Solutions for Detroit and public pension funds

The city of Detroit filed for bankruptcy protection on July 18 due to $18 billion in debt, of which $10 billion was pension and other post-employment benefits.

Overall, public pension funds have a shortfall of more than $3 trillion if they mark to market. If TARP I was a national emergency at $800 billion, what do you call this financial situation?

I recommend four solutions to the Detroit and public pension/budget crisis:

1. Cut the budget Just a 1% cut per year can be meaningful, especially if there is growth in revenues. Hiring freezes and attrition could be a less painful approach to budget cuts.

2. A pension lottery Lotteries are big business throughout the world. There are 43 U.S. states and Washington, D.C., with games. Since the first lottery in New Hampshire in 1964, government programs have raised more than $320 billion, with $19 billion just in 2012. Most are dedicated to education. A pension lottery would be prudent without taxing any citizen.

3. Sell and/or lease valuable assets (buildings, land, libraries, roads, schools, tunnels, etc.) Most cities and states have valuable and underutilized assets that could be sold or leased.

4. Fix the pension deficit Pensions tend to be the largest debt item of any city or state. Fixing the pension deficit is the key to solving the budget crisis , and it is the focus of this research paper.

The Pension Problems

The reason this pension dilemma is a crisis is that it becomes a budget crisis for most cities and states. Most cities and states were not prepared for the budget cost escalations that came from spiking pension contribution costs, resulting in deep budget deficits, which led to increased taxes and reduced services. Although increased pension benefits have seriously affected contribution costs, they are not the intrinsic cause of the pension crisis.

The true cause of the public pension and budget crisis is the improper GASB accounting rules.

These inappropriate accounting rules misled pension systems through inappropriate valuations of both pension assets and liabilities. This caused the funded ratios (present value of assets/liabilities) to be greatly exaggerated, which led to inappropriate asset allocation, benefit and contribution decisions ... they all link!

When I testified before the ERISA Committee in 2003, I brought in a five-foot pencil I introduced as “Woody,” the weapon of mass destruction in financial America. Indeed, if you thought Enron and WorldCom had magic accounting pencils that led to their debacle, wait till to see what the pension pencil “Woody” can do.

Instead of marking to market, GASB (“Woody”) allows public pension plans to smooth assets over a moving five-year average.

Imagine the stock that went from $100 to $80 to $60 to $40 to $20 to zero over five years (sounds like GM from 2003 thru 2008). On average, it is a $40 stock; that seriously overvalues this asset. Of course, it could go the other way as it did in the late 1990s. The point here is that a five-year average price or valuation is not a reflection of reality and might mislead you into the wrong decision(s) affecting your assets.

GASB accounting allows for pension liabilities to be valued at a discount rate equal to the return on asset assumption. Based on the study by the Center for State and Local Government Excellence, the average ROA used by public pensions is 8%. Such an ROA tends to be a static and robust projection. This annual growth rate is in sharp contrast to the history of liability growth rates, which are quite volatile with high positive and high negative rates.

Based on the generic Ryan Liability index benchmark (equal weighting of the Ryan STRIPS yield curve), we see how volatile the liability growth rates (returns) of a typical pension should have been using the Treasury STRIPS yield curve as the discount rates.

Here is our estimate of the economic growth rates of pension assets and liabilities for the 13 years ended Dec. 31, 2012.

Based on market valuations shown above, pension assets would have grown by 55.2% and pension liabilities would have grown by 249.51% cumulative from Dec. 31, 1999, through Dec. 31, 2012.

As a result, pension liabilities should have outgrown pension assets by 194.3% over the last 13 years. This would have caused funded ratios to deteriorate by 55.59% requiring a funded ratio of 225.19% in 1999 to be fully funded today!

Moreover, given a deficit, the assets have to grow faster to catch up to liabilities.

A funded ratio of 50% suggests assets have to grow twice as fast as liabilities to catch up, a 75% ratio requires 33% more asset growth, etc.

