to be consumed after the productive service of the employee is finished."

The statements of funding progress in a plan's audits are useful to look at when determining whether the state or local government is paying into its plan appropriately and is maintaining or depleting assets. But these aren't perfect, the report said, noting that the statements in the audits of Detroit's plans showed unfunded actuarial liability that was significantly lower than the amount in the city's bankruptcy papers.

Market participants also should look at whether the state or local government is consistently meeting its target return on assets in the fund. The return on investments combined with government contributions help to build enough assets to support employees in retirement.

When examining whether a fund meets its targets, it is important to consider the riskiness of assets in the fund, which may make it more likely that the fund will not meet its target returns in some years but exceed them in others. Plans with riskier investments should have extra collateral to provide a cushion, Cohen recommended.

A third factor that should be examined is the reasonableness of the assumptions used by the plan, Cohen wrote. Detroit and Chicago use "open" amortization of their unfunded liabilities, which effectively means no amortization because it is recast each year. Also, some plan sponsors smooth asset gains and losses over a long period of time as opposed to using market or fair value, the report said.

A plan's governance should also be considered. This is important because in some cases, the plan's management establishes the valuation of assets.

"In some of the most troubled systems, special programs may dilute the efficiency of assets," Cohen wrote. "In the extreme, some managers have used assets for purposes other than intended,"

Market participants should look at whether there are any constraints on state or local officials enriching benefits when assets are performing well. Adding new benefits puts more pressure on funds to maintain high returns and leads to a need for a greater pay-in from employees and future taxpayers when the funds don't perform as well, the report said. "We suggest that formal or legal 'brakes' be put into place to ensure a temporary surplus is not spent down or committed to other purposes," Cohen wrote.

The report calls Puerto Rico's Employee Retirement System possibly the worst funded public pension plan at 5%, with the Teachers' Retirement System also poorly funded at 20%. The Supreme Court of Puerto Rico upheld pension reforms for the ERS but rejected them for the teachers plan.

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