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Tuesday, April 6, 2010

Tuesday, April 6, 2010

Predicting the Meltdown of the UC Pension

UC's state-paid employees took about an 8% pay cut this year.  On April 15, the total cut climbs to 10% with the restart of contributions to UCRP.  Income over the Social Security wage base ($106,800) will be withheld at 4%.  The base rate of 2% is expected to rise to 5% for employees (the current CalPERS rate) in step increases of 1% a year.  The employer share is also slated to rise: under the Regents' 2008 "Funding Policy," under a "Slow Ramp-Up" plan,  employer contributions rise 2% a year starting July 2011. 
UC salaries are already 10-15% below salaries at comparison universities, but UC's outside consultants have long claimed that UC's pension plan was so much better than the others that it brought "total compensation"at UC into a strong position.  This claim was continuously contested by the relevant Senate committees, but in any case that argument is over.  At a 5% contribution level, the "value of UCRP to active faculty is below the average value of pension plans at the Comparison 8 universities" ("TIFR Recommendation to assure Adequate Funding for UCRP, p 11).

Take a deep breath, and ponder the sheer speed of UC's deterioration as a workplace.

Then ask, why restart contributions now, in the same year in which pay was cut? The simple answer is that UCRP was shifting from being super-funded to being underfunded even before the financial crisis, and the restart was set in motion two years ago.  A good summary of current official estimates of the problem is in this Regents presentation, given by UC's actuary, the Segal Company, which shows the decline of the funding ratio (assets over liabilities) such that pension commitments could no longer be funded 100% by UCRP investment income.  (Most pensions fund about 75-80% of their benefits from investments, and depend on employee and employer contributions for the rest.)

Commentary on the subject is all over the place.  The most thorough public document is the Senate's, linked above.  This is absolutely required reading on the subject, and I'll come back to it.  Bob Samuels has suggested that a new actuarial rule is being used to overstate liabilities, create a crisis, and reduce retirement benefits.  On the other hand, one faculty participant on a listserve has suggested that Regental mismanagement has led to such a large and genuine underfundng crisis that the University might consider "letting the pension fund go bankrupt," forcing the Pension Benefit Guarantee Corporation" to pay off pension obligations.

A UC economist who has followed the discussions splits the difference.
I don't think there's any question that the green-eyeshades people in Oakland want to cut benefits anywhere they can. But the crisis is indeed real. The funding status of UCRP will continue decline because the figures reported are using actuarial and not market returns.  Only 1/5 of the meltdown is recognized each year, using actuarial smoothing.  (This isn't misleading, it's openly acknowledged, and an acceptable way to keep annual contributions from being overly volatile.)  PERS uses 15-year smoothing. So we can predict how the funded status will decline, as we "recognize" more and more of the losses, through 2013.
This economist confesses some bafflement at the variations in the amounts by which the pension is said to be underfunded, and then adds an important political comment: since the state is unlikely to restart its support for employer contributions, these will increasing depend on increased student fees.  (Fees are relatively fungible UC revenues that currently help pay for salaries, among many other things).    This puts student and faculty interests increasingly at odds. If new faculty hiring stalls, it's possible to imagine a rapidly aging faculty, already overrepresented in the Academic Senate, consenting to higher tuition out of pension self-interest.

In addition, UCLA's Faculty Association offers a thorough backgrounder on UCRP in the context of state public pensions.  It calls on the state to live up to its obligation to fund the employer contribution to the pension, which the state has so far refused to do.  UCLA's FA also suggests discussion of a "tier 2" plan for new employees.

My own review of the situation started with a Stanford policy brief about California state pension, written by some public policy grad students advocating a more complicated way of assessing liabilities.  If you look at Table 2, you will see that in their "adjusted' accounting of UCRP liabilities the funding ratio is an alarming 59.3% (meaning that only about 60% of liabilities are covered by assets).  But the stated liabilities, using the standard method of discounting liabilities in lockstep with (smoothed, estimated) investment returns, are nearly 99% funded as of July 1, 2008.

I am not qualified to comment on the value of the Stanford authors' probability-based "stress test" for pensions, but am doubtful of the foresight of such modeling-- triply so in the wake of the financial crisis, whose tandem epistemological crises have yet to be resolved.  So I  humbly note that the stock value crash that occurred later in 2008 will be smoothed over 5 years, that the funding ratio is based not on market value but on actuarial value as noted above, that this method brought the funded liability to 95% after the crash (slides 7-8),  and that the ongoing, non-drastic downward smoothing will be partially countered by the bounceback of equity markets in 2009-10.

