State Pension Plans Worse Than Workers and Advisors Realize

A new study shows that U.S. state pension plans are in much worse shape than state plan administrators are conceding.

Make no mistake, that spells trouble for the 87 percent of state and local government career professionals (19.5 million total) relying on their pensions for retirement as well as the financial advisors who advise them.

Both one wonders if they’ll need to readjust retirement plans or not, depending on the quality of the pension info they're getting? And if so, how?

First, the data, which comes from a North Carolina State University study.

“An analysis of state pension plans from across the country finds that the already troubling state of pension finances may be even worse than it first appears because many pension managers are making their plan’s financial condition look better by perpetually putting off payments,” stated the study, penned by Jeff Diebold, an assistant professor of public policy at North Carolina State University and lead author of the report.

Diebold likened the shady accounting practices exercised by pension managers to a heavily-mortgaged homeowner who needs to cook the books to keep his or her home.

“Imagine having a 30-year mortgage and each year, instead of making your mortgage payments and having 29 years of payments left, you simply re-amortize the remaining liability over another 30-year period,” Diebold said.

“Using this approach, you can manufacture lower amortization payments for yourself, but you will not eliminate the underlying liability,” he added. “That’s called open-ended amortization, and despite being an unscrupulous accounting practice, it’s widespread among state pension plans.”

'Compounding the Risk'

Those open-ended amortizations bring high risk to state workers’ pensions, as they paper over non-payments to state pension funds, thus “compounding the risk” that the state will have insufficient funds to pay its pension obligations to retired state employees.

“Worse still, we find that officials are most likely to adopt open-ended amortization periods when their plan’s financial condition worsens and would otherwise require higher contributions from the state,” Diebold said.

How much are state pensions underfunded? According to recent data from the Urban Institute, the number could be as “low” as $800 billion or as high as $4 trillion.

Either way, those are numbers that need addressing. One way to address the ongoing underfunded state pension issue is to adjust anticipated investment returns downward – thus taking a more realistic view of future payouts.

“Here is what we should do to fund pensions - lower the estimated return to 5 percent,” said Holmes Osborne, a chartered financial analyst with Osborne Global Investors.

The current return projections are of the “pie in the sky” variety, he said. “So you’ll also need to increase employer and employee contributions. The low contribution levels worked when the stock market was booming and interest rates were much higher. Many plans are distributing what they are taking in in contributions. Imagine what this will be like when we have ten years of 3 percent stock market returns?”

Other pension experts advise financial advisors to take more ownership of the “underfunded” issue, accept it as a reality, and think creatively in helping clients – and pension plan managers – in overcoming retirement funding shortages.

“We’ve been seeing increased motivation on the part of management teams and pension boards to de-risk defined benefit plans, both in the government and corporate sectors,” said Michael O’Connor, leader of MassMutual’s Defined Benefit Pension Plans unit, in Springfield, Mass. “Before doing so, however, we recommend pension plan managers to speak with an experienced financial advisor who can play a key role in helping simplify the process.”

Solid Investment Strategy Needed

The first goal should be to select a solution that integrates both investment and actuarial insights, O’Connor said.

“It’s only through an integration of these services that an investment strategy can emerge that is built on diversification, prudent security selection, and value,” he noted.

That process starts by conducting an asset liability modeling (ALM) study.

“A partnership with a knowledgeable financial advisor and an integrated defined benefit pension provider can help get this process started,” O’Connor said.

With the results of the study in hand, the advisor is better positioned to provide insights into potential risk/reward tradeoffs based on the duration of assets and liabilities,” he said.

“The objective should be to remove complexity from the process that can occur if you have a separate company providing investment strategies and another providing risk-management strategies,” he explained. “The role of the advisor should be to integrate these decision points, moving to a single solution for the pension sponsor at the lowest cost possible.”

Taking action to deal with under-funded pensions is no luxury these days – it’s a necessity.

“This isn’t even a gamble, this is just a losing game in the long term,” Diebold noted. “All but two states are legally required to meet their pension obligations, and at some point those bills are going to come due.”

Brian O'Connell is a former Wall Street bond trader, and author of the best-selling books, The 401k Millionaire and CNBC's Guide to Creating Wealth. He's a regular contributor to major media business platforms, including CBS News, The Street.com, and Bloomberg. Brian may be contacted at brian.oconnell@innfeedback.com.

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