April 23, 2014
Municipal Securities Research Municipal Commentary
Natalie Cohen, Senior Analyst natalie.cohen@wellsfargo.com (212) 214-8014
Analyzing Public Pensions Determining whether underfunded pension and retiree health benefits could affect bond repayments or lead to ratings downgrades is no small task for investors. Detroit’s recent settlement, which lightly impairs retirees but cut GOULT obligations by 26%1 and other obligations by who-knows-what amount, has moved this question to the front of our mind. We believe this is mainly a concern for financially distressed governments and not the majority of capital market borrowers. That said, investors, analysts and advisors should apply the same discipline to analyzing pensions and other retiree benefits as they do to analyzing general financial conditions, in our view. However, disclosure is hard to come by and the assumptions vary widely. We share a few thoughts about how to determine whether trouble is brewing or already at the doorstep2. 1. Paying In: First and foremost, is the state or local government paying into the fund at a level recommended by the actuaries? Not doing so is effectively a commitment to consume the resources of future taxpayers without offering them a corresponding benefit. That is, resources will need to be consumed after the productive service of the employee is finished. This is a basic explanation of an important concept of “intergenerational equity.” In the current environment, it is a tough sell for politicians to advocate tax increases to cover legacy costs that may have built up due to “payment holidays.” Unfortunately, the other option is to erode service levels in an environment where benefit changes are difficult or “untouchable.” To demonstrate the adverse consequences of not paying in, we include a series of tables at the back
of this report for selected governments that have and have not been paying into their plans. 2. Meeting the Target Return on Assets: Second, is the state or local government consistently meeting its “reasonably expected” return on assets in the fund? This, combined with “paying in,” help to build enough assets to support an employee in retirement—i.e., meet the promises made—and to benefit from the effect of compounding. In this context, it is also important to consider the riskiness of the assets in the fund, discussed further below, which may increase the probability of not meeting target returns in some years while perhaps exceeding them in others (i.e., What’s the “beta?”). 3. What Are the Assumptions? Third, are the assumptions reasonable? For example, Detroit and Chicago use “open” amortization of their unfunded liabilities, permitted by the Government Accounting Standards Board (GASB), which is really no amortization at all because the amortization is recast each year. Another factor is “asset smoothing.” Some plan sponsors smooth asset gains and losses over a long period, rather than using market or fair value. Other core assumptions for measuring liabilities include the “benefit factor”3 and cost-of-living adjustments (COLA) that may be automatic or “ad hoc.” 4. How Objective Is Governance? The quality of plan governance is critical. In some cases, plan management is charged with establishing the valuation of assets themselves—particularly for alternative investments. While comparable asset values may be scanty in certain asset classes, impartiality is important.
——————————————————— 1It
is important to note that holders of insured GOULT bonds are expected to receive 100% payments. readers wishing to know more on this subject we recommend a few other research pieces we have written: Public Pension Update, May 17, 2013; Pension Tensions: A Primer, August 22, 2012; Public Pension Plans: What We Worry About, December 2, 2011 and Public Pension Primer, November 23, 2010, available for clients on wellsfargoresearch.com. 3 Typically there is a formula that multiplies the number of years of service times a “benefit factor” — such as “2” or “3” — times the base year salary (final year or some kind of average). 2For
Please see the disclosure appendix of this publication for certification and disclosure information Reports available on Bloomberg at WFRE and wellsfargoresearch.com
Analyzing Public Pensions April 23, 2014
WELLS FARGO SECURITIES, LLC MUNICIPAL SECURITIES RESEARCH
Also, in some of the most troubled systems, special programs may dilute the efficiency of assets. In the extreme, some managers have used assets for purposes other than intended. For example, the Detroit General Retirement System (GRS) had a savings program for members in the retirement plan that promised a return equivalent to the higher of the discount rate being used (8%) or the actual return on assets. In 2009 when the plan lost 24.1% of the value of its assets, the savings accounts were credited with a 7.9% investment return. To pay these returns, plan managers took money from the corpus of the other funds. Puerto Rico’s Employee Retirement System (ERS) and Teachers’ Retirement System (TRS) each have loans outstanding to members representing 20% and 22% of total assets, respectively. While the administration argues that these loans are repaid at a high rate, there are also loan losses and this type of asset is not as liquid or as flexible as assets otherwise invested. Even systems with historically satisfactory track records are using approaches that serve to dilute the quality and flexibility of assets (and increase future costs). For example, New York State has allowed local governments to “borrow” from the pension to make current-year payments. The “Contribution Stabilization” program was created by the Comptroller in 2010 and a second was created by the governor in 2013, the “Alternate Contribution” program, which extends the repayment period from 10 to 12 years. Borrowing is reportedly up 22% in 2014 over last year from $368 million to $472
