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.


“Snapshots” is a feature of the NCTR Federal E-News, intended to give you a very brief summary of an issue, event, or publication(s), and then provide links to appropriate back-up materials. This is not intended to replace the more in-depth analysis of issues which will continue to be the primary focus of the e-News, but will allow coverage of a larger number of issues of interest to NCTR members.

GASB Approves Exposure Draft for Pension Accounting Rules Changes

The week of June 27th, the Governmental Accounting Standards Board (GASB) approved Exposure Drafts as part of its project on pension accounting and financial reporting. The full documents will be available on the GASB website on July 8th. Once they are reviewed, NCTR will hold a webinar on the details and implications of this latest iteration of proposed changes to pension accounting and disclosure rules.

The GASB review of Statement No. 25, “Financial Reporting for Defined Benefit Pension Plans and Note Disclosures for Defined Contribution Plans,” and Statement No. 27, “Accounting for Pensions by State and Local Governmental Employers” began in January of 2006, when the project was added to GASB’s research agenda. Then it was added to the current agenda in April, 2008. The Invitation to Comment was issued in March of 2009, and the Preliminary Views were released in June of 2010.

Once the drafts are formally released, there will be a 90 day period in which to submit written comments. There will also be public hearings: on October 3rd (LaGuardia); October 13th (San Francisco); and October 20th (Chicago O’Hare).

GASB will then begin a final deliberation process to consider the comments and perhaps make further changes in the standards, although at this stage, it is unlikely that there will be many such modifications. Then, probably sometime in the summer of 2012, the final rules will be issued. According to Robert Attmore, GASB’s Chairman, there will likely be a transition period of at least a year before they begin to take effect for larger plans, so they probably will not begin to be implemented until 2013.


NCTR and NASRA announced the launch of their new blog, PensionDialog.com, and its corresponding Twitter account @PensionDialog, on June 22nd.

The target audience for both tools is the media, policy makers and staff, and other stakeholders. Both the blog and Twitter will be used to promote research and news, respond to articles and newly released studies, and promote initiatives, including partners' work, from across the U.S.

NASRA and NCTR will continue to serve their members with news and information on each of their individual websites. The PensionDialog blog account will be administered by Ady Dewey, the new NCTR/NASRA manager of external affairs. The new blog has already proved invaluable in getting information out on a “real-time” basis to the media and others concerning the latest Rauh/Novy-Marx study (see story above in this E-News.)

A separate venue for pension system communicators has also been created. This forum is intended to share best practices, strategic messaging, and news. For information on how to connect to this blog, please contact Ady at NASRA.NCTRcomm@gmail.com.

New NIRS Paper Finds Public Pension Asset Exhaustion Only a Remote Possibility

The National Institute on Retirement Security (NIRS) released a new review of two economic studies that evaluate pension sustainability based on the ability of pension trust funds to pay benefits promised over the coming years. The may 5, 2011, paper examines the strengths and weaknesses of these studies and assesses their value as a tool for policymakers.

One of the studies was “Can State and Local Pensions Muddle Through?” produced by the Center for Retirement Research at Boston College in March of 2011. This report investigates two concepts for estimating when plans would run out of money. It found that using a more realistic “ongoing” framework, in which normal costs are used to cover benefit payments, most plans have enough for at least 30 years. Furthermore, these estimates were conservative, as they were based on 2009 data and therefore did not reflect the more recent run-up in the stock market. Nor did they incorporate recent efforts to increase employee contributions and reduce benefits for new employees. And they assumed that states pay only the normal cost when many make the full annual required contribution.

The other study of was “The Day of Reckoning For State Pension Plans,” a posting by Joshua Rauh on the “Everything Finance” blog of the Northwestern University’s Kellogg School Finance Department. According to this study, seven states would run out of money before 2020 and thirty more states are expected to run out of money during the 2020s.

