Data and Research January 5, 2022

NCPERS Proposes New Measure for Public Pension Sustainability

A study found pension debt is sustainable in all but five states, and NCPERS says sustainability valuation can be used on local government and individual plans.

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Public pensions can be made and kept sustainable for the long haul by incorporating a new tool—sustainability valuation—into funding policies and practices, according to a study by the National Conference on Public Employee Retirement Systems (NCPERS).

The study by Michael Kahn, NCPERS director of research, suggests that pension systems can use sustainability valuation to monitor their fiscal status on a continuing basis, gaining insights that would enable them to identify fiscal adjustments needed to stabilize pensions for the long term.

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Kahn says the study’s analysis confronts a fundamental error that critics of public pensions make. They frequently compare pension liabilities that are amortized over 30 years with one-year state and local economic capacity or revenues. This erroneous mismatch is then cited as justification for extreme measures, such as cutting benefits and shutting down pension plans, he notes.

This “is like a bank telling the borrower his or her 30-year mortgage is due at the end of this year,” Kahn says in the study report. “Were that the case, almost no one would be able to buy a house.”

The report notes that the prevailing theory of sustainability is that if the ratio between debt and economic capacity of a jurisdiction is stable over time, the debt is sustainable. It compares this to household finances. “If household debt is growing faster than income, we are in big trouble,” the report says. “But if income is rising in concert with debt, we are OK.”

In the study, Kahn uses personal income (PI) (which consists of all income, earned and unearned) as a measure of the economy. He explains that this is a better measure of the economy than, for example, gross domestic product (GDP) because PI is owned by residents of the state or locality and, according to the Advisory Commission on Intergovernmental Relations, PI is one of the key ways to measure tax capacity. Tax capacity refers to the amount of revenue a jurisdiction can raise beyond what it raises now.

The study found a realistic picture comparing 30-year unfunded liabilities with 30-year own-source revenues—the time horizon under which pension plan funding operates—shows unfunded pension liabilities “are a miniscule issue.”

When the ratio between debt and economic capacity is stable or declining, debt is sustainable. The study found that state and local outstanding debt is sustainable, especially since 2010.

“Despite the increase in the ratio between 2002 and 2010, the debt is more sustainable now than it was in 2002,” the report says. “For example, the debt was about 0.81% of PI in 2002, and in 2018, it was 0.78%.”

Looking at state-by-state trends in sustainability trends in outstanding debt, the study found pension debt is sustainable in all but five states.

Using Sustainability Valuation

Kahn says states and localities can enhance the sustainability of public pensions by adding a “sustainability valuation” on top of current pension funding practices such as actuarial valuation, stress testing, employers’ funding disciplines and sound investment strategies. “By ‘sustainability valuation’ we mean monitoring sustainability on an ongoing basis and making fiscal adjustments to keep the ratio between unfunded liabilities and economic capacity stable at, say, the average of the past two decades,” he says in the report.

The study involved a state-by-state level analysis, but Kahn says the sustainability analysis can be done for individual plans by using historical plan-level data and data on local economic capacity. Such plan-level analysis can include variables such as other post-retirement employee benefits liabilities, legacy experience and reasonableness of actuarial assumptions in the multivariate models.

The study report, “Enhancing Sustainability of Public Pensions,” is available here.

Investing January 5, 2022

Practical Implications of DOL’s Latest Private Equity Statement

The Department of Labor’s supplemental statement is a tonal shift rather than a substantive change that reflects the continuing courtship for defined contribution plans and private equity investments.   

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The Department of Labor (DOL)’s recently issued supplementary statement on including private equity (PE) investments in defined contribution (DC) plans is a cautionary reminder, particularly for smaller plan sponsors, not a reversal of policy or a substantive change to prior guidance, retirement industry experts say.

The recent DOL statement reflects what sources say is the agency’s changed tone under President Joe Biden. For plan sponsors, the clarifying statement’s practical implications were to reaffirm that the duties of plan fiduciaries must be executed prudently and that they must always act in the best interest of participants and beneficiaries, says David O’Meara, director of investments at Willis Towers Watson.

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“More than anything, it’s potentially a change in tone without necessarily changing substance,” he said. “It’s definitely more cautionary, but it’s by no means a censure of the prior guidance for private equity and defined contribution plans. It’s pumping the brakes a little bit and asking plan fiduciaries to ensure that they actually have the requisite expertise and skill set necessary in order to obtain the potential benefits of private equity.”