million. In addition, the state deferred $937 million. 5. Are There Constraints on Benefit Enrichment? Finally, on the spending side, are state or local government officials enriching benefits when assets are performing well? New benefits put additional pressure on the fund to maintain high returns, or, failing that, greater pay-in from employees and future taxpayers. Formal, perhaps legal “brakes” on benefit enrichment could help overcome the timing disconnect among shorter terms of elected officials who decide and negotiate benefits, changing economic conditions as well as the longer-lived retiree funds. In many cases, the elected official may be long out of office before legacy costs appear or the economy turns for the worse. For example, at the height of the “dot com” bubble and with assurances from CalPERS that the benefit enrichment would be affordable, California’s Gov. Gray Davis implemented a “3% at 50” for public safety workers in 1999, which set up a generous benefit legacy. Who knew that the ensuing decade would include very difficult years for earnings? Our wish list would also include a requirement that there be a clear analysis of the lifetime costs of benefit increases, coupled with stress-testing of plan performance under a range of down market conditions. Exhibit 1 highlights the effect of our aging demographic (and the greater pressure to maintain intergenerational equity). In 1981, the ratio of active employees/retirees
Exhibit 1
2
Analyzing Public Pensions April 23, 2014
WELLS FARGO SECURITIES, LLC MUNICIPAL SECURITIES RESEARCH
was 2.8. The declining ratio of actives to retirees, particularly in plans with unfunded liabilities, will mean (by definition) that the cost of funding as a percentage of payroll will rise.
The Importance of Earnings
The basic premise of retirement funding (or any long term savings program for that matter) is that the employer/employee/individual may put in a smaller value today on the expectation that the saved amount will earn at some rate, producing greater value in the future. (The other rule of thumb is that the closer one gets to retirement, the more conservative investments should be. This relates to the riskiness discussion below.) Exhibit 2 breaks out the components of public pension revenue each year from 1993-2011 as reported by the Census Bureau. Earnings as a percentage of total assets varied from 60% to just over 80% (in the strong market years). One can visualize the steady climb of earnings in the late 1990s and again in the 2004-2007 bubbly period. Most system managers throughout this period assumed earnings would be around 7.5%-8.0%. However, after 2000, we entered a more volatile earnings environment, where there were three years of losses and one year of
earnings at only 3.3% of assets. To provide a simple example of the importance of compounding, $100 at 8% would grow to about $233 between 2000-2011 (without adjustment for inflation). However, based the actual earnings rates below, we would only have $175 in our pocket over that time. A plan sponsor that used “excess” earnings in the years of double-digit returns to pay “bonuses,” a “13th check” or enrich benefits would have even less at the end of the period. Covering a similar time frame (2002-2012), Cliffwater, LLC, found that earnings averaged 6.4% over the 10-year period from 2002-2012 for the 64 state plans included in its research. Individual plan earnings ranged from 5.0% to 8.1%. We reprint its chart on the following page (Exhibit 3) with permission. In this chart, a sizable number of plans exceed bond and stock returns due to alternative investments. Significant energy has been spent discussing the appropriate discount rate that governments should use when measuring the liability for benefits that are nearly irreversible. The new GASB accounting standard blends an expected rate for that portion of the liability that is secured by assets and a tax exempt municipal rate for the
Exhibit 2
3
Analyzing Public Pensions April 23, 2014
WELLS FARGO SECURITIES, LLC MUNICIPAL SECURITIES RESEARCH Exhibit 3
Source: Cliffwater, LLC portion of the liability that is unfunded. The oddity of public pension accounting is that there is one rate for discounting liabilities and expected earnings. Others argue for a “risk-free” rate, perhaps using a 10-year or 30year Treasury. Moody’s has used a high-grade taxable corporate bond rate—a rate similar to what is used with private defined benefit plans–and the agency has recast public pension liabilities using this corporate rate in its ratings analyses. One could argue long and hard about the most appropriate rate—and by then, of course, market factors would have changed (and we all would be retired).
