`Death Spiral' Awaits State-Worker Pensions as Illinois Leads Underfunding

Wednesday, September 15, 2010

U.S. state pensions such as Illinois, Kansas and New Jersey are in a “death spiral,” with assets at many insufficient to cover benefits, payouts consuming a growing portion of resources and costs rising twice as fast as investment gains.

Less than half the 50 state retirement systems had assets to pay for 80 percent of promised benefits in their 2009 fiscal years, according to data compiled for the Bloomberg Cities and Debt Briefing in New York today. Two years earlier, only 19 missed the mark. Illinois covered just 50.6 percent of benefits last year, the lowest so-called funded ratio, which actuaries say shouldn’t be less than 80 percent.

Benefits paid by funds in at least 14 states equaled more than 10 percent of assets in the fiscal year, the figures show. In 2007, none exceeded the threshold. The growing burden prompted Colorado, Minnesota, Michigan and other states to trim benefits for millions of teachers and government workers. It also forced fund managers to keep money in short-term low-return investments to pay benefits, reducing chances pensions can earn their way back to financial health.

“Once you get into that dynamic, you’re in a death spiral,” said Michael Aronstein, who manages the $295 million Marketfield Fund of stocks as chief investment strategist at Oscar Gruss & Son, a New York brokerage. “There’s no financial or return solution.”

The largest Illinois pension, the $33 billion Illinois Teachers’ Retirement System, paid $3.7 billion of benefits in the year ended June 30, 2009. That’s 13 percent of its assets at the time, up from 8 percent two years earlier, according to annual reports and Dave Urbanek, its spokesman. The New York State system, the best-funded in the Bloomberg data at 107.4 percent, paid out 7 percent of its assets in fiscal 2009.

Shoring Up the System

At June 30, 2010, after the Illinois fund’s investments had gained 13 percent and lawmakers borrowed $3.5 billion to shore up the system, benefits in the fiscal year had risen to $3.9 billion, according to Urbanek, or 12 percent of assets.

Lawmakers in Illinois, which, with California, has the lowest credit rating from Moody’s Investors Service of any state, were unwilling to approve another bond sale, for $3.7 billion, this fiscal year. As a result, the pension may sell $3 billion of assets to cover benefits, Urbanek said.

“Death spiral is too harsh a language,” he said. “It’s a concern, but we’re not on life-support.”

Selling assets, reducing services and cutting costs such as pension contributions are tactics states are using to confront what a June 29 report by the Center on Budget and Policy Priorities, a Washington-based research group, said was a record $140 billion combined budget deficit this fiscal year.

Anger Management

Lawmakers are willing to anger taxpayers and retirees to show investors who buy more than $400 billion of state and local debt a year that something is being done to stem rising costs.

Benefits paid by the 100 largest public pensions in the five years that ended June 30 grew an average of 8 percent annually, calculations based on U.S. Census Bureau reports show. In that period, the median annualized investment return was about 3 percent for public funds with more than $5 billion of assets, said an August report from Wilshire Associates, an investment adviser in Santa Monica, California.

The U.S. recession and stock-market collapse drained about $835 billion of value from the 100 largest public funds, according to the Census Bureau. As a result, benefit payments by those funds amounted to 7.5 percent of assets in the 12 months ended June 30, 2009, up from about 5 percent two years earlier, the census figures show.

Unaltered Trend

Even an investment rebound in the year that ended June 30, 2010, when Wilshire reported the median return on public retirement funds was about 13 percent, did little to alter the trend. Funds in at least eight states that reported investment results for the fiscal year still spent more than 10 percent of their assets on benefits, Bloomberg data show.

“The fact such a large portion of assets is flowing out each year really challenges the longevity of these funds,” said Joshua Rauh, who teaches finance at Northwestern University in Evanston, Illinois. He projected retirement accounts in his and other states would run out of money within a decade. “It will be a crash landing,” he said.

The rising share of assets consumed by benefits is “interesting” but misleading, said Keith Brainard, research director of the Baton Rouge, Louisiana-based National Association of State Retirement Administrators. He pointed to the offsetting effect of annual payments into funds made by workers and state governments.

