Pension Risk News & Analysis : Pension Governance, LLC : Pension Risk & Investment

Bloomberg reporters Michael McDonald and Adam L. Cataldo cite New Jersey Governor Jon Corzine as a vocal critic of pension obligation bonds. "It's the dumbest idea I ever heard," describing $35 billion in public IOUs (a record issuance level since 2003) as "speculative." From Alaska to Connecticut, state pension plans are issuing debt to replenish retirement plans and thereby avoid funding gaps later on.

As long as the cost of money falls below the realized rate of return, life is good. Unfortunately, reality sometimes intervenes. In a recent survey, Greenwich Associates reports that public pension managers project outperformance of nearly 150 basis points over market benchmarks, something they deem "unrealistic." Another critic, Warren Buffett, writes about "fanciful figures" in his 2007 Letter to Shareholders, adding that few pension plans will be able to achieve their assumed investment rate of return. Read "Warren Buffet on Pensions - Crazy Assumptions?"

Click to read "'Dumbest Idea Ever' Used as Pensions Plug Deficits," May 1, 2008. Also check out the Pew Study entitled "Promises with a Price: Public Sector Retirement Benefits" and dated 12/18/07.

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According to State Editor Jay Jochnowitz for timesunion.com, Attorney General Andrew Cuomo is investigating "alleged abuses of the state pension fund" at school district, town and village levels. External contractors may be costing Empire State taxpayers a bundle in the form of "undeserved" retirement benefits. (See "Cuomo expanding pension probe," April 14, 2008.)

Not surprisingly (and assuming facts bear out the presence of fraud), folks are in a major huff. To read a few takes on the fast-changing situation, check out these items.

• "Cuomo: 90 attorneys' pensions potentially fraudulent" by Robert E. Kessler (Newsday.com - April 10, 2008)
• "New York's Pension Scams Must End Now" by James Ostrowski (Free New York - April 14, 2008)

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Governor Arnold Schwarnegger has put the kabosh on a state legislative attempt to prohibit the state's two largest public pension funds from allocating to certain money managers. Arguing that AB 1967 puts undue strain on the California Public Employees' Retirement System and the Calfornia State Teachers' Retirement System by prohibiting money managers who invest in countries with human-rights issues. If adopted, The Carlyle Group (owned in part by the United Arab Emirates) would be off limits and thereby shut off private equity deal flow. In his April 9, 2008 op-ed piece, published by the Los Angeles Times, Governor Schwarnegger writes that measure AB 1967 would "cause a deep wound to our retirement funds and government programs when we can least afford it." Though he earlier signed measures to divest from Sudan and ban investing in Iran, the state's head politico avers that this bill would (a) cost CALPERS and CalSTRS billions of dollars in lost opportunities over the next 5 to 10 years (b) do little to discourage sovereign wealth fund investing overall and (c) be a fig leaf with respect to boosting human rights. Click to read "California can't afford a symbolic divestment that won't affect human rights."

On April 10, 2007, Sacremento Bee reporter Dale Kasler writes that Assemblyman Alberto Torrico (D-Newark) is withdrawing Assembly Bill 1967 "for the time being. (See "Lawmaker pulls bill to set human-rights limits on public pension fund investments.")

Of course, this does not eliminate an obvious question. Should the state (in an editorial sense, not a particular geographic locale) direct public plan investing?

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Related to our April 6, 2008 post about risk management oversight (asking who is in charge is a logical query), Wall Street Journal reporter Jed Horowitz writes about unhappy pension campers.  Three plans are now on record as opposing the re-election of various Morgan Stanley directors, including Chairman and CEO John Mack. They include: (a) California State Teachers' Retirement System (b) State Universities Retirement System of Illinois and the State of Connecticut Retirement Plans & Trust Funds. Citing "failure to generate returns consistent with the broad stock market," inter alia, they decry an adverse impact of the company's risk-taking on the value of their Morgan Stanley shares. See "Morgan Stanley Board Feels Heat Over Loss" (April 7, 2008).

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According to "Pension burden grows for states" (Seattle Times, March 15, 2008), available pension assets are quickly shrinking, especially as equity returns continue to plummet. The article states that global stock market value dropped by more than $5 trillion in January 2008, prompting Standard & Poor's analysts to warn of danger ahead in the form of poor funding ratios.

The accompanying visual says it all, with the biggest pension deficits reported for Illinois ($32.4 billion) and Connecticut ($14.8 billion). 

