Friday, January 25, 2013

Dealing with the underfunding of pension funds

I recently interviewed Phil Page of Cardano for The Journal of Performance Measurement(r), regarding the all-too-common situation that many (most?) pension funds, both private and public, are facing: underfunding. Phil identified three possible solutions:

1) increase contributions (from the company, for private; from the taxpayer, for public)
2) increase returns (most likely from taking on more risk)
3) reduce benefits.

When I was the (part-time; meaning only 25 hours a week!) mayor of the Township of North Brunswick (2000-2003), the New Jersey state police pension fund was OVER funded; and so, we got a gift: we weren't obligated to provide our traditional funding, which saved us around $1 million a year, which we used to reduce property taxes. A few years later, after I was out of office, and as a result of the crisis started by the subprime mortgage debacle, the fund was severely underfunded, meaning more money was needed from the municipalities, meaning increases in property taxes.

It appears evident that many pension funds are attempting to increase their returns. Just this week, in The Wall Street Journal, we had two articles address investment methodologies being employed ("Money Magic: Bonds Act Like Stocks" (1/22/13) and "Pensions Bet Big With Private Equity" (1/25/13)). Have the funds' appetites for risk taking increased, or have they concluded that the alternatives (increased funding / reduced benefits) are steps they wish to avoid?

On the public side, I can see how we got into the mess we're in. Politicians, seeking the support of police unions, for example, were all too quick to grant attractive pension benefits (I recall hearing of a municipality in California, that gives its police officers 85% of their highest pay, after working something like 25 years...AMAZING!). When the benefits are initially granted, or even boosted, the politicians in office are immune to their impact; at least the brunt of it. And so, they reap the benefits of union support, while passing on the funding challenges to their successors: clever. Imagine what will happen today, if a mayor or governor tries to get their police unions to agree to reduce their benefits.

As for additional funding, as a taxpayer I have little interest in providing more of my money to pension funds that have, due to no fault of mine, run low, so that the beneficiaries can receive pensions that most of us in the private sector could only dream about.

While I am happy that I am no longer a politician, I fear for how this mess will be resolved.


  1. David, you might be interested in connecting with John Minahan, who is doing some interesting work on the ethics of accounting assumptions for pension funds.

  2. You should have rejected that gift when you were mayor and kept paying for new benefit accruals. I am sure none of your consultants ever recommended such a thing. The pension fund becoming underfunded within a few years is a sign that the investment strategies and contribution policies were not compatible. If I take a lot of risk such that a financial crisis can wreak havoc, I need to acquire a sufficient funding cushion in good economic times. Contribution holidays are a no-no for risky strategies.

    If we really want to measure overall pension plan performance, we need to measure not only the returns from plan investments, but also the return impact that typical plan sponsor actions have. I have thus designed the Pension Plan Internal Rate of Return (PenPIRR) as a combined measure of Investment Returns and the "Returns on Governance". The latter gauges the adequacy of benefit and contribution policies.

    A decision to grant higher benefits would lower the Returns on Governance (and thus PenPIRR) immediately. With our current measurement practices, it would never show up in a return measure, it would only affect the funding ratio.

    I believe that the current pension mess is the result of bad accounting and performance measurement in the corporate and public pension world. It won't be pretty to see how this will be sorted out in the public sector. There will be plenty of work for lawyers.

  3. Norman, I'm not sure that any single municipality had the right or ability to contribute to a state fund, that pools the monies. Perhaps there was a "work around." And, as they say, hindsight is "20/20." As a municipality, we have no input into the running of the plan; we have no consultant. As a mayor, you're obligated to be respectful of your citizenry; your taxpayers; essentially, your clients. As for the reason(s) the fund went underfunded, my guess is that many such plans, the subprime mortgage crisis was the major cause. Did that mean the fund was not in the right instruments? I can't say, as I was not nor am not privy to these details.


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