Wednesday, December 21, 2011

GASB Update: Latest News on Overall Process; Two Views of Proposed Reforms

The Governmental Accounting Standards Board (GASB) still appears to be on track for a final decision by the middle of 2012 on its proposed changes to governmental pension reporting and accounting rules contained in the Exposure Drafts issued earlier this year, but there are some signs that changes in response to the results of the field testing process, and the concerns of cost-sharing plans, may yet be possible.   In the meantime, two recent studies provide contrasting views of the likely results of the proposed changes as they now stand.  The first, a working paper by Robert Novy-Marx, concludes that under the GASB rules as proposed, a governmental pension plan can improve its funding status “literally by burning money.”  The second, a brief produced by the Center for Retirement Research at Boston College (CRR) finds that employers and plan administrators should be prepared for funded ratios reported in their financial statements to decline sharply under the new GASB rules, but that “[p]olicymakers should not let new numbers throw them off course.“  

Current Status of GASB Proposals
In response to its Exposure Drafts containing proposed changes to the accounting and financial reporting for pensions by plan sponsors and to the financial reporting for pension plans by the plans themselves, GASB received 645 comment letters, including the letter prepared by NCTR, NASRA and NCPERS, which was signed by over 130 executive directors, administrators and trustees of 109 State and local government retirement systems.

In addition, GASB held three public hearings at which 33 organizations and individuals testified.   Three user forums were also held, with 19 participants, including representatives of citizen groups, bond rating agencies, academics, financial analysts and research organizations. 

Finally, field tests were held.  These were designed to obtain information about one-time and ongoing preparation time and costs associated with the proposals in the Exposure Drafts; to identify difficult-to-understand provisions of the Exposure Drafts; and to receive feedback on the methodology employed by field test participants on certain proposals in the Exposure Drafts.  Field test participants were also asked to provide pro forma note disclosures and required supplementary information and details of the calculation methodologies used to determine the discount rate—specifically, their projections of benefit payments and plan net position.

In a memo to the GASB board members, staff summarized the results.  According to this memo, GASB received results from 18 participants, including 3 single-employer Plans; 3 single employers that also report plans; 3 multiple-employer agent plans; 2 agent employers; and 7 multiple-employer cost-sharing plans. 

As noted, participants in the field test were asked to provide estimates of time and cost related to both initial implementation efforts and ongoing efforts that would result from the Exposure Draft proposals.  (For purposes of the field test, it was requested that the estimates of time include only internal staff time and that cost estimates include out-of-pocket expenditures (such as consulting fees), software acquisition, and system changes but not include costs associated with staff time.)  The results varied dramatically.  Initial implementation time ranged from 2 hours for one agent employer to 56.000 hours for one cost-sharing plan.

Similarly, implementation costs varied tremendously, from a low of around $3,000 for one cost-sharing plan to as high as $18 million for another cost-sharing plan.   This was then compared to current costs under existing GASB rules, which were much, much lower, underscoring the impact of the proposed GASB changes.

The staff memo also details many of the specific concerns with various aspects of the Exposure Draft that participants identified, as well as the methodologies used in the calculation of (1) the weighted-average expected remaining service life of active employees and (2) the proportionate share of collective totals of employers in cost-sharing plans. 

The memo concludes with issues that arose from the field tests and which “will be considered in the redeliberations of the Exposure Drafts,” including:
  • Concerns about increased internal costs and external actuarial and audit costs, particularly in multiple-employer plans in which employers have different fiscal year-ends.  GASB staff notes that “Specific concerns were expressed regarding the valuation of assets without market prices and the determination of other changes in plan net position that currently are evaluated only annually”
  • Applicability of the proposals to hybrid plans and plans in which defined contribution pensions may be converted to annuities 
  •  Request for additional guidance related to proprietary funds and entities that use regulatory accounting
  • Request for clarification regarding the projection of benefit payments in circumstances in which employees provide services to multiple employers that participate in a plan or in which employee contributions are greater than service cost
  • Request for additional guidance related to plan reporting of investment types, pensions of the plan’s own employees, and presentation of a statement of plan net position
  • Concerns about proposed plan note disclosures, including issues related to the separation of investment expenses from returns in the calculation of return on plan investments, difficulty in obtaining or calculating rates of return on a money-weighted basis, and a general concern about the volume of disclosures.
All of this suggests that these “redeliberations” may well result in changes to the Exposure Draft, although it should also be noted that , based on the projected GASB work plan,  the final voting on the Exposure Draft is still scheduled for the May-June, 2012, time frame.   In other words, the “fast-track” still appears to be in place.

Cost-Sharing Plans
One area of the proposed changes in the GASB rules that has been particularly worrisome has been those related to the manner in which cost-sharing plans will be required to allocate their net pension liability, pension expense, and deferred outflows of resources and deferred inflows of resources  to their participating employers.   The impact of this aspect of the proposed GASB changes on employers who participate in cost sharing plans could be devastating. 

For example, in a recent article on the specifics of the cost-sharing proposal as it applies to employers, David Powell with the Groom Law Group stresses that “If these proposals are finalized without change, participating employers will need to substantially revamp their accounting systems at considerable expense.”   Compliance is expected to be the responsibility of the employer, he explains, “and the retirement system's ability to provide assistance in many cases may be limited.”  Powell warns that this “may leave the burden of compliance on the contributing government employers” and not the plans – a point that many plan sponsors have yet to fully appreciate.

NCTR continues to believe that cost-sharing plans constitute a form of insurance and that the costs should not be allocated to the individual employers, and has made this point consistently in comments filed with GASB.   Nevertheless, for now, GASB appears to be set on its allocation approach.

Accordingly, a number of cost-sharing plans have formed an ad hoc group, the Employer Cost-Sharing Coalition, which has filed separate comments with GASB focused solely on this issue.   These comments, prepared by the Groom Law Group, argue that:
  • There is a lack of a clear relationship between the arbitrary proportionate share and actual liability
  • Varying and uncertain rules in different jurisdictions means that actual liability of a cost-sharing employer for plan underfunding, however measured, will often be difficult or impossible to predict with any certainty; thus, it is not a faithful representation of the potential liability. 
  • Instead, plan underfunding and other information could be disclosed in notes with a description of any rules in the jurisdiction for determining employer liability for underfunding. 
  • Comparability to the new FASB multiemployer rule also justifies this approach.   (In 2010, FASB had initially proposed a rule similar to the one GASB has proposed, to be applicable to private sector multiemployer plans, but changed its mind because of cost concerns; because the actual payment in the future might be limited by legal constraints; and because the estimate of a liability did not represent the amount an employer would actually have to pay.)
This new approach, which has reportedly been received with much interest by GASB staff, as well as the comments from the field testing conducted by cost-sharing plans, may be having an impact.  For example, GASB has now indicated that, at its March, 2012, meeting, it will consider the creation of a working group to assist the Board with regard to cost-sharing matters. 

Hope springs eternal.

Novy-Marx Working Paper
Robert Novy-Marx is an Assistant Professor of Finance with the Simon Graduate School of Business at the University of Rochester, as well as a member of the National Bureau of Economic Research, which published his new paper.  It is entitled “Logical Implications of GASB's Methodology for Valuing Pension Liabilities,” and in it, Novy-Marx argues that GASB does not really provide a valuation method.  He notes that a valuation method should recognize that “more is more,” in the sense that adding a dollar to any given set of assets and liabilities increases the set’s value.  Furthermore, he says that a valuation method should also assign a unique value to a given set of assets and liabilities.

But the GASB methodology for accounting for net pension liabilities “does not satisfy either of these conditions,” he asserts.  GASB instead gives different “valuations” for the exact same assets and liabilities when they are partitioned differently among plans, he argues, and moreover, since the marginal valuation of assets can be negative under GASB, then in such cases, GASB would allow a plan to improve its GASB funding status literally by burning money.

For example, he claims that GASB, while recognizing that cash and bonds are valuable assets, nevertheless “penalizes a plan for holding these, by forcing it to recognize a larger liability.”  Thus, he says, destroying a dollar (i.e., reducing its cash or bond holdings by a dollar while holding all other asset holdings fixed) reduces a plan’s assets by exactly a dollar, but can reduce its GASB liability by more than a dollar.  “In these cases plans can reduce their GASB recognized underfundings by destroying assets,” he concludes.

Finally, Novy-Marx insists that GASB’s methodology for accounting for liabilities has an equivalent alternative formulation.  “The explicitly prescribed procedure, which entails discounting a plan’s liabilities at the expected return on its assets, is completely equivalent,” he argues, “to one in which a plan’s liabilities are discounted at rates that reflect the liabilities own risks, but the plan’s stock holdings are valued at more than twice their market values.”