Don't forget OPEB (Other Post-Employment Benefits). GASB 45 (Government Accounting Standards Board) is creating real pain for a significant number of public entities. Check out this exchange of unhappy taxpayers in West Hartford, Connecticut regarding the extent of unfunded healthcare promises to municipal workers.

Click to read a "GASB Q&A." If you missed the October 2007 cover story of Governing, click to read "The $3 Trillion Challenge" by Katherine Barrett and Richard Greene. Also read the "Q&A With Experts," including one about risk management prescriptive steps by this blog's author, Susan Mangiero.

Editor's Note: GASB 45 is entitled "Accounting and Financial Reporting by Employers for Postemployment Benefits Other Than Pensions."

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As a result of its investigation of the Retirement System of Alabama ("RSA"), the U.S. Securities & Exchange Commission, Division of Enforcement, issued a March 6, 2008 report "to emphasize the responsibilities of all investment professionals, including large public retirement systems and other public entities, under the federal securities laws and to highlight the risks they undertake when they operate without a compliance program."

At the heart of the matter was an allegation of improper trading of shares in The Liberty Corporation, prior to the public announcement of its acquisition by Raycom Media, Inc. ("Raycom"). While this state agency, with over $30 billion in assets under management, is described as having cooperated with the SEC, pre-event, it had no "program, policy, practice or training to ensure that its investment staff understood and complied with the federal securities laws in general or insider trading laws in particular. RSA also did not have a compliance officer, and the responsibilities of its general counsel did not include oversight of RSA's investment activities."

According to this official report, RSA founded Raycom in 1996 and was its "primary financing source." (Enforcement investigation aside, this begs an interesting question. Why was the Retirement System of Alabama in the business of creating a private business?) A disturbing excerpt from the SEC report is shown below.

<<RSA's purchases of Liberty stock were unusual in at least two respects. First, RSA's CEO directed the trades even though he normally was not involved in equity trading decisions. Second, Liberty's market capitalization at the time was less than $1 billion and did not satisfy the $5 billion market capitalization guidelines RSA generally used for the two funds that purchased the shares.>>

While state pension plans are not subject to the Investment Company Act of 1940 and the Investment Advisers Act, public plans and their employees are subject to anti-fraud provisions of the "federal securities laws and Commission rules thereunder."

The Commission concluded that bad acts could have been avoided if the state pension plan "had adequate policies and procedures to assure compliance with the federal securities laws." The SEC took into account the following - (a) RSA's cooperation (b) remedial action and (c) the fact that no individual gained from said trades.

Click here to read "Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The Retirement Systems of Alabama.".

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According to Global Pensions (January 10, 2008), Canadian, US and UK public pension fund investors are satisfied private equity investors. Surveying 108 institutions, Private Equity Intelligence Ltd (Preqin) found that "private equity out-performed for these pension plans in 82% of cases." In another survey, Preqin found that "95% of these investors predicted their private equity investments would out perform public market returns from a 2% advantge to over 4% in coming years."

Acknowledging the huge amount of money making its way into private equity, this blog's author wrote about the 4P's on December 31, 2007 - Pensions, Private Equity, Performance and Placement. We urged readers to study the risks, alongside the expected benefits, adding that valuation of private company economic interests can be challenging.

In response, Mr. Doug Miles, CEO of Globalprivatequity.com, Inc. wrote that life has surely changed when it comes to estimating value. We hope you find his commentary interesting. We welcome guest bloggers on any topic related to pension investing and risk management (which importantly includes the topic of valuation). Drop us a line if you want to share your thoughts with our fast-growing audience.

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Early editions of today's business papers describe an imminent sale of roughly 10 percent of technology private equity fund Silver Lake to pension giant, the California Public Employees’ Retirement System ("Calpers"). With a price tag of $275 million, Calpers will have a say in managing Silver Lake and also receive a pro-rata share of their earned investment fees. Private equity investors typically pay 2 percent of assets under management per annum plus 20 percent of gains in excess of an agreed upon benchmark. (See "California Pension Fund Expected to Take Big Stake in Silver Lake, at $275 Million" by Andrew Ross Sorkin, New York Times, January 9, 2007).  

A direct investment stake in Silver Lake creates new challenges, not the least of which is the subsequent negotiating power of Calpers with other private equity funds.

