The California State Teachers' Retirement System might feel more secure in considering recent proposals to reduce its investment risk because it has started to collect a higher rate of contributions.
The CalSTRS proposals to take a less aggressive risk exposure recognize that investing cannot close its $73.7 billion funding gap without taking a higher level of risk than it can tolerate.
Its 7.5% annual rate of return assumption isn't high enough to cover its shortfall. Even if it met that expected rate of return each year, its own projections show its funds would run out of money by 2045.
For too often and too long, many public retirement plan sponsors have shortchanged their pension system of their annual actuarially required contributions, as well as a necessity of increasing contribution because of demographic changes.
Sometimes retirement plan trustees resist increases. The California Public Employees' Retirement System, facing rising longevity risk, sought to delay increases in contributions. But Gov Edmund G. Brown Jr. took a tough stance, calling on CalPERS to “fully phase in the increased” contributions, which would rise about 32%, he wrote in a letter last year to Rob Feckner, president, CalPERS board. CalPERS' resistence “would delay acknowledging the true cost of our pension system,” the governor wrote. CalPERS ultimately relented in its opposition.
Politicians in other states and municipalities short-changing their public employee funds of the required contributions should take notice of the California legislature's action to raise contributions and begin to fund the necessary annually required amounts.
Pension plans have only two sources of funds to finance retirement benefits. One is investments — dividends, interest payments and net market appreciation. They provide only on average about 65% of funding necessary to finance pension benefits.
The other source is contributions. To expect investments to make up much of the shortfall in contributions would require pension funds to take on risks that likely exceed their ability to tolerate, or easily recover from in the event of unexpected losses.
Plans sponsors looking for guidance ought to examine the City of Milwaukee Employes' Retirement System. It has one of the strongest pension systems, public or corporate, in the nation. And it has a history of being consistently, year after year, funded about 100%.
Because of its strong funded status, the Milwaukee common council's practice was to contribute to the plan only in those years the funding level dipped below 100%. But the council changed its practice in 2013, deciding to provide funding for the system every year, to make it a regular part of the city budget as part of a process to recognize pension contributions as part of the city's budgetary spending priorities.
The California legislature last year enacted a bill that seeks to close the funding gap and fully fund CalSTRS in 32 years by raising contribution rates of participants, member employers as well as the state itself.
The new funding would end the practice of many years of shortchanging the contributions that had resulted from the expectation that CalSTRS could make up a large part of it through higher investment return.
Other pension plans facing deep shortfalls in their funded levels have moved toward riskier asset allocations to close funding gaps caused in part because of shortchanging in their actuarially required contributions.
The Financial Stability Oversight Council, set up under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and assigned to identify and respond to emerging risks to the financial system, warned in its latest annual report about excessive risk taking by pension funds and other investors.
“The low-rate environment is also making it difficult for pension and retirement funds to meet their long-term liabilities, some of which are seeking to boost returns by extending the duration of their assets or by purchasing lower quality, higher-yielding assets,” according to the FSOC 2015 annual report. The FSOC proposed no action.
In the same way that investment returns cannot fully fund retirement benefits, plans sponsors cannot afford to fully fund pension payments through contributions alone without damaging other budgetary spending priorities.
Asset owners have to embrace risk to achieve their expected return objectives. But that means balancing return objectives against the amount of risk plan sponsors can tolerate.
Trustees must do more to pressure legislators to fully fund required contributions, or risk leaving a fund and retirement benefits more vulnerable to market collapses from assuming aggressive investment risk.
In New Jersey, trustees of the $79 billion New Jersey Pension Fund, Trenton, earlier in October lost a legal challenge to the withholding of pension contributions by Gov. Chris Christie.
Judge Mary Jacobson of the Superior Court in Trenton dismissed the lawsuit brought by the trustees of the New Jersey Public Employees' Retirement System, the Teachers' Pension and Annuity Fund and the Police and Firemen's Retirement System — which together account for about 97% of the total pension fund assets — accusing the governor of a breach of contract.
The trustees deserve credit for challenging the governor. But New Jersey's pension funding challenges date to administrations and legislatures before the current ones. Once in a deep hole, plan sponsors cannot easily shift budgetary priorities to begin immediately making up for a history of contribution funding shortfalls. But they need to put forth a plan for doing so. By under contributing, New Jersey is requiring future generations to pay for pension benefits long ago earned.
Fully funding a plan achieves generational equity. Plan sponsors kicking the can of contributions down the road leads to generational inequity, leaving it to future generations that haven't even been born to finance pensions of many participants who have already retired. Pension funds, to be sustainable, must achieve generational equity, which is another way of saying full funding.
Public plan sponsors, either now or in the future, will have to fund the contributions.
Doing it on an actuarial basis and making it an essential part of a budgeting process, and taking advantage of the power of compounding investment return, would reduce the size of future contributions. As Gov. Brown noted in his letter, a CalPERS delay in contributions would cost an estimated $3.7 billion more over 20 years. Making required contributions annually would lessen the chance of suddenly having to plow massive amounts into their funds, upsetting taxpayers and other budgetary spending priorities, and keeping them from having to sell investments in untimely situations in order to have the necessary liquidity to pay pension benefits. n