CRR Brief
The CRR brief is entitled “How Would GASB Proposals Affect State and Local Pension Reporting?”  It  takes a look at the GASB proposals and focuses on those elements dealing with valuation of assets and liabilities, namely (1) plan assets would no longer be smoothed but rather valued at market; (2) liabilities would be discounted by a blended rate that reflects the expected return for the portion of liabilities that are projected to be covered by plan assets and the return on high-grade municipal bonds for the portion that are to be covered by other resources; and (3) the entry age normal/level percentage of payroll would be the sole allocation method used for reporting purposes.  CRR examines these effects by first determining funded ratios based on current GASB standards and then funded ratios calculated using the market value of assets.  Next, CRR combines market assets with liabilities discounted by the blended rate to demonstrate the full impact of GASB’s proposed changes.

Looking at the effect of the change from an actuarially smoothed l value of assets to a market value, CRR finds that the aggregate funded ratio using market assets was only 67 percent in 2010 compared to 77 percent using actuarial assets.  “[P]olicymakers should be prepared for a sharp decline in funding if GASB introduces this change,” the CRR brief concludes.

Next, looking at the new blended rate for determining liabilities, CRR found that the aggregate funded ratio of state and local plans (based on 2010 numbers) would have decreased from 77 percent to 53 percent under the GASB plan.  

Thus, CRR finds that the GASB proposals “will sharply reduce the reported funded levels of public sector plans.”  However, CRR also stresses that it would be “unfortunate if the press and politicians characterized these new numbers as evidence of a worsening of the crisis when, in fact, states and localities have already taken numerous steps to put their plans on a more secure footing.”   The Brief concludes that “[r]eforms need to be done carefully and thoughtfully, remembering that pensions are an important part of the total compensation of public sector workers.”   

The CRR brief also makes a number of other observations that are very similar to those made by NCTR and its members in connection with the GASB exposure drafts.  For example, CRR says that there will be implementation problems, the main one being with GASB’s proposed blended rate.  It will require a complicated calculation based on a number of assumptions, including assumptions not only about plan returns but also about future contributions from the government and from employees.   “These contributions may or may not come to pass,” CRR observes, and “[o]ne can imagine extended disputes about the validity of the underlying assumptions.”

CRR also criticizes the new GASB discounting proposal because the data it will produce will fail to provide meaningful measures of government obligations and be inconsistent across states and localities and over time. 

Finally, the CRR brief is worried about the impact on the annual required contribution, or ARC.  First, the move from actuarial to market value of assets and the new liability measure increase the unfunded liability and thereby the required amortization payment, CRR notes.  Then, a blended discount rate will raise the normal cost.  Therefore, CRR cautions that “reported” ARCs are likely to increase substantially but employers may likely continue to use the traditional actuarial smoothing techniques to calculate their ARCs for funding purposes.  As NCTR has warned, there could be an unfortunate and confusing disconnect between the reported number and the number being used for funding.

Next, CRR is also worried about what they refer to as the “disciplinary role of the ARC” and the likelihood that it will be undermined.  Specifically, they point out that in states with statutory contribution rates, they will no longer technically be required to calculate an actuarial ARC.  “This change not only represents a loss in analysts’ ability to assess how close plan contributions are to those required to keep the system on track,” CRR notes, “but also creates an escape valve that states could use as ARCs rise beyond reach:  introduce a statutory rate and dispense with ARC calculations.” 

In an effort to address some of these concerns with the loss of the ARC, NCTR and other national public sector organizations, in conjunction with the public plan actuarial community, are holding preliminary discussions to determine what could be a possible alternative and how its uniform use could be encouraged.

One final note regarding the CRR brief:  appendix B of the brief contains a “run-out” date for 126 public pension plans.  It is well to note that CRR has reassured Keith Brainard, Research Director of the National Association of State Retirement Administrators (NASRA), that these dates are not actual projections of when the plan could become insolvent.   According to CRR, these dates “are not reflective of an ongoing plan, and are only intended for use in implementing GASB’s particular liability concept.”  As Keith puts it, “in other words, these dates are based on an accounting basis, not a funding basis.” 

Monday, November 14, 2011

House, Senate Passes H.R. 674 Repealing 3% Non-Wage Withholding Requirement; Treasury, IRS Move to Define “Governmental Plan;" and Teacher Benefits Under the Microscope

Some good news for a change:  The House, Senate Vote to Repeal 3% Withholding Law.
After always seeming to be the messenger of gloom and doom, I actually have some good news to report for a change.  Both the House and the Senate have now voted to repeal the 3% non-wage withholding requirement set to begin applying in a little over a year to all Federal and state governments and their agencies, including their pension plans.  (Political subdivisions of a state, as well as their instrumentalities, would be excluded if they made less than $100,000,000 in payments annually.)  The withholding requirement would not apply to pension payments made to retirees and other beneficiaries, but it would apply to all payments made by a pension plan for property or services.

To read more about the Repeal of the 3% Withholding Law; the Treasury,IRS' Move to Define “Governmental Plan;" and Teacher Benefits Under the Microscope CLICK HERE

Tuesday, July 5, 2011

Ways and Means Holds Hearing on Nunes Bill; New CBO Report Complicates Matters

Following a series of hearings before other House Committees, the subject of public pension accounting and the so-called “Public Employee Pension Transparency Act” (PEPTA), sponsored by Congressman Devin Nunes (R-CA), finally came before the House Ways and Means Committee in early May. The hearing is significant because this Committee – unlike the others which have held hearings to date -- has legislative jurisdiction over the Nunes bill, and could actually send it to the floor of the House for a vote. To complicate matters, the Congressional Budget Office (CBO) released an issue brief on “The Underfunding of State and Local Pension Plan” the day before the hearing. The CBO document discussed investment return assumptions and was quickly seized upon by Nunes and his supporters as endorsing the need for the disclosure of the market value of liabilities (MVL). Nevertheless, the next step for the Nunes legislation is unclear. However, GOP insistence that an increase in the nation’s debt ceiling must be linked with a blueprint for significant deficit reduction has placed the issue of pensions in the crosshairs, and there is some concern that this could open the door for the Nunes bill as a part of a debt-limit deal.

House Ways and Means Committee Hearing

On May 5, 2011, the Oversight Subcommittee of the House Ways and Means Committee held a hearing on “The Transparency and Funding of State and Local Pension Plans.” A stated purpose of the hearing was to explore whether “enhanced transparency in the reporting of the financial health” of public plans was warranted, and to review H.R. 567, the Nunes PEPTA bill.

Subcommittee Chairman Charles W. Boustany, Jr. (R-LA), began by saying that whether the underfunding of State and local pension plans is $700 billion or over $3 trillion, “it is a serious concern for workers and retirees, for State and local governments, and for taxpayers in general.” Boustany charged that “There is growing consensus that accounting standards for public sector pensions encourage state and local governments to overpromise, underfund, and take on risky investments by discounting guaranteed future benefits against unrealistic rates of return.“ He also stressed that since some have raised the specter of a Federal taxpayer bailout to cover the unfunded liabilities of public pension plans, “it is important for the Subcommittee to review this issue and to consider possible approaches to ensure that no such Federal taxpayer bailout is ever needed.”

Congresswoman Lynn Jenkins (R-KS) was much more candid, saying that she found it “a bit ironic that Congress, which doesn’t have the political will to take action to fix Social Security, is here today talking about our great concern with state and local government pensions.” She said that she wasn’t sure “if any of us have great credibility on the issue.”

Democrats on the Subcommittee raised strong objections to the hearing. The Ranking Member, Congressman John Lewis (D-GA), asserted that “Republicans have set their sights on the teachers who educate our children, police officers who keep our communities safe, and first responders in moments of crisis.” “They are not the cause of the current economic situation” Mr. Lewis said. “They are simply hard-working Americans trying to retire with dignity and escape poverty as they age,” he stressed.

Congressman Jim McDermott (D-WA) agreed. “Let’s be clear,” he said, “there is no problem with most state-run pensions.” Although Mr. Boustany claimed that public plans are legitimate reasons for federal concern because the Internal Revenue Code “subsidizes retirement savings and gives preferential tax treatment to state and local debt,” Mr. McDermott said that there is “no federal role in state-run pensions.” McDermott charged that Republicans were using the hearing simply as a “political tool to attack the middle-class workers who teach the children of wealthy people, and the cops and firefighters who keep them safe, and the workers who pick their trash.” There is no pension problem, he said; the Republicans just “want to attack unions.”