NIRS found that the Rauh study’s theoretical estimates of the number of years in which public pension plans can continue to pay existing benefits based on the investment of current assets “represent a flawed, simplified way to view the sustainability of these pension plans.” The author of the NIRS paper, Diane Oakley, the new NIRS Executive Director, wrote that “With some limited exceptions, states and localities do not face an immediate pension shortfall that would require sponsors to pay benefits from operating revenues even under dire termination assumptions.”
Bipartisan Effort to Control 401(k) Leakage

Noting that the gap between what Americans will need in retirement and what they will actually have saved is estimated to be a staggering 6.6 trillion dollars, Senators Herb Kohl (D-WI), Chairman of the Senate Special Committee on Aging, and Mike Enzi (R-WY), the Ranking Republican member of the Senate Health, Education, Labor and Pensions (HELP) Committee, have introduced legislation intended to help stop 401(k) plan leakage by providing flexibility to loan repayment hardship tax rules and limit 401(k) loan practices.

“As the frequency of retirement fund loans have gone up, the amount of money people are saving for their retirement has gone down,” Senator Kohl noted. “While having access to a loan in an emergency is an important feature for many participants, a 401(k) savings account should not be used as a piggy bank.”

The “Savings Enhancement by Alleviating Leakage (SEAL) in 401(k) Savings Act of 2011” (S. 1121) would:

  1. extend the period for repayment of loans if a 401(k) plan terminates or a plan participant becomes unemployed; 
  2. prohibit 401(k) plans from allowing the use of credit cards or similar arrangements to access loan amounts; and 
  3. allow 401(k) plan participants to make additional contributions to a plan during the six month period following a hardship distribution.
The legislation has been referred to the Senate Finance, where no further action has been taken.

The SEC and Credit Rating Agencies

The Securities and Exchange Commission (SEC) has been very busy the last three months on several matters relating to Credit Rating Agencies, which were a major focus of criticism for their perceived role in the collapse of the mortgage securities market that, when it collapsed, contributed significantly to the financial meltdown that followed.

  1. On April 27th, the SEC proposed amendments that would remove references to credit ratings in several rules under the Securities Exchange Act. These proposals represent the next step in a series of actions taken under the Dodd-Frank Wall Street Reform and Consumer Protection Act to remove references to credit ratings within agency rules and, where appropriate, replace them with alternative criteria. The purpose is to eliminate over-reliance on credit ratings by both regulators and investors – and to encourage independent assessments of creditworthiness rather than uncorroborated reliance on credit ratings.

    According to SEC Chairman Mary Shapiro, “The most significant proposed change in this area would preclude firms from looking solely to ratings when calculating capital charges for commercial paper, nonconvertible debt, and preferred stock under the Commission’s net capital rule. Instead, each firm with proprietary positions in these instruments would need to look at a variety of factors, and they would need to have and document procedures for doing so.”
  2. On May 10th, the SEC requested public input to assist in their study on the credit rating process for structured finance products. Specifically, they are seeking comments on (a) the credit rating process for structured finance products and the conflicts of interest associated with the issuer-pay and the subscriber-pay models; (b) the feasibility of an assignment system in which a public or private utility or a self-regulatory organization would assign a credit rating agency to determine credit ratings for structured finance products; and (c) alternative means for compensating credit rating agencies that would create incentives for accurate credit ratings for structured finance products. Comments will be accepted for four months. The SEC is to submit the findings of its study to Congress by July 21, 2012.
  3. On May 18th, the SEC proposed a number of new rules and amendments intended to increase transparency and improve the integrity of credit ratings. According to the SEC. the proposed rules would implement certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act and enhance the SEC’s existing rules governing credit ratings and Nationally Recognized Statistical Rating Organizations (NRSROs).

