Reuters Money

from Felix Salmon:

How volatility hits pension plans

Nanea Kalani of Honolulu Civil Beat has obtained non-public performance numbers for the Hawaii Employees' Retirement System, and they're not pretty at all: in the three months to September 30, the fund managed to lose $1.4 billion, or 11.2% of its value.

What we're seeing here is the brutal effect of volatility on portfolio performance. Let's say you start with $1,000. If your portfolio falls by 5% and then rises by 5% -- or, for that matter, if it rises by 5% and then falls by 5% -- you end up with $997.50 -- just a quarter of a percentage point away from where you started. But if it falls and rises (or rises and falls) by 20%, then you end up with just $960, down 4% on your initial investment.

There's two different lessons to be drawn from the way that Hawaii is investing its money. Firstly, going for active rather than passive investment doesn't work very well. The policy benchmark -- what the fund would have returned if it was passively invested rather than actively managed -- has consistently outperformed actual performance. And

Secondly, Hawaii hasn't chosen its managers very well: it's also consistently underperforming the median public pension fund. If you're relatively small (about $10 billion, in this case), it's hard to outperform. As the Pension Consulting Alliance note puts it, "Relative underperformance can largely be attributed to the Plan's equity (domestic and international) managers' combined performance trailing their respective benchmarks".

But there's a deeper problem here, I think -- and that's related to the fact that the fund is being asked to return an "assumed actuarial rate" of return of 8% per year -- in an environment of high volatility and extremely low interest rates. The right thing to do is to say "sorry, I can't do that" -- but that's a great way to get fired. So instead, fund managers move further and further out the risk curve, in an attempt to hit their target returns. With predictable consequences.

Sometimes, the strategy works. In fact, the strategy is always going to work some of the time. The note proudly says that "the Plan outperformed the policy benchmark and the Median Plan in three of the last five 12-month periods". But this is the problem with volatility: if you overshoot on the way up and you overshoot on the way down, you end up underperforming overall.

“Retirement Heist” book asks: Who stole America’s pensions?

Can we afford retirement in this country? Not if you believe politicians who claim entitlement spending is out of control and that the economy is being dragged down by our aging population.

I don’t buy it. Soaring healthcare spending is a critical problem, but not only because our population is aging. And Social Security is affordable as a percent of GDP — it’s equal to 4.7 percent of GDP this year, and will slowly rise to 5.3 percent by 2021, according to the Congressional Budget Office.

Now comes an important new book that debunks another retirement myth: Retirement Heist: How Companies Plunder and Profit from the Nest Eggs of American Workers (Portfolio/Penguin). Written by Ellen E. Schultz, an award-winning investigative reporter for The Wall Street Journal, the book takes on the often-heard claim that private employers no longer can afford to provide traditional defined benefit pensions.

Schultz’s thesis is that the near disappearance of defined benefit pension plans in the private sector didn’t have to happen at all.

“It wasn’t an accident,” Schultz says in an interview. “It is the result of actions companies took starting in the 1990s to profit from their plans. Employers took perfectly healthy plans with a quarter trillion dollars in aggregate surpluses, and they siphoned out the money through a variety of means.”

The result has been a severe decline in private sector defined benefit (DB) coverage.

The percentage of Fortune 1000 companies with at least one frozen DB plan (where the sponsor company retains the plan but stops future accruals for all or some workers) more than quadrupled between 2004 and 2010.

Public pension rebound bolsters optimists’ case on liabilities

Public sector pension funds racked up a strong rebound in assets last year, bolstering the argument of supporters that plans are healthier than critics argue.

At the end of 2010, aggregate state and local pension fund assets were up 35 percent from their quarterly trough after the market meltdown (March 31, 2009), and stood at a two-year high, according to a report issued today by the National Association of State Retirement Administrators (NASRA) and the National Council on Teacher Retirement (NCTR).

The new data underscores the argument made by the two groups — and other pension advocates — that some recent estimates overstate the unfunded liabilities of public sector plans.

“Discussions of pension funding should use these more recent figures instead of depressed asset values that are no longer accurate,” said Keith Brainard, research director for NASRA. “Out-of-date numbers create misleading impressions about the true financial condition of public pension plans and their state and local government sponsors.”

Last year’s gains are due to investment returns and changes by many plans to pension benefit levels and contribution rate structures, according to Brainard.

