During the last legislative session, lawmakers “fixed” the state’s Public Employees Retirement Association pension fund, principally by diverting 0.5 percent of employee raises to PERA for the next six years and introducing a “rule of 85” for retirement eligibility.
But an analysis of PERA’s finances indicates that its unfunded liability, far from decreasing in future years, could easily increase. And, questions exist concerning mortality assumptions by PERA’s actuaries and about PERA’s projected rates of return on its investment portfolio that raise red flags about the long-term solvency of the pension plan.
Moreover, other assumptions that are embedded in PERA’s actuarial assumptions, such projected length of employment by PERA contributors, could be dubious.
PERA is the 25th largest public pension fund in the United States. It provides benefits to more than 250,000 active and retired employees of more than 400 governmental entities in Colorado, including employees of the City of Colorado Springs and of every public school district in El Paso County.
At the end of last year, the fund had more than $34 billion in assets.
While contributing to PERA, public employees do not pay into Social Security, meaning that most retirees rely on PERA for retirement income.
PERA’s retirement benefits are, by any measure, generous. At the end of last year, the average PERA retiree was 58 years old, had 23 years of service, and received a monthly benefit of $2,447. Retirees receive an automatic 3.5 percent annual cost-of-living increase.
Retirees with 30 or more years of service are handsomely rewarded — the average monthly benefit is more than $4,000, far above the maximum Social Security benefit of $2,053, payable to workers who have paid into the system for 44 years.
As recently as 1999, PERA was classified as “overfunded” — that is, its assets were more than adequate to cover future claims for pensions.
But between 2001 and 2005, PERA’s financial condition had so deteriorated that its unfunded liability had reached $12.5 billion. Absent any change in member contributions, or retirement policies, the fund would have been depleted within 30 years.
Prodded by Gov. Bill Owens and State Treasurer Mike Coffman, PERA’s board of directors and the legislature agreed to “the fix” and the crisis was avoided — or was it?
In signing the bill which implemented changes, Owens stated that “Senate Bill 235 makes substantive changes to return the pension plan to solvency and establishes greater safeguards to prevent this problem from happening in the future.”
But Coffman was less enthusiastic.
“PERA is living on the edge with its actuarial assumptions,” he said. “One misstep or another bear market could plunge the system into financial chaos.”
Coffman is particularly concerned that PERA’s forecast rate of return on its portfolio, 8.5 percent, is unrealistically high. He points out that PERA’s financial advisers believe that any level above 7.75 percent is unsustainable — but that PERA’s board of directors chose to ignore that opinion.
How did PERA get itself in such a jam in the first place? Why won’t the bipartisan “fix” work? And what’s the solution?
The first two questions are easy to answer. The third is less obvious, since any answer involves the intersection of public policy, financial realism and politics — and, as Coffman is quick to admit, when financial realism meets politics, politicians tend to “kick the ball down the road, and hope that someone else will deal with it.”
From the mid-1970s to 2000, PERA’s assets grew rapidly, moving from 70 percent of liabilities in 1980 to 90 percent 10 years later. Between 1980 and 2005, PERA’s average annual rate of return on its investments was 10.9 percent, as the fund reaped the benefits of the longest sustained bull market in American history.
From 1974 to 2000, the Dow Jones Industrial Average climbed from 580 to 11,750. Double-digit returns over a quarter of a century were easily achievable, even by unmanaged portfolios invested in market index funds.
Entering the new century, PERA would have been comfortably funded, and able to weather any transient market downturn, but for bad decisions by both the legislature and PERA’s portfolio managers.
In 1997 the legislature passed a PERA-sponsored bill that increased pensioner benefits by 15 percent. In other words, a 30-year employee making $50,000 annually would receive $37,500 a year, as well as cost-of-living increases, instead of $32,500. This legislation, by increasing PERA’s liabilities, moved it from being comfortably “overfunded” to slightly underfunded.
PERA’s investment portfolio had been heavily weighted toward equities during the bull market of the ’90s, but steep declines in 2001 and 2002 persuaded board members to “rebalance.” Equities were sold, at or near the market bottom, and replaced by debt instruments, bought at or near the market top.
The combined impact of these two decisions was to transform PERA, in less than five years, from being more than 100 percent funded to 70 percent funded — a potential shortfall of $12.4 billion.
In December 2001, PERA Executive Director Meredith Williams told a legislative committee that PERA is “rock solid, even in the face of volatility and financial insecurity.”