    “In passing the Dodd-Frank Act, Congress noted that credit ratings applied to structured financial products proved inaccurate and contributed significantly to the mismanagement of risks by financial institutions and investors,” SEC Chairman Mary Schapiro said. “Our proposed rules are intended to strengthen the integrity and improve the transparency of credit ratings.”
Under the SEC’s proposal, NRSROs would be required to:

  • Report on internal controls.
  • Protect against conflicts of interest.
  •  Establish professional standards for credit analysts.
  • Publicly provide – along with the publication of the credit rating – disclosure about the credit rating and the methodology used to determine it.
  • Enhance their public disclosures about the performance of their credit ratings.
The SEC’s proposal also requires disclosure concerning third-party due diligence reports for asset-backed securities. Public comments will be accepted on the proposals for two months.
New Pew Center Study Finds Pension Underfunding Increased in 2009

In April, the Pew Center on the States released a new report entitled “The Widening Gap: The Great Recession’s Impact on State Pension and Retiree Health Care Costs.” The report found that “In the midst of the Great Recession and severe investment declines, the gap between the promises states made for employees’ retirement benefits and the money they set aside to pay for them grew to at least $1.26 trillion in fiscal year 2009, resulting in a 26 percent increase in one year.”

Pew reported that the shortfall was about evenly divided between pensions, which they found had a $660 billion funding gap, and retiree health care and other benefits , which accounted for the remaining $607 billion, with assets totaling $31 billion to pay for $638 billion in liabilities. In other words, with $2.28 trillion in funding for $2.94 trillion in pension liabilities in 2009, state pension plans were 78 percent funded, while retiree health care benefits are only 5 percent funded.

While PEW found that the value of assets in state pension plans dropped a record 19.1 percent in 2009, it also recognized that, “For most states, whose fiscal year 2009 began on July 1, 2008 and ended on June 30, 2009, these data capture the worst effects of the financial crisis.” Pew also acknowledges that “ More recently, many plans have reported double-digit investment gains for fiscal year 2010.”

In an effort to put the Pew report in some perspective, NCTR and NASRA worked together to put out a joint Issue Brief prior to the Pew Center report’s release. This Issue Brief – entitled “Strong Investment Gains and Legislative Changes Speeding Public Pension Recovery” -- underscored that, at the end of calendar year 2010, aggregate state and local government retirement system assets totaled $2.93 trillion, a 35 percent increase from their quarterly low point during the market collapse.

“These asset levels are also nearly 25 percent higher than they were on June 30, 2009 – a date on which many recent studies on the financial condition of state and local pension trusts are based,” the brief noted. “Since then, not only have investment returns rebounded sharply, but many states have adopted changes to benefit levels and financing structures that have positively impacted pension trusts,” it reminded readers.

GAO Finds that Most Private Sector Retirement Plan Tax Benefits go to Higher Income Workers

In a foreshadowing of what will likely be a centerpiece of any future debate over tax reform and deficit reduction, the Government Accountability Office (GAO) has taken a look at the tax expenditures associated with retirement savings in the private sector and found that they benefit mostly higher income employees.

GAO said that while the existing system of tax preferences for pensions has played at least a supporting role in fostering current levels of pension plan coverage, private plan participation nevertheless remains stalled at roughly 50 percent of the private sector workforce. Furthermore, even for the 50 percent of the private sector workforce that does participate in a plan, GAO found that for defined contribution plans, “a disproportionate share of these tax incentives accrues to higher income earners.”

Specifically, while 72 percent of those who make tax-deferred contributions at the maximum limit earned more than $126,000 annually in 2007, less than 1 percent of those who earned less than $52,000 annually were able to do so. Also, GAO said that “even the additional $5,500 contribution permitted to participants 50 and older may not allow moderate income workers to catch up anytime soon.” In short, private sector retirement savings tax incentives accrue primarily to higher income employees and do relatively little to help lower income workers save for retirement.

The subject of the tax expenditures associated with retirement savings incentives is an increasing topic of conversation among policy makers on and off Capitol Hill. Tax expenditures are losses to the U.S. Treasury that result from granting certain deductions, exemptions, deferrals or credits to specific categories of taxpayers in order to encourage or promote certain policy objectives. They are an indirect form of government spending on specific policy programs. According to the Joint Committee on Taxation, the largest FY 2009 tax expenditures were the exclusion of health benefits from income taxation ($94.4 billion); the home mortgage interest deduction ($86.4 billion), and the net exclusion of pension contributions and earnings associated with defined benefit and defined contribution retirement plans ($73 billion).