standard deviation of investment returns in the portfolio. Elsewhere, in a discussion draft distributed by the Stanford Institute for Economic Policy Research, Professor Joshua Rauh explained that the riskier the invested assets in a plan, the higher the probability that targets would not be met over the required savings period.4 Anchoring the level of required assets to an analysis of their probable volatility over time, in our view, is an approach that could give policy-makers and taxpayers an idea of the risk that might be baked into a pension plan.
Accounting for Risk
Using a risk-adjusted rate may result in a plan’s actual earnings in certain years to exceed the interest rate that expresses long-term risk. If loss probabilities are appropriately calculated, this seeming “overfunding” will likely even out over the long term—as there would likely be years when a plan loses money and would then need a substantially higher return (or higher pay-in) to regain ground. This too is why 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.
We take a more pragmatic view, and one we believe is better aligned with current practice. For example, when regulators evaluate the capital adequacy of banks and insurance companies to ensure that funds will be available for depositors or to meet claims payments, they risk-weight assets. Rating agencies too, when evaluating securities backed by a specific pool of assets analyze the potential risk of default, loss and recovery in the pool. In these cases, the regulatory body or rating agency may require more collateral for riskier investments to protect against potential losses. A few proposals and analyses are emerging along these lines. The Society of Actuaries (SOA) independent Blue Ribbon Panel released a report on funding public pensions in February. SOA suggests that plans provide a risk free analysis as well as analysis of the expected 4
The Importance of Paying In
As we mentioned above, not paying into a fund shortchanges the amount of assets that can be put to work. Over time, unfunded liabilities grow, exacerbating the potential draw against future resources. Pew Charitable ————————————————————
The Causes and Consequences of the Rising Costs of Public Employee Pensions, January 23, 2014.
4
Analyzing Public Pensions April 23, 2014 Trusts studied state plans and came up with measures for how much of the annually required contribution was made. We show states that paid in the highest and least amount of the required contribution along with their funding levels in Exhibit 4. Note that Pew aggregates state employees’ plans with local government as well as cost-sharing (mostly teachers) plans. In some states the teachers’ plans are more underfunded than the general employee plans. For investors in school districts versus municipalities, this distinction is important. As a result, we suggest reading these two tables mainly as a “proxy” for an overall state approach to funding. Exhibit 4
WELLS FARGO SECURITIES, LLC MUNICIPAL SECURITIES RESEARCH the city’s bankruptcy papers. It is difficult for investors to “second guess” such a presentation, which highlights the dramatic effect of using different assumptions. Puerto Rico’s Employee Retirement System (ERS) is perhaps the worst funded—at 5%—with the Teachers’ Retirement System (TRS) a close second at 20% (Exhibit 6). As you can see from the table, the ERS nearly doubled its unfunded liability in the five years from 2007-2012, while the TRS more than doubled its unfunded liability. The governor proposed pension reform of the ERS that was upheld by the Supreme Court. The reforms were quite remarkable in that they cut off the defined benefit program for all members, not just the new hires. The savings will not bring the plan to full funding, but at least the reforms will make draws on the plan’s corpus of funds “less bad.” Part of the plan includes higher annual payments from the Commonwealth, and its financial ability to maintain this extra cost remains to be seen. The Supreme Court of Puerto Rico recently rejected similar TRS reforms as unconstitutional. The path forward is unclear, but we would expect some kind of alternative program to be proposed in the future. Needless to say, plan assets continue to be depleted. California Teachers Retirement System (CalSTRS) unfunded liabilities grew from $18.7 billion to $70.5 billion in the five-year period 2007-2012 and the funding ratio fell from 89% to 67% (Exhibit 7). Assets fell from $155 billion in 2008 to $144.2 billion in 2013, according to the plan’s actuaries. Clearly, 2013 was good to market investors, including many pension plans, and these improved figures will show up in the next reporting cycle. CalSTRS reports that assets were valued at $180.8 billion as of Feb. 28, 2014. However, it also reports that the unfunded liability has grown to $73.7 billion, implying a jump in the accrued liability from $214.8 billion to $253.7 billion and roughly 70% funding level.
