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We Can't Handle the Truth

Rick Roeder       May 8, 2009

When one of Jack Nicholson’s most famous characters, Colonel Nathan Jessep in “A Few Good Men”, arrogantly retorted to Tom Cruise that “You can’t handle the truth”, it was one of the most memorable lines of Nicholson’s legendary career. Colonel Jessep could just as easily made such smack talk to defined benefit pension plan sponsors over the past 25 years.

Plan sponsors have made many poor decisions when plan funded ratios approached or exceeded 100%. A funded ratio compares plan assets (sometimes on a smoothed basis to minimize recent market volatility) to plan liabilities. One would think that having a funded ratio of 100% would be a wondrous thing worthy of a parade or at least a celebratory drink at the nearest watering hole: Except that attaining a 100% funded ratio has been a recipe for disaster in both the private and public sectors.

First, let’s consider the private sector. When the markets really started to perk up in 1983, the funded ratios for many such plans soon exceeded 100% on a “termination” basis. To the extent there were “excess” pension assets, such excesses looked really attractive both to CEOs, looking for extra cash, and to the corporate raiders looking for their next takeover target. The raiders could buy the company, terminate the plan and pocket the pension excess. The 1987 movie, “Wall Street” should be required viewing for several reasons. The movie was brilliant in depicting the greed, amorality and short-term thinking that was becoming more prevalent and would crescendo on Wall Street during the Bush years. An integral part of the “Wall Street” plot was the planned takeover of fictional Blue Star Airlines for its purposeful destruction and seizure of the “excess” pension assets.

Congress woke up to what was going on by placing significant restrictions on asset reversions in the late 1980s. Plan sponsors were disappointed in the penalties accruing to a well funded plan upon termination. Since plan sponsors assume all the investment risk in defined benefit plans, it struck some as unfair that they could not reap more reward with “excess” assets. This law change proved to be about the 20^th reason for the steady decline in the popularity of defined benefit plans in the private sector.

The public sector has been an entirely different animal. First, they were not saddled with the dizzying array of pension rules that helped fuel the demise of private sector plans. Second, there is a much higher degree of unionization among public sector employees. The unions have wisely fought hard to retain defined benefit plans. Last, disability benefits, which fit better with defined benefit structure than other pension designs, are near and dear to safety employees and their powerful unions.

So, while private sector defined benefit plans were withering up and dying, traditional defined benefit plans continued to flourish in the public sector during the go-go 1990s. Many funded ratios stood above 100% as the new millennium began. Public plans shared the good times with employees in terms of increased benefits. Some conferred benefit increases were almost prudent in that they were ad hoc benefits such as increased COLAs, one-shot increases or payment of a portion of retiree medical premiums. However, many increases of benefits rose to historically unprecedented levels and extended to forever. Such increases usually applied to service already rendered as well as future service. What did unprecedented benefits look like? 3% benefit multipliers became common for safety employees. – in other words, an age 50 retiree, hired at age 25, would be entitled to a pension equal to 75% of final pay. Actuarially, with COLAs and survivor benefits tossed in, the actuarial value of such pension could easily exceed $1 million dollars.

Non-safety employees were able to ride the coattails of the Safety employees. I live in San Diego where the largest local plans have multipliers in the 2.5% area at age 55. It is often a benefit to the local community to encourage retirement for Safety employees at early ages due to the physical rigor of their jobs. However, to encourage non-Safety employees to have early retirements is not borne out of a similar necessity – it simply is a drain on local taxpayers and desired services.

OK, a lot of public entities made a mistake, you agree. You think that they will just undo their error and life will go on – logical thinking but incorrect!! In most states, the doctrine of “contract impairment” applies for government employees. What this means is that if I work for one hour in my career under a richer level of benefits, the plan sponsor cannot tell me on my 2^nd day of employment that my pension benefits for ANY of my years of potential future service will be unilaterally reduced. For example, the embattled City of San Diego just announced that retirement benefits will be significantly cut back for all new hires after July 1, 2009. However, the actuarial impact of such change is very gradual and does not start to be marked until almost a decade after such change is implemented.

There is rich irony that many plans would have a higher funded ratio today if there funded ratios never exceeded 100% in the late 1990s! Decision makers either did not understand that it was important to squirrel away money for a bear market, caved into powerful political interests or both. Many Plans would have been better off if their funded ratios had stayed “under the radar” in the 80%-95% range given the dynamic of the times.

Now we are left with an utter mess in the public sector. Take the Kern County Retirement System (for non-Californians, think Bakersfield, home of agribusiness and the Buck Owens Hall of Fame) with a 30% contribution rate BEFORE the stock collapse in the 2^nd half of 2008. There are many Kern Counties, nationally, who simply cannot afford current benefit levels.

What can we learn from some of the egregious errors made over the past quarter century? Most people think existing good times will last forever and they never do – ebbs and flows are an inevitable byproduct of capitalism. During the good times, entities should not consider benefit changes unless they can stand the shock of a 25% market correction. People should understand that a 100+% funded ratio can have the permanence of a castle in the sand. During a bull market, contribution holidays or reductions should be strongly discouraged. I recommend that the plan sponsor always contribute a healthy percentage of normal cost (the actuarial value of the benefits earned during the current year), regardless of funded ratio, and have a policy not to have any ad hoc benefit increases until the funded ratio reaches at least 125%.

This Ramble is now academic in the sense that last rites have been administered to the private sector defined benefit market and most public funded ratios will not be in shouting distance of 100% once the impact of the market dive is fully absorbed. However, I remain an optimist that things can change for the better. So, in the year 2025, when public sector funded ratios are getting closer to 100% and perhaps there is a rebirth in private sector plans, maybe this article can be rescued from the archives and dusted off.
Rick Roeder

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