Given that interest rates are quite volatile, the GASB accounting rules ignore reality and the true economic valuation of liabilities. Indeed, such accounting rules were established to avoid volatility in contribution costs by smoothing assets and keeping liability growth a constant. In the end, these GASB accounting rules created volatile contribution costs, added benefit costs and produced inappropriate asset allocation by misleading pension fund executives as to the proper return objective (ROA instead of economic liability growth) and proper valuation of their funded ratios (smoothing overvalued assets + ROA undervalued liabilities).

The worst consequences of the GASB rules are their impact on asset allocation, benefit and contribution decisions ... it all links to the ROA!

Because GASB made the ROA the liability growth rate, the ROA became the target growth rate for assets. Notably, pension funds are told that when assets don't grow at the ROA level they create an actuarial and GASB accounting deficit that is funded through extra contributions.

This is not correct thinking since GASB grows assets and liabilities at the same ROA growth rate. If there is a deficit, then even if the assets grow at the ROA rate, the deficit and contribution costs go up!

Mathematically, the ROA on a higher value (liabilities) will outgrow in dollars the same ROA on a lower value (assets). Table 2 shows that if assets and liabilities both grow at 8% with a 60% funded ratio, there will be a 46.93% increase in the deficit after just five years, which will increase contributions. With any deficit, assets must outgrow liabilities for the dollar deficit and contributions to stay the same. Table 2 shows that asset growth must exceed liability growth by 5.33% per year just to stay at the same dollar deficit level. If there is a surplus, assets can grow less than the ROA and still have no contribution costs (a pension holiday)! With a 40% surplus, Table 2 shows that for assets to have the same dollar growth as liabilities, they can grow about 2% less per year (@ 5.71% to 6.18%).

With a deficit, assets have to outgrow liabilities to reduce contribution costs and reach full funding. With a surplus position, assets don't need to grow at the ROA.

If assets just match liability growth in economic dollars (market value growth) they will secure the surplus. At 100% funded, liabilities yielding 4% require 4% asset growth to match liabilities not the ROA of 8%. In truth, assets and liabilities never grow at the ROA so the ROA is a bad forecast that leads to a lot of bad decisions ... it all links! The ROA problems start with asset allocation.

The ROA needs to be validated by an asset allocation model. Usually, the pension consultant is required to come up with an asset allocation that has the highest probability of achieving the ROA. Asset allocation models use an optimization technique based on the average returns from long historical index data bases (@ 20 years) for every asset class but one ... bonds! Bonds go into the asset allocation models at their current yields. In the 1990s most pension funds enjoyed surpluses wherein they reduced, if not eliminated, contribution costs. Benefit increases also were a beneficiary of these surplus times. One would think the prudent pension investor would have altered their asset allocation to more and more bonds matched to liabilities (i.e., an immunization strategy) to secure this victory and lock in reduced contributions for the future (i.e., a pension holiday).

But asset allocation models are based on achieving the ROA and never consider the funded ratio — a fatal flaw. When bond interest rates went below the ROA (8%) back in the late 1980s, bonds became a drag on achieving the ROA so asset allocation models reduced the allocations to bonds. This continued as a consistent trend such that by 1999 most asset allocation models had the lowest allocation to bonds in modern history and the highest allocation to equities ... the $3 trillion mistake! When the equity correction arrived in 2000 through 2002, public pension funds were hard hit because of their asset allocation skew to equities. Most pension assets underperformed liability growth by more than 70% in those three years.

Pension boards of trustees were given reports that communicated their funded ratio based on GASB accounting and actuarial valuations, but not economic reality. Such accounting overvalued assets in the early 2000s by more than 20% due to smoothing, and undervalued liabilities by 30% to 50 % during most of the past 13 years.

This caused a severe exaggeration of the funded ratio such that pension funds increased benefits and reduced contributions at a time they could not afford either.

The Pension Protection Act is a good model here that requires private pension funds to have a high funded ratio based on market values before they can increase benefits. I recommend that public pensions adopt the PPA guidelines based on economic valuations and not GASB or actuarial valuations such that there can be no benefit increases if the funded ratio falls below 90% based on market values. I also recommend that these are an annual benefit bonus rather than a permanent benefit increase due to the volatility of the funded ratios.