Defenders of public sector pensions argue that estimates of unfunded liabilities tend to ignore the outsized impact of the financial crisis and market meltdown. Economist Dean Baker of the Center for Economic and Policy Research estimates that if pensions had continued to earn on average a 4.5 percent nominal rate of return since the end of 2007, state and local pension fund assets would have been $857 billion higher at the end of the third quarter of 2010.

Experts also have debated whether to measure the long-range funding gap based on historical rate of return on portfolios, or a more conservative riskless rate of return that could be earned on safe investments such as Treasuries.

The role for DC plans in the public sector

Alicia H. Munnell is the Director of the Center for Retirement Research at Boston College and the Peter F. Drucker Professor of Management Sciences at Boston College’s Carroll School of Management. The opinions expressed here are her own.

In the wake of the financial crisis, policymakers have been chattering about moving to defined contribution (DC) plans in the public sector. Defined contribution plans may well have a role in the public sector, but not as an alternative to defined benefit (DB) plans. Defined benefit plans should remain as a secure base for the typical public employee and defined contribution plans could be “stacked on top” of them to provide additional retirement income for those at the higher end of the pay scale.

Before the financial crisis, ten states had introduced some kind of comprehensive DC plan.  Many of these states provide stand-alone DC plans, either as a requirement (Alaska and Michigan) or an option. Two states (Oregon and Indiana), however, recognizing the value of offering some secure benefit, provide a combined DB/DC plan.

In the wake of the financial crisis, three states (Michigan’s public schools, Georgia, and Utah) have introduced such combined DB/DC plans, where new employees will get some of their retirement income from each type of plan. And an additional six states are discussing DC options.

Why the enthusiasm for DC plans?  Some arguments are wrong; others hold water. Starting with wrong: Some supporters highlight the magnitude of the unfunded liabilities in public sector DB plans as justification for switching to a DC. The reality is that even with a new DC plan, states and localities are still left to deal with past underfunding. A new plan only addresses pension costs going forward, it does not help close the current gap between pension assets and liabilities.

Similarly, some contend that switching to a DC plan would save money in the future. But for any given level of benefits, DC plans have higher investment and administrative expenses than DB plans. Some proponents think that even if total costs increased, taxpayers could gain by shifting contributions from the government to the employee.

Transferring the burden to the employee provided a major economic incentive in the private sector to move from DB plans, where employees make no contributions, to 401(k) plans, where employees make the bulk of the contributions. But such a gain is difficult to achieve in the public sector where employees already make substantial contributions to their DB pensions.

Is $250,000 in savings enough to retire?

A version of this post originally appeared on Portfolioist.

The Employee Benefits Research Institute has issued the 2011 Retirement Confidence Survey. And the answer is: We are not confident. This seems to be, one could argue, an acknowledgment of the obvious.

One statistic that was surprising, however: 31 percent of people surveyed said they expected they could retire comfortably on under $250,000 in savings.

That sounded incredibly low, so I reached out to Mike Piper, the author of Can I Retire? and the Oblivious Investor blog, and asked him, how crazy is that?

Piper did some extremely quick back-of-the-envelope noodling and found that while such a retiree would probably be taking more than ideal out of their savings each year, they weren’t completely off the reservation.

Here’s how he parsed the question:

According to the U.S. Census Bureau, in 2008, 24.7 percent of households earned less than $25,000. And another 10.9 percent earned between $25,000 and $35,000. So $30,000 appears to be a decent ballpark estimate of the 30th percentile for household income in the U.S. (We’re going for 30th percentile here so that it lines up with the idea that 31 percent of people estimate needing less than $250,000.)

If we go to the Social Security Administration’s “Quick Calculator” and plug in 1/1/1946 as a birthdate (such that they’re 65 now, and about to retire) and $30,000 as current earnings, we get a ballpark estimate of Social Security benefits of $10,848 per year.

If we assume the person ends up paying 7.65 percent less total tax (due to not having to pay payroll tax), that’s $2,295 in tax savings.

That leaves approximately $16,857 per year left to be satisfied by pension income, work income and withdrawals from investments. If we assume no work or pension income, that’s a withdrawal rate of 6.74 percent based on a $250,000 portfolio. [Editor's note: compared to the most common four percent  rule of thumb.] Definitely a bit too high for comfort from a regular portfolio. But if the person annuitizes via a single premium immediate lifetime annuity, it’s not terribly outside the range of possibility.

