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Issues in US Public Pension Management

Issues in US Public Pension Management © Olivia S. Mitchell The Wharton School mitchelo@wharton.upenn.edu 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?

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Issues in US Public Pension Management

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  1. Issues in US Public Pension Management ©Olivia S. Mitchell The Wharton School mitchelo@wharton.upenn.edu

  2. 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

  3. US Public Retirement System Federal Military Plans State & Local Plans Federal Civilian Plans Private Sector National Social Security System: Defined Benefit, mostly unfunded

  4. 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.

  5. OASDI Payroll Taxes/yr: $493B Workers w/ taxable earnings: ~153M OASDI Taxes/Worker: $3,200/year OASDI revenues/yr: $568B OASDI Benefits/yr: $408B Recipients: ~45 M Av. Retiree Benefit: ~$9,100/year OASDI expenditures/yr: $415B Social Security System (00) www.ssa.gov

  6. Problem: Current Rules Not Sustainable

  7. 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 US public sector employees:

  8. 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

  9. Federal DB plans • Assets Liabilities Funded % • CSRS $361B $962B 38% • FERS $97B $191B 50% Hustead (2000)

  10. 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%

  11. 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 5 Investment Options in TSP:

  12. G fund: 0.05% of assets C fund: 0.06% of assets F fund: 0.07% of assets Compare to retail mutual funds: 1-2% of assets TSP admin charges very low (00)

  13. 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]

  14. TSP Investment Performance

  15. 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 month • Payouts: • Annuities, or • Cash refund

  16. Federal Military Pensions • ~3M employees, high turnover even in peacetime (>1/2 have < 7 years tenure) • 1st Pillar DB plan for 20+ years service Benefit = 1/3 of compensation Most retire ~ age 42 • 28% funded: $150B assets, $529B liabilities

  17. 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

  18. 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 plan • Increasingly: CHOICE (DB or DC) – Florida, for example

  19. 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

  20. S&L Plan Investments: Now VS 25 years ago: bonds the norm

  21. 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.

  22. 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)

  23. “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 ETIs: Economically Targeted/Social Investments

  24. How to enhance pension asset security? • Institutional Structure: Board size, composition, membership, authority • Set performance standards: fiduciary role, penalties: ERISA as a model

  25. 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.

  26. 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.

  27. 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.

  28. Movement toward DC plans Hybrid plans Concern over admin costs Poor investment performance DB DC Investor advice and education Emerging public plan challenges:

  29. Conclusions • Public pension design and management not simple. • Usual pension issues PLUS political risk • Funding avoids retirement insecurity and later problems

  30. 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

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