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 Federal Civilian Plans Federal Military Plans State & Local Plans 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: $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
Problem: Current Rules Not Sustainable
US public sector employees: Whos included? Federal govt civilian, Military; State and local govt workers (eg teachers & legislators, police/fire, municipal) 75% covered by Social Security as 1 st pillar plan Most have 2 nd pillar DB pension too Lately DC growing
Federal Civilian Pensions 3M employees, including Congress and Postal Service 1 st 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% *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: Intl Stock Index Fund (EAFE Index) Money Manager is Barclays –
TSP admin charges very low (00) 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 Asset Allocation Patterns (3/01) G fund (Govt secs): 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
Other TSP design issues: Transfers: – 1x per month, Web or by mail – Transfer effective by end of month, if in by 15 th, otherwise end of next month Payouts: – Annuities, or – Cash refund
Federal Military Pensions ~3M employees, high turnover even in peacetime (>1/2 have < 7 years tenure) 1 st Pillar DB plan for 20+ years service Benefit = 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))
State and Local Pensions (S&L) 2200 systems, 13M employees, 5M beneficiaries Generally 1 st pillar DB plan: Benefit = 2% Pay * Service Some also have 2 nd pillar DC plan Increasingly: 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% and PENDAT 1998
S&L Plan Investments: Now VS 25 years ago: bonds the norm
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: l Retirees on boards cuts returns slightly (more bonds). l In-house vs external money managers have similar investment patterns (but competition critical) l Requirement to invest in own-state projects can reduce returns. l 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