Committee member Sen. Norma Anderson (R-Lakewood) added, “The plan is solid, one of the best in the nation.”
PERA’s actuarial consultants were equally sanguine. In response to a committee member’s question about financial fallout from the events of Sept. 11, 2001, William Fornia of Buck Consultants said, “We take the long-term view of looking at plans over 30 to 35 years.”
Ups and downs in the market are all factored in within that time period, he said.
Five years later, after their predictions had proved disastrously wrong, the same players expressed the same optimism.
Evaluating the legislative “fix,” Williams said on July 19 that “The bottom line is that the data clearly indicate that the reform legislation [will] have the desired effect, returning PERA to a stronger financial footing.”
And a month previously, David Slishinsky, consulting actuary for Buck Consultants, said that “It is our opinion that the current funding is sufficient to pay benefit payments through the projected actuarial period of 30 years.”
Coffman doesn’t buy it. “You know, [PERA pensioners] think I’m the bad guy, trying to reduce their pensions, or up their contributions — and I’m trying to bail them out.”
Analyzing Buck’s post-fix actuarial projections, Coffman stresses that unless PERA achieves the target return of 8.5 percent annually, the “fix” will be ineffective. Lower the annual return on investment to 7 percent, and, instead of being 80 percent funded in 2034, the fund will drop to a 30 percent funding ratio.
That’s without adjusting PERA’s retiree mortality assumptions, which might underestimate retiree longevity, and also assuming that the average length of service of PERA recipients will not change during coming years.
As Brian Anderson of the treasurer’s office points out, if employees leave PERA for the private sector after 10 or 20 years of service, the fund doesn’t receive the high employee contributions that come from folks during their peak earning years.
Those public employees who are now retiring expected to remain with the same employer for most of their working life. Today’s hires, in common with their peers in the private sector, might be less anchored to any single employer.
Retiree mortality assumptions are generated by complex actuarial formulas, which are largely impenetrable to laypersons. But despite this complexity, they are, at best, educated guesses.
How long will a given population live? Just as no one knows the date, or the hour, of his or her demise, no one can predict with surety the average longevity of a particular group of pensioners.
Actuaries have devised standard mortality tables which are, with certain adjustments depending upon the nature of a given retiree population, adjusted either upward or downward.
From an actuarial standpoint, the sooner you die the better. For PERA, every year of average annual retiree lifespan will add to its projected liabilities.
PERA’s present actuarial assumptions predict that a 60-year-old male retiree can expect to live another 24.11 years; a female an additional 26.78 years. These tables are derived from PERA’s actual retiree mortality experience — not from national tables.
Are these figures reasonable? They may be — but the most recent actuarial predictions of retiree mortality from Great Britain suggest that they might err on the low side.
On Aug. 1, the British actuaries’ trade body adopted a new set of mortality tables, based on data collected between 1999 and 2002. The tables reflect, in the words of the Economist “a fundamental demographic shift … Britain’s pensioners are proving a hardier bunch than expected.”
In 1999, actuaries assumed that a British male retiring at 60 would live to 84, almost exactly the lifespan that PERA predicts. They’ve now revised that estimate to 87.5. Moreover, they’ve found that pensioners drawing substantial incomes (as do most PERA retirees) are likely to live four years longer than those receiving subsistence-level incomes.
The British experience might not exactly parallel America’s, but it seems to indicate that average life expectancy might increase, rather than decrease or remain constant. PERA, whose recipients are overwhelmingly well-compensated professionals, can expect its retirees to be at the upper range of longevity, if the British experience is any guide.
Plug in worst-case assumptions to PERA’s projected funding ratios, and PERA literally implodes.
If, for example, retiree mortality assumptions are raised by three years and return on investment falls to 4 percent, PERA may become dangerously underfunded within a few years. Everything depends, then, on PERA achieving a rate of return of 8.5 percent or greater.
Are such returns either likely or sustainable?
That may depend on the investment environment of the next 15 years. If it mirrors the years between 1984 and 2000, when the market soared, PERA will thrive.
But if the next decade and a half resembles the years between 1965 and 1980, when market averages scarcely budged, PERA may quickly become insolvent.
In 2005, PERA’s overall investment portfolio rose by 9.8 percent, a rate which, if sustainable, would eliminate PERA’s unfunded liability within 15 years.
