CHICAGO — Richard Ennis says officials at public defined benefit plans need to own up to their pension obligations and stop shifting investment risk to future taxpayers.
And some of those officials aren’t happy about it.
A draft paper on “Moral Hazard in Public Pensions” that Mr. Ennis sent to clients and posted on his firm’s website was yanked for retooling following strenuous objections from some public fund officials. Mr. Ennis, chairman of consultant Ennis Knupp and Associates, Chicago, and editor of the Financial Analysts Journal, says the paper will be posted again soon, but some of its wording will be toned down. He wouldn’t identify the pension fund officials who objected.
In the original paper, Mr. Ennis criticized a number of sacred cows — particularly, he argued that public plan liabilities should be valued using an accumulated benefit obligation standard, already employed by corporate plans. Other experts, including Thomas J. Healey, a retired partner at Goldman, Sachs & Co., New York, and now a senior fellow at Harvard University’s Kennedy School of Government, Cambridge, Mass., also have argued in favor of a shift to the corporate standard.
Using the ABO standard, large public plans were roughly 75% funded as of June 30, 2005, considerably lower than the 86.6% funding level cited by the National Association of State Retirement Administrators, Georgetown, Texas, in its most recent survey, according to Mr. Ennis’ estimates. Using an ABO standard meant the 101 state plans surveyed by NASRA had a $1 trillion unfunded liability in 2005, a $540 million jump.
That finding led some public and union pension fund officials to see red, Mr. Ennis said in an interview.
They disagree
“We fundamentally disagree (on the paper’s findings), particularly with how you value the liabilities of the pension plan,” said Jim Mosman, executive director of the National Council on Teacher Retirement, Sacramento, Calif. Mr. Mosman said he had shared his views with Mr. Ennis before the paper was pulled from the website.
Mr. Ennis said, “We could see places where the tone wasn’t as respectful as it could have been.” He said some public fund officials viewed the paper as being “anti-DB,” which he says it isn’t. Mr. Ennis said the paper will undergo “a little wordsmithing,” but he doesn’t expect the paper’s conclusions to be changed.
Mr. Ennis said his intent was to focus attention on how to save the public defined benefit system, not to wreck it. Ennis Knupp has numerous public defined benefit clients, including the $77.6 billion Ohio Public Employees Retirement System, Columbus, and the $124.5 billion Florida State Board of Administration, Tallahassee.
In the paper, Mr. Ennis says public defined benefit plans do an admirable job: They provide benefit security to participants; they’re cost-effective; and their overall investment performance has been good.
“The greatest threat to public pension plans is moral hazard,” he wrote. That is, current policy-makers make decisions that affect future taxpayers, whose absence is notable from debates.
One major problem is that public-fund actuaries use return assumptions as discount rates in valuing plan liabilities. The higher the risk taken, the greater the return assumption and thus the lower the contribution, Mr. Ennis explained. “To financial people, allowing a plan sponsor to contribute less because an agent elects to take risk with trust investments is wacky, pure and simple,” he wrote.
He argued that reserve requirements should increase as investment risk is hiked, as they are for insurance companies and for pension funds in the Netherlands and elsewhere.
Mr. Ennis also said that adoption of an ABO standard — which imposes tougher discount-rate assumptions — would provide a truer measurer of a plan’s funding status.
Data adjustments
Mr. Ennis made three adjustments to the 2005 NASRA data. First, he eliminated the effect of future pay increases in calculating benefits, which improved the funding ratio.
Next, he valued liabilities using a 5.5% discount rate, based on the 5% or less that 30-year U.S. Treasury bonds yielded in 2005, which sharply reduced the funding ratio. Next he used the market value of assets, eliminating actuarial smoothing, which slightly improved the ratio.
The net effect was to reduce the average funding ratio by more than 11 percentage points.
Actuaries specializing in public fund analysis said Mr. Ennis’ approach was flawed because governmental plans rarely are terminated, and thus there is far less risk than in corporate plans that participants won’t receive their benefits.
“I can’t think of a good justification for using 5.5%. I think that’s ridiculous,” said Rick Roeder, senior consultant at Gabriel, Roeder, Smith & Co., San Diego. “An ABO standard is much more appropriate for the private sector than for the public sector because private sector companies go out of business all the time.”
The tougher ABO standard also is necessary for companies to lessen risk to the Pension Benefit Guaranty Corp., which backs up private defined benefit plans, said Stephen McElhaney, principal with Mercer Human Resource Consulting, Richmond, Va. Public defined benefit plans are not guaranteed by the PBGC.
Mr. McElhaney also said Mr. Ennis’ notion that public pension funds should put aside greater reserves when they take more investment risk is wrong. Comparing public funds to insurance companies is flawed because insurers can go bankrupt, leaving policyholders high and dry.
Mr. Ennis also took aim at efforts to “do good” through socially oriented investment policies generated by political pressures. In the interview, he said trustees must say “no” to these investments. “We need more backbone in the investment decision-making process,” he said.
“This is something the trustees owe everybody: Stop being a pushover for social investments, economic developments, emerging manager programs,” he said. Mr. Ennis said he has nothing against emerging managers, but in some cases it’s “just a naked attempt” to reward “firms that are very supportive of politicians. These are the nasty secrets.”
Exploiting opportunities
Richard Ferlauto, director, pension and benefit policy, for the American Federation of State, County and Municipal Employees, Washington, said economically targeted investments offer opportunities to invest in unexploited markets. “That’s why hedge funds were developed: to exploit opportunities that otherwise weren’t developed,” he said, drawing an analogy.
Among other recommendations Mr. Ennis made in his paper:
•Plan participants should share in the risk. For example, inflation adjustments of benefits could be tied to the funding level of the plan.
•State legislatures should impose funding disciplines so they don’t boost benefits without adequate funding. He cited Maine’s constitutional requirement that the state must immediately fund any new past-service liabilities and increase the normal cost to cover future benefit accruals.
•State legislatures should create commissions to protect the interests of future taxpayers. However, Mr. Ennis acknowledged it’s not clear whether legislatures will listen to the commissions they create, and whether the agencies would be funded adequately.