Congressman Ron Kind (D-WI) picked up on this anti-union theme, discussing the recent events in Wisconsin involving collective bargaining. He also chided Republicans for their support of the Nunes legislation, saying “You know, for the party that claims to be the party of less government in Washington and more responsibility at the state, proposing this one-size-fits-all approach is contrary to even, I think, your principles.”

Mr. Kind also entered into the record a letter opposing the Nunes bill from Dave Stella, Secretary of the Wisconsin Department of Employee Trust Funds (ETF). Congressman Kind specifically quoted from Mr. Stella’s letter, in which the Wisconsin retirement system director warned that "contrary to what the proponents of the legislation suggest, the issue is not a current lack of transparency and disclosure. It's simply an effort to justify a federal takeover of areas that are the financial and regulatory responsibility of state and local governments."

Finally, Congressman Javier Becerra (D-CA) underscored what he called a “disconnect between what we're doing here in Washington” and what the American public feels. Mr. Becerra pointed out that a recent public survey by the National Institute on Retirement Security (NIRS) found that the vast majority of Americans believe that the disappearance of pensions has made it harder for them to achieve the American dream. He noted that 81 percent said that they think Congress should make it a higher priority to ensure that more Americans -- not less -- can have a secure retirement. Congressman Becerra’s questioning of witnesses also helped to clarify that the state of Illinois was not seeking a federal bailout of its pensions.

Witnesses in favor of the Nunes legislation included the Treasurer of Colorado, Walker Stapleton, who is also a trustee of the Public Employees’ Retirement Association (PERA) of Colorado; Josh Barrow, a Fellow with the Manhattan Institute for Policy Research; Jeremy Gold, an actuary and one of the most vocal advocates of financial economics and MVL (who goes so far as to insist that public pensions should not invest in equities); and Robert Kurtter, Managing Director, U.S. Public Finance, for Moody’s Investors Service. The sole witness who spoke against the need for the Nunes bill was Iris Lav, Senior Advisor with the Center on Budget and Policy Priorities (CBPP).

Treasurer Stapleton, stressing that he was the only elected official on the COPERA board, was very critical of COPERA’s assumed 8 per cent rate of return, calling it “unrealistic and unachievable.” He also argued that since approximately 25 percent of COPERA’s portfolio is currently invested in fixed-income products (yielding about 4 per cent), this means that the rest of the portfolio must return closer to 10 percent in order to average an overall return of 8 percent. “The only way to achieve this unrealistic return is to take outsized market risk, further exposing our public pension plans to more volatility,” Stapleton argued.

Treasurer Stapleton said that the Nunes legislation “makes a lot of sense.” In addition, in response to a question from Congresswoman Jenkins asking if Stapleton, as an elected state official, thought it was fair that the Nunes bill conditioned a state’s continued ability to issue tax- exempt bonds upon the filing of certain information about state and local pension plans to the Internal Revenue Service, Stapleton answered “Absolutely.”

Josh Barrow of the Manhattan Institute for Policy Research agreed that that the discount rates used by public pension plans are “unreasonably high,” and supported what he called the “enhanced transparency” that he said would be provided by the Nunes legislation. He also recommended that pension plans should annually issue five-year projections of employer contribution rates.

Jeremy Gold, not surprisingly, testified in favor of the use of MVL to measure liabilities and generally endorsed the Nunes bill. However, he suggested several changes to the legislation, including substituting the use of unadjusted Treasury rates to measure MVL in lieu of the bill’s 24-month averaging and segmenting of Treasury rates. He also said that some of the required restatements of 20 year projections would be expensive and the disclosures they provided would be “uninformative at best and may actually be misleading and counterproductive in the decision-making context.”

Robert Kurtter of Moody’s Investors Service said that the Nunes legislation would increase access to, and comparability of, public pension plan data. However, he also said that by “requiring an employer to make multiple disclosures, using different calculation methods and in different places, about the same set of assets and liabilities could increase the complexity of disclosures and the time required to analyze the information.” Finally, he said that Moody's comments “should be not be taken as an endorsement” of the legislation.

Ms. Lav, with the CBPP, called the Nunes legislation “a solution in search of a problem.” She said that the bill “would be likely to increase public confusion, could spook bond markets, and could lead states and localities to cut spending for education and other key areas — or raise taxes — more than necessary.” She said that the Nunes legislation “also would create a new federal bureaucracy to regulate something that should be ‘regulated’ by market forces.”

Ms. Lav underscored that “underfunding problems of most state pension systems can be addressed with relatively modest increases in state and local contributions from employers and employees, along with a set of sensible, moderate changes in benefits.” She also warned that moving state and local employees from defined benefit to defined contribution plans — which she called “an objective that some of the sponsors of H.R. 567 have said they would like to accomplish” — would not address the funding problems public pension systems currently face. “On the contrary,” she testified, “it generally would raise annual costs by making it harder for a state to pay down the existing liabilities for employees still in the defined benefit plan, because that plan would include fewer employees and fewer contributions going forward, while requiring additional contributions for the employees in the defined contribution plan.”

Congressman Nunes, while not a member of the Oversight Subcommittee, also attended the hearing as a member of the full Ways and Means Committee. Afterwards, he said that the hearing made a “powerful case” for Congressional action. Mr. Nunes also claimed that there “is near unanimity among financial economists that public pension accounting reforms are needed.” Furthermore, he claimed that “No compelling arguments against the bill were made” during the hearing.

New CBO Report On Public Pension Plans

The day before the Ways and Means Committee hearing, the Congressional Budget Office (CBO) released a new issue brief entitled “The Underfunding of State and Local Pension Plans.” The brief discusses the chief alternative approaches to assessing the size of pension funding shortfalls – (1) the guidelines issued by the Government Accounting Standards Board (GASB), which compute liabilities by discounting future benefit payments using a discount rate based on the expected rate of return on the plans’ assets; and (2) what CBO unfortunately refers to as the “fair-value method,” which claims to measure the market value of the liability, often known as MVL.

(The CBO was founded and is funded by Congress. Its purpose is to provide objective, nonpartisan, and timely analyses to Congress to aid in economic and budgetary decisions. By law, CBO is also required to produce a cost estimate and mandate statement for every bill reported by a Congressional committee. As such, it is a well-respected organization both on and off the Hill, and its staff of economists and public policy analysts are highly regarded.)

The CBO report was the proverbial “mixed bag.” It did not directly endorse the use of a particular approach to assessing governmental pension liabilities, and it noted that the market-value approach would likely increase volatility, making budgeting for the required contributions more difficult. Finally, CBO found that “most state and local pension plans probably will have sufficient assets, earnings, and contributions to pay scheduled benefits for a number of years and thus will not need to address their funding shortfalls immediately.”

However, CBO also found that the MVL approach “more fully accounts for the costs that pension obligations pose for taxpayers.” Furthermore, the brief said “Most of the additional funding needed to cover pension liabilities is likely to take the form of higher government contributions and therefore will require higher taxes or reduced government services for residents.’

Not surprisingly, Congressman Nunes quickly claimed that the CBO report “supported the conclusions and testimony” presented by Republican witnesses at the Ways and Means hearing. He also said that “According to CBO, fair valuation (such as the reforms included in the Nunes bill) offers a more complete picture and transparent measure of the cost of pension obligations.”

Many in the media also seized on the CBO report as an endorsement of the MVL method of measuring unfunded pension liabilities as well as the Nunes bill. For example, Pensions and Investments ran a story entitled “CBO: Public Pension Plans Should Change Reporting, Contribution Methods,” while Governing magazine announced “CBO Endorses GOP’s Methods for Pension Projections.”

The CBO issue brief will clearly be used to support any effort to have the Nunes legislation adopted. It is therefore important that opponents of this legislation have something with which to rebut such efforts. NCTR is therefore in the process of finalizing a letter to the CBO raising a number of concerns with the issue brief:

• The brief lacks context critical to evaluating the suitability of each approach for the financial statements of state and local governments. For example, the paper describes market-based valuation as “what a private insurance company operating in a competitive market would charge to assume responsibility for those obligations.” However, the brief does not clarify that public pension liabilities are not for sale, state and local governments do not go out of business and are not acquired, and state and local governments can reasonably be expected to outlive any private business that would take over a public trust for profit.