• Will this $260+ billion institutional investor now have greater sway with alternative fund managers, bargaining hard for fewer restrictions on transferability?
• If so, how will that impact the riskiness of its investment portfolio?
• Will Calpers ask Silver Lake to be more institution-friendly with respect to greater disclosure, lower fees, asset selection that reflects suitability, better risk controls and so on (assuming that Silver Lake is not already doing everything it can in these areas)?
• Will Calpers be exposed to fiduciary liability in the event of a Silver Lake buy-out gone bad?
• How will Calpers change its internal risk management policies and procedures as a result of this investment in Silver Lake? This includes the process by which "hard to value" holdings are marked to model or market.
• How will Calpers recognize the Silver Lake investment in terms of strategic asset allocation?

Notwithstanding these unanswered questions, this announcement is fascinating news to some, especially on the heels of a January 7, 2007 Financial Times article that quotes representatives of pension funds such as the Oregon Public Employees Retirement System and the California State Teachers' Retirement System as saying "never mind" to eroded returns. Acting defiantly, these institutional investors are in no mood to make private equity executives whole for higher taxes that may soon be mandated by Washington. (The current tax rate of 15 percent could rise to 35 percent.) (See "Pension funds in threat over private equity fees" by Francesco Guerrera and James Politi.)

Editor's Note: We talked about private equity on December 31,2007. Read "Pensions, Private Equity, Performance and Placement."

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According to a just released study by the Pew Center on the States, state pension plans in aggregate owe nearly $3 trillion in pension benefits, of which about $400 billion is unfunded. Unfortunately, for some state residents, the financial pain is not evenly spread throughout the nation. Consider some of the findings.

• "Only a third of the states have consistently set aside the amount their own actuaries said was necessary to cover the cost of promised benefits over the long term.
• Twenty states had funding levels of less than 80 percent at the end of FY 2006—below what most experts consider healthy.
• Several states have seen particularly troubling drops in their pension funding levels. Some of the biggest drops have occurred in Hawaii, Kentucky, New Jersey, Pennsylvania and Washington."

Hold onto your hats.

The study further reports that post-employment healthcare benefits have a price tag of about $381 billion with only 3 percent of this total liability having been funded to date. "None of the five largest states—California, Texas, New York, Florida and Illinois—had put aside money for non-pension benefits as of FY 2006." and 11 states, including California, New York, New Jersery and Connecticut owe more than $10 billion to plan participants.

Ouch!

As this blog has pointed out repeatedly, there is no free lunch. Putting off the inevitable is going to be painful for employees, retirees and taxpayers.

Now imagine you are a resident of a state with post-employment funding woes. Your taxes go up to pay for someone else to retire at the same time that you are struggling with your own situation. That's exactly what is happening for millions of people, causing great angst for all.

Read "Promises with a Price" in full text. If you missed it, the October 2007 issue of Governing (by the same authors of this new Pew report) addresses anemic pension governance standards at the state level in "The $3 Trillion Challenge." Part of that article includes a sidebar with yours truly on suggested questions to ask as part of a governance check-up for a particular plan. Read the Q&A with Susan Mangiero.

Also check out our earlier blog post entitled "Tea Party Redux: State Pensions in Turmoil." Written a year ago, the message is still the same. Ask your state legislators for their proposed solution to the retirement funding crisis.

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Attorney Francis Pileggi, creator of the Delaware Corporate and Commercial Litigation blog, has an interesting post about a recent pension lawsuit. In Louisiana Municipal Police Employees' Retirement System v. Countrywide Financial Corporation, 2007 WL 2896540 (Del. Ch., Oct. 2, 2007), statistics played a central role in an option backdating case brought by the Louisiana Municipal Police Employees' Retirement System ("LAMPERS"). 

The court, citing the "close call" nature of the statistical evidence, nonetheless concluded in favor of the plaintiff. Pursuant to Section 220 of the Delaware General Corporation Law, LAMPERS will have some access to the financial records of Countrywide.

Click here to read this interesting October 10, 2007 post.

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Talk around the pension water cooler often turns to questions about which system will implode first. In a newly published article about pension governance, Governing correspondents, Katherine Barrett and Richard Greene, suggest that some public plans may soon make the "most wanted" list. Citing LongHorn state blues, Texas Attorney General Greg Abbott is quoted as saying that ”Inadequate governance will cause a pension fund to nose-dive and crash.” Other states are feeling the heat too, especially now that accounting rules have forced additional disclosures of post-employment health care benefit costs.