Most pension fund executives have been brainwashed into thinking the ROA is their focus and target. Had pension funds matched asset to liabilities using high-quality zero-coupon bonds in the surplus years of the 1990s, they would have secured a fully funded position for the future, thereby reducing or even eliminating contribution costs.

The focus of pension funds should be their funded ratio and not the ROA. A surplus funded ratio should have a radically more conservative asset allocation than a deficit position to secure the surplus and reduce contribution costs long term. But in the 1990s and 2000s the opposite took place because of a secular trend toward lower interest rates that skewed asset allocation increasingly away from bonds (which yielded less than ROA) into more risky securities trying to validate the ROA ... the $3 trillion asset allocation mistake!

Pension Solutions

1. Tell the financial truth (economic books) Until a custom liability index is installed as the proper benchmark, all asset allocation, asset management, benefit and contribution decisions will be made based upon erroneous and misleading calculations trying to achieve the ROA (wrong objective).

Imagine a doctor who gets the wrong blood work and X-rays; I wouldn't want that surgery. Imagine the pension consultant (i.e. pension doctor) getting the wrong valuation of assets and liabilities; I wouldn't want that asset allocation.

The proper benchmark for pension assets must be a custom liability index because no two pensions are alike due to different salaries, mortality and plan amendments. The CLI will allow pension funds to know the market value of liabilities such that the true economic funded ratio will now be known frequently and accurately so all decisions are well informed with accurate economic valuations. The pension actuaries have a most difficult job to calculate future benefits. As a result, actuarial reports come out annually several months delinquent. Moreover, these reports tend to use actuarial valuation of liabilities and not economic or market values. As a result, public plan sponsors have infrequent and erroneous valuations on which to base their asset allocation, benefit and contribution decisions. With a CLI, the boards of trustees and their consultants will now have monthly accurate valuations of liabilities including size, shape, growth rates and interest rate sensitivity tests based on market values and GASB valuations so they can see the great differences.

2. Replace the ROA with the CLI as the pension growth objective The pension growth rate objective should be positive relative growth vs. liability growth and not an absolute growth rate (ROA).

With the CLI in place just like a scoreboard in sports, the pension plan can now adjust its asset allocation whenever the score (funded ratio) indicates it's time to do so. The sports team way ahead will change its strategy and get conservative (and vice versa) ... all based on the relative score vs. their opponent. The same should be true for pensions. As the funded ratio improves, asset allocation should be responsive (i.e. tactical). A 90% funded ratio should have more bonds than a 70% funded ratio. What was missing all these years was a scoreboard (i.e. the CLI) measuring assets vs. liabilities continually and accurately.

3. Base asset allocation on funded ratio, not the ROA Asset allocation is the most important asset decision because it affects all assets. A funded ratio deficit should have a radically different asset allocation than a funded ratio surplus. Any surplus funded ratio should be immunized with a core portfolio of a liability index fund (i.e. liability beta portfolio) to match and fund liabilities at no risk (the proper way to derisk liabilities). A separate surplus portfolio should be created for the excess funds as a reserve against actuarial noise in their liability projections. A 70% economic funded ratio would require a more aggressive asset allocation to make up the deficit over time.

Fortunately, pension funds have time to cure deficits equal to the average life (duration) of their liabilities. This is best measured by the CLI. A 30% deficit with 10-year duration suggests assets have to outgrow liabilities by 4.29% per year (100/70 – 1 divided by 10 years) on average for 10 years to reach full funding. With 10-year Treasury STRIPS yielding around 2.72% now, that suggests that the assets need to grow around 6.99% annually to reach full funding in 10 years.

4. Interest rates go up as a secular trend If interest rates trend upward in the next five years, then the present value growth rate of liabilities will be less than their yield to maturity of 2.72%. In fact with 10-year duration, an average interest rate increase of only 60 basis points per year would cause liabilities to have a slightly negative cumulative growth over five years.

