Fiduciary Accountability for Managing Funding Ratios in Florida's Local Government Pension Plans or 'You've Got to be Very Careful if You Don't Know Where You're Going, Because You Might Not Get There' - Yogi Berra

Abstract

Fundamental fiduciary investment practice standards require the development of an investment policy in order to further a plan’s funding policy objectives. Until now, local government pension plans used almost the opposite approach. Under this old paradigm, local government plans used “long-term” investment policies regardless of the plan’s financial and cash flow needs; and then used the “expected return” from that policy as the dominant element of a faux funding policy; namely, the actuarial valuation. On October 1, 2000, the City of Fort Myers had fully funded the accrued liabilities of its general employee pension plan. By October of 2010, plan assets were insufficient to cover any liabilities for either the accrued benefits of its covered active employees, or for the contributions that employees themselves had made to the plan. Moreover, only 83.2% of obligations for existing retirees were covered by assets, even at the high 7.75% discount rate used to value liabilities.This decline to 0% coverage also occurred in the large general employee pension plans of nine other Florida cities. The thesis here is that, at least in Florida, where a local government is required to make its ARC (actuarially required contribution) that this kind of decline is a result of funding policy discipline failures. The paper reviews the performance of a range of standard asset allocation portfolios to confirm that the market over this period was generally consistent with 7% expected returns, if not the above average actuarial expected return assumptions returns used by each of these 10 general employee pension plans. A changing public pension paradigm, best illustrated by the Robert Novy-Marx burning money hypothetical, is at the core of this discipline failure. This hypothetical showed how a public pension plan could improve its apparent funded status by actually burning bonds in order to get rid of stable, but relatively low expected return investments. The objective of the burning was so that the remaining assets would be invested – for the long-term – in high volatility / high expected return equity assets. Under the old “long-term” only paradigm, the actuary would then discount liabilities by this higher equity expected return rate rather than a blended portfolio rate, showing an actuarially better funded plan.GASB (Government Accounting Standards Board) principles for liability accounting and disclosure have changed such that a “long-term” liability discount rate can, for future disclosures, only be used to the extent that an investment policy with that expected return will be used on real assets. This paper helps to show how many of the conclusions of recent LeRoy Collins Institute research on Florida’s underfunded municipal pension plans relate to a plan’s funding ratio objective. One of the most significant of these conclusions is that the cash flow out of many local government plans are now very significant; and can be much larger than the monies being contributed for the plan’s unfunded accrued liability.The GASB change is very significant, not just because of its new standards, but also because these standards reinforce fundamental fiduciary practice standards. These practice standards require that investment policies further a plan’s funding policy objectives rather than the other way around. The GASB change will also help to remove the moral hazard in public sector pension governance that had restricted both investment consultants and actuaries from helping plans achieve a plan’s funding ratio objectives.Local government pension trustees should be setting and managing to plan funding ratio objectives; and they now should have additional valuable resources for helping them in this role; namely, the actuary and the investment consultant.