“Employer contributions tend to fluctuate, but employee contributions are remarkably steady,” he said.

Unequal Gains

From 1998 to 2008, the most recent full statistics from the Census Bureau, state and local government payments into retirement funds almost doubled to $82 billion. Over the period, worker contributions rose 70 percent to $37 billion.

During the same decade, however, benefits paid increased by 130 percent to $175 billion. Payments from the 100 largest public funds grew by another 9 percent during the first three quarters of the 2010 fiscal year compared to the first three quarters of 2009, according to the census.

The $11 billion Kansas Public Employees Retirement System had the seventh-lowest funded ratio in Bloomberg’s ranking at 63.7 percent in 2009. It paid out benefits equal to 10 percent of its assets in the fiscal year, double the rate of 2007, fund records show.

The pension’s funded ratio fell from 70.8 percent two years earlier and is projected to drop to 41 percent by 2015, according to a February report to state lawmakers. Another market decline could jeopardize the fund, the report said.

Capital Preservation

“Preservation of sufficient cash flow to fund current benefits may become paramount,” it said, which could constrain investment strategies and make it harder to achieve assumed returns.

The problem is magnified in states where officials skipped billions of dollars of contributions.

New Jersey Governor Chris Christie, 48, a Republican who took office in January, withheld $3.1 billion of payments in his first budget to cope with a record $10.7 billion deficit. Since 2004, the state has made only $2.7 billion of the $11.9 billion in scheduled contributions, according to bond-sale documents.

New Jersey’s $68 billion retirement system had a funded ratio of 66.1 percent in the Bloomberg data, the 11th-lowest. The state in August settled Securities and Exchange Commission claims that it failed to disclose the extent of its underfunding in documents for $26 billion in bond sales from 2001 to 2007. It didn’t admit wrongdoing.

Projected Payments

Benefit payments are projected at 11.4 percent of available pension assets during this budget year, even after a 14 percent investment gain in the fiscal period that ended June 30, New Jersey records show.

Payouts by the New Jersey Teachers Pension and Annuity Fund, which serves about 236,000 working and retired educators, grew to $2.8 billion from $1 billion in the 10 years through 2009, an average annual increase of about 10.4 percent, its yearly reports show. Over the period, holdings returned an annualized 2.3 percent, according to the state’s Division of Investment.

Retiree benefits last year amounted to 11.2 percent of the fund’s $25 billion value, compared to 3 percent a decade earlier. Payments are on track to exceed 11 percent of assets again this year, state budget documents say.

Prescription for Health

To remain healthy, the New Jersey teachers fund should pay out no more than 9 percent of its assets each year, Scott Porter, of the Philadelphia office of Milliman Inc., the fund’s actuary, told trustees in February. He said benefit costs will rise to $4 billion a year within a decade, making it questionable the state will achieve its assumed 8.25 percent annual investment gain.

“As baby boomers retire and the benefit payments increase, that’s going to keep the market value of assets from growing substantially,” he said.

With such prospects, U.S. governors and lawmakers are proposing lower benefits. Colorado, Minnesota and Michigan are in court defending cuts, including a reduction in annual cost- of-living increases imposed on retirees during the last year.

In Connecticut, where benefit payments rose to $2.7 billion this year from $2.1 billion in 2007 as assets lost almost $5 billion in value, outgoing governor Jodi Rell wants to eliminate guaranteed pension payments for future employees. New Jersey’s Christie plans to revoke a 9 percent increase in benefits awarded in 2001.

Advocates for pensioners say such strategies illegally renege on promises to workers. Politicians themselves caused the problem by failing to make required payments, they say.

“This has been in motion for a long time,” said John Stember, a partner at Stember Feinstein Doyle Payne & Cordes in Pittsburgh, which represents retirees in six states challenging rollbacks.

“The state is making a compelling argument based on a set of facts it’s confronted with now, but that it didn’t necessarily have to be confronted by,” he said.