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Cypen & Cypen
NEWSLETTER
for
October 17, 2013

Stephen H. Cypen, Esq., Editor

1.   THE PLOT AGAINST PUBLIC PENSIONS?: Liz Farmer ofGoverning writes that when the 2008 stock market crash slashed investment and retirement accounts in the public and private sectors, it opened the door to a seething debate that up until then had largely stayed within the confines of actuarial circles. The debate was over how best to approach governments’ pension liabilities and what rate of return should fund managers use to help lawmakers allocate the right amount of money each year?  Those who support the traditional pension system say pensions are under an ideological attack that is dressed up as an argument for better accounting practices. Their opponents say more conservative accounting measures should be used because pensions are a financial promise that governments must pay out. It may at first seem like a mathematical quibble -- but as more experts weigh in on each side and governments have begun the process of reforming their pension systems -- it has ballooned into a war between two ends of the spectrum, with no clear resolution in sight. The latest report commissioned by Campaign for America’s Future, is entitled “The Plot Against Pensions.” The writer blasts the Pew Charitable Trusts and others for what he calls the right’s ideological crusade against traditional pensions while helping billionaires and the business lobby preserve corporations’ huge state tax subsidies. The report gets at a longstanding complaint of traditional pension advocates: that any problems with the system’s sustainability are being grossly distorted by those who want to abolish it altogether. But for the market crash, very few people today would be asking whether the system is unsustainable. A number of forces in the pension debate are not acting in good faith, and the way policy choices have been presented in such a limited fashion, it shows that there is something more than objective pragmatism going on. The big problem in this whole debate is ideology is masked under the veneer of actuarial language. The debate is generally divided between economists and actuaries, and dates back to before the recession. Economists have argued that pension funds’ rate of return, or discount rate used to determine a system’s unfunded liability, should follow financial theory: that a liability should be discounted in a manner that is commensurate with its riskiness. Therefore, since a public pension liability is generally required to be paid by governments, it should be discounted on the basis of an interest rate that is risk free, or nearly so. That rate, the market rate typically associated with low-risk investments like bonds, is in the 3-to-4 percent range.  The public pension community, however, believes that the way to discount liabilities and determine the funding costs of public pension plans should reflect the long term expected rate of return based on prior performance. In this case, the expected rate of return over 20-to-30 years has typically been between 7-and-8 percent.  Of course the difference of a few percentage points when calculating a pension fund’s liability (the difference between what it has promised and what it currently has in assets) creates two very different pictures of pension funds. One says that most are doing fine and the other says the entire system is unstable.  But that mindset ignores a crucial fact from the public pension community’s point of view: that today’s most hard-up plans (Illinois and New Jersey for example) are largely that way because governments failed to make their annual contributions to the system every year. Again, ideology comes into the picture.  The crash left funds where lawmakers failed to pay the annual contribution particularly vulnerable, which is part of what drives the argument.  But an other part is a very calculated, coordinated effort to undermine public workers.  Additionally, the practical matter of how governments should contribute to their pension plans should not be left up to economic theory -- it should be based on past experience. Never before has then been such a gap between current interest rates and current return assumption.  Pension spending is projected to remain a fairly small share of government spending over the next 30 years.
 