• The CBO statement that market value “more fully accounts for the costs that pension obligations pose for taxpayers,” is purely subjective. One could say with equal or greater validity that the current GASB approach more accurately accounts for the cost of the pension obligation, as it reflects the expected government contributions to state and local pension funds, not what a theoretical insurance company would charge to assume them.

• The brief suggests that market-values are always going to produce a higher liability number. This is not correct. The same market-based measures that inflate pension liabilities in times when interest rates are low, such as now, would mask them during inflationary times. Furthermore, empirical studies of funding patterns under both approaches find that only rather recently, when 30-year Treasury bond yields fell below 6 percent and then declined to nearly 4 percent, did the market-based approach produce a higher liability than existing governmental plan methodologies. In the 1980s, when 30-year Treasury yields were high (almost at 14%), the market-based approach produced a dramatically smaller liability.

• Conjecture contained in the issue brief that public pension underfunding will “likely” lead to increased taxes or reduced government services, and that the federal government might be asked to assist with funding, is completely subjective, inappropriate for a CBO analysis, and at a minimum should have been qualified. For example, State and local governments, their plans and their employees, working through their legislative and regulatory structures, have responded to public pension underfunding by making an unprecedented number of changes to benefit levels, employee contributions, or both, in an effort to avoid increased taxes or cuts in service. Also, NCTR and other national organizations have gone on record numerous times, including in recent testimony before Congress, that state and local government retirement systems do not require, nor are they seeking, Federal financial assistance.

The Senate

The Senate companion measure to the Nunes bill, introduced by Senator Richard Burr (R-NC) as S. 347, has yet to be the subject of any Senate hearings, either in the Senate Finance Committee to which it was referred, or elsewhere. Furthermore, according to meetings with Senate Democratic staff, none are planned.

Nevertheless, of the bill’s seven GOP cosponsors, five were members of the Finance Committee when the bill was originally introduced: Senators Grassley (R-IA), Kyl (R-AZ), Coburn (R-OK), Ensign (R-NV) and Thune(R-SD). Furthermore, Senator Burr has just recently been named to the Finance Committee as well, meaning that a majority of the Republicans (6 of 11) are now cosponsors. Reportedly, they are pressuring the Committee’s Ranking GOP member, Senator Orrin Hatch (R-UT), to obtain a commitment for a hearing from the Finance Committee’s Chairman, Senator Max Baucus (D-MT).

Senator Baucus does not appear to be so inclined. However, it is difficult to imagine, given the wide range of issues that he and Senator Hatch will be working on together in the days ahead, such as the deficit reduction package to be made a part of the debt ceiling hike, that Senator Baucus would refuse a hearing on the bill if Senator Hatch seriously pressed him for one. Also, while Senator Hatch has not indicated support for the Burr legislation, he has previously stated on the Senate floor that it is his intention, “as Ranking Member of the Finance Committee, to find a way to address the public pension crisis.”

Therefore, a hearing on the legislation in the Senate is not entirely out of the question.


The House Ways and Means Committee hearing on the subject of the Nunes legislation was significant for a number of reasons. First, it was held before the Oversight Subcommittee, which does not have legislative authority to consider legislation. Some believe that this is a clear sign that senior Ways and Means Committee Republicans such as Congressman Pat Tiberi (R-OH), the Chairman of the Select Revenues Subcommittee which is technically the Subcommittee with legislative jurisdiction over the Nunes bill, are not interested in seeing the legislation advance.

However, others point out that the fact that the hearing was held anyway – over the objections of Subcommittee Democrats who called for “regular order” – demonstrates the strong support for the legislation among the House leadership. The fact that Ways and Means has now arguably held a hearing on the legislation could also make it much easier for the bill to be brought up before the full House on its own, or as an amendment to another piece of legislation.

Some think that this other piece of legislation to which the Nunes bill could be attached might be the deficit reduction package which Republicans insist be agreed upon before they will vote for an increase in the debt ceiling. Such a package is now the subject of top level negotiations between President Obama, Senate Majority Leader Harry Reid (D-NV), and Senate Minority Leader Mitch McConnell (R-KY).

This idea of using the deficit reduction package as a vehicle for the Nunes legislation was floated as early as April by none other than Grover Norquist, president of Americans for Tax Reform and a big supporter of the Nunes bill. In an interview in Time, Norquist said that “There should be a requirement that structural reform takes place before Republicans give Obama more money to spend and borrow” by increasing the debt ceiling. When asked what such structural reform would look like, Norquist responded:

“One reform that people have talked about is, at the lowest level, a vote on a constitutional amendment to require a balanced budget, and require a two-thirds vote to raise taxes. Another would require local and state governments to have complete transparency in their pension obligations, so the city of Chicago, for example, would have to tell the people they borrow money from what obligations they have on pensions.”

More recently, a number of pension-related issues have become the focus of the deficit reduction package. For example, in May, the Washington Post reported that Republicans had proposed saving more than $120 billion over the next decade by requiring the Federal civilian workforce to contribute six percent of their salary toward their pensions, or more than seven times the 0.8 percent they contribute currently. President Obama’s bipartisan fiscal commission had also endorsed the idea, calling the Federal system “out of line” with the private sector, and reportedly, Federal pension reform seemed to have support from both the right and the left in these earlier negotiations.

There are also reports that the Pension Benefit Guarantee Corporation (PBGC) could see its premiums increased as part of the deal. One proposal is to determine a company's premium by its overall financial condition, but the Chamber of Commerce and other business interests are expressing "serious concern" with the proposals.

Finally, there now appears to be a proposal on the table to eliminate indexing in the tax code related to retirement savings, which would raise revenue without obvious tax increases. According to Brian Graff, executive director of the American Society of Pension Professionals and Actuaries (ASPPA), ideas that are being considered are to decrease the Section 415 annual contribution limits to defined contribution plans from $49,000 a year to $20,000 a year or 20 percent of pay, whichever is lower. Another idea is to change the Section 402(g) limits) to eliminate catch-up contributions and to cap Section 401(k) annual contributions at from $10,000 to $14,000.

If pension “reforms” remain a focus of the deficit reduction “side-bar” legislation, this could provide the perfect opportunity to also slip in the Nunes bill, as Norquist has suggested. An agreement on the debt ceiling must be reached by August 2, 2011, in order to avoid a Federal default. Negotiations on the debt limit being led by Vice President Biden fell apart recently when the GOP insisted that higher taxes could not be allowed as part of the deal.

Ways and Means Committee Hearing Statements and Transcript

CBO Issue Brief on Public Pension Underfunding 

Repeal of 3% Non-Wage Withholding Requirement Appears Possible

Following the active engagement of the U.S. Chamber of Commerce and 125 other trade associations in a grassroots effort to repeal the 3% withholding tax, now scheduled to take effect on January 1, 2013, there now appears to be a good chance that Congress might finally do away with the burdensome requirement. According to the Chamber, a private-sector study has estimated that the 3% withholding requirement could cost Federal, state and local governments as much as $75.2 billion in implementation costs during the first five years after it takes effect and NCTR, NASRA and other public sector groups have been fighting for years to obtain repeal. However, the potential impact of the provision on small business cash flows and their ability to finance new jobs seems to have finally done the trick. A repeal amendment is currently pending in the Senate, and repeal legislation in the House of representatives has 176 cosponsors.

The 3% withholding requirement was a last-minute provision (Section 511) added to raise revenue during the 11th hour of conference negotiations on the “Tax Increase Prevention and Reconciliation Act” of 2006. It requires Federal, state, and local governments and their instrumentalities to deduct and withhold 3% of any payment for property or services. There is a small entity exception for political subdivisions and their instrumentalities that make less than $100,000,000 in payments annually.

The withholding requirement was originally to take effect January 1, 2011, but was delayed for one year in the 2009 American Recovery and Reinvestment Act, and then was once again pushed out a year (until January 1, 2013) in the final Internal Revenue Service (IRS) regulations issued in May of this year.

Implementation of Section 511 presents a number of significant challenges to State and local governments. For example, the sophistication of systems necessary to capture and report the required data vary greatly between governmental entities, and many may not have the resources, capacity or staff to undertake the required withholding and remittance. In addition, there are costs to purchase or retrofit existing payment and procurement systems, which are particularly unwelcome given state and local government fiscal situations at present.

Repeal efforts in the past have run afoul of the revenues that would be lost as a result. For example, in 2009, the Congressional Research Service reported that eliminating the provision would cost close to $11 billion over 10 years. However, the costs of implementation to businesses and governments are estimated to be much higher. For example, the Department of Defense (DOD) prepared a report for Senate and House Armed Services Committees that anticipates DOD costs to comply will be over $17 billion for the first five years alone, presenting a net revenue loss for the Federal government based on just this one agency’s expected costs. The Chamber of Commerce claims that a private-sector study has estimated that the 3% withholding requirement could cost Federal, state and local governments as much as $75.2 billion during those first five years.

