Center for Business and Public Policy
at the University of Illinois, Urbana-Champaign

My good friend Douglas Elliott, who is now a Fellow at the Brookings Institution, just issued a new paper “The Financial Crisis’ Effects on the Alternatives for Public Pensions.”  The paper is yet one more in a growing chorus of voices pointing out the significant fiscal woes facing our state and local pensions in the U.S.  And, as I have pointed out before, Illinois is the poster-child for everything that is wrong with the funding status of our public pensions.  

After reviewing the net losses on pension assets, Doug makes the following simple but astute observation:

“The situation is even worse than those figures show on the surface, because pension funds are essentially walking on a treadmill. They need to earn an expected return each year in order to stay standing in place, since the value in today’s dollars of the pensions they have promised to pay goes up each year as those payouts come closer in time. The situation is analogous to inflation. The public pension funds may have lost 15% over two years on a “nominal” basis, but, if their target return was 8% a year , they lost 31% compared to their targeted level of investment value, excluding the effects of contributions and pension payments.”

I have previously noted in this blog that the Government Accounting Standards Board (GASB) allows public pensions to discount future liabilities using the expected return on plan assets.  This approach has no basis whatsoever in financial market theory – indeed, I have yet to meet anyone with a PhD in economics or finance who believes such an approach is correct or sensible.  Actuaries and plan administrators often defend it, but when you dig below the surface, their defense is often rooted in the political or P.R. ramifications of reporting the true nature of the liabilities, rather than in any good economic reasoning.

Let’s bring this home to Illinois.  Specifically, let’s bring this home to the State Universities Retirement System, or SURS.

According to the SURS Investment Update (see page 3 here), the average annual return on the SURS Total Fund over the 10 years ending February 2010 was dismal 3.4%.  But SURS, in accordance with GASB, uses an expected return on assets that is more than double this amount.  Even worse, SURS credits participants in the old Money Purchase option with an investment return that is far greater than this.  Doing so amounts to an implicit transfer from Illinois taxpayers to Illinois pensioners that is above-and-beyond the standard pension formula. 

As we discuss pension reform in Illinois and other states, here are three related points that are worth considering:

1. We should start with truth in accounting.  Stop hiding behind high discount rates and let’s at least define the size of the problem honestly.  A starting point would be disclosing the size of the public pension liabilities discounted using something more akin to a risk-free rate.  (See here for discussion).
2. Let’s stop pretending that we can achieve higher returns without taking on higher risk.
3. Let’s stop making irrevocable transfers from taxpayers to pension participants on the basis of “average” or “expected” returns.  In SURS, that means bringing the Effective Rate of Interest way, way down from historical levels.   

In at least one previous post, as well as in other research papers and articles, I have discussed the enormous problems facing the Pension Benefit Guarantee Corporation (PBGC), the government corporation that insures private defined benefit pension plans.  This week, a very talented MBA student at Illinois – Gagan Bhatia – reminded me of a terrific idea that would go a very long way toward providing plan sponsors with economically appropriate incentives for funding their plans.  Right now, plan sponsors lack appropriate and sufficient incentives to fully fund their plan or to choose a portfolio that immunizes the plan funding from market risk.  Sure, the government imposes funding requirements, but they have proven woefully inadequate.

In fairness, while Gagan Bhatia came up with this idea on his own and independently, it is an idea that has been out there, including in some work by Doug Elliot of the Center on Federal Financial Institutions.  Regardless of who gets credit, I think it is a terrific idea.

In a nutshell, the idea is to increase the seniority of pension claims in the event of a bankruptcy.  When a company files for Chapter 11 bankruptcy, the company’s creditors and claimants fall into different pools as per their priority over the company’s assets. PBGC’s obligations fall into the Unsecured Creditors pool which are paid after the Secured Creditors.   

Under this proposal, the PBGC would be moved up the line and be considered a senior, secured claim.  In essence, it would allow the PBGC to get paid first (or at least earlier than under current law) from any assets that the plan sponsor has remaining.

Why does this help?  Currently, creditors have insufficient incentive to consider the funding status of a firm’s pension plan when the firm is issuing debt.  If creditors knew that the PBGC’s claim on the firm’s assets was senior to that of the creditors, then creditors and potential creditors would become powerful enforcers of economically appropriate funding behavior.  Plan sponsors that failed to adequately fund their pension or plan sponsors who failed to engage in asset-liability matching would be considered – appropriately – to be a higher credit risk.  Thus, the firm would have to pay more to borrow.  Firms that funded their pensions and invested them in a manner that mitigated future funding risk would benefit from lower borrowing rates. 

In essence, this approach would harness market forces to achieve a worthwhile public policy goal.  Along the way, both pensioners and taxpayers would benefit. 

Last Friday, the Pension Benefit Guaranty Corporation (PBGC) announced that its deficit had doubled over the past year.  The PBGC is the government agency that insures defined benefit (DB) pension plans in the U.S.  While this doubling of the deficit was widely reported in the press, the only thing surprising about this announcement was that anyone was surprised by it.

