UCRP, GASB, and the Rate of Return

In an article in yesterday's NYT, Mary Williams Walsh reports on an increasing dual trend in public pension funds' investment strategies. On the one hand such funds are shifting their portfolios away from stocks, which they view as too volatile, and towards "safer" long-term bonds; on the other hand, to make up for the lower returns traditionally afforded by bonds, they are increasing their exposure in instruments that are viewed as riskier, such as "commodity futures, junk bonds, foreign stocks, deeply discounted mortgage-backed securities and margin investing," which are usually traded over the counter.

The mixed strategy might look as sheer madness, and indeed it is, but there is a method to the madness, or at least a rationale if not a justification. This has to do with (relatively) new accounting rules for governments, education boards, and other public entities imposed by the Governmental Accounting Standards Board (GASB). Two GASB statements, in particular, are relevant to public pension funds, including UCRP:

1. Statement 45 (issued in 2004) requires pension funds to disclose in their financial sheets the unfunded actuarial liabilities deriving from "post-employment benefits other than pensions," in particular retiree health care and life insurance. 
2. Statement 50 (issued in 2007) aligns reporting requirements for pensions to those for other post-employment benefits, as laid out in Statement 45. In particular, pension plans must disclose both the funded status of the plan and the "methods and assumptions" employed to determine the fair value of investments (including, supposedly, the expect rate of return). This is especially relevant for defined benefit plans, such as UCRP, whose liabilities are not linked to market performance.

Now obviously, in recent times, public pension funds' portfolios have taken a severe beating.  As reported by Walsh, for instance, CalPERS has lost billions of dollars in private equity and real estate in recent years. And according to the presentation of the UC task force on post-employment benefits, the value of the UCRP portfolio has plummeted by about $20B between 2001 and 2009 (bringing down its funded status from 149% in 2001 to 95% in 2009 — further projected to drop to 61% by 2013, even with 17% contributions scheduled to resume this coming April 15).

So it becomes clearer why public pension funds are under increased pressure to sustain their expected rate of return on investments, even if this means "going to Las Vegas," as the former chairman of the Texas Pension Review Board put it in the Walsh article. Without such riskier investment strategies, and given the shift to long-term bonds, the expected rate of return would further drop and their unfunded actuarial liabilities (which now have to be disclosed) would balloon.  Notice that pension funds have also been systematically over-estimating their rate of return, expecting it to be somewhere around 8% annually, whereas it has historically been a lot lower.

It is important to notice that private funds are in a somewhat different place. They also have been shifting their portfolios from stocks to bonds in recent times (this is the case, for instance, at Boeing), not planning however to sell the bonds at some future point, but to hold on to  them for many years and use the yield from the bonds to pay off pensions to their retirees as needed. Of course, it also helps that private funds are not subject to the same disclosure requirements as government entities.

So, where does that leave UCRP? For a long time, UCRP pursued a very similar strategy to the current Boeing plan, light in stocks and heavy in bonds. These were the heydays of UCRP, when contributions went on vacation for twenty years and UC Treasurer Patricia Small was single-handedly managing the immense portfolio from her office in Oakland. Then, in one of the most obscure episodes in UCRP history,  Small was forced to retire, as the Regents decided — in a not completely disinterested fashion — to shift their strategy to better yielding instruments managed by brokerage firms charging the University millions of dollars in fees. As a result, contributions have resumed and the funded status of UCRP has plummeted.

Still, this does not explain why the GASB disclosure requirements have everyone in Oakland in a panic. After all, these are just accounting rules, and disclosure of unfunded actuarial liabilities does not change the substance of the funded status of UCRP. People in Oakland knew full well that a storm was gathering even before they were hit by the GASB requirement (and if they didn't, then someone at UCOP was not doing their job).

But therein lies the rub. Disclosure of liabilities is bound to affect the University's credit rating and a case can be made that defending the credit rating has been behind a lot of UCOP's actions lately, from the furloughs to the fee increases. In fact, the announcement of the post-employment benefits task force says that explicitly. After noting that UC's unfunded liability will increase from $13 billion today to $18 billion by 2013 and to nearly $26 billion by 2018, the announcement points out that

Such a significant liability could affect UC's credit rating when seeking funding for campus buildings, hospitals and other bond-funded programs.

So UCOP is under increasing pressure to reduce its unfunded liabilities in order to protect its rating. We do not know if UCRP is also "going to Las Vegas," but it would not be a surprise if they decided to turn to riskier investments in order to boost their rate of return, which in turn will show up on their financial sheets as decreased liability. Notice that UCOP is still assuming a rate of return of 7.5%, even though the market value of assets dropped 5.6% in 2007-08 and a whopping 19.2% in 2008-09. And yet, even on that optimistic assumption, and even with resumed contributions, they project that UCRP will be funded at 61% by 2013.

So they must be desperate in Oakland, and everything is on the table. The post-retirement benefits task force has been talking explicitly of reduced benefits for new hires, but expect them to consider reduced benefits for current employees as well, given a chance they might be able to get away with it (a question for UCOP's office of the legal counsel). The same holds for retiree health care, which is increasingly expensive. In contrast to retirement, the University is under no prima facie contractual obligation to provide a given level of health care insurance to employees, past, present, and future. So post-retirement health care is probably on the table not just for new hires, and not just for current employees, but nobody would be surprised if it was on the table for current retirees as well (in the form of higher premiums and deductibles).

Furthermore, the  office of the legal analyst has already requested that the state not fund the University's share of the resumed contributions to UCRP, not even the $20M appropriated in the January budget vis a vis the $228M requested by the Regents for that purpose (but notice that the state fund contributions to CalPERS). The legal analyst also recommends that UC employees be required "to cover a portion of the costs of any future benefit enhancements or unfunded liabilities that might emerge in UCRP."

We understand why the University is in such throes when it comes to retirees' benefits. Quite simply they need a whole lot of money, which must must however come from within the UC budget other than the general fund, i.e., in the form of student fees, increased premiums and contributions, a change from a defined benefit to a defined contribution model, or even extended furloughs.

A lot will be happening soon. Stay tuned.