Legislation has once again been introduced in the Congress to eliminate the provision. For example, H.R. 674 has been offered by Congressman Wally Herger (R-CA), and currently has 176 cosponsors in the House of Representatives. In the Senate, Senator Scott Brown (R-MA) has introduced S. 164, which is cosponsored by 17 other Senators and seems to be the Senate bill garnering the most attention.

House Ways and Means Chairman Dave Camp (R-MI) has also said that he wants to explore a repeal , and that it could possibly be included as part of a larger tax bill that he said could be moving later this year. In addition, on May 26th, the House Small Business Committee’s Subcommittee on Contracting and Workforce held a hearing entitled “Defer No More: The Need to Repeal the 3% Withholding Provision.” No one testifying, nor any Member of Congress attending the hearing, opposed the repeal of the 3% withholding requirement.

The House Small Business Committee Chairman, Congressmen Sam Graves (R-MO), and Mick Mulvaney (R-SC), chairman of the House Small Business Subcommittee on Contracting and Workforce, also have written an op-ed entitled “Stop Withholding Small-Business Payments” that was published in the June 20th issue of Politico. In it, they stressed that many small-business government contractors work for less than a 3 percent profit margin. “Withholding 3 percent of their payments may force some of these companies out of the public-sector market - or out of business entirely,” they warned. This would result in “a loss of jobs, a loss of competition and higher costs to taxpayers,” the two pointed out.

Currently, there is an effort underway on the Senate floor to pass repeal of the provision. Senator Brown, along with Senators Olympia Snowe (R-ME), James Inhofe (R-OK), and David Vitter (R-LA), filed an amendment (No. 405) to S. 782, the Economic Development Revitalization Act of 2011, to repeal the 3% withholding provision of the IRC on June 9th. Since then, Senators Ayotte (R-NH), Barrasso (R-WY), Begich (D-AK), Enzi (R-WY), and Moran (R-KS) have cosponsored the amendment. The amendment is still pending, as the Senate has yet to complete business of the underlying bill. It would pay for repeal using “unobligated funds” as the offset.

NCTR and NASRA have joined with other governmental organizations, spearheaded by the National Association of State Auditors, Comptrollers and Treasurers (NASACT), in sending a letter to Chairman Camp urging prompt action. In addition, NCTR has signed onto a statement of support submitted for the record on the Small Business Committee hearing. The Chamber and more than 1,000 organizations, individuals and business from all across the country have also written a letter to all members of Congress, calling the 3 percent withholding provision onerous and asking them to support the Brown amendment.

Although repeal is finally looking like a real possibility, the IRS’s Office of Federal, State and Local Governments will hold a free, one-hour webcast on July 14th that will address a number of questions concerning implementation of Section 3402(t), the section of the Internal Revenue Code implementing repeal,

• Who must perform Section 3402(t) withholding?

• What payments are subject to Section 3402(t) withholding?

• What are the exceptions to Section 3402(t) withholding.

So for you pessimists (realists?) out there, registration instructions for the webcast can be found here.

NASACT Summary of IRS Final Regulations

IRS Final Regulations

House Small Business Committee Hearing

NCTR, National Organizations Statement for Record

Graves/Mulvaney Op-Ed

Chamber Letter

Mandatory Social Security Update

Last year, the idea of mandatory Social Security for all newly-hired public employees was included in the recommendations of two major Commissions tasked with examining the Federal deficit and ways in which to reduce it. This year, as Congress struggles to come up with a plan to achieve major reductions in the Federal deficit as part of the debt-ceiling increase, some are concerned that the idea of mandatory Social Security may resurface. In response to this potential threat, the Committee to Preserve Retirement Security (CPRS) has been increasing its engagement with Congress, and held a bipartisan Congressional staff briefing in early June. Later that month, CPRS also participated in a hearing by the House Committee on Ways and Means on “Social Security’s Finances,” testifying in opposition to mandatory coverage.

The idea of mandatory Social Security coverage for all new hires of State and local government is an idea that has often been discussed on Capitol Hill over the years. However, it has always eventually been abandoned as too disruptive and costly for State and local governments, with too little benefit to overall Social Security reform. Indeed, it has always been assumed that such an effort would not be considered separate and apart from an overall discussion of Social Security reform.

Now, however, this linkage appears to no longer be a given. Late last year, both the President’s Deficit Commission and the Domenici-Rivlin Budget Task Force proposed that all newly-hired employees of state and local governments after 2020 be covered under Social Security, and the reasons for this had more to do with retirement security for public employees and the desire to avoid a federal bailout of public pension plans than it did the solvency of Social Security.

For example, the Deficit Commission said that excluding some public employees from Social Security and instead maintaining separate retirement systems “has become riskier for both government sponsors and for program participants and a potential future bailout risk for the federal government” due to prolonged fiscal challenges and an aging workforce. The Commission argued that mandatory coverage is necessary to mitigate these risks. “Full coverage will simplify retirement planning and benefit coordination for workers who spend part of their career working in state and local governments,” the deficit Commission argued, “ and will ensure that all workers, regardless of employer, will retire with a secure and predictable benefit check.”

The Domenici-Rivlin Task Force took a somewhat similar tack, explaining that including these new government employees in Social Security would “provide better disability and survivor insurance protection for many workers who move between government employment and other jobs.”

Furthermore, the Task Force explained the delayed effective date of 2020 as an acknowledgement of the “poor fiscal condition of state and local governments” as well as what they referred to as “the significant underfunding of public employee pensions.” According to the Task Force, this “grace period” was intended to provide governments the time to “shore up and reform their pension systems.” The Task Force concluded that “Over the long run, covering all of their employees under Social Security could help states and localities get their fiscal houses in order through transitioning to more sustainable pension programs.”

With public pensions under the microscope in the new Congress, with fears of a potential Federal bailout being raised as the rationale for Federal regulation of state and local governmental pension accounting, the recommendations and reasons for mandatory coverage, offered by the two deficit reduction panels, are increasingly worrisome.

Accordingly, CPRS held a Congressional Staff Briefing on June 6th. The briefing was a bipartisan event designed to educate Congressional staff from the 13 states that would be most significantly impacted by mandatory coverage for new State and local public employees regarding the history of Social Security as it relates to state and local employees, the retirement plans that currently protect the financial futures of public employees, and the unintended consequences that would result from Congress mandating coverage for future hires.

(The Coalition to Preserve Retirement Security (CPRS) is composed of individuals and organizations having an interest in maintaining a Social Security system which does not impose mandatory participation on state and local governmental units and their employees. Its purpose is to support continued voluntary participation of state and local government employers and employees in the Social Security program and oppose legislation to compel program participation. NCTR and NASRA are both National Partners of CPRS.)

Speaker of the Ohio House of Representatives, William Batchelder, addressed the group through a previously recorded video. He stressed the importance of the issue for both Ohio public employees and taxpayers, explaining the long-term pension security that Ohio's public retirement systems currently provide their participants. He also discussed the fact that Ohio is currently addressing ways to make sure the systems remain secure in the future.

Kevin O'Connor, assistant to the general president for Governmental Affairs for the International Association of Fire Fighters (IAFF), then discussed the unique impacts such a mandate would have on uniformed public employees. He explained that an estimated 70 percent of all fire fighters are covered by pension plans that are independent of Social Security, and that these comprehensive plans are tailored to meet the unique needs of fire fighters by taking into consideration the early retirement ages and high rates of disability retirement that are characteristic of public safety occupations.
Finally, Tom Lussier, administrator for CPRS, discussed the myths and facts surrounding the debate over mandatory Social Security. Approximately 70 staffers attend the event, and according to Tom, “we’ve had very favorable feedback.” CPRS helped orchestrate bipartisan “Dear Colleague” letters in both the House and Senate prior to the briefing supporting the CPRS message and urging attendance. “Regardless of whether an office actually attended, we know that every Member of Congress within our targeted population received our message from a bipartisan group of their colleagues,” Tom underscored.

CPRS also participated in a June 23rd hearing before the House Committee on Ways and Means’ Subcommittee on Social Security. The focus of the hearing was on the sources of Social Security’s revenues, how those sources have changed over time, options for change and their impacts.