Statement of Funding Progress
To illustrate the consequences of not paying in, we present a series of tables on the following pages for a few selected plans, some that are well-funded and some that are not. In each case, the table is taken from the “statement of funding progress,” which is found in the “required supplemental information (RSI)” at the back of a plan’s audit. We find this statement to be a useful tool to determine whether a plan is maintaining or depleting assets and paying in appropriately. The statement alone is not foolproof. For example, the Detroit Police and Fire Plan shows 96% funding and the GRS shows 77% (Exhibit 5). The 2012 unfunded actuarial liability for both plans of $985 million is substantially lower than the $3.5 billion represented in 5
Natalya Shnitser of Yale University found5 that institutional design (a.k.a. governance) is associated with better/worse funding discipline. She found “...the widely adopted ‘cost-sharing’ arrangements that have permitted municipal and state employers to pool assets and liabilities without delineating responsibility for underfunded pools, in conjunction with lax disclosure requirements, have been associated with worse funding discipline.” CalSTRS is a cost-sharing plan. Last December, the state of Illinois passed pension reform that aims to achieve full funding in 30 years and save $160 billion. (Exhibit 8 presents the Illinois ———————————— 5 Funding Discipline for U.S. Public Pension Plans: An Empirical Analysis of Institutional Design, Working Draft as of September 13, 2013.
Analyzing Public Pensions April 23, 2014 statement of funding progress prior to the reforms). As with other reform plans, changes to cost-of-living adjustments (COLA) are able to provide significant savings and the Illinois reform adjusts COLA payments. At the beginning of April, the state legislature, which controls changes to Chicago’s pensions, approved giving the city the flexibility to change its pensions, but punted the vote to raise taxes to the city council; however, the governor has yet to sign the bill (Exhibit 9). Not all plans are underfunded, and many have maintained fiscal discipline. We include the same statement of funding progress for the North Carolina, Wisconsin and Maine plans, which portray a different picture (Exhibit 10). We also underscore that these tables are selective, for illustration. For example, New Jersey has been notorious for payment holidays and significantly underfunded plans. Connecticut, Pennsylvania and Rhode Island also have significant funding issues to resolve, whereas the state of Washington’s plans are funded at respectable levels. Exhibit 5:
6
WELLS FARGO SECURITIES, LLC MUNICIPAL SECURITIES RESEARCH
Bringing Plans Back to Fiscal Health Is a Tough Process
Warren Buffett called public pensions a “financial tapeworm” in his letter to shareholders this year. He also referenced a letter he wrote to Katherine Graham White of the Washington Post in 1975, where he described, “The Irreversible Nature of Pension Promises...with every pension decision...you almost certainly are playing for keeps.” Many pension plans and their members now recognize the need to make changes, whether through increased contributions, the elimination of “extras” such as above inflation COLAs, bonuses and “salary spiking” (wherein an employee works extra hours during the years that form the base for pension payments.) In California, for example, while in office former Gov. Schwarzenegger was able to raise the retirement age for new public safety employees to 55. Gov. Brown raised the retirement age for new “miscellaneous employees” to 67 from 62 and to 57 for new safety employees. He had proposed a hybrid 401(k) type system, but this did not
Analyzing Public Pensions April 23, 2014 pass. Employees are eventually to pay for 50% of their benefits, although this may phase in over a number of years. Retroactive enhancements were eliminated as was the practice of allowing employees to buy extra service credit. The state expects to save $55 billion plus another $22.7 billion for teachers over 30 years against an unfunded liability of $164 billion. Changing legacy obligations is slow, litigious and Exhibit 6:
Exhibit 7:
7
