Where public pension funding went awry

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Optimistic investment assumptions are the primary cause of public-sector pension plan underfunding, according to a report by Hilltop Securities.

“Almost 10 years after Pew [Charitable Trust’s] first state pension report, the public pension funding landscape has not improved,” said Tom Kozlik, Hilltop’s head of municipal strategy and credit. “In fact, funded levels are close to — if not the weakest — they have ever been.”

Rosy assumptions in many cases have pushed up plans’ unfunded actuarial accrued liabilities, Kozlik said, citing research from the Center for Retirement Research at Boston College.

“This is a troubling fact considering the U.S. economy is in the middle of its 11th consecutive year of the current economic expansion,” Kozlik added.

The vexing problem of public pension underfunding has mushroomed over the past decade, since the recession and since Pew's eye-opening report in 2010, "The Trillion Dollar Gap."

Concerns include the investment risk exposure governments have through their pension systems and their effects on bond ratings; how plans that have progressed can protect against backsliding; and voter backlash from diversion of new revenue sources toward increasing pension contributions.

S&P Global Ratings three weeks ago released new pension and other post-employment, or OPEB, guidance for its state and local government analysis.

It considers the discount rate and funding progress measures as leading risk indicators and will continue to report liabilities under Governmental Accounting Standards Board standards.

S&P uses 30 as a minimum funding progress factor, saying that number leads to a “reasonable” amount of principal unfunded liability to be paid down in a given year, and that it does not equate to amortization years.

A 20-year amortization period, according to S&P, mitigates negative amortization and reduces the likelihood of “intergenerational inequity.”

Boston College reported that 60% of the time, unfunded liabilities rose because investment returns were lower than assumed rates of return used by plan sponsors.

Higher discount rates understate the costs of pension benefits, according to Kozlik. While the order magnitude varies, understanding the true costs of final expenses is essential for stakeholders.

“Largely, the use of optimistic assumptions occurs because a problem of asymmetric information about key pension funding concepts and benefit costs,” Kozlik added. “The pension funding dilemma will remain unresolved unless this gap is bridged.”

The second-largest trigger for increased liability, said Kozlik, is failure to contribute the required amount — normal cost plus interest, according to Boston College. The BC analysis found that 24% of the change in liabilities was due to contributions less than the required amount.

Kozlik cited Illinois as an example, though extreme. The state’s unfunded pension liability spiked to $134 billion in 2018 from $19 billion in 1996. The leading contributor, he said, was inadequate employer contributions, or so-called pension funding holidays.

Inadequate contributions accounted for $51 billion, or 44%, of the increase in the unfunded liability of all five Illinois state pension plans, according to an April 2019 analysis by the Illinois Commission on Government Forecasting and Accountability. This 44% is well above the 33% the CRRBC analysis shows in the bottom third of plans.

Chicago, according to Kozlik, provides an example of “asymmetric Information,” where one party to a transaction has more information than another.

He cited a two-page citizens guide to the city’s fiscal 2020 budget that referenced a $1.3 billion pension contribution.

“The core of the problem is that if Chicago came close to funding the actuarial determined contribution they would need an additional $1.3 billion. For that amount, they would need significant increases in revenues. That type of fiscal pain would be politically difficult.”

Kozlik cited San Diego’s pension overhaul as a success story.

There, the city collaborated with business and labor leaders after the technology bubble crashed early in the millennium. At the end of 2003, San Diego’s pension plan was 67% funded.

After incorporating recommendations from a pension reform committee, the level increased to 73% in fiscal 2017, assuming a 7% discount rate.

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Public pensions State budgets State and local finance Tom Kozlik Hilltop Securities Illinois