So far, this looks like less than a major emergency.  A "gentle ramp-up" on contributions? Yes. Weighing better accounting methods, investment strategies, and accountability? Yes. Rethinking the status of UCRP and public pensions?  No.

But it gets worse.  The issue is the gap between the Segal Company's Recommended Contribution and UC's actual plan for restart, the Slow-Ramp Up.  The Recommended Contribution was 11.6% of covered compensation for 2009-10 (due by the end of 2010), which would come 2% from employees and 9.6% from the employer. Segal recommended nearly doubling this to 20.4% in 2010-11, the current year,  3% from employees and 17.4% from UC.  This Recommended Contribution is based on the scary action in Segal's Regents slides in Slide 12 and Slide 13. The really big pension funding gaps - $10 Billion in 2010, $20 Billion in 2014, and so on that we see there, comes from projecting the effects of continuing insufficient contributions from both the employer (via the state) and the employees, causing the Unfunded Accrued Actuarial Liability (UAAL) to grow each year.

Is the red line a scare tactic designed to induce employees, already financially destabilized, to take more money out of their shrunken pockets?  We have no way of checking the public math because there isn't any.  The red line does seem to be a worst-case scenario, based on projecting low contribution increases (the Slow Ramp-Up of 2%/1% annually) out into the future, and coupling these with unknown but probably pessimistic assumptions about investment returns (not still 7.5% / year?).  We need more explanation of the generation of these scenarios before we react to the bad one.

But now we come to the Senate's TIFR report, cited above (TIFR stands for Task Force on Investment and Retirement, and it is part of the systemwide Faculty Welfare  Committee (UCFW).  TIFR has looked at the math, has better access to UCOP data than any other systemwide Senate committee, and has membership that doesn't rotate and so keeps its accumulated expertise.  Their report is as scary as Segal.  The "Slow Ramp‐Up," they say, "will lead to a catastrophic underfunding of UCRP over the next 15 years" (6).  There are a number of factors-- do read this report of 13 double-spaced pages--that starts with a gap of 10% between recommended and actual contributions in 2009-10, and 14% in 2010-11. In this scenario, the gap compounds, until by 2022 the contributions rise to 50% of covered compensation, doing further major damage to UC's ability to spend money on actual education.

Underfunding looks inevitable: the state won't pay the costs of the employer start-up, UC seems not to have the money, most employees are broke, and in fact they got their contribution "holiday" in the first place to make up for flat or falling pay during the cuts of the early 1990s. Although the assumptions and scenarios need to be checked, and although I would like to know if they are assuming everyone retires at once as some suggest (and as dumb an assumption as that may seem), I have no grounds to doubt the TIFR-Segal projections.

If more laissez-faire will lock us into a death spiral, what would get us out of it?  We have the usual two funding sources of sufficient size - major student tuition increases, and restored state money.  TIFR recommends adding a third - the issuance of "Pension Obligation Bonds" as a way of providing the employer contribution (employees would still pay through their income).  The idea is that paying interest on the bonds is cheaper than making up the shortfall later on.

That is no doubt true, but I have two objections to this TIFR proposal.  The first is discomfort with older people borrowing to pay for their stuff and sticking the young with the bill.  We've been funding state services this way in the Arnold era and it isn't right.   The second is that raising money with bonds is like raising money with tuition hikes: both allow the state to say, "good, you've solved your own problem, no further need for you to come running to us."

The only solution I see is restoring public funding on the multiple educational grounds this blog has often described, with the added twist that refusing to honor pension payment obligations sets UC up for a step-function decline.  How low does Sacto want us to go?

This solution of extracting state support for its retirement obligations has to buck pervasive predictions, as in an op-ed by a Schwarzenegger aide in today's LA Times, of a coming pension nuclear winter.  These predictions could at some point persuade the state to two-tier and eventually eliminate its public pension system.  I can imagine the Gov. Meg Whitman special commission on the pension crisis, a Parsky promotion of an "employee independence from unaffordable pensions" scheme, an Edley endorsement, a ballot proposition like that of 2005, and a "Fast Ramp Up" phase out of future accruals and benefits.