Conflicts of interest, fraud in some cases, political cronyism and little, if any, board training for persons making multi-million dollar decisions are some of the reasons to think the glass is half-empty.  Uncertainty for retirees is bad enough but don't forget that taxpayers are ultimately on the hook for funding these benefits. (Click here to read our 2006 post entitled "Tea Party Redux: State Pensions in Turmoil.")

This blog's author is quoted in an accompanying featured Q&A. Offering suggestions to improve board performance, I likewise provided thoughts about the rise in pension fiduciary breach litigation and described a few of the many risk management standards for prudent investing.

Click here to read the Q&A interview and here to read the full text article entitled "The $3 Trillion Challenge" (Governing, October 2007 cover story).

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According to the Michael Page International Salary Survey 2007, "demand for risk professionals continues to grow with increasing focus on strong technical skills" at the same time that "packages have been upgraded as clients struggle to retain/attract the best people." According to their research, total compensation for directors in the market risk area ranges from $350,000 to $800,000 while directors in the quantitative areas enjoy $400,000 to $950,000 in salary and bonus.

So how do pension professionals fare? In the Lonestar State, things aren't so bad. According to American-Statesman reporter Robert Elder, the Texas Retirement System board just approved a bonus plan that could mean $9 million in goodies for its investment staff. He adds, "The pension fund faces a shortfall of $12 billion between its assets and payout obligations, and retirees haven't had an increase in benefits in six years. It serves 1.2 million active and retired public school workers." (Click here to read "Bigger bonuses approved for Texas Retirement System investment staff" - September 14, 2007.)

From the outside looking in, it's impossible to know if Texas is on the right track or not. After all, Harvard Management Company lost "dozens of staffers" over compensation. While not a pension fund, the Boston experience is one of many where seemingly high pay packages are insufficient to keep talented risk professionals in place.

Expect plan sponsors to feel the pinch even more. According to its newly released "Strategic Plan FY 2008-2013," the Pension Benefit Guaranty Corporation announced plans to "improve risk monitoring and early warning activities and align resources to assure proper plan terminations." Of course, plan sponsors are likely to want their own team to tackle pension risk for a variety of reasons that go beyond regulatory inspection. This blog author's contention is that the investment management process is incomplete in the absence of a comprehensive risk management policy.

The bottom line is that risk managers don't come cheap. Plan sponsors (regardless of plan design - DB or DC) should factor in the costs of hiring skilled leaders in this area now, before demand skews in favor of the sellers even further.

Click here to read "Pension Risk Management: A New Paradigm" (Risk! - January 2007). Click here to request an email copy of "Life in Financial Risk Management: Shrinking Violets Need Not Apply" (AFP Exchange - July/August 2003). You may also want to click here to read our September 4, 2007 post on the topic of investment banking compensation.

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Voices of San Diego reporter Evan McLaughlin writes that the Fourth District Court of Appeal "upheld the district attorney's prosecution of six former pension board members." After several years of wending its way through the court system, allegations that trustees violated California's "conflict-of-interest law" will be heard. Charges emphasize "an agreement in 2002 that boosted the future pension pay of the defendants and thousands of other city employees in exchange for allowing the city to underfund the pension trust that year." Click here to read "DA's Pension Case Moves Forward" (September 7, 2007). Click here to read the ruling.

Regardless of the outcome, and acknowleging a presumption of innocence until proven guilty, a key take-away is that pension fiduciaries are absolutely on the hook. Not to be taken lightly, the job of retirement steward is a serious one. Civil and criminal penalties in the event of proven wrong-doing are possibilities. It's no surprise then that liability underwriters are fielding frequent calls for greater and more comprehensive coverage.

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One of the original thirteen colonies of an infant America, Massachusetts has a special place in history books. In an about face with respect to economic freedom, lawmakers are making it difficult for state pension officials to do their job. According to The Boston Globe, attempts by both the state House and Sentate (and efforts by the governor) would force liquidation of investments in companies that do business with countries such as Sudan, Iran and North Korea. 

Journalist April Simpson quotes Michael Travaglini, as saying that $1.1 billion would be impacted, roughly two percent of total assets. Executive director of the Pension Reserves Investment Management Board, Travaglini adds that "The rule of thumb for investments is you sell the stocks that aren't performing well and run with the funds that are. This type of legislation runs counter to that. There's a very real potential to negatively impact the investment returns of the pension funds." Click here to read "Pension divestment effort gets complicated" (August 31, 2007).