2.  PUBLIC PENSION PLAN INVESTMENT RETURN ASSUMPTIONS:  A new Issue Brief from National Association of State Retirement Administrators says that as of June 30, 2013, state and local government retirement systems held assets of $3.58 trillion. These assets are held in trust and invested to pre-fund the cost of pension benefits. The investment return on these assets matters, as investment earnings account for a majority of public pension financing. A shortfall in long-term expected investment earnings must be made up by higher contributions or reduced benefits. Funding a pension benefit requires the use of projections, known as actuarial assumptions, about future events. Actuarial assumptions fall into one of two broad categories: demographic and economic. Demographic assumptions are those pertaining to a pension plan’s membership, such as changes in the number of working and retired plan participants; when participants will retire; and how long they will live after they retire. Economic assumptions pertain to such factors as the rate of wage growth and the investment return on the fund’s assets. As with other actuarial assumptions, projecting public pension fund investment returns requires a focus on the long-term. This brief discusses how investment return assumptions are established and evaluated, and compares these assumptions with public funds’ actual investment experience.  With current low interest rates and volatile investment returns, some believe these assumptions are unrealistically high. Because investment earnings account for a majority of revenue for a typical public pension fund, the accuracy of the assumption has a major effect on the plan’s finances and actuarial funding level.  An investment return assumption that is set too low will overstate liabilities and costs, causing current taxpayers to be overcharged and future taxpayers to be undercharged. A rate set too high will understate liabilities, undercharging current taxpayers, at the expense of future taxpayers. An assumption that is significantly wrong in either direction will cause a misallocation of resources, and unfairly distribute costs among generations of taxpayers. Although public pension funds, like other investors, have experienced sub-par returns in the wake of the 2008-09 decline in global equity values, median public pension fund returns over longer periods meet or exceed the assumed rates used by most plans. At 8.6% the median annualized investment return for the 25-year period ended June 30, 2013, exceeds the average assumption of 7.75%, while the 10-year return is slightly below this assumption.  Public retirement systems employ a process for setting and reviewing their actuarial assumptions, including the expected rate of investment return. Most systems review these assumptions regularly, pursuant to state or local statute or system policy. The process for establishing and reviewing the investment return assumption involves consideration of various financial, economic, and market factors, and is based on a very long-term view, typically 30-to-50 years. A primary objective for using a long-term approach in setting the return assumption is to promote stability and predictability of cost. Unlike public pension plans, corporate plans are required by federal regulations to make contributions on the basis of current interest rates. This method results in plan costs that are volatile and uncertain, often changing dramatically from one year to the next. This volatility is due in part to fluctuations in interest rates. The volatility has been identified as a leading factor in the decision among corporations to abandon their pension plans. By focusing on the long-term and relying on a stable investment return assumption, public plans experience less volatility of costs. Since 1982, public pension funds have accrued an estimated $5.3 trillion in revenue, of which $3.2 trillion, or 61%, is estimated to have come from investment earnings. Employer contributions account for $1.4 trillion, or 26%, and employee contributions amount to $662 billion, or 13%.  Public retirement systems operate over long timeframes and manage assets for participants whose involvement with the plan can last more than half a century. Consider the case of a newly-hired public school teacher who is 25 years old. If this pension plan participant elects to make a career out of teaching school, he may work for 35 years, to age 60, and live another 25 years, to age 85. This teacher’s pension plan will receive contributions for the first 35 years and then pay out benefits for another 25 years. During the entire 60-year period, the plan is investing assets on behalf of this participant. To emphasize the long-term nature of the investment return assumption, for a typical career employee, more than one-half of the investment income earned on assets accumulated to pay benefits is received after the employee retires. The investment return assumption is established through a process that considers factors such as economic and financial criteria; the plan’s liabilities; and the plan’s asset allocation, which reflects the plan’s capital market assumptions, risk tolerance, and projected cash flows. Standards for setting an investment return assumption, established and maintained by professional actuaries, recommend that actuaries consider a range of specified factors, including current/projected interest rates; rates of inflation; historic and projected returns for individual asset classes; and historic returns of the fund itself. The investment return assumption reflects a value within the projected range. Many public pension funds have reduced their return assumption in recent years. Among the 126 plans measured, more than one-half have reduced their investment return assumption since fiscal year 2008. While 8.0% remains the predominant rate assumption, the average is 7.75% (like the Florida Retirement System).  The brief concludes that the last 25 years, a period that has included three economic recessions and four years when median public pension fund investment returns were negative (including the 2008 decline), public pension funds have exceeded their assumed rates of investment return. Changes in economic and financial conditions are causing many public plans to reconsider their investment return assumption. Such a consideration must remain consistent with the long timeframe under which plans operate.
 
3. PUBLIC PENSION PLANS AND INFLATION: Key economic assumptions made by pension fund actuaries include estimating future investment returns (linked to discount rates), employee compensation growth, cost-of-living adjustments and assumptions about future inflation rates, among others. Techniques Et Recherche says the assumptions used to generate the "ideal" discount rate certainly have been the focus of many academic studies, think tank/association reports and financial media outlets.  However, the article does not focus on those items; instead, it is a descriptive piece that aims to focus on the inflation assumptions used by public plans in the United States.  Accuracy of the inflation assumptions used can have a considerable impact on the underlying fiscal soundness and management of a retirement plan. More specifically, this article highlights the inflation assumptions used by a selection of public pension plans, describes the past inflationary environment experienced by their sponsoring governments and briefly covers the global inflationary outlook today. Towers Watson found in a 2009 survey that it is common to deter-mine an underlying long-term estimate of the level of price inflation, or Consumer Price index, which then forms the basis for the assessment of the other economic assumptions (in particular, those assumptions that may be directly linked to inflation, such as salary, social security, and pension increases).  Most state and local government (full time) employees in the United States have access to and participate in a defined benefit pension plan. Between 2001 and 2009, these U.S. state and local government pension plans used an average inflation assumption of between 3.45% and 3.85%.  During the same period of time, World Bank World Development Indicators US Inflation Rate generally ranged from 1.60% and 3.80%.  (In 2009, U.S. inflation was -0.40%.) The maximum assumptions used during the 2001-2009 time period averaged 5.42%, and the minimum assumption used averaged 1.25%. Also, for the nine years analyzed, the largest plans (top 10% in assets) used inflation assumptions 0.33 to 0.57 percentage points lower than the smallest plans (bottom 10% in assets).  Over the same years, average inflation assumptions used by state and local plans in the U.S. ranged from actual inflation by a difference of between 2.24 percentage points and 0.16 percentage points, with an average difference of 1.13 percentage points An example of the upper end is the Arizona Public Safety Personnel Retirement System (5% to 5.5% for all of the years analyzed).  Examples on the lower end include State Universities Retirement System of Illinois (1.25% to 1.5%).
 
