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How to Assess Impact of a Market Correction on Pension Payments

On January 28, 2018, the Dow Jones stock index closed at a record high of 28,610. Nine days later, on February 6, the Dow index hit an intraday low of 24,198, a drop of over 15 percent. Since then the Dow index has recovered somewhat, along with other stock indexes and the underlying stocks around the world.

Nobody knows whether this sudden plunge is the beginning of a major downward correction, or even the beginning of a bear market, but it is a sobering reminder that permanently high returns on investment are not guaranteed. And it is a good opportunity to offer tools that local elected officials can use to assess the impact of a market correction on their agency’s required pension payments.

The tool presented here is a spreadsheet dubbed “CLEO Pension Calculator” (download here) that allows a layperson to evaluate various scenarios of pension finance. Before summarizing these tools, here’s how this spreadsheet predicts the impact of a 15% drop in the value of pension fund assets. This example shows the impact on all of California’s pension systems.

A recent CPC analysis “California Government Pension Contributions Required to Double by 2024 – Best Case,” using CalPERS official projections along with U.S. Census Bureau data, estimated California’s total pension assets for all of California’s state and local government agencies at $761 billion. Liabilities were estimated at $1.087 billion, meaning the total “unfunded” liability (assets minus liabilities) was estimated at $326 billion. Using that data as a starting point:

–  If there is a 15% drop in pension fund assets, the unfunded liability rises from $326 billion to $440 billion.

–  If there is a 15% drop in pension fund assets, the unfunded contribution, or “catch up” payment, rises from $30.8 billion to $41.5 billion.

–  To summarize, for every sustained 10% drop in the value of pension fund assets, California’s state and local government pension funds will require another $7.0 billion per year. In reality, however, it could be worse, because a serious market correction could trigger another reassessment of the projected earnings. For example:

–  If there is a 15% drop in pension fund assets, and the new projected earnings percentage is lowered from 7.0% to 6.0%, the normal contribution [1]will increase by $2.6 billion per year, and the unfunded contribution will increase by $19.9 billion. Total annual pension contributions will increase from the currently estimated $31.0 billion to $68.5 billion. [2]

These are mind-boggling numbers, but they are well-founded. The calculations used to arrive at these figures use formulas provided by Moody’s Investor Services in their current guidelines for municipal pension analysts, as reflected in their 2013 “Adjustments to US State and Local Government Reported Pension Data.”

This spreadsheet can be used by anyone, for any city, county, or agency.

INSTRUCTIONS TO USE THE SPREADSHEET

(1) To recalculate the unfunded pension debt, and to recalculate the unfunded pension payment:

On the tab “Unfunded Debt and Payment,” just enter the balances for your agency for your pension fund’s assets, liabilities, and assumed rate of return. Then change the rate of return from the official number to something lower, and see what happens. Change the value of the assets to something lower, and see what happens.

(2)  To recalculate the normal pension payment:

This shortcut method, approved by Moody’s but discontinued in their final guidelines partly due to the difficulties in getting the data, requires the user to know the amount of their current normal contribution. CalPERS, to their credit, provides this information for each of their participating agencies in their “Public Agency Actuarial Valuation Reports.” If your agency is not part of CalPERS, you may be able to find this number in your pension system’s Consolidated Annual Financial Report, or you may have to contact the pension system and request the information. The fact that it is not easy for many participating agencies to know how their pension contribution breaks out between the normal contribution and the unfunded contribution is a scandal. If you know your normal contribution, just enter it on the “Normal Payment” tab on the spreadsheet, along with a revised rate-of-return projection, and see what happens.