Under then-President Donald Trump, the DOL aimed for a more relaxed tone on private equity in DC plans. But the current administration under President Joe Biden issued the supplemental statement to express its concerns and emphasize that, while plan sponsors can include private equity investments in DC plans, they must carefully weigh the potential risks and benefits to participants.

“While the effect of the Trump authority was to get plan sponsors, providers and managers excited about the possibility of private equity, the Biden authority is a little bit more jaundiced,” says Andrew Oringer, a partner at law firm Dechert and co-chair of its ERISA and Executive Compensation group. “The Trump authority didn’t permit private equity [on its own] to be to be used in plans—[fiduciaries] still had to satisfy the technical rules and get comfortable that it was a prudent investment—nor does the Biden authority say plan sponsors can’t use private equity.”

The earlier DOL letter said a plan fiduciary would not violate the duties of a fiduciary by offering a professionally managed asset allocation fund with a private equity component as a designated investment alternative, yet it did not greenlight plan sponsors to make private equity investments available for direct investment on a standalone basis.

Rather than an enormous change, the recent statement reflects “a matter of tone,” Oringer adds.

The Biden tone is unlikely to greatly change the approach plan sponsors are taking to include PE in DC plans by adding options for participants’ investments exposures to potentially higher-returning investments. That’s because the new supplemental statement neither adds nor takes away from the DOL’s previous statement issued under the Trump administration, O’Meara explains.

“The [statement] says that plan sponsors need to be more aware of their potential limitations in understanding those investments, and that’s certainly a valid concern for any plan investments—that the plan fiduciaries need to understand them,” he says.

O’Meara adds that the recent DOL statement did intend to highlight heightened risk for smaller plan sponsors.

“There’s potentially a risk among the smallest plan sponsors—potentially those investors that don’t already have experience managing or building private equity portfolios—and that’s where the [DOL] is focused,” he said. “The statement is more focused on the smaller end of the market and whether or not the smaller plans have the requisite expertise to execute in private equity, and that they should not rely on the 2019 guidance as an ‘endorsement’ of private equity in defined contribution plans.”

A growing body of research is investigating the effect that adding PE exposures to DC plans can have on boosting retirement savings and lessening shortfalls.

In a report, “The Impact of Adding Private Equity to 401(k) Plans on Retirement Income Adequacy,” from the Employee Benefit Research Institute (EBRI), the agency examined the impacts of replacing TDF equity allocations with 5%, 10% or 15% allocations to private equity.

“We found that every level of private equity modeled resulted in additional 401(k) participants (who are currently ages 35 to 64) being able to retire at age 65 without running short of money in retirement,” the paper states.

The agency also used its Retirement Readiness Ratings (RRRs) to estimate the effects of changing allocations to participants’ retirement income and peg the probability that a household will not run short of money in retirement.

“For the youngest cohort (those currently ages 35 to 39) who have the longest period to benefit from the change, the RRR increases by 1.3 percentage points,” the paper states. “This differential decreases with age, and those currently ages 50 to 54 are simulated to have RRR increases of 0.6 percentage points.”

The scenario modeled in the paper would only impact some of the current aggregate retirement deficit, since some households will be simulated never to have a DC plan, and even those who do would need to be simulated to invest in a TDF for this scenario to apply. 

O’Meara says research from Willis Towers Watson showed improved retirement outcomes for participants when adding alternative investments—including, but not limited to, PE investments—to DC plans. The research was conducted with the Georgetown University McCourt School of Public Policy Center for Retirement Initiatives to produce a paper, “The Evolution of Target-Date Funds: Using Alternatives to Improve Retirement Plan Outcomes.”

“We found that over the long term, and implemented appropriately with the expertise and acumen required, [alternatives] could potentially improve retirement outcomes by upward of 17% while also reducing downside risk,” he says.

Despite the growing research into the potential benefits of adding PE investments to DC plans from academics, government agencies and private businesses, DC plan sponsors have not shown great interest in adding such investments to DC plans, says Rachel Weker, senior manager in product platforms and services for retirement plan services at T. Rowe Price.

T. Rowe Price offers its clients the opportunity to include PE investments in DC plans that use collective investment trusts (CITs).

“Talking to our people who are responsible for talking to clients, that’s not something that we have seen clients or the advisers that work with them, or even prospective clients, asking about,” she says. “It’s something we’ll continue to monitor but it’s not something that we have seen a lot of demand for at this point.”

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