A Fund Adrift
In the 1980’s, the Pennsylvania School Employees Retirement System (PSERS) had a problem with its pension plan—the fund was deep in the red, with only 50 to 60% of the assets required to meet its projected benefit obligations. In response, the state and school districts ramped up their contributions and by 1997–thanks also to a bull market in financial assets–the retirement fund was back on track and fully funded.
Flash forward twenty years. The PSERS retirement fund was devastated by the collapse of financial markets in 2008—dropping to a funded ratio of 57%. In response, the school districts and the state began ramping up contributions, increasing them from $535 million in 2010 to $3.8 billion in FY2017. The stock market also cooperated, going on a fantastic bull run. And so we might expect the Comprehensive Annual Financial Report (CAFR) of the PSERS plan for the year ended June 2017 to show the pension fund on the mend. Instead, the pension fund is now only 52 % funded, with assets of $53 billion and a projected benefit obligation of $100 billion (net present value).
What happened? How can the retirement fund have lost ground when employer contributions are at their highest percentage of payroll ever and the stock market is booming? The answer is not complicated or obscure, but rather simple math. PSERS’s inability to make any progress towards meeting its projected obligations stems from the inevitable consequences of continued low interest rates and a rising ratio of retirees to employees.
In the mid-eighties, the PSERS’ fund was able to provide the money it needed to pay benefits with the cash flow from its investments, because the interest and dividends it earned were in the high-single digit percentage. Even though the PSERS plan was underfunded with regards to its future obligations, its current income sufficed to meet its cash flow needs—paying out pensions to retirees and their beneficiaries. This allowed the fund to invest its state and school district contributions, which compounded the returns of a rising stock market. In contrast, today’s PSERS fund is now only able to meet 20% of its annual benefit payments with its cash flow from investments. To make its required payments to retirees and their beneficiaries, it is forced to use all of the employee and employer contributions it receives. Even this is not enough, and year after year the PSERS fund has been forced to be a net seller of assets in order to make ends meet.
Why are the cash flows from PSERS’ investments so inadequate? In my view, there are two primary reasons. The first is that the Federal Reserve’s policy of maintaining very low interest rates since the financial crisis in 2008 has dramatically reduced the current cash flow from PSERS’ investments. Combined with a shift into equities and alternative investments, which tend to have low current income payouts, this means the fund receives a mere 2% return in interest, dividends, rents, and other cash flow on its money. After deducting investment fees and expenses, this amount is less than 15% of the annual payout to beneficiaries.
The second reason why the Eighties playbook has failed in the 2010’s is that the aging of Pennsylvania’s population has meant that the ratio of teachers to retirees has fallen dramatically. Whereas benefit payments amounted to 26.6 % of active payroll in 2000, they totaled 50% in 2017, and the trend shows no sign of reversing. In the last decade, the number of active members contributing to the PSERS’ fund has fallen by 3% while the total of annuitants and beneficiaries has grown by 36%.
For the last five years, the annual reports presented by PSERS have painted a hopeful picture of reversing the underfunding trend. However, these projections rely on unrealistic assumptions of large increases in the employee payroll. In some sense, the annual increases in the required percentage that the school districts are forced to contribute to the plan have kept them from filling staff positions and providing substantial raises. In essence, Pennsylvania’s school districts have two payrolls—one for those currently employed and one for those who used to be employed, and right now the payments to the latter are preventing any meaningful increase in the former.
It is hard to say what will get us out of this mess What is clear is that a repeat of the 1980’s is not in the cards. As for now, the PSERS’ retirement fund drifts along like a sailboat with a broken mast, unable to gain ground on the shore even with favorable winds. Any storm on Wall Street will reveal just how unrealistic its expectations of reaching land are.
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