Yesterday, we reported on how CalPERS’ new fiduciary counsel, Ashley Dunning of Nossaman LLP, endorsed the practice of pension fund staff withholding investment fund documents from board members. She defended her position by false claim that some fund sponsors might insist on that as a condition of investing. New board member Margaret Brown raised the issue because CalPERS staff is apparently not merely denying the board access to fund documents, but even the terms of some funds.
Today, we will discuss another toad that hopped out of Dunning’s mouth in her fiduciary training session for the board. As you will see in the exchange below, Dunning twice endorsed the idea that CalPERS should pressure its actuary to come up with more favorable, as in lower, estimates of what employers needed to pay to fund pensions if his recommendations were higher than what CalPERS was willing to present to employers.
Understand what this means: the position of CalPERS’ chief actuary is considered to be the second most difficult in the United States, with the most demanding actuarial position being that of the chief actuary to the Social Security Administration. CalPERS manages roughly 2200 pension plans. No one has ever suggested that his is not competent to do his work or that it suffers from any analytical flaws.
However, like many public pension funds, CalPERS has been using a discount rate for its future liabilities higher than the one the fiduciary has been using.1 Using a higher rate results in lower payments by plan sponsors like the State of California and the many municipalities and government entities that have CalPERS manage their pension plans.
CalPERS use of a higher discount rate than its actuary recommends results in ongoing pension underfunding. This is a classic “kick the can down the road” approach. CalPERS is essentially betting that the financial markets will somehow bail it out. But with valuations at nosebleed levels, and even normally evenhanded commentators like Mohamed El-Erain giving loud warnings about investment risks, CalPERS is far more likely to suffer from a market swoon that be rescued by more years of robust returns.
Before we turn to the particulars of what Dunning said, it is important for backers of employee pension rights to stop sticking their heads in the sand on the issue of underfunding and the need to provide for adequate payments on a current basis. The right wing so far has been making noise about the problem of public pension underfunding, which is in many jurisdictions a real issue. The silence of unions and the left means they are ceding this issue to public pension fund and government haters. The first deliberate underfunding of a major public pension fund took place in New Jersey in the early 1990s, when Governor Christine Todd Whitman decided to shortchange pension payments to make meeting the rest of the budget easier.
Unlike what pension opponents will try to have you believe, there is no reason these commitments, which were made in lieu of giving employees higher salaries, could not have been funded properly. Pages 95 and 95 of Mayberry v. KKR, embedded in this post, contains a list of well-funded public pension plans.
As for the point of view that pay out the necessary pension reserves will harm the budgets of states and cities, it is remarkable that no one raises similar concerns when the same government entities give massive tax breaks to big box retailers and manufacturers to locate facilities in their jurisdictions. Academic studies have found that the companies have gotten so good at playing localities off against each other that these projects often make zero or even a negative net contribution to tax rolls, even allowing for supposed vaunted job creation. Similarly, too few on the soi-disant left were willing to point out that the Obama Administration policy of intervening on behalf of bank servicers to allow foreclosures to proceed, even though in most cases, mortgage modifications would have been better not just for homeowners but also mortgage investors, also damaged communities though the decline in home values (both directly and by depressing the value of neighboring properties) which hurt tax revenues.
Dunning Encourages CalPERS to Pressure Its Actuary
Board member Dana Hollinger asks about the return assumptions starting at 1:01:55. The most telling part is at 1:04:40. Notice also how carefully Dunning picks her words:
Board Member Dana Hollinger: Going with, regarding the recommendation of the chief actuary, a lot of times we’re also taking into account what our stakeholders can afford, so there may be a disparity between the discount rate the chief actuary recommends and maybe what we think is realistic in terms of affordability for our stakeholders. In that event, do we have to document why we don’t, say, just hypothetically, say something like 6 1/2 percent, say something lower than we’re currently at, we realize when we’re talking to our stakeholders that they couldn’t afford the increased contributions, that there would be financial repercussions to them, does that have to be documented?
Ashley Dunning, Partner, Nossaman LLP: The more documentation you have for that conclusion, the better, because what I am hearing from a fiduciary perspective, you seem to be saying, is that the, um. soundness of the plan, in the sense of “can your employers afford it” [Hollinger cross-talk, “Pay for it”], may be compromised if you increase their costs.
Dunning: Usually the, often the employers complain of financial woes are not given a whole lot of credence by courts in many circumstances, they are required to pay the benefits that they promised. On the other hand…
Hollinger: But you create systemic risk to the extent that they file bankruptcy, that is systemic risk.
Dunning: Absolutely. That’s the response. The response as a fiduciary is that you are minimizing that systemic risk by moderating how you, the time period over which you collect those contributions. Because ultimately, the contributions have to be paid.
Hollinger: No, I’m not disputing that. I’m disputing…that we get from out consultant, that..it’s a balance.
Dunning: It’s a balance.
The ideal circumstance is for your actuary to incorporate sort of a holistic view of the goal so that collectively you are considering those various factors. Because it is everyone’s goal to make sure, or it should be everyone’s goal to make sure that the system is funded in a manner that will make sure that those promised benefits are paid on time. Now…
Hollinger: I’m just trying to protect us as fiduciaries if the actuary recommends one thing and for these other reasons, we don’t follow it. I just, you know, for the record, and to know that.
