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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

Issues in US Public Pension Management

©Olivia S. Mitchell

The Wharton School

mitchelo@wharton.upenn.edu

pension plans are long term financial contracts
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
US Public Retirement System

Federal

Military Plans

State & Local

Plans

Federal

Civilian Plans

Private

Sector

National Social Security System: Defined Benefit, mostly unfunded

us social security
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

Social Security System (00)

www.ssa.gov

us public sector employees
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:
federal civilian pensions
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

federal db plans
Federal DB plans
  • Assets Liabilities Funded %
  • CSRS $361B $962B 38%
  • FERS $97B $191B 50%

Hustead (2000)

federal thrift saving plan tsp
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%

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: Int’l Stock Index Fund (EAFE Index)

Money Manager is Barclays

5 Investment Options in TSP:
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 admin charges very low (00)
tsp asset allocation patterns 3 01
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]

other tsp design issues
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
federal military pensions
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
from 2001 military can join tsp
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

state and local pensions s l
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
s l plan performance
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

keys to a well run public pension system
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
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

ETIs: Economically Targeted/Social Investments
how to enhance pension asset security
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
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
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
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.
emerging public plan challenges
Movement toward

DC plans

Hybrid plans

Concern over admin costs

Poor investment performance

DB

DC

Investor advice and education

Emerging public plan challenges:
conclusions
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
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