Issues in US Public Pension Management © Olivia S. Mitchell The Wharton School [email protected].

Issues in US Public Pension Management

©Olivia S. MitchellThe Wharton School

[email protected]

Pension plans are long-term financial contracts:

Objective: to deliver affordable, reliable retirement benefits

Key: A long term financial promise- Nature of promise- How long?

US public pension environment complex

US Public Retirement System

National Social Security System: Defined Benefit, mostly unfunded

FederalCivilian Plans

FederalMilitary Plans

State & LocalPlans Private

Sector

US Social Security:• Mandatory retirement system, defined

benefit (DB)• Payroll-tax financed, mostly PAYGO • Single largest government program Payroll tax: 15.3% tax on covered earnings

(split)

– OASI: 5.26% of pay to cap ($80,400 in ‘01,indexed)

– DI: 0.94% “ “ “– HI: 1.45% on all earnings

– ==>Most HH in US pay more to SS than to IRS.

Social Security System (00)

• OASDI Payroll Taxes/yr: $493BWorkers w/ taxable earnings: ~153M

• OASDI Taxes/Worker: $3,200/year

OASDI revenues/yr: $568B

• OASDI Benefits/yr: $408BRecipients: ~45 M

• Av. Retiree Benefit: ~$9,100/year

OASDI expenditures/yr: $415Bwww.ssa.gov

Problem: Current Rules Not Sustainable

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US public sector employees: Who’s included?

• Federal govt civilian, • Military;• State and local gov’t

workers (eg teachers & legislators, police/fire, municipal)

75% covered by Social Security as 1st pillar plan

Most have 2nd pillar DB pension too

Lately DC growing

Federal Civilian Pensions

3M employees, including Congress and Postal Service

1st pillar DB plan with old and new vintages: • CSRS set up before Social Security (1920)

Benefit = 2% Pay * Service• FRS (1983) when federal workers into SS

Benefit = 1% Pay * Service

Plus TSP plan: defined contribution • CSRS: 5% ee, no employer match• FRS: up to 10% ee, +5% employer match

1.5% to 5, 1.75% next 5, 2% thereafter; FAP=Hi3

Federal DB plans

Assets Liabilities Funded %

CSRS $361B $962B 38%FERS $97B $191B 50%

Hustead (2000)

Federal Thrift Saving Plan (TSP)

2nd pillar defined contribution plan for federal employees (1984).

~$93B assets, 2.5 M participants (3/01)

Average account balance ~$37,000 Employer contributes 1% of pay for all;

then employees elect 0-10% and have employer match* to total of 15%

www.tsp.gov *100% to 3%, 30% to 5%

5 Investment Options in TSP: G fund: Special issue Treasury Securities C fund: Stock index fund (S&P500) F fund: Fixed Income index fund (Lehman Bros

Aggr. Index)

2 New Additions: 2001 S fund: Small Cap Stock Index fund (Wilshire 4500

Index) I fund: Int’l Stock Index Fund (EAFE Index)

Money Manager is Barclays

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TSP admin charges very low (00)

G fund: 0.05% of assetsC fund: 0.06% of assetsF fund: 0.07% of assets

Compare to retail mutual funds: 1-2% of assets

TSP Asset Allocation Patterns(3/01)

G fund (Govt sec’s): 38% ($35.5B )C fund (equities): 56% ($52.4B)F fund (fixed income): 6% ($5.4B)

[Private pensions: 55-60% equities, too]

TSP Investment Performance

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G Fund F Fund C Fund

Other TSP design issues:

Transfers:– 1x per month, Web or by mail– Transfer effective by end of month, if in by

15th, otherwise end of next monthPayouts:

– Annuities, or– Cash refund

Federal Military Pensions

~3M employees, high turnover even in peacetime (>1/2 have < 7 years tenure)

1st Pillar DB plan for 20+ years serviceBenefit = 1/3 of compensation

Most retire ~ age 42 28% funded: $150B assets, $529B

liabilities

From 2001: Military can join TSP

Voluntary contribution: – Up to 7% of base pay – To $11K indexed, $15K by 2006 (sec

402(g))

www.tsp.gov/uniserv/forms.tspbk-u-08.pdf

State and Local Pensions (S&L)

2200 systems, 13M employees, 5M beneficiaries

Generally 1st pillar DB plan: Benefit = 2% Pay * Service

Some also have 2nd pillar DC planIncreasingly: CHOICE (DB or DC) –

Florida, for example

S&L Plan Performance

All Systems (’99)

• Assets ~$2Trillion• Contributions $62B• Benefits paid $82B

Funding Status: 98%

5-yr ROR ($wtd to 98): 14%

www.census.gov and PENDAT 1998

S&L Plan Investments: Now VS 25 years

ago: bonds the norm

Cash0%

Govt Bonds14%

Corp Bonds16%

Corp Stocks38%

RE1%

Other31%

Keys to a well-run public pension system:

Good governance: contributions, recordkeeping, money management, benefit payments.

Shielded asset management. Performance standards, reviews,

penalties for noncompliance. Transparent reporting/disclosure.

Governance concerns include:

Ignorance/Fraud: Pension invests in junk bonds (Orange County).

Asset valuation: Japanese pensions hold large interest in insolvent banks.

Shareholder activism: Fund managers tell companies what to do (e.g. Penn fund divests insurers; TIAA-CREF proxy votes on social fund)

ETIs: Economically Targeted/Social Investments

“When pension assets must be invested according to political/social criteria; ignore risk/return”

Malaysian Provident funds had to help insurers. Korean pensions loaned 2/3 of assets to MOF for

“social” purposes African and Mexican public funds must invest in

mortgages. Alaska Ret System lost ~$80M in local home

mortgages when oil prices fell

How to enhance pension asset security?

Institutional Structure: Board size, composition, membership, authority

Set performance standards: fiduciary role, penalties: ERISA as a model

The Prudent Person Rule:

• Requires managers to be “prudent” and manage in best interest of participants;

• Show diversification;• Investments part of risk/return portfolio;• Held personally liable if found

imprudent.

Related: Operational Controls: liability insurance. Investment Authority: Competitive bids

for outsourced investment Reporting/Disclosure: Frequency/form

of asset /liability valuation, common assumptions, reporting format for expenses, returns, risk.

Governance affects S&L investment outcomes:

Retirees on boards cuts returns slightly (more bonds).

In-house vs external money managers have similar investment patterns (but competition critical)

Requirement to invest in own-state projects can reduce returns.

Requiring fiduciary insurance can help.

Emerging public plan challenges::

Movement toward – DC plans– Hybrid plans

Concern over admin costs

Poor investment performance– DB– DC

Investor advice and education

Conclusions

Public pension design and management not simple.

Usual pension issues PLUS political risk

Funding avoids retirement insecurity and later problems

Benefits of stronger public pensions in developing countries:

Primary: More reliable old-age support for aging population, less uncertain tax environment

Secondary: better-run real sector (reporting/disclosure stronger), capital market broader/deeper, robust insurance market, possibly higher national saving