As this blog's author pointed out just a few months ago on CNBC, there are potential fiduciary consequences. While no one in their right mind supports terrorism, fallout is inevitable.

"First, selling stocks because of statehouse mandates could cost taxpayers and plan participants in the form of "unexpected" transaction costs. This would in turn exacerbate funding problems for any states already in the red. Second, trustees would have to decide how to invest the proceeds of disposed equities, possibly earning less than before. Third, there could be a conflict for fiduciaries in terms of duty. Do they follow new rules that require divestiture, even if it forces them to violate state trust laws that demand careful analysis before deciding on an "appropriate" strategic asset allocation? Fourth, plan fiduciaries will likely need to spend considerable time and money in order to identify which companies offend, now and regularly thereafter." Click here to read the rest of "Is There Fiduciary Liability Attached to Divestment?" (June 15, 2007). 

 

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Wall Street Journal reporter Craig Karmin reports that, post credit crunch, some public pension funds are having second thoughts about hedge fund and private equity investments. Cited as a "significant reversal in thinking," the article points out that pension funds have oft-cited alternatives as a way to diversify against shifts in market conditions. (See "Pension Managers Rethink Their Love of Hedge Funds," August 27, 2007.)

In an August 26 article entitled "Just How Contagious is That Hedge Fund," New York Times contributor and financial pundit, Mark Hulbert, debunks the notion that all hedge funds generate market-independent returns. He attributes asset class interconnections and similar strategies made by large hedge funds as culprits. A loss in one sector or fund is likely to appear elsewhere. Investing in "hard to value" positions is another challenge. (This blog's author, an accredited appraiser, is working with the National Association of Certified Valuation Analysts to develop a hedge fund valuation course for October 2007.)

The Pension Governance team has been playing the role of Cassandra for many months. Click here for our January 4, 2007 post about contagion, the notion that what occurs in one market or fund cascades throughout the system. Regarding valuation, we've described the issue ad nauseum. Click on the Hedge Funds and Valuation folders on the left side of this blog's home page for lots of posts about these two topics.

For those who missed our six webinar series entitled Hedge Fund Toolbox^SM, we're nearly finished with the ebook equivalent. Email us if you want to be notified when it's ready.

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According to americanrevolution.org, colonial soldiers (and their widows) received pensions until about 1832 when benefits were stripped. For history buffs, the site's author encourages a reading of the archived details.

"All of the Revolutionary War Pensions have been abstracted and are at most Archives. These are large books and include a number of volumes.  Also, the Federal Archives have the original pensions on microfilm....reading these (as opposed to the abstracts) is quite interesting, because of details of exciting battles, and personal information."

For more information about the history of this important U.S. holiday (no Virginia, it's not just a sale day at the mall), check out the following sites.

History of the Fourth - PBS.org

Fourth of July - Wikipedia.com

Today in History - Library of Congress

Fourth of July - HistoryChannel.com

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According to Wall Street Journal reporter Craig Karmin, some legislators want public pension funds to shun companies that invest in terrorist countries such as Iran. Citing efforts by Missouri State Treasurer, Sarah Steelman, Karmin lays out the pros and cons of forced liquidation. (See "Missouri Treasurer's Demand: 'Terror-Free' Pension Funds," June 14, 2007.)

As part of a June 14 interview with CNBC's Maria Bartiromo, I offer four considerations (as much as I could say in a short on-air appearance). First, selling stocks because of statehouse mandates could cost taxpayers and plan participants in the form of "unexpected" transaction costs. This would in turn exacerbate funding problems for any states already in the red. Second, trustees would have to decide how to invest the proceeds of disposed equities, possibly earning less than before. Third, there could be a conflict for fiduciaries in terms of duty. Do they follow new rules that require divestiture, even if it forces them to violate state trust laws that demand careful analysis before deciding on an "appropriate" strategic asset allocation? Fourth, plan fiduciaries will likely need to spend considerable time and money in order to identify which companies offend, now and regularly thereafter.

No one supports terrorism but this "solution" might invite more problems. There is never a free lunch. Someone, somewhere pays.

Click here to watch the interview.

