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Dallas fund mired by plan design, performance

Keith Brainard
NASRA’s Keith Brainard: At Dallas, ‘you’ve got this unique combination of unique DROP design combined with very poor investment returns. These two conditions have exacerbated one another.’

The clock is ticking on the Dallas Police & Fire Pension System's solvency where poor investment decisions and plan design have both exacerbated the problem

Segal Consulting, the pension system's actuary, projected in July that the $2.1 billion pension fund would become insolvent in 2030, absent any changes to benefits or contributions. A record $523 million in withdrawals from the pension fund's Deferred Retirement Option Plan since then moved the date closer to 2027.

The pension fund has proposed raising member and city contributions and reducing cost-of-living adjustments and DROP benefits. Those changes, which would have moved the insolvency date back to 2030, were rejected by active participants in a two-week election that ended Dec. 17. There's still a chance for the reforms to be passed by the state Legislature. The pension fund is revising its proposals with input from the city to present to the Legislature. Discussions are still being held, but Kelly Gottschalk, the pension fund's executive director, anticipates greater benefit reductions and contribution increases will be necessary to bring the pension fund to full funding in 30 years up from the roughly 36% funding ratio currently.

“Everything is on the table,” Ms. Gottschalk said. Texas' legislative session starts Jan. 10.

Uncertainty over what the Legislature will or will not approve puts the pension fund's asset allocation up in the air, Ms. Gottschalk said. Also unclear is how long the pension fund will be able to restrict lump-sum withdrawals from its Deferred Retirement Option Plan.

To protect its liquidity, the pension fund board voted Dec. 8 to temporarily suspend DROP withdrawals. It will decide Dec. 29 whether to lift the suspension on monthly withdrawals. A hearing Jan. 17 could decide whether lump-sum withdrawals may once again be permitted.

The pension fund is in the process of selling a significant portion of its private equity portfolio to provide liquidity and bring the portfolio more in line with its target allocation for the asset class,which was reduced to 5% in March from 15%, Ms. Gottschalk said. (She declined to provide the size of the sale.)

Risky real estate

A review of the pension fund's real estate portfolio is also ongoing.

For years, the pension fund poured money into high-risk and speculative real estate deals. A failure to obtain regular appraisals concealed the properties' true value and losses are estimated at $545 million. After the magnitude of the losses began to be realized in 2014, the pension fund's administrator, Richard Tettamant, resigned at the request of the pension fund board

For the fiscal year ended Dec. 31, 2015, the pension fund returned a net -12.6%, driven by realized private equity and real estate losses. For the three, five and 10 years ended June 30, the retirement system returned an annualized -0.7%, 1% and 2.7%, respectively. The pension fund lowered its assumed rate of return to 7.25% from 8.5% in July 2015.

Ms. Gottschalk said staff is working with real estate managers to determine whether certain holdings should be sold, developed or held.

Other assets the pension fund is looking to sell include natural resources and infrastructure, where the portfolios exceed the target allocations.

“We're not doing a fire sale or anything like that,” Ms. Gottschalk said. “The goal is to get to our targets, of course.”

The pension fund approved a new target asset allocation in March. The changes, aimed at improving the pension fund's liquidity and maximizing risk-adjusted returns, included increases to public equity and fixed income and decreases to real and illiquid assets.

Ms. Gottschalk acknowledged, however, that the entire pension fund portfolio probably will have to be re-evaluated after the fund's legal and legislative questions are answered. Deferred retirement option plans, introduced in the early 1980s and adopted by the Dallas pension fund in 1993, allow workers eligible for retirement to continue working and have their monthly pension payments deferred into a notional account where they can earn interest and be withdrawn in lump sums.

According to the Boston College's Center for Retirement Research, 16% of state retirement systems and 37% of local systems offer DROP.

DROP provisions vary by plan, but typically, participation is limited to three to five years and funds must be withdrawn upon retirement.

For the Dallas plan, however, there is no limit on the amount of time active workers and retirees can participate in DROP. The guaranteed interest rate, currently 6%, was once as high 10%. As a result of these features, Dallas' DROP assets accounted for more than 55% of total pension fund assets as Jan. 31., which is now closer to 49% with the recent withdrawals, Ms. Gottchalk said.

Bill Hallmark, Portland, Ore.-based vice president at the American Academy of Actuaries and consulting actuary at Cheiron, said the DROP plans he has seen make up a small part of total system assets and haven't driven liquidity issues.

Unusual case

Keith Brainard, Georgetown, Texas-based research director at the National Association of State Retirement Administrators said: “Normally, DROP assets do not account for such a large share of the asset base,” and participation periods are more defined. “Retirement fund managers would know or have an idea of when DROP payments would be due and could invest around that.”

A DROP plan with an unlimited participation period for active and retired workers is “very, very rare,” said Hank Kim, executive director at the National Council on Public Employee Retirement Systems in Washington.

Ms. Gottschalk believes pension fund officials were concerned about a run on DROP assets before she joined the plan in March 2015 and led to a decision to lower the DROP interest rate incrementally, rather than suddenly, in 2014, she said.

Ms. Gottschalk said the level of DROP withdrawals in 2016 surpasses previous years and that withdrawals spiked after an Aug. 11 board meeting where pension fund officials discussed reducing benefits to cut plan liabilities.

“Everyone was concerned we were going to close DROP or do something to it,” she said.

Ultimately, the pension fund proposed limiting the amount of time active workers and retirees can participate in DROP to 10 years and one year, respectively, and changing the interest rate calculations — 3% annually for seven years for active workers and up to 4% based on the payout option for retirees.

Only 45% of active members voted in favor of the pension fund's changes; 65% approval was required. Because too few active members supported the changes, the pension fund needs the state Legislature to approve all the proposed changes, in order for them to take effect.

Increased scrutiny

Originally promoted as cost-neutral, DROP costs started to receive increased scrutiny around 15 years ago, Mr. Hallmark said.

The dot-com bust of 2000-2001 focused more attention on the costs of public pension plans in general, and around this time, concerns over certain plans' provisions were raised.

Outcry over the unlimited DROP period and 8.5% to 9% interest rate for members of the $1.7 billion Milwaukee County Employees' Retirement System in 2002 resulted in the departure of several county officials.

While DROP plans have been controversial elsewhere, “no one is facing the degree of the problem that Dallas is facing,” Mr. Brainer said.

At Dallas, “you've got this unique combination of unique DROP design combined with very poor investment returns,” Mr. Brainard said. “These two conditions have exacerbated one another.”

The experience in Dallas “should not be an indictment on DROP plans per se but on how (that plan) was designed,” he added.

Ms. Gottschalk estimates about a third of the pension fund's problems stem from its investment decisions, while the remainder comes from generous benefits like DROP, an aging population, unrealistic return assumptions and other plan design issues. n

This article originally appeared in the December 26, 2016 print issue as, "Dallas fund mired by plan design, performance".