Since the PBGC was created through the passage of ERISA in 1974, the basic design of the program has been fundamentally flawed.  As I have discussed in several papers, the PBGC fails to price this insurance properly, fails to provide adequate incentives for funding, and fails to provide adequate information to market participants.  As a result, DB plan sponsors have the incentive – and the legal right – to fund their pensions in a manner that imposes large future obligations on U.S. taxpayers.  (And as for the PBGC experts out there who will quickly point out that the PBGC is not funded by taxpayer dollars, I ask you only one question – given our experience of the past 15 months in which the U.S. government has not only bailed out government sponsored enterprises such as Fannie and Freddie, but also private sector companies such as G.M., do you really think Congress will let millions of pensioners lose their benefits when the PBGC runs out of money?)

Given that the program’s finances have been underwater for years, and given that numerous academics, think-tanks, and government policy experts such as the GAO and the CBO have all pointed out that the PBGC is on an unsustainable course, the latest numbers simply confirm what we already intuitively know – the PBGC’s finances are deteriorating rapidly.

Here are the facts as of September 30, 2009:

-         The PBGC had only $68.7 billion in assets to cover an estimated $89.8 billion in liabilities.

-         The PBGC “acquired” responsibility for an additional 144 plans during the year.

-         27 large plans – with liabilities of over $1.6 billion are now listed as “probably losses” on the PBGC’s balance sheet

-         The PBGC notes that “potential exposure to future pension losses from financially weak companies” is approximately $168 billion.

I do, of course, realize that it is difficult to get people exercised about this issue.  Even $168 billion, let alone $22 billion, no longer seems like a big number coming in a year after trillions have been spent on stimulus plans and TARP-like programs.  Nor does it seem large relative to the tens of trillions in unfunded liabilities facing Social Security or Medicare.  But $168 billion is still real money – even in Washington. 

What needs to change?  One useful first step would be to give the PBGC the authority to charge market-based premiums for the insurance it provides.  It is true that this might hasten the decline of DB plans in some sectors.  But I would submit that if making firms pay the true cost of their pensions means that they no longer find it attractive to offer them, then perhaps the efficient outcome is for them to end the plans before they dig the fiscal hole any deeper.

The past year has not been good for 401(k)s and other retirement plans.  Among many implications of the financial crisis and deep recession, we have seen the dramatic, correlated losses across nearly every major asset class underscore the fragility of a 401(k) system that is focused predominantly on wealth accumulation rather than secure retirement income.  In essence, the 401(k) system was exposed for what it truly is – a promising supplemental savings plan, but an inadequate vehicle for ensuring a secure retirement.  

I’m not alone in this view.  I spend much of my time interacting with people who specialize in thinking about retirement income security – academic researchers, policymakers on both sides of the political aisle, insurance companies, financial advisors, consultants and consumers.  Over the past 12 months I have noticed a striking degree of commonality in their thinking around the fact that we need a better retirement system in the U.S.  This is not to say there are not still important areas of disagreement - for example, I find proposals to increase Social Security benefits, to return to a defined benefit system, and/or to have the government guarantee retirement income to be a combination of naive, reckless and fiscally irresponsible.  But when it comes to the future of private sector retirement plans, I believe there are a number of common themes emerging that make very good sense.

Yesterday, I had the opportunity to speak at the annual conference of the American Council of Life Insurers (www.acli.com) about my proposal for encouraging plan sponsors to use guaranteed lifetime income products as the default distribution option.  Before my session, I had the privilege of hearing Dr. Roger Ferguson, President and CEO of TIAA-CREF – one of the largest providers of retirement income in the world – speak on this issue.  (In the interest of full disclosure, I should note that I am a trustee of TIAA). 

Dr. Ferguson outlined 5 areas that need improvement in our system.  (I should note that I am paraphrasing here and including some of my own thoughts – so please do not interpret this as an exact representation of his remarks!)

1. We need to return to a focus on providing guaranteed income.  During the shift from Defined Benefit (DB) pension plans to Defined Contribution (DC) pension plans like the 401(k) and 403(b), we somehow lost sight of the fact that the point of saving for retirement is to provide income security.  We need to get the focus back on annuitized, lifetime income.  This does not mean a return to the old style DB systems.  It does mean looking for innovative ways to convert 401(k) and 403(b) wealth into income before, during, and after retirement.
2. We need to broaden coverage.  Millions of households do not have access to any employer sponsored retirement plan.  Somehow, someway, we need to fix this.  While it is true that individuals can save on their own, the evidence is overwhelming that “employers matter” in promoting saving.  Social Security alone is sufficient to replace adequate income for only a minority of households.  Indeed, given the poor fiscal trajectory of the program, the rising normal retirement age that will reduce benefits for those who claim at earlier ages, and rising Medicare premiums, its adequacy will only diminish further.    
3. We need to ensure that individuals are broadly diversified.  I, personally, would love to see us put together individualized retirement plans that include a life cycle portfolio trajectory that gradually converts into annuitized income the closer one gets to retirement.  The investment options need to include not just stocks and bonds, but also real estate and other asset classes.  
4. We need to ensure that individuals have access to good information and advice.  Our current regulatory structure – designed to protect consumers from tainted advice by those who might have a conflict of interest – has had the unfortunate effect of making plan sponsors go through a torturous and administratively complex route to provide good advice to participants.  We need to find sensible ways to streamline this process. 
5. We need to provide vehicles for individuals to be able to save for retiree health care expenses.  Health Savings Accounts and other similar tools have a useful role to play here.