If assets could grow at just 6% per year, then in five years the plan would be fully funded. Please note that at no time would the assets achieve the ROA growth rate! Perhaps, the best way for public pension plans to enhance their funded ratios is through a trend of higher rates. It is most difficult for assets to outperform liability growth by enough to restore full funding. They will need help by liability growth being low to negative.

5. Separate liability beta from liability alpha assets For pension funds, beta is redefined as the portfolio that matches the liability objective risk/reward behavior (not a generic market index). As proven through defeasance, dedication and immunization, this is best executed with a portfolio of high-quality bonds matched to the cash flows of the liability benefit payment schedule. With a CLI in place, the liability beta portfolio is a liability index portfolio. Without a CLI, it would be hard or impossible to immunize the liabilities risk/reward behavior.

Performance measurement studies prove that active bond management using investment-grade bonds have little or no alpha vs. a bond market objective like the Barclays Capital Aggregate index. PIPER shows consistently that the median bond manager loses to the market index (especially after estimated fees of 25 basis points) over extended periods time (i.e. 10 years). This performance trend gives more credence why a liability beta portfolio should be installed as the core portfolio for liability objectives.

If any asset class consistently underperforms its market index benchmark, you index that asset class! The only question is, what index to use? The answer: The index that best represents the client (i.e. custom liability index). As a result, pension funds need to reconsider active bond management. Investment-grade bonds should be the core (liability beta) portfolio but not be actively managed against generic bond market indexes. Instead investment-grade bonds should be managed passively as the liability-matching portfolio. This rearrangement of investment-grade bonds to passive management from active will also save fees and eliminate tracking deviations vs. liabilities.

Alpha is also redefined as the excess return above the liability growth rate (return) measured by the CLI. For example, if an equity manager outperforms the S&P 500 but loses to liability growth, the pension plan loses (no alpha)! The allocation between the beta and alpha assets is based on the funded ratio. The lower the funded ratio, the more is allocated to the alpha assets (and vice versa). A 70% funded ratio with a 10-year duration CLI should require a high alpha allocation (i.e. 75%). If the alpha assets can outgrow liabilities by 4.29% per year, then a 75% allocation to the alpha assets reaches full funding in 10 years.

With liabilities yielding 2.72% (based on 10-year Treasury STRIPS), this suggests an alpha average growth rate of 6.99% is required. However, if interest rates go up, then for every 1% of reduced liability growth (every 10-basis-point increase in rates) then the alpha assets can work 1% less in growth. Note the allocation to the beta assets (bonds) is the reciprocal (25%) from this asset allocation process.

6. Measure total asset growth vs. total liability growth In the end, it's the funded ratio that counts. It decides on the deficit that is to be amortized, which is the base of the contribution calculation. The funded ratio also plays a role in the credit rating process, especially now under GASB 67/68. Traditionally, much time and expense is spent analyzing the performance of each asset portfolio vs. its market index benchmark. Seldom do total assets get measured against total liabilities or the progress of the funded ratio monitored.

Since asset allocation is the critical asset decision, it should be monitored and measured. The best way is to simply compare total asset growth vs. total liability growth (as measured by the CLI) to see if the funded ratio and funded status (surplus/deficit in dollars) are on track to being enhanced such that contribution costs will go down consistently. There should be no investment review meeting without liabilities and the funded ratio being reviewed. Months delinquent annual actuarial reports are the reason for the absence of liabilities at the investment meetings. The CLI cures this problem.

Both beta and alpha require a CLI to be managed and measured. Traditionally, performance measurement has been entirely focused on the risk/reward behavior of assets vs. generic market indexes. Pension plan sponsors need to know the risk/reward behavior of their assets vs. their liabilities (especially the alpha assets) and the resulting funded ratio. Unfortunately, liabilities are usually missing in action at every pension investment review meeting. With a CLI, asset allocation, asset management, performance measurement, benefit and contribution decisions are all now in harmony with the liability objective and focused on the funded ratio.

Given the wrong index objective, you will get the wrong risk/reward.

Ronald J. Ryan is CEO of Ryan ALM Inc., Palm Beach Gardens, Fla.