(3) To perform sensitivity analysis to evaluate how various assumptions affect pension contributions:

This tab provides, using a hypothetical individual beneficiary as the example, an excellent way to see just how sensitive contribution rates are to various changes to benefits or other assumptions. To do this, go to the “Sensitivity Analysis” tab and enter any values you wish in the yellow highlighted cells. They include age of retirement, percent COLA growth per year during employment, the pension multiplier, the percent pension COLA growth during retirement, life expectancy, age when work commenced, percent of salary increase per year of employment, the percent of salary each year to the pension fund, the annual percentage return of the fund, and the final salary. Then the fun starts: The user must vary these inputs in order that the model displays a near-zero (within $10-$15K) value in the green highlighted cell “fund ending balance.” While this model is a simplification (for example it doesn’t account for the gap which sometimes occurs between a participant leaving the workforce and becoming eligible for retirement benefits) this model will help any user develop insights into what factors have the most impact on pension solvency.

(4) To determine the value of an individual pension:

A common and useful way to compare pension benefits to private sector 401K plans is to estimate what a pension benefit is worth at the time of retirement. Using this method is a valid attempt to provide an apples-to-apples comparison, by showing how much someone would have to have saved in a 401K plan to have an income stream in retirement equivalent to a pension. To do this, enter on the “Value of Individual Pension” tab a set of assumptions – age of retirement, years worked, pension “multiplier,” final year’s pension eligible compensation, pension COLA during retirement, and life-expectancy. There are also cells to enter various rate-of-return assumptions (discount rates). The green highlighted cells then display the present value of this pension benefit at various rates-of-return.

Any policymaker who is required to negotiate over pension benefits, explain pension benefits, consider changes to pensions, or understand the impact of pensions on current and future budgets, or for that matter, contemplate any sort of increase to local taxes and fees, needs to understand the basic financial concepts that govern pensions. They should understand the difference between the total pension liability and the unfunded pension liability. They should understand the difference between the normal payment and the unfunded payment. They should understand the difference between unfunded payment schedules that use the “percent of payroll” method vs. the “level payment” method. They should know what “smoothing” is. They should thoroughly understand these concepts and related concepts.

This spreadsheet is offered to reinforce understanding of these concepts, and to further better understand the impact of lower rates of return (and changes to other assumptions) on required contributions to the pension system.

Download CLEO Pension Calculator

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FOOTNOTES 

[1]  Unless the projected annual earnings percentage also drops from the 7.0% (which CalPERS is phasing in over the next few years, down from the current 7.5%), only the so-called “unfunded contribution” increases. This is because the “normal contribution,” is only required to fund the future pension benefits earned for work just performed in the current year. By definition, the normal contribution cannot change merely because the unfunded liability increases.

[2]  The attentive reader will note the discrepancy between the currently estimated total employer pension contributions noted in the table “Employer Contribution 2017-18” of $31.0 billion in the report “California Government Pension Contributions Required to Double by 2024 – Best Case,” and the default values for total pension contributions in the spreadsheet of $15.2 billion (normal) and $30.8 billion (unfunded), totaling $46.0 billion. This is because the spreadsheet calculates the unfunded contribution based on 100% of participating pension systems adopting the 20 year straight-line amortization, whereas the numbers in the report reflect the fact that many if not most pension systems have not yet required their participants to amortize their unfunded liability in 20 years. This is validated by the report’s data for 2024-25, where the unfunded contribution rises dramatically, reflecting the determination of most pension systems to require their participants to begin adopting the more aggressive 20 year payback schedules. It should also be noted that the spreadsheet’s default normal contribution amount of $14.0 billion only reflects the employer’s share of the normal contribution, and that typically (if not invariably), employee’s are never required to share via withholding in the burden of the unfunded contribution.

This article is cross-posted on the CPC project website “California Local Elected Officials” (CLEO), where viewers can find policy briefs, sample reforms, and news alerts on a variety of local public policy issues.

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How Fraudulently Low “Normal Contributions” Wreak Havoc on Civic Finances

Back in 2013 the City of Irvine had an unfunded pension liability of $91 million and cash reserves of $61 million. The unfunded pension liability was being paid off over 30 years with interest charged on the unpaid balance at a rate of 7.5% per year. Irvine’s cash reserves were conservatively invested and earned interest at an annual rate of around 1%. With that much money in reserve, earning almost no interest, the city council decided use some of that money to pay off their unfunded pension liability.

