In his latest annual letter, Warren Buffett writes about local and state financial problems accelerating “in large part because public entities promised pensions they couldn’t afford.” Noting that “citizens and public officials typically underappreciated the gigantic financial tapeworm that was born when promises were made that conflicted with a willingness to fund them,” he concludes that “unfortunately, pension mathematics today remain a mystery to most Americans.”
One of those mathematical mysteries is how pension funds can earn loads of investment income but still develop big deficits. The reasons are pretty simple to understand, but only when audiences are presented with the whole story.
A good example is the California State Teachers’ Retirement System (CalSTRS), which despite a wonderful investment record over the last two decades has developed a massive deficit that will swamp classroom spending unless it gets a large infusion of capital. The fund has asked Gov. Jerry Brown and the state Legislature for a cash injection of $240 billion over 30 years, starting with $4.2 billion this year.
Over the last 20 years — through big ups and downs, including the Great Recession and the dot-com bust — CalSTRS reports it earned at a compounded annual rate of 7.5 percent, a very healthy return that would be the envy of many investors. Yet over the same period its deficit grew nearly 10 times, leading it now to need at least $240 billion in assistance (that’s CalSTRS’ estimate; financial economists calculate it needs even more).
How can an investor earn at such a healthy rate yet develop such an unhealthy deficit? A recent report by a panel commissioned by the Society of Actuaries on the causes of pension underfunding sheds some light.
One cause is when pension obligations grow faster than assets. Pension funds don’t exist in a vacuum — instead, they exist to pay pension promises. As a result, pension investment performance should always and only be viewed in the context of pension liability changes over the same period. That context explains a large share of CalSTRS’ deficit: During the same 20-year period, its pension obligations quadrupled.
Another cause is insufficient contributions. Pension funds get the cash with which to pay pension promises from a combination of investment earnings and contributions. Each year actuaries determine a minimal contribution that, together with investment earnings, is supposed to be adequate to meet current and future pension promises in a manner that assures intergenerational equity by not passing one generation’s operating expenses on to future generations. But sometimes even those minimal contributions are skipped. When that happens, deficits arise and, if not addressed, compound. A Boston College retirement expert calls those who skip minimal pension contributions “bad actors.”
The three actors responsible for contributions to CalSTRS are employees, school districts and the state. They make sizable contributions every year but not enough to provide that minimal contribution. This year alone they are falling short by $3.5 billion. Worse, they know that their contributions are insufficient and that skipping full contributions imposes a huge cost on innocent future generations (the skipped contributions accrue expensive interest). Yet to date they haven’t done anything about it, which is why the request from CalSTRS keeps growing in size.
The cause of demystifying pension mathematics isn’t helped when public pension fund executives don’t tell the whole story or obscure the truth. For example,
Calpensions.com reports that CalSTRS CEO Jack Ehnes recently told an Assembly committee that two-thirds of its deficit is due to “investment underperformance” but didn’t explain that investments themselves performed just fine but just not well enough to keep up with the growth in pension obligations and the shortfalls in contributions. Obviously, he should’ve been more forthcoming — after all, he is a public employee in charge of a public institution that is applying for one of the largest bailouts in U.S. history — but also, legislators need to ask better questions. For example, when it comes to pension fund investment performance, legislators should ask “relative to what?” and demand charts showing liability growth. Likewise, they need charts showing how actual contributions have compared to actuarially determined contributions.
The Society of Actuaries’ report recommended changes in actuarial practices in order to assure adequate funding, intergenerational equity and full disclosure. Public pension plans should adopt the changes and dedicate themselves to operating and reporting transparently. Pensions are a wonderful source of retirement security and can be successfully managed — but only if truthful, comprehensive and understandable information is provided and all responsible parties act conscientiously and sensibly.
Link to original article: http://www.utsandiego.com/news/2014/Mar/08/david-crane-calstrs-funding-nightmare/