September 24, 2013
SOME ISSUES never lend themselves to permanent solutions. Government-run pension plan projections fall into that category.
I posted a pension column on July 31, which spurred historical recollections from former state Sen. Bobby Neall (August 7), state Treasurer Nancy Kopp (August 8) and former Ehrlich budget director Cecelia Januszkiewicz (August 8), followed by Del. Andy Serafini’s plea for a more cautious approach to estimating future rates of return, and state pension director Dean Kenderdine’s explanation of why the state pension trustees opted for a gradually reduced rate, but not by as much as some urged.
Now Serafini delivers another essay that lays out more reasons why the state should further lower expectations of investment returns in the years ahead.
His point echoes conservative economists, who see the glass as half-empty rather than half-full. This is an age-old conundrum: Should the Federal Reserve encourage or discourage higher interest rates and if so by how much? Should the Fed reduce its quantitative easing policy or maintain it? What’s the proper projection for pension investment returns?
No one has a crystal ball that is accurate all the time. Only after the fact does someone suddenly claim “genius” status for predicting a bull or a bear market — until the next time.
Serafini, a financial planner, notes there are political reasons for Maryland maintaining a much higher expected rate of investment return than he would like.
That was made clear when the pension trustees opted to gradually lower the projected rate of return a tad. Len Lazarick, ace reporter/publisher of MarylandReporter.com, covered the pension trustees meeting and noted that when the state’s actuary said it would be wiser to drop the projected rate right away to lower levels, state budget secretary Eloise Foster responded: “I don’t know whether we could afford it right now.”
It would cost hundreds of millions of dollars each year to drastically scale back Maryland’s assumed rate of investment return. That money would have to come out of the general fund budget, forcing major cutbacks in social programs and aid to the counties.
Democratic Gov. Martin O’Malley isn’t about to ruin his reputation for preserving and strengthening social programs just to fortify the pension program’s financial underpinnings . Even Republican Gov. Bob Ehrlich didn’t pursue that course.
Dissatisfied Conservative Voices
Given this fact of life in Annapolis, the pension trustees voted to take a gradual approach in shaving projected investment returns. It doesn’t satisfy Serafini and other conservative voices, as he makes clear in his latest essay:
Dear Mr. Rascovar,
I read with great interest [Dean] Kenderdine’s recent response to my comments. Unfortunately for Mr. Kenderdine [Executive Director of the Maryland State Retirement and Pension System] I have kept him very busy responding to my various letters to the editor or other past commentaries. I should say that I have tremendous respect for members of the Board of Trustees as well as Mr. Kenderdine. They have a very difficult job to do. It is made more difficult having to put up with politicians.
Currently, there is a great debate occurring across our country regarding the proper basis for valuing liabilities in pension plans. Whether it is the bond rating agencies, Pension Benefit Guaranty Corporation or the American Academy of Actuaries, the opinions vary greatly. Corporate defined-benefit pension plans are federally required to use an index tied to corporate bond rates which allows them to use a rate in the 4% to 6% range (with certain exceptions). Many public pension plans justify their current rates in the range of 7% to 8% based upon past experience. However, the current assumptions are forward-looking and few believe the next 25 years will prove to be as favorable to investors as the past 25 years.
I particularly found Mr. Kenderdine’s comment that Moody’s “arbitrarily” selected a lower rate in calculating the unfunded liabilities of states such as Maryland to be interesting. If we are supposed to trust that the AAA rating Maryland receives to be well-earned through the august body of analysts such as Moody’s, why would we expect that they would be arbitrary in choosing such a significant method for determining pension liabilities? For the record, they use an indexed rate based upon a corporate bond rate that is duration specific and relevant to most plans, including Maryland’s.
To remove all the clouds and esoteric conversations, we need to consider what is really going on here. If we consider what is known as the “prudent man rule,” it may shed a different light. This is a requirement of all fiduciaries that states that any one exercising control over assets for another person (i.e. the pension participants as well as the taxpayers) should exercise the care and prudence acting in the beneficiaries’ sole interest. The problem is that if we use a lower assumed rate like private pensions and the others are suggesting, that would lead to significantly higher annual contributions.
What Mr. Kenderdine did not say is it is politically uncomfortable to lower the expected earning rates because of these significantly higher annual contributions. These increases could be as much as several hundred million dollars or more over the years if we were to lower the rates just by a percent or two. Compounding matters, the annual growth in contributions to these plans is currently restricted by Maryland law, which precludes contributing an amount recommended by the actuaries. Such a practice would be illegal in private sector pension plans. While it may create significant budget strains, I believe as fiduciaries the lower rates tied to an index is acting in the best interest of the plans. Keep in mind that if there are shortages the taxpayers and participants ultimately bear the risk. Just ask the people in Detroit.
They will argue that public plans can use higher rates due to the past performance and that, unlike corporations, they do not risk going away. In my previous letter I explained why future results will struggle to match the past 30 years. Warren Buffet has also said that anyone expecting over 7% is foolish.
Rick Dreyfuss a senior fellow with the Manhattan Institute and pension expert argues there is another problem with the current funding methodology. Most of the current employees that have significant accrued pensions will retire in the next 15 years. We are planning to pay off the unfunded liabilities for these individuals over 25 years. This would be like buying a car that you plan to own for five years and taking out a ten-year loan. This means that we will be paying for the liability well after the people retire. Not a prudent approach in my opinion. Moreover, such a demographically driven accounting policy for pensions was recently revised and adopted by the GASB as their formal accounting standard. Bond rating agencies such as Moody’s also analyze credit risk with such a concept in mind. Both entities also favor the use of the market value of assets to determine annual pension cost versus the rolling average approach used by most public sector plans including Maryland’s. The use of the market value of assets is also a federal requirement of private sector defined benefit plans. This approach, while arguably creating somewhat more volatile results, better ensures costs are properly recognized rather than deferred to future generations.
The bottom line is, as I said in my earlier correspondence, a more cautious rate is more prudent to properly fund the pension plan. If the performance is better that would mean future contributions could be reduced once the funded status reached appropriate levels of 80% or more. Using higher expected interest levels reduces the mandatory contributions and passes the risk not only to pension participants but to the taxpayer who is the ultimate backstop. As a public official, taxpayer, and financial adviser I cannot support that type of approach.