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A few months ago, California Governor Schwarzenegger created the Public Employee Post-Employment Benefits Commission. Tasked with identifying the nature of their $49 billion unfunded liability for state retirement programs, this group must submit a report to the Governor and state legislators by January 1, 2008 that (a) quantifies unfunded post-employment health care and dental benefits for which the state is obliged to pay (b) assesses and compares possible solutions to address unfunded liabilities and (c) recommends which course of action makes sense. Click here to read the official press release about the Commission. Click here to access the names, titles and affiliations of the original appointees.

A few weeks ago, San Francisco Chronicle reporter Greg Lucas wrote that two of the dozen members, including the head of the commission, have business ties with California pension funds. Not surprisingly, eyebrows raised. In response, "Schwarzenegger administration officials and CalPERS -- the nation's largest institutional investor -- say there is no conflict between the two commission members' private business ties and their role on the commission, but some independent observers say the connection could harm the credibility of the panel's recommendations." Click here to read "Pension reform panelists' ties to firms questioned" (San Francisco Chronicle - March 8, 2007).

Call me crazy but doesn't it make sense to remove any doubt about the ability for commission members to render an impartial analysis? The persons in question may be the most honest of men. I don't know them personally. What I do know is that this type of news is likely to be yet another nail in the coffin of uncomplicated pension reform. I've spoken to countless taxpayers across this great country who are starting to wake up and smell the cappuccino. They are not happy about the prospect of soaring taxes to fund these benefits and even less satisfied with the way change is proceeding.

Kudos to Governor Schwarzenegger for creating the Commission in the first place. However, for a task so important -- huge dollars at stake and millions of plan participants  -- why keep dreaming that no one will mind a few conflicts of interest, perceived or actual?

Continue Reading...

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According to its website, the SEC sanctioned the City of San Diego "for committing securities fraud by failing to disclose to the investing public important information about its pension and retiree health care obligations in the sale of its municipal bonds in 2002 and 2003."

The SEC-issued Order "finds that the city failed to disclose that the city's unfunded liability to its pension plan was projected to dramatically increase, growing from $284 million at the beginning of fiscal year 2002 to an estimated $2 billion by 2009, and that the city's liability for retiree health care was another estimated $1.1 billion.

According to the Order, the city also failed to disclose that it had been intentionally under-funding its pension obligations so that it could increase pension benefits but defer the costs, and that it would face severe difficulty funding its future pension and retiree health care obligations unless new revenues were obtained, pension and health care benefits were reduced, or city services were cut. The Order further finds that the city knew or was reckless in not knowing that its disclosures were materially misleading."

The Order makes for fascinating reading. For one thing, an eight percent assumed rate of return on investments was used "without regard to its actual historical rate of return." Some increased benefits were treated as contingent liabilities that were not reflected in certain liability calculations.

Some general observations ensue.

1. Assuming no fraud, a plan's actuarial report should be read in conjunction with any other disclosures about a plan. To the extent that there are differences, responsible fiduciaries must ask hard questions in order to reconcile the "tale of two pensions."

2. This is unlikely to be the last event of its kind. Does this put additional pressure on rating agencies and other watchdog groups to identify potential red flags before the fact, to the extent possible?

3. What is the future of public plan pension and health care benefits? Courtesy of Sean McShea, president of Ryan Labs, a recent Economist article about Other Post-Employment Benefits ("OPEB") augurs poorly for taxpayers in states adversely affected by a new government accounting decree. "Going into effect on December 15, the rule requires municipal government employers to "treat their health-care promises to workers the same way they already handle their pension obligations: by reporting on the total size of their future commitment, instead of just this year's cost." (See "The known unknowns, Economist, November 16, 2006)

4. The size of the liability is important as is the rate of growth in the liability, netted against the expected change in asset performance.

5. Plans in crisis will be tempted to reach for higher expected returns. Identifying and evaluating incremental risk is essential. A bad choice could exacerbate an already grave situation.

With Thanksgiving in the U.S. only a few days away, we'll have to think long and hard about why we are grateful in benefits land.

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According to a recent article in the Press-Enterprise, University of California workers expressed their outrage at being asked to contribute to their pension plans. Likely to impact 18,000 workers, "UC officials maintain that employees must contribute to the pensions to preserve them." A university spokesman, Mr. Brad Hayward, said that this sharing of responsibility is nothing new. "UC employees did contribute to their pensions until the early 1990s." He added that employee contributions wil occur gradually with no expected impact on take-home pay during the first post-reform year.

Critics argue that clerical and other lower-wage workers are already in a financial pickle without adding additional burdens.

