Posted June 14, 2007

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· Missing the bull's-eye
· Hounding the fat cats

‘Over-funded’ Pensions? Hardly!

Keep those hands out of the cookie jar.

It happens like clockwork. Like tomb-raiders at the end of each Egyptian dynasty, the pension-fund raiders are already lurking around, waiting to get their hands on so-called “over-funded” pension assets created by a magnanimous stock market. In Pennsylvania, the raiders have already been sighted.

In Washington State during the last bull market cycle, the buzzword was “gain-sharing,” which meant that pension assets over the 100 percent funding level would be shared with employees. New legislation signed by the governor repeals that 1998 law. State officials have painfully learned that markets and funding ratios are cyclical.

So now the state’s teachers’ union has filed suit to defend gainsharing as a constitutionally protected property right, which is the kind of thinking that should send a warning to governments worldwide to avoid this practice like the plague.

Santa Barbara County reportedly has seen the same light, as their practice of gainsharing also left them in a deficit.

Every time the stock market hits new highs, the investment portfolios of many pension funds reach a high-water mark. For well-managed funds, assets may soon exceed the plan’s liabilities and their funding ratio will exceed 100 percent. Oregon just reported this result. But let’s not forget that many pension plans had funding ratios of 80 percent or less at the bottom of the last recession. And that many pension plans gave away the store in the late-1990s market bubble. They spent so much money on enhanced benefits that their funding ratios today are far short of 100 percent — even with the stock market setting new records. But in the Alice-in-Wonderland world of pension politics, the “Free Lunch” crowd would have us believe that any pension plan with a funding ratio over 100 percent is over-funded and must be relieved of its “excessive assets.” They want to raid the vaults again.

The politicians will want to skip making contributions, so they can spend the money elsewhere to please their constituents. That’s fiscal madness. If you can’t afford to make pension payments when the economy is expanding, how will you ever come up with the dough in the next recession without imposing layoffs and service cutbacks when citizens most need government help?

Employees, retirees and unions will all seek benefits enhancements. Retirees will lobby for a supplemental cost-of-living increase, which raises costs permanently. Employee groups will seek benefits-formula enhancements, usually to increase the payout rate — again a permanent increase in costs and liabilities. And they expect it to apply retroactively to past service, which creates a pure windfall for employees who are nearing retirement. They don’t seem to worry about what happens in the next recession, when the economy tanks, stock prices plummet and pension-fund assets again fall short of liabilities. That job is always left to the taxpayers — who are never at the table in these deals.

History does repeat itself. The capitalist system, so flourishing now, is a cyclical creature. In recessions, the stock market has typically fallen by 25 percent. Sometimes it implodes more, as in the 2000-03 and 1973-74 bear markets, and sometimes the market declines less. But on average, negative 25 percent is a pretty reliable estimator for the damage a typical bear market can do to a stock portfolio.

So here’s the math: Pension funds usually invest about 60 to 65 percent of their assets in stocks and other forms of equity, and the rest in bonds. In a recession, bonds often gain a little in value, so the impact of a typical 25 percent stock market decline on a pension fund is about 13 to 15 percent of the entire portfolio’s value, resulting in assets declining to 85 to 87 percent of their peak levels.

In light of this inherent cyclicality, the lowest point at which a pension fund could be considered to be over-funded must be 100 percent divided by 85 percent, which requires a market-peak funding ratio somewhere in the vicinity of 118 percent in assets-to-liabilities. And to protect against a 40-45 percent stock market decline (such as 1973-74 or 2000-03), a belt-and-suspenders over-funding point is 130 percent, depending on the extent of high-quality bond market diversification.

If taxpayers alone are responsible for amortizing a deficit when the pension fund has a ratio below 100 percent, then the taxpayers alone should benefit from amortizing surpluses to reduce employer contribution rates until the ratio reaches 130 percent. Symmetry is the only fair approach. Unless employees and retirees are prepared to ante up when a plan is underfunded, they should keep their hands out of the cookie jar until the plan reaches this level of cyclical safety

I expect that in this market cycle, we’ll hear from a new voice in the Free Lunch crowd — the hedge fund managers. They have a 2007 version of 1987’s “portfolio insurance.” They’ll tell us that they can short-sell the market on the downside and thus provide protection against declining markets. They will whisper that trustees can then afford to give away the pension surplus now, hire them to protect the downside, and “This Time It Will Be Different.

As Santayana said, those who forget history are doomed to repeat it. I’m not predicting a stock-market meltdown now, or a recession in the near future. But when the Free Lunch crowd re-emerges, as they will, you must present them with the math and the hard facts of life in cyclical markets. Once somebody finally presents a public pension plan with a funding ratio above 130 percent, we can then discuss intelligent ways to amortize and equitably share any “excess” over the lives of the taxpayers, the employees, the retirees and the politicians. (If there is a surplus, it could be used to fund OPEB liabilities. I’ll explain how in a follow-up column.)