Board President Priya Mathur: I think what I am hearing Ms. Hollinger say is that 1) we should encourage our actuary to incorporate those risks into his own analysis, and 2) that we should document and set a record about the rationale behind our decision.
Dunning: That’s right. And it may be that your actuary disagrees with your assessment. He’s not to be a rubber stamp either for certain directives. But the conversation needs to occur with the eye on the ball, which is duty of loyalty to the members and the beneficiaries. You’re not in the business of making sure that the employers are able to pay for other things, but you are in the business of making sure that you’re getting your own required contributions, and that those contributions are going to be able to pay the benefits that they have promised, or the legislature has promised to their employees. That’s why this is a challenge.
This is revealing, and not in a good way.
On the one hand, Dunning does in the end firmly state the only proper conclusion, that CalPERS is tasked to serve its beneficiaries, and that means “getting your own required contributions.”
But on the other hand, Dunning was uncomfortable discussing a practice that takes place not just at CalPERS but at many public pension funds, of setting discounts rates that are high in light of recent and likely future investment returns, as well as in comparison to their own actuaries’ assumptions.
Several elements of Hollinger’s concerns were concern-making. First was that she depicted the reason for not charging the many entities that have CalPERS manage their pensions the full contribution that the actuary deems necessary is that it could create “systemic risk” in the event of bankruptcy. Even worse, Dunning echoes that comment even though she later says that courts haven’t been sympathetic to employers who try to renege on their pension obligations.
Specifically, Dunning and Hollinger should know that CalPERS pension contributions have been backed by courts in the case of municipal bankruptcies. San Bernandino filed for bankruptcy and tried getting its CalPERS obligations reduced. Not only did it fail, but it also owed CalPERS a penalty for not making its full payment on a timely basis, which CalPERS in its infinite munificence decided to reduce…in part. Stockton, which also declared bankruptcy, didn’t even try to have its CalPERS contributions cut. There were more recently three very small entities that did fail where the result instead was that CalPERS cut the payouts to their beneficiaries.
Shorter: there is no such thing as “systemic risk” to CalPERS. CalPERS is a pass through. Its state pensions are backed in the Constitution by the State of California. If a particular employer becomes totally bereft of ability to raise revenues, there is no “systemic” impact. Any consequences will be limited to the beneficiaries of that particular plan.
The second bit that is distressing is to see that Hollinger appeared to be interested primarily in how the board should paper its records so as to avoid liability, as opposed to how to address the underlying issues.
But the most troubling part is that Dunning encourage CalPERS to pressure its actuary to change his recommendations so that CalPERS can dun its various employers for more politically acceptable contributions. Dunning first makes her suggestion in a coded manner, that the actuary should take a more “holistic” view, meaning incorporate the question of the (supposed) ability to pay of various employers. When asked specifically by Mathur, about “incorporating those risks,” Dunning approves, then tries to pretend this isn’t interfering with the work of an independent professional by saying “he’s not a rubber stamp.”
It is particularly surprising to see Dunning endorse the idea of prevailing on the actuary to relent and give more employer-friendly, as in lower, contribution levels. The presumption is that the original estimate by the actuary was his best professional opinion and any reworking will be a fudge and therefore artificially low by design.
The use of inflated return estimates that in turn exacerbated pension underfunding is one of the grounds in Mayberry v. KKR for suing the trustees of Kentucky Retirement Systems and other advisers to the fund. The filing specifically cites the trustees making use of “false actuarial assumptions”. This suit has the potential to be a path-breaking, yet Dunning appears to either be ignorant of it or unwilling to consider that its mere filing of could lead other potential litigants to make similar arguments.
But this proposed fix, to try to influence the grader because he is producing scores that CalPERS finds to be politically inconvenient, is even worse than it appears on the surface.
One of the core practices of fiduciaries is to rely on experts. It goes so far as to turn many duties of a trustee as passively accepting the advice of hired guns, when real investment mavens, like Forbes 400 members and the private equity fund managers, will obtain the opinions of informed parties, but also make a point of discounting them for their biases and commercial agendas. Yet despite fund trustees being held to a “prudent person” standard, applying common sense and a certain amount of skepticism has been absent from the fiduciary trainings at CalPERS in recent years. See the embedded article below for a more nuanced view.
CalPERS’s actuary has no expertise whatsoever on the financial condition of CalPERS’ plan sponsor. Not only is not in the business of making that sort of judgment, it would be a mammoth task to even attempt it. Even bond rating agencies would be loath to deem their ratings as being applicable for the decades-long time frames of public pension funds. The overwhelming majority of the 2009 plus plans in the CalPERS system either have no ratings or have bought municipal bond insurance in lieu of getting a stand-alone rating.
That means that what Dunning is proposing that the actuary do is not “incorporate those risks into his own analysis.” That assessment is completely outside his skill set. Dunning instead is authorizing CalPERS staff and board muscling the actuary to provide results that would be more convenient for them.
And CalPERS wonders why it has a credibility problem.
1 More specifically, the CalPERS investment office has provided the discount rate for the next ten years, and then used the actuary’s discount rate for years 11 onward. As anyone who had done financial modeling will attest, even with low discount rate assumptions, the results will be dominated by results for the early years.Monitoring Experts