As reported in Governing magazine, starting in 2013, Irvine increased the amount they would pay CalPERS each year by $5M over the required payment, which at the time was about $7.7M. With 100% of that $5M reducing the principal amount owed on their unfunded liability, they expected to have the unfunded liability reduced to nearly zero within ten years, instead of taking thirty years. Here’s a simplified schedule showing how that would have played out:

CITY OF IRVINE, 2013  –  PAY $5.0 MILLION EXTRA PER YEAR
ELIMINATING UNFUNDED PENSION LIABILITY IN TEN YEARS

This plan wasn’t without risk. Taking $5 million out of their reserve fund for ten years would have depleted those reserves by $50 million, leaving only $11 million. But Irvine’s city managers bet on the assumption that incoming revenues over the coming years would include enough surpluses to replenish the fund. In the meantime, after ten years they would no longer have to make any payments on their unfunded pension liability, since it would be virtually eliminated. Referring to the above chart, the total payments over ten years are $127 million, meaning that over ten years, in addition to paying off the $91 million principal, they would pay $36 million in interest. If the City of Irvine had made only their required $7.7 million annual payments for the next thirty years, they would have ended paying up an astonishing $140 million in interest! By doing this, Irvine was going to save over $100 million.

Four years have passed since Irvine took this step. How has it turned out so far?

Not so good.

Referring to CalPERS Actuarial Valuation Report for Irvine’s Miscellaneous and Safety employees, at the end of 2016 the city’s unfunded pension liability was $156 million.

Irvine was doing everything right. But despite pumping $5M extra per year into CalPERS to pay down the unfunded liability which back in 2013 was $91M (and would have been down to around $64M by the end of 2016 if nothing else had changed), the unfunded liability as of 12/31/2016 is – that’s right – $156 million.

Welcome to pension finance.

The first thing to recognize is that an unfunded pension liability is a fluid balance. Each year the actuarial projections are renewed, taking into account actual mortality and retirement statistics for the participants as well as updated projections regarding future retirements and mortality. Each year as well the financial status of the pension fund is updated, taking into account how well the invested assets in the fund performed, and taking into account any changes to the future earnings expectations.

For example, CalPERS since 2013 has begun phasing in a new, lower rate of return. They are lowering the long-term annual rate of return they project for their invested assets from 7.5% to 7.0%, and may lower it further in the coming years. Whenever a pension system’s rate of return projection is lowered, at least three things happen:

(1) The unfunded liability goes up, because the amount of money in the fund is no longer expected to earn as much as it had previously been expected to earn,

(2) The payments on the unfunded liability – if the amount of that liability were to stay the same – actually go down, since the opportunity cost of not having that money in the fund is not as great if the amount it can earn is assumed to be lower than previously, and,

(3) the so-called “normal contribution,” which is the payment that is still necessary each year even when a fund is 100% funded and has no unfunded liability, goes up, because that money is being invested at lower assumed rates of return than previously.

That third major variable, the “normal contribution,” is the problem.

Because as actuarial projections are renewed – revealing that people are living longer, and as investment returns fail to meet expectations – the “normal contribution” is supposed to increase. For a pension system to remain 100% funded, or just to allow an underfunded system not to get more underfunded, you have to put in enough money each year to eventually pay for the additional pension benefits that active workers earned in that year. That is what’s called the “normal contribution.”

By now, nearly everyone’s eyes glaze over, which is really too bad, because here’s where it gets interesting.

The reason the normal contribution has been kept artificially low is because the normal contribution is the only payment to CalPERS that public employees have to help fund themselves via payroll withholding. The taxpayers are responsible for 100% of the “unfunded contribution.” CalPERS has a conflict of interest here, because their board of directors is heavily influenced, if not completely controlled, by public employee unions. They want to make sure their members pay as little as possible for these pensions, so they have scant incentive to increase these normal contributions.