Other factors that could work in the investor’s favor:

• We didn’t back out the no-longer-needed savings for retirement from the $30,000 figure.
• If the person is married, there could be spousal Social Security benefits as well. (Though exactly how this works out depends on the breakdown of the $30,000 income between the two of them.)
• The tax savings could be greater than we estimated, as income tax would likely be lower as well.
• There could be some pension or work income.

Of course, there are a whole list of factors that could work in the opposite direction. For example:

• Many investors probably wouldn’t recognize that they’d need to annuitize in that situation.
• Most investors pay far too much in investment fees, making even a four percent withdrawal rate too high for safety.

5 ways to revive pensions in the private sector

Government workers in Madison are trying to save their pensions by camping out in Wisconsin’s capitol building. That’s the state of things in the public sector, where nearly all employees still have traditional pensions. How about the private sector? Can anything be done to bring back the Great American Pension in Corporate America, where it’s an endangered species?

Workers still want defined benefit (DB) pensions –- 84 percent of poll respondents tell Matthew Greenwald & Associates that workers with pensions are more likely to have a secure retirement, and 77 percent think the disappearance of pensions has made it harder to achieve the “American Dream.”

A wide array of research shows that guaranteed income sources — like pensions — offer the best route to long-range retirement security. For example, a National Institute on Retirement Security study (NIRS) found that “DB pension receipt was associated with 1.72 million fewer poor households and 2.97 million fewer near-poor households in 2006.”

The shift to defined contribution (DC) plans, coupled with the 2008 market crash and general stock market volatility, has made it difficult for some employees to retire. That has forced some plan managers to re-think their approach to retirement benefits.

“The last few years have sent a wake-up call to sponsors that you need to have the right balance as to where risk ought to be” says Alan Glickstein, a senior consultant and pensions expert at Towers Watson. “If an employee can’t afford to retire it’s not just the employee’s problem. It becomes a risk for sponsors when they have a large number of employees who can’t afford to leave. It has real financial implications and it disturbs the flow of the workforce.”

Yet, companies that once offered DB plans are dropping them at a record pace. The percentage of Fortune 1000 companies with at least one frozen DB plan (where the sponsor company retains the plan but stops future accruals for all or some workers) more than quadrupled between 2004 and 2010, as this chart shows:

Social Security: It’s not the end of the world

Call it a bad omen that the Social Security doom-and-gloom was largely left untouched in President Barack Obama’s 2012 budget. The pension program not only took a hit during the economic downturn, but there are plenty red flags about its long-term viability.

Stuart Rubinstein, managing director of client engagement for TD Ameritrade, says you should consider Social Security as what it was designed to be: not a guaranteed income, but rather, an income supplement. Thus, the right time to get on track for your retirement goals is today.

Q: What exactly can we expect from the Social Security program?

It’s been widely reported that Social Security is probably insolvent. I think that the American public is going to continue to look at this and Congress will need to act [since] the landscape has really changed over the years. A number of things have changed: one, we’ve moved from a defined benefit structure to a defined contribution structure; and two, life expectancy has changed dramatically since Social Security was enacted. People have to prepare for a much longer life expectancy than they did way back when it was first enacted.

Q: How do we prepare for the worst-case scenario?

People have to take control of what they can control. And what can they control? Well, two big things: one is how much they spend and one is how much they save. Saving and investing is critical for people in older generations to ensure they’re able to retire [or] they’re able to work if they want to, and for how long they want to. Starting earlier is better than later, but the time to start if someone hasn’t is today.

Q: Is there a particular demographic that should be more concerned?

How worried should government workers be about their pensions?

Bob worked as a firefighter in Arizona until last September, when he was determined unfit to work for medical fitness reasons.

Like most public sector workers, Bob (not his real name) participates in a traditional defined benefit pension plan, this one sponsored by the state’s Public Safety Personnel Retirement System and he’s applied for early medical-related retirement. But he worries about the future reliability of the pension fund.

“My concerns are that since the Arizona state retirement system is only 68 percent funded, and seeing the backlash in the country toward public retirements, I wonder if I should consider taking a lump sum? The lump sum would be $110,000, or I could receive a monthly annuity of $2,000.”