Last year’s two major deficit commissions both called for a scrapping of the existing system, including many of the expenditures related to retirement savings. For example, the Domenici -Rivlin Task Force suggested restructuring itemized deductions, eliminating “almost all” tax expenditures and modifying those for 401(k) plans, IRAs and Keogh plans, permitting individuals and employers combined to contribute up to 20 percent of annual earnings to such qualified plans, up to a maximum of $20,000 per year, indexed to inflation. The goal, they said, was to ensure that “qualified plans will no longer be a vehicle for wealthy individuals to convert a substantial share of their assets into tax-free retirement assets.”

In response to these suggestions that the tax expenditures related to defined contribution plans be cut, the American Society of Pension Professionals & Actuaries (ASPPA) recently produced a study examining these estimates of tax expenditures as they applied to defined contribution plans. They argue that tax expenditure estimates for retirement savings provisions should be prepared on what they refer to as a present-value basis. “Measuring retirement savings provisions on a present-value basis would help policymakers understand the lifetime tax benefits occurring with respect to retirement savings contributions and would allow an ‘apples to apples’ comparison with tax expenditures such as current deductions and credits,” they argue..

Using this present-value basis, they find that the one- tax expenditure estimates related to contributions to defined contribution retirement plans are 34 percent lower than the Joint Committee on Taxation’s one-year estimates and 54 percent lower than the Treasury one-year estimates. In addition, the present-value tax expenditure estimates of contributions made in the first five years are 55 percent lower than the JCT five-year estimates and 75 percent lower than the Treasury five-year estimates.

A similar analysis theoretically could extend to defined benefit plans, the study notes, but to simplify the discussion, the ASPPA study presents only defined contribution plans.

For the DC plan community, the fight over tax expenditures related to retirement savings is a very real one. But what about defined benefit plans? Is it conceivable that Congress would cut DC plans’ tax expenditures but leave DB plans untouched?

CRR Suggests “Stacked” Hybrid Plans as New retirement Model

Boston College’s Center for Retirement Research has a report suggesting a new way in which to combine the defined benefit (DB) model with the defined contribution (DC) plan in the public sector.

The new approach would be to “stack” the two together, combining a defined benefit plan based on a certain amount of wages – for example, the first $50,000 – with a defined contribution plan on amounts above that.

“The advantage of the ‘stacked’ approach is that it allows employees with modest earnings to receive the full protection of a defined benefit plan,” the report argues. “This group would be the most vulnerable if required to rely on a 401(k) for a portion of their core retirement benefit.”

More highly-paid public employees would still have the protection of a defined benefit plan as a base and would then rely on the 401(k) for earnings replacement that exceeded the earnings of a typical private sector worker. “This overall arrangement offers a reasonable balance by providing adequate and secure benefits targeted to public employees who need them most while limiting the risk to taxpayers of covering large pension shortfalls,” the report concludes.

“Defined contribution plans may well have a role in the public sector,” the report’s authors note, “but in combination with, not as an alternative to, defined benefit plans.”

GASB Issues Report on Timeliness of State and Local Financial Reporting

GASB has released a research brief that examines how long it takes state and local governments to issue financial reports prepared in conformity with generally accepted accounting principles (GAAP), and how the passage of time affects the usefulness of the financial information for users.

Based on its review of the financial reports of the 50 states, the 100 largest counties and localities, and the 50 largest independent school districts and special districts for the 2006–2008 reporting periods, GASB found that in general, 73 percent of the largest governments issued their reports within 6 months, while 2 percent took more than 1 year.

The largest local and county governments and independent school districts issued their financial reports approximately six months after the fiscal year-end on average, while State governments averaged closer to seven months. Special districts averaged about four months.