After consultation with the Committee and with its Chairman, Congressman Sam Johnson (R-TX), Tim Lee, a CPRS Board Member and the Executive Director of the Texas Retired Teachers Association, was selected to testify on behalf of CPRS. Mr. Lee told the Subcommittee that mandatory coverage would only add two years of solvency to the 75-year projection for the Social Security program, but it would cost public employees, their employers and ultimately taxpayers nationwide more than $44 billion over the first five years, according to a 2005 update of a study conducted by the Segal Company. (Segal is once again updating this study that they originally performed in 1999, and a final version is expected in July.)

Mr. Lee also stressed that public pension plans were not in crisis. “Contrary to the premise upon which the most recent Debt Commission based its recommendation, most state and local government employee retirement systems have substantial assets to weather the recent economic crisis; those that are underfunded are taking steps to strengthen funding,” he told Subcommittee members.

There are currently no vocal supporters of mandatory Social Security coverage for state and local government new hires pushing for such on Capitol Hill. However, the increasingly heated discussion of the need for entitlement reforms is creating a possible environment in which Social Security changes could finally be in the making. The recent report by the Wall Street Journal that AARP is “dropping its long-standing opposition to cutting Social Security benefits” -- despite AARP’s subsequent denial that they have altered their position – has also helped to increase speculation that change is inevitable.

Whether or not Social Security reforms could actually be accomplished before the 2012 elections remains to be seen, but the cost impacts on a number of states will likely continue to make mandatory coverage for new public employees as hard a sell as it has always been, particularly given the current financial challenges confronting state and local governments.

However, it is clear that a new rhetoric supporting mandatory coverage suggests a new approach for its advocates: it is necessary as a means of reforming State and local pension systems to make them “more sustainable” and to avoid the need for a Federal bailout. If this idea takes root, it could well play beautifully into the hands of those who are anxious to appear to be helping address the “impending” financial threat that underfunded public plans pose to their sponsors, their participants, and eventually to the Federal government.

Should Congress becomes convinced that it must “do something” to address a perceived public pension crisis, mandatory coverage could surface as one piece of some larger, overall package (a Nunes/Burr super bill?) designed to make State and local governments “reform” their pensions to become more sustainable. If mandatory coverage is effectively removed from the context of overall Social Security reform, where it has always been able to be argued as providing too little relief at too great a cost, it could change the entire tenor of the discussion.

Ways and Means Testimony of Tim Lee

New Studies by Rauh, Biggs, Focus on Public Plans Investment Practices; GAO also Looking at Plan Alternative Investments

Two new academic studies, one by Joshua Rauh, and the other by Andrew Biggs, call into question the investment practices of public pensions. The Rauh study concludes that public pension funds’ own-state investments perform significantly worse than their out-of-state investments, at a cost of as much as $1.2 billion annually. Rauh also suggests that the problem is greater in states with higher levels of corruption. In the meantime, Andrew Biggs has written about how public pensions responded to the recent financial crisis, and has concluded that they have done so by “doubling down,” thus jeopardizing taxpayers. Finally, the Government Accountability Office (GAO) is in the process of conducting a review of defined benefit pension plan investments in alternatives, with a particular focus on any modifications plans have made resulting from the 2007-09 “financial market turbulence.” Such studies can serve to erode public confidence in state and local government plans, and suggest to Congress that, absent Federal intervention, plan failures – and Federal bailouts – are imminent.

Rauh Study

Associate Professor Joshua Rauh and Yael Hochberg, Assistant Professor of Finance, both with the Kellogg School of Management at Northwestern University, released a new paper on May 3rd entitled “Local Overweighting and Underperformance: Evidence from Limited Partner Private Equity Investments.” This paper considers the asset allocation choices of institutional investors, and more specifically, how they choose particular investments within asset classes, doing so in the context of private equity (PE) and examining allocations to and performance of limited partner (LP) investments. The goal, according to the authors, is to “attempt to quantify the extent and costs of a particular investment bias, the preference for home-state investments. “

They make the following findings:

  • While institutional investors of all types (endowments, foundations, public and corporate pension funds) exhibit substantial home bias in their PE portfolios – on average, an excess 8.1 percentage points of the investments in institutional PE portfolios are in funds headquartered in their own state, relative to a given state’s share in the population of investments by out-of-state LPs -- public pension funds make a substantially larger over-allocation to instate investment funds.
  • Public pension funds perform worse by 5.5 percentage points on average on their in-state PE investments than on the investments they make in out-of-state funds, with the overweighting and underperformance of public pension funds largest in venture capital and real estate.
  • A similar analysis for other types of institutional investors does not reveal similar significant performance differences, “suggesting that despite evidence of some level of home-bias in their investment choices, their performance is not adversely affected.”
Rauh and Hochberg then question why public pension funds overweight home-state investments with poor performance. They assume that since home-state investments are often justified in the context of Economically Targeted Investment (ETI) programs, “a natural hypothesis” is that public pension systems are subject to political pressures to invest in their home state.

They then presume that these political pressures may be higher “in states where self-dealing, corruption and quid pro quo activity is more commonplace.” Relating overweighting in home-state investments to “commonly accepted measures of state-level corruption,” the two professors find that “home-state overweighting by public pension funds is indeed higher in states with greater corruption” and that higher state-level corruption appears to be unrelated to home bias for public institution endowments and foundations, and is actually associated with lower home-state overweighting for private institution endowments.

Later in their paper, they do acknowledge that recent work by others -- while suggesting that public pension funds exhibit substantial home bias in their investment choices, and that this home bias is larger in states with higher levels of corruption -- also finds that public pension funds outperform on their in-state investments, whereas Rauh and Hochberg find that public pensions perform worse on their in-state investments. Their conclusion, however, is that the corruption results of both papers “suggest that further examination of the relationship between pension fund (and state-level) governance and public pension investments is warranted.”

Finally, they quantify the cost of such home bias by public pension funds, and state that their calculations “suggest that if each public pension LP performed as well on its in-state investments as out-of-state public pension LPs performed on investments in the same state, the public pension LPs would reap $1.23 billion annually in additional returns.”

Interestingly, Rauh and Hochberg do not address what they refer to as “the welfare implications of home-state investments.” That is, they note that public pension funds “may face political pressures to invest in in-state funds in an effort to support the local economy even if doing so reduces return on investment.” However, although they concede that it is possible that there are “positive externalities” for residents, taxpayers and public sector retirees due to the local economic development resulting from these investments which may offset the lower returns earned by the public pension fund -- and they therefore “cannot say unilaterally that the home bias and underperformance on home-state investments documented by our analysis is suboptimal” -- they nevertheless “leave explorations of net welfare to future research.”

They conclude that they have made a contribution on public pension fund governance. They go on to state that public pension systems are underfunded by $3 trillion and “operate under an accounting regime that rewards the taking of risks that allow funds to assume high expected returns.” “This might be expected to push funds towards riskier investment categories,” they surmise. Furthermore, they announce that “[a]n important question that we are addressing in ongoing research is the extent to which our state level corruption measures are correlated with poor governance features at the level of the public pension funds.”

Biggs Study

Andrew Biggs is a Resident Scholar at the American Enterprise institute (AEI). AEI is a private, nonpartisan, not-for-profit conservative think tank, dedicated to research and education on issues of government, politics, economics, and social welfare.

As part of a recent Wharton School/Pension Research Council conference, Biggs analyzed the target investment portfolios of 30 large public pension plans holding over half of total pension assets. He looked at target investment portfolios because he believes that, unlike day-to-day portfolios,” which can appear low-risk simply because all the high-risk assets lost value,” target portfolios indicate the broad direction plan managers wish to take.

Biggs begins by asserting that public pensions’ losses of 27 percent of the value of their investments from 2007 to 2008 “stemmed from a decades-long trend toward riskier investments, which began with a shift toward equities in the 1980s, and today toward so-called alternative investments such as private equity and hedge funds.” (Perhaps it could also have had something to do with the unprecedented global financial crisis, in which, according to research from Credit Suisse Global Investment Returns, global stock market losses totaled $21 trillion or $21,000 for every individual in the developed world, between the market peak of October 2007 and the trough of November 2008?)