To get there from here, we do need some regulatory and policy changes.  I suspect that we may see this discussion rise closer to the top of the agenda after health care reform is behind us …

Given the hundreds of billions of taxpayer dollars that have been handed out to financial services companies, automakers and other companies over the past year, it should not come as a surprise that corporate sponsors of Defined Benefit (DB) pension plans are also coming to Washington looking for a handout.  Admittedly, this issue has not been at the top of the news lately, but given the increasing number of calls I am receiving from policymakers in our nation’s capitol on the issue, it is pretty clear that this issue is on the political horizon.  

The basic story goes as follows: Despite the decline of DB pensions in the U.S. over the past several decades, millions of employees are still covered by these plans.  DB pension plans are essentially promises to workers that they will receive a monthly check for life after retirement, and this promise is supposed to be “made good on” even if the firm that sponsors the plan disappears in the interim.  The way Congress decided to ensure this back in 1974 was to require that companies sponsoring DB plans fund them (that is, set aside assets in a trust fund that would be dedicated to paying future benefits), and then provide participants with a government guarantee (through the PBGC) that their benefits will be paid even if the employer goes bankrupt with an underfunded plan.

For a variety of reasons that I won’t go into here (I’ll leave that for future posts about pension accounting rules and the flaws of the PBGC – the agency that insures the benefits), most DB plan sponsors invest their pension trusts heavily in stocks.  Thus, when the stock market declined precipitously over the past year, many plans sponsors found themselves facing substantial funding shortfalls. This increases their required contributions at precisely the moment when the economy is sagging.  Earlier this year, Watson Wyatt released a study showing that in 2009, plan sponsors would be required to contribute over $100 billion to their plans, up from just $38 billion in 2008, so the numbers involved are quite large.

Thus, the call for “relief.”  Essentially, plan sponsors are asking Congress to allow them to take a pass on meeting their funding obligations (and basically kicking the can down the road to another year).  Doing so, they say, will free up much needed cash to meet other obligations.  The two other uses for the cash most frequently mentioned are to avoid layoffs and to promote investment.  It is therefore argued that funding relief will be an effective economic stimulus.  (Isn’t it interesting how everything looks like a nail when you are holding a hammer?)

On the first question, I am unaware of any empirical evidence showing a link between mandatory pension contributions and employment.  On the second point, there is a very nice paper by my friend Josh Rauh (now at Northwestern University) showing that when firms are required to make contributions to their pension funds, they reduce investment (as measured by capital expenditures).

Despite these rationale, I remain highly skeptical of the wisdom of funding relief.  My skepticism arises for 4 primary reasons.

1. While I accept the notion that freeing up internal cash may be useful during a period in which external financial markets are frozen, it is not at all clear that funding relief is a useful way to go about it. First, there is no guarantee that Rauh’s results will hold up in a period in which “cash is king.”  Instead, firms may just sit on the cash to provide a safety cushion.  Second, DB plan sponsors strike me as precisely the *wrong* set of firms to target for relief.  Why?  Because they almost surely have lower growth opportunities than other sectors (keep in mind these plans are concentrated in “old economy” firms).  And because these are precisely the firms where assets are most tangible (and thus less susceptible to the information problems that are often used to explain the advantage of internal over external financing).  If we think firms are being prevented from taking on good investments due to problems in the credit market, I’d much rather see us take steps to provide access to credit directly, rather than directing towards an arbitrary subset of firms.
2. Even if the firms that are granted funding relief use it to increase investment, this will not necessarily increase the aggregate level of investment.  Why?  Because the money used to fund pensions is not thrown in the ocean.  Rather, it is redistributed by financial markets to those projects with the highest present value.  It is quite possible that funding relief will do little more than redirect funds away from the highest value projects in the overall economy and towards the highest value projects within a small subset of firms.  In short, I am not sure there will really be any stimulus to this stimulus.  
3. This will further increase the risk to taxpayers.  If an underfunded plan sponsor goes bankrupt with an underfunded plan, the benefits are guaranteed by the PBGC.  But guess what?  The PBGC is already underfunded by at least $11 billion (and possibly much higher) and is expected to grow substantially in the coming decade.  At some point, taxpayer money will be needed to fill this gap.
4. Most importantly, this simply treats the symptom, and not the cause, of the funding problems.  What we really need is a major overhaul of the funding rules – more on this in a future post.