Pension politics puts solvency at risk

State pension systems are, by their very nature, subject to the political vagaries of the government funding them. In New York, Thomas DiNapoli, the state comptroller, presumes the state’s two pension funds – one for police officers and firefighters and one for the rest of the state workforce – will return 7 percent per year, compounded annually, for the foreseeable future. That may sound like a reasonable estimate, given that the state’s pension system earned around 11.5 percent for the fiscal year ended March 31, 2017.

But the pension funds have also had lean years: For the fiscal year that ended in March 2016, for example, the plan earned just 0.03 percent, or 3/100ths of a percent. Averaging those years with the good ones, as of March 31, 2017, the plan’s ten-year return has been only 5.6 percent. The Pew Charitable Trust recommends assuming a 6.5 percent assumed return, and the federal Pension Protection Act of 2006 requires private pensions to use a rate based on the 25-year average return on high-quality corporate bonds. That rate is currently just around 4 percent.

Assuming a 7 percent rate of return offers numerous political advantages to DiNapoli. First, it allows him to claim “well-funded” status for the state’s pensions. Currently, DiNapoli says the pension fund is at about 94 percent of its expected obligations – an impressive percentage that is always handy in an election year. Moreover, that “well-funded” pension allows DiNapoli and his former colleagues in the state Legislature to spend more on other “goodies” for their respective constituencies. (Any pension shortfalls will, after all, be realized only in future years, making it someone else’s problem.)

But if the pension funds aren’t actually averaging 7 percent returns, then it is irresponsible to assume that average rate will be reached in the future, consistently, year after year. Reality-based New Yorkers recognize that the 7 percent rate creates several risks to plan participants and to New York taxpayers who must, ultimately, deliver on the state’s pension promises under the state constitution, whether they are funded or not.

Assume that the state’s pensions return just 6 percent instead of 7 percent, just a single percentage point below the 7 percent DiNapoli estimates. That single percentage point shortfall on the state’s pensions would cost New York taxpayers an estimated additional $24.4 billion beyond the $11.5 billion pension shortfall DiNapoli already acknowledges.

In total, that’s $35.9 billion, more than New York state government spends on school aid and all 100 of its executive agencies, combined. It is more than 45 percent of all the tax revenue New York state took in for the fiscal year ending March 2018. A 6 percent rate of return would also lower the state’s pension funding to just 77 percent of its current liability, below the old (and debunked) 80 percent “rule of thumb” pension managers used for years to judge whether pensions were well-funded. Today, though, the Government Finance Officers Association’s best practices target a 100 percent (full funding) of pension liabilities.   

But even a 6 percent return is likely overly optimistic, as it’s a little higher than New York’s average return from the last decade. The risk-free rate of return, the U.S. Treasury interest rate on 10-year and 30-year bonds, is currently around 3 percent, so the state’s pension fund managers must substitute security with risk to realize the 7 percent estimated return. While state law requires the pension funds’ bonds to be kept in “investment grade” holdings, the spectrum of “investment grade” goes from the highest quality ratings of Moody’s, Fitch and S&P to just one step above junk.

For example, the state’s fixed-income portfolio back in 2007, before the financial crisis, was almost entirely domestic, save for some bonds from Canadian, Nordic and Israeli bond issuers and some European issuers that had significant operations in the U.S. But in 2017, a review of the state’s asset listing shows what is now called the “Global Fixed Income” portfolio, including over $200 million in bonds from China Air, Alibaba and a variety of other foreign entities that come with a higher level of geopolitical, currency and financial reporting risk from less-stringent foreign financial regulation.

A review of the 2017 pension investment portfolio also shows considerable fixed income investments in New York state bonds, mortgages and real estate. That might be politically advantageous to donors and other political allies, and it might even help boost local New York economies, but it’s the pension fund equivalent of an individual with a 401(k) plan investing a disproportionate amount of his or her retirement funds in the stock of his employer: If your employer runs into trouble, you lose not only your job but your investment in your employer’s stock.

As the pensions’ trustee, DiNapoli owes a fiduciary duty to pension participants to never put political appeals ahead of investment returns. But will he? His handling of fossil fuel divestment leaves reason for concern. Environmentalists are a part of the Democratic primary voter base, and green energy investors are a huge part of the party’s contributor network. Gov. Andrew Cuomo, a likely 2020 presidential candidate, has pressured DiNapoli to divest from fossil fuel companies. The comptroller created an advisory panel to ameliorate the political risks of divestment, treading carefully between the progressive voter base and traditional allies in government employee unions who largely oppose divestment at cost to their pension assets. We don’t yet know if DiNapoli will go along with fossil fuel divestment, or if other divestment calls may follow – tobacco, firearms, fast food – and how it might affect the funds’ returns if DiNapoli gives in.

New York’s next comptroller needs to be mission-focused on his or her pension management to ensure that the state meets its promise to its employees: a secure pension when they retire, without sleight of hand or unrealistically bullish assumptions about the fund’s funds’ growth, and without subjective virtue signaling or political favoritism.  

That means lowering the presumed rate of return on the state pension fund by at least 100 basis points, to 6 percent, over the next couple of years and asking the state Legislature to fund the shortfall, preferably by applying management techniques that have reduced costs and boosted efficiency in the private sector, such as Zero Base Budgeting and Lean Management. These management practices and others need to be brought to bear on state government to reduce waste, lower costs, improve efficiency and better serve New York’s “customers,” our citizenry.

Fully funding pensions now at a lower discount rate will reduce investment risk and allow additional pension resources to accrue value for the benefit of pension plan participants and inoculate New York taxpayers from the potential for cost of future crippling pension shortfalls.

Ultimately, honorable governments, like honorable people, pay their creditors and live up to their promises. New Yorkers should expect nothing less in our public promise to our public employees.