Biggs then states that “Since target investment returns, usually around 8 percent, are often imposed by state legislatures—who are reluctant to pay the increased contributions that a lower return would require—plan managers often have no choice but to construct a portfolio that will generate the desired return, without regard to risk.” Biggs believes that “If projected asset returns fall, then pensions have to take more risk to maintain a targeted 8 percent return”

(For a slightly different view on how investment return assumptions are set and subsequently reviewed, please see the NASRA Issue Brief on “Public Pension Plan Investment Return Assumptions.” This Issue Brief explains that (1) public retirement systems employ a process for setting and reviewing their actuarial assumptions, including the expected rate of investment return; (2) most systems review these assumptions regularly, pursuant to statute or system policy; (3) the process for establishing and reviewing the investment return assumption involves consideration of various factors, including financial, economic, and market data; and (4) this process also is based on a very long‐term view, typically 30 to 50 years.)

Biggs estimates that, from 2007 to 2010, the typical plan shifted around 7 percent of assets out of equities into higher-returning—“but riskier,” Biggs asserts —alternative investments. “Some plans have gone much further—Maryland, Pennsylvania, and South Carolina increased the alternative investment shares of their portfolios by up to 25 percentage points, and New Jersey’s pension board recently voted to allow its plans to hold up to 38 percent of assets in alternatives,” Biggs reported. He does not, however, note if these plans have invested up to these limits.

Biggs concludes that public-sector pensions have responded to the recent financial crisis by “doubling down.” (For you non-gamblers, “doubling down” refers to a blackjack player’s option to double his original bet by turning over his first two cards and placing an amount equal to the original bet on the new layout. The phrase has come to also mean engaging in risky behavior, particularly when in an already risky situation.) “By taking more risk” Biggs warns, “pensions impose a contingent liability on taxpayers to bail out pension funds if investments fall short.”

Biggs also testified before Congress in April, at a hearing of the House Government Oversight and Reform Committee on “State And Municipal Debt: Tough Choices Ahead." At that time, he also was critical of what he saw as increased risk-taking by public pension plans, stating that, “In their search for higher returns, states and localities are increasingly shifting to riskier and more exotic investments.” He went on to note that this not only increases their sensitivity to shifting market returns but, “with the trend toward so-called ‘alternative investments,’ raises the possibility that governments are taking on risk that they do not fully understand.”

Noting his Wharton research finds that public sector pensions have actually increased the risk in their target portfolio allocations since the financial crisis of 2007, Biggs says that “We should worry about states becoming like a late-night gambler, hoping to recoup prior losses by doubling down.” He went on to observe that “state and local government finances are coming to resemble hedge funds, with the worrying exception that they are being run by elected officials rather than by hedge fund managers.”

Biggs’ conclusions are contrary to the findings in a November 2008 report from the National Institute on Retirement Security (NIRS) entitled “In it for the Long Haul: The Investment Behavior of Public Pensions.” The NIRS study was based on U.S. Federal Reserve and U.S. Census Bureau public pension data from 1993 to 2005, and concluded that public pension plans are prudent investors because they:

  • Actively rebalance investments in response to price changes. 
  • Do not get caught up in a “herd mentality,” but rather follow the best investment practices in the industry. State plans, in particular, systematically follow the practices of performance leaders.
  • Hold higher risk assets when funding levels are higher, and assess their financial situation before modifying the plan’s asset allocation. If anything, public pensions are somewhat overly cautious following periods of lower funding, indicating they avoid “chasing returns.”
  • Hold smaller amounts of stocks when employers face higher contribution rates. This trend continued even after the 2000 bear market. This indicates that public pensions avoid pressure to invest more aggressively after experiencing losses.
According to Beth Almeida, NIRS’ Executive Director at that time, “The data indicates that these institutional investors have performed largely as they should: they are prudent in their asset allocation and ‘buckle down’ during adverse circumstances.” Co-author Dr. Christian Weller noted that the data “suggest that public pensions followed well-established practices for prudent, long-term investing during the market plunge that occurred through 2001,” and that going forward, “this is an indicator that public plans are well situated to recover from today’s financial crisis in a manageable way."

GAO Study

The GAO is in the process of conducting a review of both public and private defined benefit pension plan investments in alternatives. The study was requested by Congressman Robert Andrews (D-NJ), the ranking member on the Subcommittee on Health, Employment, Labor, and Pensions of the House Committee on Education and the Workforce.

GAO is looking at the following questions:

  • What is known about the experiences of private DB plans with alternative investments, especially in recent years;
  • What lessons have plan fiduciaries learned from their experience with alternative investments, and how have they changed investment practices as a result; and
  • What actions has the Department of Labor taken to aid fiduciaries in effectively making and monitoring alternative investments, including the disclosure of information, and what additional actions might be warranted?
This current GAO project has been designed in part as a follow-up to their 2007-08 research on DB plans' investments in hedge funds and private equity. This time, they are especially interested in DB plans' experiences during what they refer to as “the 2007-09 financial market turbulence<’ and any modifications resulting from that experience. It is not certain when this report is expected to be finished.

It is true that public pensions are expected to increase their investments in hedge funds in 2011, based on a number of studies. However, this is often a result of portfolio rebalancing, and not “doubling down.” As was recently noted by Ronnie Jung, Executive Director of the Teachers Retirement System of Texas, in Institutional Investor, recent fund-level changes at Texas Teachers, including expanding the hedge fund allocation from 5 to 10 percent and looking at emerging markets, were done in part to reduce dependency on public markets and make the fund as diversified as possible.

Nevertheless, claims regarding increased risk-taking to chase returns, hints of corruption resulting in plan investment losses, and suggestions that some plans are not capable of managing sophisticated alternative investments will inevitably serve to erode public confidence in state and local government plans, and suggest to Congress that, absent federal intervention, plan failures – and federal bailouts – are imminent. Public plan investment practices, which have been an “on-again, off again” concern for some in Congress, look like they could be about to be “on” again.

Bond Lawyers Group Proposes Voluntary Industry Initiative on Pension Disclosures in Official Statements

The National Association of Bond Lawyers (NABL) has provided basic guidance to NABL members on the issues to be considered when assisting municipal bond issuers in the preparation of disclosures relating to public pension plans in Official Statements. A discussion draft of “Considerations in Preparing Defined Benefit Pension Plan Disclosure” has been made available to NABL Members and was also circulated to a number of groups representing key stakeholders in municipal market disclosure, including actuaries, accounting firms, financial analysts, investors, issuers and other interested person, as well as NCTR and NASRA. A group consisting of representatives of these organizations, working together with NABL as facilitator, hopes to have a final version of these considerations by the end of the year. While NABL says that neither the discussion draft nor the final product are intended as guidelines or as best practices for Official Statement disclosure regarding pension systems, some bond counsel across the country are reportedly already using them as such. In addition, there is some confusion regarding the development of certain information that may not currently be prepared by the plan. Securities and Exchange Commission (SEC) officials have applauded the NABL effort. Their clear message is self-regulate in this area, or else the SEC will do it for you.

NABL states that it created its own Pension Disclosure Task Force last year in light of the heightened focus of SEC on the quality of disclosure concerning state and local government defined benefit pension plans contained in bond issuers’ Official Statements. Their discussion draft was released on May 2, 2011, and initially raised concerns among some issuers about a “one-size-fits-all” approach.

When assisting an issuer in the preparation of pension disclosure, the NABL draft suggests that the following information “should be considered:”

  • General Overview of Pension System
  • Summary of Fiscal Health
  • General Funding Practices of Pension System
  • Funding Status of the Pension System
  • Investment Policy
  • Litigation, Investigations
  • Transfers of Investment Earnings
  • Reserves
  • Pension Obligation Bonds
  • Independent Reports
The suggestions regarding the funding status of the pension system is an area where there are some possible causes for concern. For example, NABL says that “[f]or ease of presentation” the historical funding status of the pension system, based on actuarial value and market value in separate ten-year tables, should be considered. These ten-year tables would include:

  • An Actuarial Value table, indicating the AVA, AAL, UAAL (actuarial value), the Funded Ratio, member payroll, and ratio of UAAL (actuarial value) to member payroll. 
  • A Market Value table, indicating the market value of assets, AAL, UAAL (market value), Funded Ratio, member payroll, and ratio of UAAL (market value) to member payroll. (This table would only be necessary if the plan does not use the market value of assets as the actuarial value of assets.)
  • A Comparative Ratios table, presenting the comparison of the actuarial value of assets to the market values, the ratio of the AVA to market value and the funded ratio based on AVA compared to funded ratio based on market value of assets.
  • An Annual Employer Contribution Status table, indicating, on a Fiscal Year basis, the ARC, Employer Offsets, if any, the actual contribution and any amount unfunded.
  • A Prospective Funding Status table, indicating the projected ARC, Employer Offsets, AVA, AAL, UAAL, and Funded Ratio.
Most of this information can likely currently be found in a government’s annual financial reports. However, the proposed 10-year table of the plan’s prospective funding status could be problematic. For example, it has been pointed out that such projections would only be estimates, and, since many of them are related to volatile investment returns, it is very probable that such estimates would not end up accurately reflecting future experience. Therefore, there is some concern that such projections might suggest a higher level of certainty than they actually have, and that they might therefore ultimately mislead bond investors. And if they do, who would be liable for such?