This story caught my eye for several reasons, not the least of which is what I believe is the beginning of a heated (perhaps incendiary) debate about the rights of taxpayers versus municipal workers. This would include public universities such as the University of California, self-described as among the best in the world.

(In case you missed it, click here to read about the modern day version of the Boston Tea Party.)

An oft-cited position is that municipal workers agree to accept relatively lower wages in exchange for generous benefits. Accepting this point as reality (and ignoring for a moment that some do not accept that view), does a public employer's proposed rule change suggest a violation of an implicit work arrangement with employees? (The situation is arguably different when a labor-negotiated contract exists.)

What are the rights of the taxpayers who fund these benefits? Do they ever get a chance to approve or veto benefit payments or are they simply expected to pony up when benefits are due?

Moreover, this event illustrates the undeniable trend towards shifting post-retirement financial responsibility to employees and away from employers. Low-wage workers are not the only ones affected. Even middle managers know that the array of post-employment benefits is dwindling. Many companies no longer offer a defined benefit plan or, in some cases, any type of defined contribution plan.

Then there is the issue of fiduciary responsibility with respect to oversight of a growing net unfunded liability. Returning to the article, Hayward is quoted as saying "We need to be in a position where employees who retire actually receive the benefit that has been promised to them."

On the outside looking in, this statement is disturbing. It seems to suggest that there are insufficient funds to make current retirees whole without getting monies from those who still draw a regular paycheck.

This sounds familiar, doesn't it?

Think Social Security and any other "pay as you go" scheme that cannot survive without cash from current payrolls.

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Gregory J. Volpe reports that New Jersey property taxpayers may be on the hook after all for state pension promises, despite efforts to cut costs by rescinding employee benefits.

In his August 24, 2006 article, Volpe writes that "The Office of Legislative Services, a nonpartisan agency comprising state workers, told the Joint Legislative Committee on Public Employee Benefits Reform on Wednesday that any law the Legislature passes to diminish retirement benefits for retired or active workers with more than five years in the system would be unconstitutional."

Despite disagreement about whether pension benefits can be cut to keep property taxes in check and otherwise enhance the state's financial position, legislators offered that health care benefits may be next on the chopping block.

As we'll discuss in future blog posts, if you think the pension issue makes you sick, health care benefits are going to take center stage in both the private and public arena in very short order.

More to come...

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New York Times reporter Mary Walsh and Michael Cooper offer a grim assessment of New York City's pension finances in their August 20, 2006 article entitled "New York Gets Sobering Look at Its Pensions". Their research suggests a funding gap as large as $49 billion or "nearly the size of the city's entire annual budget and the equivalent of the city's publicly disclosed outstanding debt."

A key point of contention is how to properly measure the true economic value of the city's pension obligations. According to the article, New York City employs a unique method that sets the pension shortfall to zero. By doing so, it is never clear whether the plan is in deficit and to what extent. Apparently the method started at a time of bounty, with the aim of preventing a raid by officials.

As this author has repeatedly said, you must be able to properly measure the pension liability. Otherwise, how can one identify what corrective action to take, if any, to set the plan right? (Written for private plans, the same commentary applies in concept to public plans. Good information is everything. Click here to read "Will the Real Pension Deficit Please Stand Up?")

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If her intent was to scare, New York Times journalist Mary Williams Walsh succeeds. Her August 8 front page story entitled "Public Pension Plans Face Billions in Shortages" cites a Barclays Global Investments calculation that "if America's state pension plans were required to use the same methods as corporations, the total value of the benefits they have promised would grow 22 percent, to $2.5 trillion" with only $1.7 trillion having been set aside to meet these obligations."

Importantly, municipal plans are not covered by the Pension Benefit Guaranty Corporation ("PBGC") nor does the Employee Retirement Income Security Act ("ERISA") apply. If a state, county or city government comes up short, taxpayers are on the hook.

At a time when many taxpayers are struggling to save for their own retirement, how happy will they be to get someone else's tab? We cautioned that taxpayer blues may soon be upon us. (Click here to read "Tea Party Redux: State Pensions in Turmoil", posted on July 27, 2006.)

Mary Walsh is right when she decries the absence of oversight and "comparable systems of checks and balances." This author finds it particularly appalling that Congressional lawmakers spent hours wrangling over the Pension Protection Act without word one about government plans.

What will it take for taxpayers to really "get it" and vote for fiscal prudence?