So expert groups like TIFR need now to put as much energy into solving the UCRP problem as they have put into exposing it-- in a way that fits with the public character of the university.


California Prof said...

Chris, I agree that we are headed towards a nuclear winter with UCRP. I would like to point out that it's not clear how much UCRP will benefit from a stock market rebound, depending on how much of its portfolio is in private equity.

Private equity has been hyped as beating the stock market, but that is far from clear, and any profits have to be taken net of the huge fees charged by equity firms (usually 2% of invested capital and 20% of profits) If UCRP invests, say, 6 billion in private equity, that's 120 million AT LEAST in fees. I eyeballed the PE investment by putting the value of UCRP portfolio at 50 billion and assuming the same proportion of PE as for CalPERS (about 12%).

The other factor is that, by GASB rules, unfunded liabilities have to be reported on the financial sheets discounted at the expected rate of return on investments, which UCRP puts at what seems to me a wildly optimistic 7.5%. With a more realistic estimate of the ROR, the liabilities would further balloon.

Harry Nelson said...

This is a terrible problem... I don't really see any easy solution, including Pension Bonds. When the market was at historical highs, UC stopped contributing to the pension fund... someone thought, `This Time Its Different'. Not a few people noted that what must go up must come down, which in technical terms translates to `Regression to the Mean'.

So had regular contributions been made since 1990, I doubt we'd be where we are right now. Actually, I know someone quite well who did keep contributing to their 403(b) right through the 1990's and 2000's, and their 403(b) fund is in pretty good shape.

UC is in great contrast to much of the rest of the California pension system, where new benefits were introduced in 1999 (without new contributions). At UC we kept the system going starting in 1990 or so by wagering with the pension fund, and we lost the wager.

So one possible option is: since we are right now still near 100% funded (it is future projections that go awry), hand out the entire existing pension fund right now into the DCP's to each person with a claim, at their lump-sum payout. For the future have a 403(b) + employer match.

I don't like that option. But I'm hesitant to trust the Regents and their money managers again, they've fooled us once.

Michael Meranze said...

California Prof: According to the last available UCRP reports the private equity was at 5.3% which is about 1.7 billion.

What is interesting about the Stanford study that Chris notes and that was sponsored by Arnold is that basically the way they get their figure for the "true" liability is by saying that since pensions are guaranteed they should be treated as no-risk investments and should therefore only be given credit for the return on treasury bonds (I gather the figure they use is 4.14%). But later when they criticize Calpers for its investment strategy they say that had they invested in less volatile corporate bonds they could have had a safe 7-7.5% investment return. So it is clear that they are gaming the figures.

That doesn't mean that there isn't a serious problem here and I am not sure what corporate bonds they claim are safe and what those companies would be, but it would be great if some of the economists could actually get into their calculations (which I gather are based on a model rather than accepted practice) as well as the UCRP reports which are available on the UCOP website.

California Prof said...

Michael, I agree that there is something fishy with the discount rate assumed in the Stanford report. The argument seems to be that since UCRP is a defined benefit plan, it is risk free, and so the liabilities should be discounted at the same rate as risk-free assets par excellence, i.e., 10-year treasury bills (which carry 4.14% interest).

But that seems a non sequitur: the benefit is risk-free to the beneficiaries, it does not follow that UCRP should invest in risk-free financial instruments only.

Even in the golden days of UC Treasurer Patricia Small, UC took some risk with the portfolio, going into safe stocks, bonds, and other fixed-income assets short of T-bills. So a more appropriate estimation of the RoR would be somewhere in between the 4.14% of T-bills and the 7.5% of the actuarial discount rate.

Let's keep in mind that each 1-point drop in the actuarial rate results in a 10% to 20% increase in liabilities.

Thanks for the correction on the proportion of private equity in the UCRP portfolio.

Michael Meranze said...

California Prof: You might also want to look at the Calpers response (I put up a link at Pensions and latest links) to the Stanford Study. It is pretty devastating. Of course, UCRP probably won't publish a response as well because they want the narrative to help them make changes.

California Prof said...

Michael, yes the CalPERS response seems right on target. It might be interesting to look at the different allocation strategies between UCRP and CalPERS portfolios.

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