However, NABL officials point out that these prospective funding status projections are only to be considered for such a table “if available.” If they have been developed, whether internally prepared or publicly available, then NABL believes that they should be disclosed. But NABL has stressed that it is not otherwise calling for their development.

In an interview with The Bond Buyer, Maryland Treasurer Nancy Kopp summarized the situation by saying that the ultimate goal is to “arrive at an understanding of what information would be most beneficial to the potential purchasers of our bonds and what is just extraneous information.”

Treasurer Kopp is representing both the National Association of State Treasurers (NAST) and the National Association of State Auditors, Comptrollers, and Treasurers (NASACT) on the newly-created “Municipal Market’s Task Force on Public Pension Disclosure” that NABL has brought together to review NABL’s initial draft. Dana Bilyeu, the Executive Officer of the Public Employees' Retirement System of Nevada, is representing NCTR and NASRA on this new group. Mary Beth Braitman and Terry Mumford ith the Ice Miller law firm also participated by telephone on behalf of the National Association of Public Pension Attorneys (NAPPA). The Government Finance Officers Association (GFOA) is also on the new Task Force.

This Task Force met in Washington, DC, on June 28th for the first time, and, following a general discussion of the draft, members have been asked to provide formal comments to NABL by July 25. NABL’s pension task force will then redraft the guidance, based on these comments, and the NABL Pension Disclosure Task Force will reconvene for more discussions with the new Municipal Markets Task Force in Washington on Aug. 24. The goal is to complete the comprehensive pension disclosure project by December of 2011.

The NABL effort can play a very significant role in helping temper the SEC’s growing interest in municipal bond disclosures related to issuers’ pension plans. For example, the same week that the NABL draft was released, SEC Commissioner Elisse Walter gave the keynote address at the National Federation of Municipal Analysts (NFMA) Twenty-Eighth Annual Conference. In that speech, she singled out the NABL effort, saying that “I think this is an excellent topic for collaborative industry efforts and see a huge potential for disclosure improvements.”

In that same speech, Commissioner Walter spoke of the SEC’s desire to strengthen protections afforded to investors in municipal securities. She explained that the series of field hearings she has held on this subject was in preparation for a staff report concerning what was learned during the hearings, including “any recommendations for legislative changes, new or changed rules, and suggested high quality industry practices.”

She also discussed the SEC’s lack of authority to set even general disclosure requirements or require that reports be issued on a periodic basis in the municipal securities arena, noting that in order to obtain “information improvements,” the Commission has been forced to rely on its authority over the professionals in the marketplace and its antifraud jurisdiction. She said that the SEC staff is currently preparing an update to its interpretive guidance (issued in 1994) regarding the application of the antifraud provisions of the Federal securities laws to municipal securities and municipal securities market participants.

Finally, she spoke of the need for additional authority from Congress to further enhance investor protections in the municipal securities market. In this regard, she specifically alluded to the Nunes PEPTA legislation and the May Ways and means Committee hearing on the legislation, referenced in the first story of this E-News :

“I believe that additional authority from Congress would be quite helpful. Of course, it’s far too early to tell if this will go forward, but I am extremely pleased that a number of key Members of Congress have indicated an interest in municipal securities market reform and, in particular, more timely and consistent financial disclosure by municipal securities issuers. In fact, tomorrow there is a hearing on Capitol Hill concerning the measurement and transparency of funding levels of State and local pension plans, including whether municipal issuers should lose their ability to issue debt that is tax-preferred under Federal income tax law in the absence of making certain pension disclosures.”

While she didn’t endorse the Nunes legislation, mentioning it the context of “municipal securities market reform” is very disturbing.

In summary, while there are some serious concerns with the NABL draft, the overarching message is that unless there is self-regulation in this area, the SEC is clearly willing to use its antifraud powers to obtain what it sees as appropriate and necessary -- and to seek legislative authority from Congress to be able to do even more.

New Rauh/Novy-Mark Study: Public Pension Promises Will Cost $1,398 Annually Per Household

Robert Novy-Marx and Joshua Rauh have released a new paper that makes dramatic projections about the condition of public retirement systems and their effects on state taxes. Using underlying assumptions that bear no resemblance to those used by most public retirement systems and other experts, the new study purports to show how much each state needs to increase taxes per household per year to eventually fund its pensions 100%. However, calculations are made using overly pessimistic economic forecasts and an incomplete understanding of state and local revenue sources and financing requirements. NASRA’s research director, Keith Brainard, was widely quoted in a number of press reports about the study -- including the original story on it in the New York Times -- questioning the report’s findings. NASRA is also producing a formal critique that will be available shortly. The new NCTR/ NASRA External Affairs Manager, Ady Dewey, reports that the new PensionDialog Blog and Twitter account was very effective in getting Brainard’s critique out to stakeholders as well as reporters in real time, thus helping assure that the new study’s authors were not the only voices being heard on this subject.

Novy-Marx, an Assistant Professor of Finance at the Simon Graduate School of Business at the University of Rochester, and Joshua Rauh, Associate Professor with the Kellogg School of Management at Northwestern University, released a paper entitled “The Revenue Demands of Public Employee Pension Promises” in June. The paper served as the centerpiece for a New York Times story on June 22nd.

The two have previously co-authored similar studies that inaccurately portray the true condition of public pension plans in order to make draconian predictions concerning these plans’ sustainability. For example, in 2010, they released “The Crisis in Local Government Pensions in the United States” and “Are State Public Pensions Sustainable?” In an earlier critique of this work, Keith Brainard writes that they “vastly underestimate projected future contributions to public pension plans and expected investment returns to draw dramatic and improbable conclusions regarding the solvency of these plans.”

In their latest collaboration, they purport to calculate the increases in state and local revenues required to achieve full funding of public pension systems over the next 30 years. They conclude that “Without policy changes, contributions to these systems would have to immediately increase by a factor of 2.5, reaching 14.2% of the total own-revenue generated by state and local governments (taxes, fees and charges).” Put another way, they claim that this would represent a tax increase of $1,398 per U.S. household per year, above and beyond revenue generated by expected economic growth.

Furthermore, in thirteen states, their paper – and an accompanying graphic in the New York Times – finds that these tax increases would be more than $1,500 per household per year. In five states, they claim the increases would be more than $2,000 per household per year.

They conclude that “substantial revenue increases or spending cuts are required to pay for pension promises to public employees, even if pension promises are frozen at today’s levels.” Furthermore, they also state that “A significant finding of our analysis is that the GASB rules significantly undervalues the cost of providing DB plans to state workers, as the true present value of new benefit accruals averages 12-14 percent of payroll more than the costs recognized under GASB.”

However, upon careful examination of their work, it becomes clear that their paper is based upon a number of seriously flawed assumptions. The following are several problems that Mr. Brainard has identified with their paper:

  • It discounts liabilities on a risk-free basis;
  • assumes future economic (GDP) growth of 1.99 percent, well below the nation’s average rate of GDP growth over the last 60 years and the Federal Reserve’s long-run estimate of 2.5 to 28 percent;
  •  assumes pension fund real investment returns of 1.7 percent, well below historic norms;
  • assumes that non-Social Security employees will join Social Security, and that employers (taxpayers) will pay the full (12.4%) cost;
  • discounts or fails to incorporate higher employee contributions implemented in 17 states since last year;
  • does not account for reductions in future benefits, particularly COLAs, affecting existing plan participants;
  • ignores the 20 percent of state and local revenue that comes from shared programs with the Federal government and the significant revenues that come from other non-tax sources, such as tuition and fees; and it
  • implies that pensions must be fully-funded
NASRA’s formal critique of the new paper is expected shortly. It will underscore the fact that policymakers need practical information pertaining to the cost of funding pension plans – not the extreme projections the new Rauh/Novy-Marx paper presents. As has been stated before in earlier critiques of these two authors’ works, information that ignores the differing plan designs and pension financing arrangements across the country , the reasonable future return expectations for capital markets, and common public fund portfolio construction, is misleading and unhelpful. Furthermore, to dismiss all the other available policy options for increasing long-term sustainability of state and local retirement systems and focus only on tax increases or spending cuts is deceptive.