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Sky High

Rick Roeder       March 2018

Pension contributions for most California entities have risen to unprecedented levels in recent years. If you had opined in 1998 that contribution rates would exceed 30% of payroll (sometimes markedly so) for a sizable number of the 37 funding entities in California, some folks would have been tempted to drug test you immediately.

What makes this development so baffling is that two factors exist this decade that have acted to lower pension contribution rates from even loftier levels. We have been experiencing really strong domestic equity markets since 2009. The Dow Jones Industrial Average was slightly above 10,000 on New Year’s Day 2010. Fast forward eight years later, the DJIA skyrocketed to 26,000+. Tune in to CNBC on many of tbe fjrst business days of 2018 and you would have heard a repeated chorus singing sweet music as to the Dow’s latest all-time high.

In September 2012, the Legislature passed a bill (“PEPRA”) to deal with benefit levels that were not perceived to be sustainable. Post-2013 hires would not only have significantly lower benefits but would have to pay 50% of the estimated costs of those pensions. However, in the short-term, PEPRA was the fiscal equivalent of locking the barn door after the animals have fled. Since only the pensions of new hires were affected, the impact as of January 1, 2013: Nada. Zip. Zero. PEPRA will start to have a significant impact in the 2020’s after a good chunk of the accrued liabilities will start to be linked to post-2012 hires but until then……..

When Governor Brown attributes one of the reasons for unsightly current pension contribution levels to “flawed actuarial analyses,” it triggered a reaction from this actuary. Not that I am defensive.   While I agree with Governor Brown to a slight degree, bigger reasons were in play to set the stage for these unimaginable contribution rates. What follows is a list made by yours truly in an attempt to rank causes in terms of importance. You will find that “flawed actuarial analyses” will be pretty far down on the list.

1. Human Psychology

2. Retirement Board Composition

3. Exuberant Benefit Formula Design

4. CalPERS Retirement Board

5. CalPERS Actuaries in the 1990’s

6. The Fund Manager Community

7. Governing Bodies

8. Labor Negotiations

9. The Actuarial Community

The era from 1983-2000 represented one of the most unique eras in America’s financial history. Despite a few relatively minor bumps, America was reveling in the midst of a 17-year period best described as a raging bull market. The heady rise may have been a byproduct as to how badly stocks had been trampled in the previous generation as a combination of high inflation and ever higher interest rates placed a low ceiling on the market. How low? In late 1981, I vividly remember attending a seminar where a touted investment advisor had the audacity to predict that the Dow Jones was going to someday rise to 2,000. A number in the audience thought this prediction to be quite remarkable and a touch reckless given the troubled financial waters of the prior decade.

The duration of the subsequent raging bull market served to scrub memories of the Sad Seventies, the 1929 Crash and any other bear market ever perpetrated. I have a personal anecdote that speaks to how fully “bear market amnesia” had taken hold. I was in a relationship with a homemaker who made a dramatic shift into “day trader.” Her lack of any financial background was not a perceived barrier. Human psychology seems to tilt toward unbridled optimism during persistent good times. Decision makers in public plans proved not to be immune. As pension contribution rates plummeted, the decisions to raise benefit levels proved easier and easier to make.

2. The composition of Retirement Boards created a strong tilt toward labor. Not only were employee representatives reasonably close to 50% on most Boards, their influence often far outstripped their numerical representation. Politicians who were on the Board often benefited from labor’s campaign contributions. Board actions often reflected such realities. Labor certainly deserved a seat at the table, if for no other reason that plans were contributory (although this basic feature was emasculated by employers often agreeing to “pick up” some or all of the employee contributions during labor negotiations). One of the manifestations of this “tilt” particularly during the Raging Bull market could be evidenced by Board actions such as “13^th checks” and the creation of “air time” to allow employees to purchase service at favorable rates. The notion of squirreling away enough monies during the good times to fill in the troughs during bear markets was usually deemed quaint.

3. In California, “3% at 50” became a prevalent formula for Safety members. Which meant that Safety members retiring in their early fifties morphed into instant actuarial millionaires. Perhaps even more surprising, 3% multipliers at later ages surfaced for non-Safety members. All this occurred as defined benefit plans for private sector taxpayers were in the process of being gutted. When Gray Davis signed SB 400 in 1999, this legislative act cast a huge shadow over contract agencies and other independent entities. For example, a police officer for the City of Ventura, one of CalPERS’ 2000 contract agencies, could brag to a Ventura County Sheriff, a member of a separate County plan under the 1937 Act, of his upgraded, generous pension. The pressure for entities to follow CalPERS’ lead was enormous. As a result, we know numbers of people who actually get a pay increase in retirement when one factors in the elimination of employee contributions and work-related travel expense. The rallying cry for those proponents of the SB 400 legislation: Ongoing investment income will help the bill pay for itself.

As a result, the state’s systems evolved from providing good benefits to offering “Cadillac benefits.”