WELLS FARGO SECURITIES, LLC MUNICIPAL SECURITIES RESEARCH difficult as we are witnessing in Detroit, Chicago, California, Puerto Rico, Illinois and elsewhere. The transit strike in New York City in 2005 was largely due to the MTA’s proposal to raise employee pension contributions from 2% to 6% when unions wanted to lower retirement from age 55 to 50 after 20 years of service rather than 25 years. There is renewed talk about a transit strike in the New York area. In addition to the Puerto Rico Supreme Court rejection of the TRS reforms, this week Rhode
Analyzing Public Pensions April 23, 2014 Island’s courts agreed to hear a challenge to the state’s pension reforms. The changes in Illinois are also subject to litigation and are expected to be heard May 22, 2014, in Sangamon County. Ultimately, in an insolvency situation, we would expect elected officials and workout managers to behave as they did in Detroit—directing extra funding to the retirees, particularly to provide a floor that keeps retirees from falling into poverty. Many public pensions do not participate in Social Security, and
Exhibit 8:
8
WELLS FARGO SECURITIES, LLC MUNICIPAL SECURITIES RESEARCH there is no Pension Benefit Guarantee Corporation for financially insolvent governments. However, courts and negotiators also have to follow laws and practice governing capital markets as they did by recognizing the stronger position of Detroit’s voted GOULT debt. We favorably handicap the outcome of the Detroit water and sewer debt for similar reasons.
Analyzing Public Pensions April 23, 2014
Exhibit 9:
9
WELLS FARGO SECURITIES, LLC MUNICIPAL SECURITIES RESEARCH
Analyzing Public Pensions April 23, 2014
WELLS FARGO SECURITIES, LLC MUNICIPAL SECURITIES RESEARCH
Exhibit 10: A few selected plans that are maintaining funding discipline
10
Analyzing Public Pensions April 23, 2014
WELLS FARGO SECURITIES, LLC MUNICIPAL SECURITIES RESEARCH
Additional information is available on request. This report was prepared by Wells Fargo Securities, LLC. About Wells Fargo Securities, LLC Wells Fargo Securities, LLC is a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission and a member of the New York Stock Exchange, the Financial Industry Regulatory Authority and the Securities Investor Protection Corp. Wells Fargo Bank, N.A. and Wells Fargo Securities, LLC are each registered with the U.S. Securities and Exchange Commission and the Municipal Securities Rulemaking Board as municipal securities dealers. Important Information for Non-U.S. Recipients EEA The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors. For certain non-U.S. institutional reader (including readers in the EEA), this report is distributed by Wells Fargo Securities International Limited (“WFSIL”). For the purposes of Section 21 of the UK Financial Services and Markets Act 2000 (“the Act”), the content of this report has been approved by WFSIL a regulated person under the Act. WFSIL does not deal with retail clients as defined in the Markets in Financial Instruments Directive 2007. This research is not intended for, and should not be relied upon, by retail clients. The FCA rules made under the Financial Services and Markets Act 2000 for the protection of retail clients will therefore not apply, nor will the Financial Services Compensation Scheme be available. Australia Wells Fargo Securities, LLC is exempt from the requirements to hold an Australian financial services license in respect of the financial services it provides to wholesale clients in Australia. Wells Fargo Securities, LLC is regulated under U.S. laws which differ from Australian laws. Any offer or documentation provided to Australian recipients by Wells Fargo Securities, LLC in the course of providing the financial services will be prepared in accordance with the laws of the United States and not Australian laws. Hong Kong This report is issued and distributed in Hong Kong by Wells Fargo Securities Asia Limited (“WFSAL”), a Hong Kong incorporated investment firm licensed and regulated by the Securities and Futures Commission to carry on types 1, 4, 6 and 9 regulated activities (as defined in the Securities and Futures Ordinance, “the SFO”). This report is not intended for, and should not be relied on by, any person other than professional investors (as defined in the SFO). Any securities and related financial instruments described herein are not intended for sale, nor will be sold, to any person other than professional investors (as defined in