PERA’s individual asset classes performed at very different levels. Real estate returned 28.2 percent; alternative investments returned 18.9 percent; international stocks returned 16.6 percent; and domestic stocks returned 7 percent. Bonds returned 2.8 percent.
Coffman, observing that 67.7 percent of the portfolio consists of domestic equities and bonds, points out that PERA relies upon investments in real estate, foreign stocks, and private equity funds to achieve its goals. Such investments might achieve high returns; but they carry higher risks.
In a recessionary environment, they might produce substantial losses.
Perhaps seduced by the outsized returns of the last few years, PERA’s 2005 annual report, submitted on June 1, was giddily optimistic about the prospects of further gains from investments in such assets.
“The trends in the economy and real estate markets continue to support a favorable outlook for private real estate investments … despite possibly higher interest rates.”
But as PERA’s most recent financial statements disclose, there’s no way of calculating the actual return on such investments until they’re liquidated, which might not be for more than a decade.
Theoretically, a private equity investment might show putative returns of 10 percent annually for nine years, experience a sharp drop in value during the 10th year, and produce an overall loss at liquidation — wiping out the phantom gains of the preceding years.
Gains in so-called private equity deals have been a product of business profitability, which has accelerated in recent years. Corporate profits now have their highest share of GDP since the 1960s, leading the investment bank UBS to label this “the golden age of profitability.”
But such profitability has come at a price — wages and salaries now make up the lowest share of GDP since record-keeping began 60 years ago, leading some observers to question whether such profitability can continue.
Given the possibly dire consequences of default, why have PERA’s board and the politicians who oversee the plan been willing to endanger the plan’s viability by approving low member contribution rates and high member benefits?
In a recent news release, PERA trumpeted its belief that all is well. Citing the outstanding investment results achieved last year, and projecting them into the indefinite future, PERA spread the “good news” that “With the legislation that was passed earlier in the year, the state’s largest pension plan is on track to being 100 percent funded!”
The Business Journal requested interviews with PERA’s Director, Meredith Williams, as well as with a local board member. Both refused, citing “scheduling conflicts.”
Instead, Communications Director Katie Kaufmanis e-mailed brief responses to several questions.
Kaufmanis said the reform legislation puts PERA on track to be fully funded. “The 8.5 percent investment return assumption takes into consideration the unique … structure of PERA’S portfolio … [It’s] what the trustees assume over a long time horizon (50-70 years).”
And if the markets suffer a prolonged downturn?
“PERA has a very long time horizon of between 40 and 50 years,” the e-mail said. “In the event of a downturn, it is the PERA board’s fiduciary responsibility to take action.”
PERA’s 16-member board of directors consists of the state treasurer, three directors appointed by the governor and 12 directors elected by PERA beneficiaries. Prior to this year, the entire board, except the treasurer, was selected by PERA members.
And that, as Adam Summers of the Reason Foundation has written, might explain a lot.
“At the heart of the pension crisis is a set of incentives that creates a ‘moral hazard.’ The fact that policymakers are able to make decisions for which they do not have to bear the consequences actually encourages risky behavior … underfunding a system does not create problems until years in the future … but policymakers get to reap the political rewards of creating lucrative new benefits for employees.”
Any permanent solution to PERA’s inherent problems would present enormous political difficulties.
Restructuring PERA’s investment portfolio, and removing high-risk investments, might produce safe, predictable yields. But such safety would remove the possibility that the fund could achieve better results-and even the “safest” investment carries risk.
Absent such a possibility, benefits for present and future beneficiaries would have to be sharply reduced — starting right now.
Such an outcome is so unpalatable politically that legislators, beneficiaries, board members and their hired financial advisers have chosen to, as Coffman put it, “kick the ball down the road.”
But, as California investment banker and Colorado Springs native Timothy Collins remarked, since PERA has no safety net — neither the state nor the feds have a statutory obligation to make up any investment shortfalls — it’s really not a defined benefit plan.
“The benefit depends on the dollars in the plan, not the promises to the beneficiaries,” he said. “The Mint might be in Denver, but Colorado can’t print money — it’s not like Social Security.”
Since the consequences of an adverse investment climate are unacceptable, it’s better to take the position that it just won’t happen, and that PERA will make 8.5 percent returns forever.
Collins said that as an investment strategy, it is the direct descendant of Will Rogers’ famous investment advice:
“Don’t gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.”