In theory, the funding of a California governmental pension was initially designed to be a 50/50 partnership between employee and employer. While certain measures served to tilt the financing burden toward the employer, this relationship was shattered with such large benefit increases. Such increases were not solely on a prospective basis but almost always for previous years of service, as well. What did the employees pay for this retroactive grandfathering? Zero. One could make an argument that this treatment of prior service constituted a “gift of public funds” of unparalleled precedent.

4. The CalPERS Retirement Board has had a reputation for decades as being very sympathetic to labor and its requests. This reputation has been well deserved. In addition to administering the plan for the state’s employees, the Board has a vital role in the benefits offered to the contract agencies. Pre-PEPRA, contract agencies have historically had a wide choice as to benefit design elements such as the final average compensation period and the maximum cost of living adjustment, in addition to many possible benefit formulas. Each of these “add ons” require actuarial pricing from CalPERS’ sizable actuarial staff.

During the late 1990’s, the actuarial euphoria of the times did not escape the CalPERS Retirement Board. Instead, such euphoria was embraced in steroids. A new term was funded for plans meeting certain parameters. The term: “super funded.” As an actuary for over 40 years, I can attest that there is no actuarial bible that defines this term. In 2018 parlance, one could dub this a “fake term.” However, if you were a lay person and were contemplating a benefit formula increase, how could you not say, “Well, if we are super funded, larger benefits should be affordable.” This “super funded” mind set was further fueled by CalPERS opining that the higher benefit levels would come at “no additional cost.” As Californians were to find out, having a 100% funded ratio (assets being greater than accrued liabilities) at a given time is merely one humble data point among an infinite set.

5. Which brings us to CalPERS’ actuarial honchos of the 1990’s. Yours truly does not know the genesis of the term, “super funded”, but, at the very least there should have been much stiffer resistance to the use of the term. Since the chief actuary serves at the pleasure of the Board, one can understand why his response could have been muted. Yet another conflict of interest in a sea of conflicts. Ron Seeling, CalPER’S chief actuary at the time of SB 400’s passage, said that he warned of the dire consequences associated with a significant long-term investment shortfall could be catastrophic and further observed that the greed associated with the SB 400’s passage was considerable.

6. When Jerry Brown references “flawed actuarial analysis” he principally is referring to the use of higher assumed investment returns than appropriate (and, to a much lesser degree understating the level of increased longevity). Guesstimating levels of future returns is a total crapshoot. Perhaps this suggests a degree of conservatism in setting such returns. However, a counter argument could be made that if the funding of a plan is too conservative, overfunding runs the political risk of further benefit increases. In the course of the past 15 years, the norm for the assumed net investment return has gradually decreased from 8% to 7.25% or so (If you wish to see details over the past decade, we refer to the Ramble at roederfinancial.com which shows results of our annual Funding Ranking Survey).

Money market managers have fed the notion that active management will produce positive incremental returns for funds for obvious reasons. The results have been mixed. One of the ironies of the past decade is that money managers often thought that greater windfalls would be available in emerging markets while plan sponsors scratched their heads as surging domestic returns outpaced international investments.

7. Money manager projections of assumed returns has been a factor in the very gradual reductions in assumed returns since the 2008 Great Recession. Cash strapped entities have had a vested interest in not wanting bigger reductions in assumed returns as such reductions translate into even yet higher near-term contributions. When decisions to increase benefits occurred in the 1997-2001 period, yet another conflict of interest arose as decision makers had a vested interest in ratifying benefit increases if their personal benefit also went up.

8. Often labor negotiations resulted in trading increased benefits for lower pay increases. However, this often backfired for employers in subsequent negotiations when, undaunted, labor wanted some “catch up” pay increases.

9. For almost 20 years, the actuarial community has been embroiled in a debate as to what discount rate to use. The prevalent view is that the long-term “real rate of return” should be recognized. However, there are staunch proponents that a “riskless” rate of return be employeed. Can you imagine the impact on contribution rates if 3.5% or 4% discount rates were used? If you google Jeremy Gold, you can examine the case he makes his case for “riskless rates.” Mr. Gold and his supporters have not yet converted yours truly.

Actuaries often rely on a combination of historical “real rates of return” and the outlook by the systems’ investment advisors in setting rates.

I believe the actuarial community was likely slow to recognize how much more attractive public sector employment has become in the past 20 years. Earlier recognition would have resulted in lower rates of assumed employee termination, which, in turn, results in higher rates. We have also seen cases where “early retirement incentives” (CalPERS used the term “golden handshakes”) and air time were underpriced. However, in general, we would rate “flawed actuarial analysis” as relatively low on a long, long list of causes.

In the future, PEPRA will clearly help in gradually reducing contribution rates. Battle scars will offer lessons. In the meantime, we will keep looking at current actuarial contribution rates and mutter to ourselves.

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