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A recent legislative attempt in California has apparently caused quite a stir. Assembly Bill (AB) 2122 sought to preclude companies from paying dividends to shareholders before satisfying pension obligations and to "make directors and officers of a corporation jointly and severally liable for improper distributions" under certain circumstances.

Refer to the July 13, 2006 post entitled "Dividends, Pensions and California Chaos".

Blogger Jerry Kalish provides a novel suggestion.

The proposed bill - and the politics behind it - conveniently ignores the massive unfunded pension liabilities in California, e.g, the California State Teachers' Retirement System faces a $24 billion unfunded pension liability.

But we got them beat in my home state of Illinois which at $35 billion has the largest unfunded pension obligation in the country. The Fitch Rating service released a "negative outlook" for Illinois finances - one of only three negative outlooks issued by the rating service in its review of the states. The other two? Louisiana dealing with the aftermath of Hurricanes Katrina and Rita and Michigan dealing with massive problems in the automobile industry.

Um! Should there should be a law that no more salary increases occur for state legislators until pension liabilities are met?

So where does this attempt stand now?

According to the website that tracks California legislation, the bill failed passage on June 22, 2006 with "reconsideration granted".

While laudable to encourage prudent pension funding, there are a host of problems associated with this type of reform.

Is Milton Friedman right when he said that "the government solution to a problem is usually as bad as the problem" and that "there's no such thing as a free lunch?" Notwithstanding the law of unintended consequences, empirically validated time and time again, there are a variety of better, and arguably more efficient and cost-effective ways to solve the pension "crisis" than putting state legislators in charge of a company's capital structure.

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The Star Ledger reports that New Jersey state officials "adopted a plan to shift billions of dollars in state pension money to private investment managers and set a course to reduce the funds' heavy reliance on the stock market." Journalist Dunstan McNichol describes a $16 billion reallocation from stock "in favor of larger holdings in toll roads, hedge funds and international stocks."

A harbinger of things to come?

Many experts agree that pending regulations and increased focus on pension obligations will move asset allocation to center stage, resulting in a variety of questions that demand good answers. (Asset allocation is oft-cited as the most important determinant of performance.)

1. How will an increased emphasis on alternative investments change the expected return-risk tradeoff of the pension portfolio (particularly as relates to estimating pairwise correlations of returns that vary over time)?

2. What are the liquidity implications of investing in public works projects, hedge funds, international stocks, commodities, private equities and so on?

3. How should pension plan decision-makers proceed in selecting alternative investment consultants (especially with respect to their ability to thoroughly analyze the impact of performance fees on net returns)?

4. How do alternative fund managers value their holdings, if at all?

5. How will overseers evaluate performance in the event of diminished transparency of returns and risk drivers that influence returns?

6. Will fiduciary liability change for funds that invest outside the traditional mix of equities and debt?

7. Do fiduciaries need additional training to feel comfortable asking the right questions about alternatives (and interpreting the answers with confidence)?

8. How should the Investment Policy Statement change to accommodate the use of alternatives?

Get ready pension fiduciaries! There is a lot of work to be done in moving the money around.

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According to CFO.com, the State of California may soon prohibit a company from paying out dividends or buying back shares until all required defined benefit plan payments have been made. AB 2122, introduced by Democrat Johan Klehs, could impact corporate leaders individually as well since it "would make directors and officers of a corporation jointly and severally liable for improper distributions", even if they had no knowledge of the impropriety.

Needless to say that if this bill becomes law, other states would likely follow, creating a cascade of new challenges for chief financial officers everywhere.

Think about it.

Capital structure, securities issuance and debt rating assignments would necessarily change as a function of a company's mix of employee benefits. Modeling a defined benefit plan liability (and related liquidity obligations) would take center stage. Shareholders seeking current dividend income may get an unpleasant surprise if dividend payouts become more volatile, even if a company enjoys steady growth in economic earnings.

Then there is the philosophical issue about the role of government with respect to corporate management. Does the state have the right to micromanage this way? Would shareholders shy away from investing in companies with defined benefit plans, knowing that the state has the right to prevent dividend distributions? Would companies rush to shed defined benefit plans, possibly exacerbating an already pronounced trend towards defined contribution plans? Would companies lobby more aggressively for exemptions from the dividend rule? Would that worsen campaign finance problems? Would D&O insurance costs skyrocket as a result of increased liability exposure for board members? Would federal lawmakers seek to follow suit?

The little bill that could ...

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