Bob posed his question after I wrote in December that taking a lump sum at retirement is often a bad deal for private sector workers. Most private sector workers take a lump sum, succumbing to a “it’s my money” mindset. Yet most often, they would get more in lifetime payments from an annuity-style pension. And the guaranteed income stream provides valuable insurance against longevity risk –- that is, the risk of outliving your money.

But what about the public sector?

Most government workers still participate in defined benefit pension plans — unlike the private sector, where they’ve become a disappearing breed. Yet state and municipal employees approaching retirement are worried by headlines about rising levels of unfunded pension liabilities.

There’s even been chatter in Washington about a Republican-led charge to revise federal law to allow states to file for bankruptcy to cope with rising debt and pension obligations. While it’s not likely to happen so long as Democrats control the U.S. Senate and White House, allowing bankruptcy could set the stage for states to rip up union agreements and unilaterally reduce benefits — not to mention setting off havoc in the municipal bond market.

The Prairie State pestilence: Pensions, budget woes spread

The fiscal malady that plagues Illinois — and its painful treatment — may be coming to a state, county or municipality near you.

What will cure this spreading pox on the populace? Higher taxes, lower spending and that rare commodity: political honesty.

I feel the pain since I live in Illinois and will pay higher taxes. This couldn’t be more personal to me. My daughters’ school district is owed state money and has fired teachers. My father’s teachers’ pension fund (among others) has been methodically underfunded for years. I went down to our state capitol last year with other University of Illinois alumni to lobby the state legislature to pay more than $400 million in unpaid education bills.

The Prairie State’s teaching moment was ignited by the Illinois legislature’s passage on January 11 of a tax increase that will raise $6.8 billion for state coffers and impose spending limits. The personal income tax will climb from three percent to five percent; the corporate levy from seven percent from 4.8 percent. It’s a mere finger in the dike as the state still needs to borrow to cover pension obligations. The rates may ratchet down over time.

Sad as this may sound, the Chicago Cubs have been managed better than the Illinois budget. The state was running a $13 billion budget deficit, which could balloon to $15 billion; it was in the worst fiscal shape of any state. Its shortfall was nearly twice that of California, which has nearly three times the population.

As a taxpayer, I’m outraged that things got this bad. As a citizen, though, I still want education to be fully funded, public-employee pensions to be honored and my state to invest heavily in infrastructure and job-creating programs.

While Illinois is a poster child for horrendous fiscal management, other states and municipalities are hurting in a similar way. Banking analyst Meredith Whitney says 50 to 100 municipalities may file for bankruptcy.  JPMorgan Chase CEO Jamie Dimon recently echoed that concern.

Pension annuity or lump sum? Don’t take it with you

When it comes to pensions, the advice of playwrights George S. Kaufman and Moss Hart doesn’t apply – you can, in fact, take it with you.

About one-third of private sector workers who have traditional defined benefit pensions are given a choice at retirement between a monthly annuity-style payment or a lump sum. Most retirees choose the lump sum – even though it’s rarely the smartest move.

Most retirees will come out ahead over the course of retirement with an annuity. And, lump sums are getting to be an even worse deal due to recent pension reform legislation that mandates changes in the way lump sum payments are calculated.

Under federal law, pension plan sponsors calculate lump sums using longevity and interest-rate statistics, aiming to match the amount you’d need to invest to match the annuity-style checks you’d receive from your normal retirement age. In that sense, the choice between lump sum and annuity should be neutral, producing the same result over time.

But that’s not the case. While the outcome depends on a number of factors —how you invest the money, whether you’re a male or female, and whether you’re married—most people will come out ahead with an annuitized pension. Here’s why:

Lower lifetime income. Say you’re entitled to a monthly pension of $1,000 at age 65, payable for life. That converts to a lump sum of about $140,000. Of course, that sounds like a lot more than $1,000 – and that’s why so many retirees take the lump sum if they’re offered a choice. But the $1,000 comes every month of your life, in good times or bad.  And if you’re married, you could elect a joint-and-survivor benefit with a slightly lower monthly payment around $850. If you go first, that payment continues until the death of your spouse.

The lump sum? You’ll need to invest it to generate lifetime retirement income, and you run the risk that you’ll withdraw too much, suffer market setbacks or live much longer than average – creating the need to stretch your nest egg much further. Actuaries say the odds of success with a monthly payment are much higher.