4. STOCKTON AFTERMATH: Utsandiego.com reports that in the aftermath of last year’s bankruptcy, the Stockton City Council approved a plan that restructures debt and fully funds the California Public Employees’ Retirement System, thus leaving pension benefits for city employees unscathed.  As announced by CalPERS, by continuing fully to fund its pension obligations, Stockton acknowledged the importance of a secure retirement to its current employees and retirees, and the positive impact that pensions have on recruitment and retention of quality public servants.  Stockton had paid its employees 25% above the California public-sector average, and still offers its police and firefighters a “3% at 50” plan that allows them to retire at age 50 with 90% of their final years’ pay.
 
5.  PENSION PLAN ADMINISTRATOR HAS NO STANDING TO SUE CUSTODIAN WHERE ALLEGED INJURY NOT FAIRLY TRACEABLE TO CUSTODIAN: The plan administrator sued the plan’s custodian in federal court, alleging that the custodian had refused to abide by his instructions, and had exercised control over plan assets by refusing to make distribution to the participant. Although the administrator sued the custodian -- suggesting that they had a dispute -- in reality, the two parties seem to agree on all the major issues. For instance, both agreed that the plan was a retirement account that is exempt from garnishment under the anti-alienation provisions of the Employment Retirement Income Security Act. They also agreed that a single plan participant had made a claim for benefits from the plan, but had been unable to collect anything due to a freeze on distributions to her from the account. Further, both parties agreed that this freeze was the result of a Michigan state court order in a post-judgment collection proceeding. Thus, although the custodian conceded that the plan participant had been injured, the administrator conceded that the plan participant’s injury was fairly traceable to a Michigan state court order, and not to the custodian. As a matter of law, a plaintiff is required to have an injury that is fairly traceable to challenge the action of defendant, not the result of independent action of some third party not before the court. If the injury is not traceable to the defendant, the plaintiff lacks standing to bring suit against the defendant, and the federal court lacks subject-matter jurisdiction to adjudicate the matter. Here, the administrator failed to identify an injury that is fairly traceable to the custodian, so the administrator did not have standing to bring suit against the custodian.  Hence, the district court’s dismissal of the case for lack of subject-matter jurisdiction was affirmed.  Johnson v. Merrill Lynch, Pierce, Fenner & Smith, Inc., Case No. 12-3869 (U.S. 7th Cir. May 20, 2013). 
 
6.  MONTANA TEACHERS' RETIREMENT SYSTEM SUES OVER COST-OF-LIVING CHANGE:  Current and retired educators and their union filed a lawsuit in Montana state court, challenging part of a new law that will lower annual cost-of-living raises for retired teachers from 1.5% to 0.5% on January 1, 2014. Missoulian.com reports that plaintiffs asked a state district court judge for a preliminary injunction to block that part of the law from being implemented by the Teachers’ Retirement System. They contend it violates the contracts and the takings clauses of the Montana Constitution.  The individual plaintiffs worked for public schools and began paying into their retirement system before July 1, 2013, effective date of the new law. The annual benefit adjustment is alleged to be part of their contract with the state, and when the 2013 Legislature reduced that adjustment, it impaired that contract.  The challenged law also temporarily raised the mandatory contributions, but those changes were not challenged in the current lawsuit.
 
7. FLORIDA DIVISION OF RETIREMENT ANNUAL POLICE OFFICERS' AND FIREFIGHTERS' PENSION TRUSTEES' FALL CONFERENCE: The 43rd Annual Police Officers' and Firefighters' Pension Trustees Fall Conference will take place on October 22-24, 2013. You may access information and updates about the Fall Conference, including area maps, a copy of the program when completed, and links to register with at the Doubletree by Hilton Hotel Orlando at Seaworld. Please continue to check the FRS website for updates regarding the program at www.myflorida.com/frs/mpf. All police officer and firefighter plan participants, board of trustee members, plan sponsors, and anyone interested in the administration and operation of the Chapters 175 and 185 pension plans should take advantage of this unique, insightful and informative program.
 
8. JEWISH WISDOMS: I went on a diet, swore off drinking and heavy eating, and in fourteen days I had lost exactly two weeks.  Joe E. Lewis
 
9. DID I READ THAT SIGN CORRECTLY? In an office: AFTER TEA BREAK STAFF SHOULD EMPTY THE TEAPOT AND STAND UPSIDE DOWN ON THE DRAINING BOARD.
 
10. TODAY IN HISTORY: In 1970, Anwar Sadat sworn in as president of Egypt.
 
11. KEEP THOSE CARDS AND LETTERS COMING: Several readers regularly supply us with suggestions or tips for newsletter items. Please feel free to send us or point us to matters you think would be of interest to our readers. Subject to editorial discretion, we may print them. Rest assured that we will not publish any names as referring sources.
 
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Items in this Newsletter may be excerpts or summaries of original or secondary source material, and may have been reorganized for clarity and brevity. This Newsletter is general in nature and is not intended to provide specific legal or other advice.


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