the SFO). Japan This report is distributed in Japan by Wells Fargo Securities (Japan) Co., Ltd, a Japanese financial instruments firm registered with the Kanto Local Finance Bureau, a subordinate regulatory body of the Ministry of Finance in Japan, to conduct broking and dealing of type 1 and type 2 financial instruments and agency or intermediary service for entry into investment advisory or discretionary investment contracts. This report is intended for distribution only to professional customers (Tokutei Toushika) and is not intended for, and should not be relied upon by, ordinary customers (Ippan Toushika). Important Disclosures Relating to Conflicts of Interest and Potential Conflicts of Interest Wells Fargo Bank, N.A., Wells Fargo Securities, LLC and certain of their affiliates are registered municipal securities dealers and may trade the securities named herein on a principal or agency basis, may act as underwriter for one or more of the issuers or securities named herein and may receive compensation for such services or other investment banking services provided to one or more of the issuers named herein. Wells Fargo Securities, LLC Municipal Research analysts interact with the firm’s trading and sales personnel in the ordinary course of business. Wells Fargo Securities, LLC does not compensate its research analysts based on specific investment banking transactions. Wells Fargo Securities, LLC research analysts receive compensation that is based on and affected by the overall profitability of their respective department and the firm, which includes, but is not limited to, investment banking revenue. Analyst’s Certification The research analyst(s) principally responsible for the report certifies to the following: all views expressed in this research report accurately reflect the analysts’ personal views about any and all of the subject securities or issuers discussed; and no part of the research analysts’ compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst(s) in this research report. This report, IDs, and passwords are available at www.wellsfargoresearch.com Securities discussed herein may be rated below investment grade and should therefore only be considered for inclusion in accounts qualified for speculative investment. This report is for your information only and is not an offer to sell, or a solicitation of an offer to buy, the securities or instruments named or described in this report. Interested parties are advised to contact the entity with which they deal, or the entity that provided this report to them, if they desire further information. The information in this report has been obtained or derived from sources believed by Wells Fargo Securities, LLC, to be reliable, but Wells Fargo Securities, LLC does not represent that this information is accurate or complete. Any opinions or estimates contained in this report represent the judgment of Wells Fargo Securities, LLC, at this time, and are subject to change without notice. For the purposes of the U.K. Financial Conduct Authority's rules, this report constitutes impartial investment research. Each of Wells Fargo Securities, LLC, and Wells Fargo Securities International Limited is a separate legal entity and distinct from affiliated banks. Copyright © 2014 Wells Fargo Securities, LLC. SECURITIES: NOT FDIC-INSURED * NOT BANK-GUARANTEED * MAY LOSE VALUE
11
WELLS FARGO SECURITIES, LLC MUNICIPAL SECURITIES RESEARCH
Analyzing Public Pensions April 23, 2014
Global Head of Research, Economics & Strategy Diane Schumaker-Krieg, Managing Director, Global Head of Research, Economics & Strategy
diane.schumaker@wellsfargo.com
(704) 410-1801 (212) 214-5070
Municipal Securities Research Natalie Cohen, Managing Director
Head of Municipal Research
natalie.cohen@wellsfargo.com
(212) 214-8014
George Huang, Director
Healthcare
george.huang@wellsfargo.com
(212) 214-5061
Randall Gerardes, Vice President
Infrastructure
randall.gerardes@wellsfargo.com
(212) 214-5026
Roy Eappen, Associate
General Municipal Analyst
roy.eappen@wellsfargo.com
(212) 214-8045
Available on Bloomberg at WFRE and MarkitHub Available at www.wellsfargoresearch.com. You can request a Web site ID and password directly on this site. To have future reports emailed to you directly or to request access to WFRE via Bloomberg, send a request to wellsfargo.research@wellsfargo.com