These pension reforms are needed to deal with the crisis
The need for pension reform has been clear for years, but few public pension funds have followed through. As the industry deals with fallout from the coronavirus, The Institute for Pension Fund Integrity (IPFI) has some suggestions about pension reform.
Get The Full Warren Buffett Series in PDF
Get the entire 10-part series on Warren Buffett in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues
Q3 2020 hedge fund letters, conferences and more
Bailouts could lead to pension reform
In a recent report, the IPFI suggested something many lawmakers find unacceptable: bailouts for public pension funds. Numerous public funds are in a precarious position following this latest downturn, so the institute believes more and more states will seek bailouts from the federal government.
This year, reports suggested that Carlson Capital’s stock-picking fund, Black Diamond Thematic, lost more than 20% in January. This followed the fund’s terrible performance in 2019. Even though the fund, which was one of the firm’s most extensive strategies, added 18% for the year, it lost roughly 60% of assets when one of the firm’s Read More
Illinois lawmakers have already called for $40 billion in assistance, including $10 billion for its public pension funds. New Jersey lawmakers have also called for a $500 billion federal loan program to support their state’s public pensions.
The IPFI notes that any federal move to rescue pensions that have been underfunded for a long time would face severe political backlash what would effectively amount to a bailout for poorly managed pensions and fund managers who never wanted to take actions to address their problems.
However, despite the federal backlash, the scale of the issue may be so bad that federal support may be inevitable due to the high risk of insolvency in several states. If a bailout occurs, the federal government may then demand meaningful pension reforms, which public officials have so far refused to consider.
States could declare bankruptcy
Senate Majority Leader Mitch McConnell has previously said they could allow states to file for bankruptcy in response to the pension crisis. He believes states should be allowed to go bankrupt instead of receiving bailouts for their underfunded pension funds.
Dr. Walter Lane of the University of New Orleans, a bankruptcy expert, has written that the states which are thinking about bankruptcy are those that face steep pension commitments. If these states do file for bankruptcy, public pension beneficiaries would see their benefits cut entirely.
At this point, states are prohibited from filing for bankruptcy. That means states would have to follow a long process that ends at the Supreme Court. An alternative would be if Congress passes new legislation allowing them to file for bankruptcy.
Before bankruptcy, states will cut programs like Medicaid and higher education. They could also liquidate their parks and buildings. Even though bankruptcy is a last-ditch effort, the constitutional validity of allowing it will be questioned.
Pension reforms to focus on fiduciary responsibility
The IPFI also suggested that the pension reforms could turn fund managers’ attention back to their fiduciary duty obligations. That would mean the fund managers are required to make investment decisions designed to maximize returns instead of pursuing an alternative agenda.
In recent years, the institute has said that there’s been a concerning trend among some fund managers, who have begun to prioritize their social or political considerations over maximizing returns. The IPFI said calls for divestment from certain industry and a focus on ESG may have immediate political benefits for some public officials, but they don’t protect the long-term stability of pension funds.
The IPFI called attention to the California Public Employees’ Retirement System (CalPERS), which went from a $3 billion surplus to a $140 billion deficit over 10 years. The fund has been criticized because it has focused more on investing in green companies instead of on generating stable returns. The IPFI noted that CalPERS averaged a 6.7% return in fiscal 2019, while the S&P 500 and the Vanguard 500 index fund generated returns of more than 30%.
Following the coronavirus economic downturn, there has been a renewed push to include ESG products in pension funds as proponents claimed that such funds have been outperforming traditional investment products. However, the IPFI reports that this hasn’t been the case as ESG scores offered limited explanation of positive returns during the pandemic and failed to shield funds from falling stock prices.
Pension reforms around assumed returns and risk
The IPFI added that if there is one key takeaway for public pensions from the COVID-19 crisis, it should be that the trend of investing in riskier assets to offset current shortfalls through higher expected returns in the future can backfire.
Fund managers don’t seem to be factoring in any risk of economic crisis or recession into their projections. The IPFI called on public officials to move toward realistic actuarial assumptions for calculations of future pension fund growth and required contribution levels.
The institute also called for wider use of stress testing as only 10 states require stress testing for pension funds. It said those states are better positioned to adjust their projections and implement other forward-thinking policies to stabilize growth and local budgets.
Pension clauses in state constitutions
The IPFI also noted that several state constitutions include classes preventing a reduction in pension benefit payments. However, those clauses hinder the options available to public officials who are dealing with unfunded pension liabilities. Due to the nature of the economic crisis, the IPFI believes public officials should rethink these clauses.
The institute also argues that states should also more carefully examine legislation that expands benefits when those decisions can’t be reverted easily.