GASB also looked at smaller governments, and found, based on a random sample drawn from the list of 89,527 governments included in the 2007 Census of Governments, and found that smaller county governments took an average of 8 months to issue their financial reports, while smaller local governments took 6 months. Overall, under 46 percent of the smaller governments examined issued their reports within 6 months, and 7 percent took more than 1 year.
GASB also found that financial report information retains some degree of usefulness to municipal bond analysts, legislative fiscal staff, and researchers at taxpayer associations and citizen groups for up to six months after the fiscal year-end. However, afterward its usefulness quickly declines.

While GASB does not require that GAAP-based financial reports be issued within a specific timeframe, the research brief notes that timeliness -- or the lack thereof -- continues to be a central “as it strives to balance the benefits of information to its users with the cost of providing that information.”

New Survey by Prudential Finds Growing Interest in Guaranteed Retirement Income for Life

An Interesting new survey from Prudential supports the need and desire for a national response to retirement insecurity and reinforces NIRS polling data on this point. The report on the survey, “The Next Chapter: Meeting Investment and Retirement Challenges,” also suggests that there is growing interest in the kind of guaranteed income for life that DB plans provide.

Here are some of the results as stated in the Prudential survey:
  • Most investors believe that the investments they have today are not earning enough to make up for the losses they’ve experienced over the past few years (73%). In the aftermath of the recession, 72% of Americans acknowledge that they need to think differently about how they save, invest, and plan for retirement—a recognition perhaps that “the rules have changed”.
  • Six in 10 (58%) say they want to feel less pressured, less threatened, and less overwhelmed by the prospect of making financial decisions. However, 40% are going it alone with no help from an advisor; in fact, 53% don’t believe an advisor is helpful even in extreme market conditions.
  • More than half (54%) do not feel well prepared to take on the task of rebuilding their portfolios, and three-quarters (73%) point to challenges that span from deciphering confusing product information to navigating an overwhelming amount of options to overcoming distrust of advisors and firms. Nearly seven in 10 believe there are few financial services firms that are trustworthy.
The survey also found that investors of all ages find guaranteed products appealing—41% are “very” interested in investment products that can provide guaranteed lifetime income. What’s more, survey respondents showed a genuine appreciation for the value of the guarantees—nearly two-thirds (65%) agree that purchasing a guarantee is not all about the cost, but rather the value received for the price paid.

GRS Looks at Recent Trends in COLAs

In their search for ways of controlling pension costs and stabilizing required contributions, many public pension plans and their sponsors are reviewing their plan designs. This can often include taking a look at the costs associated with cost-of-living adjustments (COLAs).

Paul Zorn, Mark Randall, and Joe Newton with Gabriel Roeder Smith & Company have written an article that discusses the purpose of COLAs, how they are provided, and the advantages and disadvantages of different types of COLAs. It also discusses recent changes in public-sector COLAs and the relative costs of COLA designs.

Brand New GAO Report Looks at Ensuring Income Throughout Retirement

A newly-released report by the Government Accountability Office (GAO) examines what it refers to as the “difficult choices” in trying to ensure income throughout retirement.

GAO found that most retirees rely primarily on Social Security and pass up opportunities for additional lifetime retirement income. Furthermore, only 6 percent of those with a defined contribution plan chose or purchased an annuity at retirement. Those in the middle income group who had savings typically drew down those savings gradually, but an estimated 3.4 million people (9 percent) aged 65 or older in 2009 had incomes (excluding any noncash assistance) below the poverty level. (Among people of all ages the poverty rate was 14.3 percent.)

“Given the long-term trends of rising life expectancy and the shift from DB to DC plans, aging workers must increasingly focus not just on accumulating assets for retirement but also on how to manage those assets to have an adequate income throughout their retirement,” GAO pointed out. Furthermore, GAO noted that workers are increasingly finding themselves “depending on retirement savings vehicles that they must self-manage, where they not only must save consistently and invest prudently over their working years, but must now continue to make comparable decisions throughout their retirement years.”

GAO also stressed that although retirement savings may be larger in the future as more workers have opportunities to save over longer periods through strategies such as automatic enrollment in DC plans, “many will likely continue to face little margin for error.” “Poor or imprudent investment decisions may mean the difference between a secure retirement and poverty,” GAO warns.