When the normal contribution is too low – and it has remained ridiculously low, in Irvine and everywhere else – the unfunded liability goes up. Way up. And the taxpayer pays for all of it.

Returning to Irvine, where the city council has recently decided to increase their extra payment on their unfunded pension liability from $5 million to $7 million per year, depicted on the chart below is their new ten year outlook. As can be seen (col. 4), just the 2017 interest charge on this new $156 million unfunded pension liability is nearly $12 million. And by paying $7 million extra, that is, by paying $20.2 million per year, ten years from now they will still be carrying over $35 million in unfunded pension debt.

CITY OF IRVINE, 2017  –  PAY $7.0 MILLION EXTRA PER YEAR
REDUCTION OF UNFUNDED PENSION LIABILITY IN TEN YEARS

This debacle isn’t restricted to Irvine. It’s everywhere. It’s happening in every agency that participates in CalPERS, and it’s happening in nearly every other public employee pension system in California. The normal cost of funding pensions, which employees have to help pay for, is understated so these employees do not actually have to pay a fair portion of the true cost of these pensions. If this isn’t fraud, I don’t know what is.

It gets worse. Think about what happened between 2013 and 2017 in the stock market. The Wall Street recovery was in full swing by 2013 and by 2016 was entering so-called bubble territory. As the chart below shows, on 1/01/2013 the value of the Dow Jones stock index was 13,190. Four years later, on 12/31/2017, the value of the Dow Jones stock index was up 51%, to 19,963.

Yet over those same four years, while the Dow climbed by 51%, the City of Irvine’s unfunded pension liability grew by 71%. And this happened even though the City of Irvine paid $12.7 million each year against that unfunded liability instead of the CalPERS’s specified $7.7 million per year. Does that scare you? It should. Sooner or later the market will correct.

DOW JONES INDUSTRIAL AVERAGE
PERFORMANCE FOR THE PAST FIVE YEARS, 2013-2017

While the stock market roared, and while Irvine massively overpaid on their unfunded liability, that unfunded liability still managed to increase by 51%. Perhaps that normal contribution was a bit lower than it should have been?

Irvine did the right thing back in 2013. CalPERS let them down. Because CalPERS was, and is, understating the normal contribution in order to shield public sector workers from the true cost of their pensions. The taxpayer is the victim, as always when we let labor unions control our governments and the agencies that serve them.

REFERENCES

CalPensions Article discussing CalPERS recent polices regarding pension debt repayments:
https://calpensions.com/2017/09/25/calpers-considers-paying-down-new-debt-faster/

Irvine 2017-18 Budget – discussion of faster paydown plan on UAAL
http://legacy.cityofirvine.org/civica/filebank/blobdload.asp?BlobID=29623

Irvine Consolidated Annual Financial Report FYE 6/30/2016
http://legacy.cityofirvine.org/civica/filebank/blobdload.asp?BlobID=28697

Irvine – links to all Consolidated Annual Financial Reports
http://www.cityofirvine.org/administrative-services-department/financial-reports

CalPERS search page to find all participating agency Actuarial Valuation Reports
https://www.calpers.ca.gov/page/employers/actuarial-services/employer-contributions/public-agency-actuarial-valuation-reports

CalPERS Actuarial Valuation Report – Irvine, Miscellaneous
https://www.calpers.ca.gov/docs/actuarial-reports/2016/irvine-city-miscellaneous-2016.pdf

CalPERS Actuarial Valuation Report – Irvine, Safety
https://www.calpers.ca.gov/docs/actuarial-reports/2016/irvine-city-safety-2016.pdf

Governing Magazine report on Irvine
http://www.governing.com/columns/public-finance/col-irvine-california-plans-prepay-pension-bill.html