IPFIUSA

Just like many other parts of the economy, the stock market took a heavy hit due to the pandemic. At their lowest points of the crisis, both the Dow Jones and the FTSE 100 were down over 30%. Five months later, they each sit down 13.3% and 19.3% respectively. 

With the stock market crashing in mid-to-late March, pension fund returns have shrunk. Moody’s Investors Service estimates that returns for many pension funds this year will reach only 1%, instead of the widely targeted 7% return rate. Roughly $1 trillion of value has been lost by public pension funds stemming from the poor market performance.

Investment returns are vital to pensions because employee and government contributions aren’t enough to support the scheduled payouts to retirees. This likely means that unfunded liabilities are going to increase. To cover for this increasing gap, funds will call on employees to contribute more. This will prove to be more tricky considering that unemployment is in poor shape as well, creating a smaller pool of contributors to pension funds across the nation.  In 2007, federal and local government pension debt totaled about $1.6 trillion according to the Federal Reserve, or roughly 11% of US GDP. In 2019, unfunded liabilities reached $4.1 trillion, about 19% of the GDP. 

Unfunded liabilities have more than doubled since the crash of 2008, with the COVID-19 pandemic greatly exacerbating the issue. Because of the handling of the pandemic to this point, many health experts predict that COVID-19 will be prevalent for many months to come. This, in turn, means a prolonged economic downturn, longer than originally anticipated. As reported before on the IPFI blog, remedies to these pension shortfalls will likely be brought up by elected officials in DC and elsewhere in the coming months. With the second stimulus bill stalling in Congress, it seems like the American economy, and people, will be faced with a tough road ahead.

The state of Kentucky revived and expanded a lawsuit that claims former officials of the state pension system and hedge fund firms violated their fiduciary duty by choosing risky investments. The state is demanding compensation from hedge funds for their excessive fees and underperformance. 

Kentucky’s pension system remains one of the worst-funded in the nation, hovering around a 32.8% funding level. Lawmakers have discussed cost-saving measures such as cutting agencies’ spending and reevaluating employee contribution caps, but little progress has been made towards revitalizing the fund. Recent accusations may explain, in part, Kentucky’s lack of funding.

A case, which was originally filed in 2017 by eight state pension recipients, accused Kentucky Retirement System employees and a number of prominent hedge funds of mismanaging pension investments. Earlier this month, the Kentucky Supreme Court dismissed the case, asserting that the plaintiffs lacked legal standing to bring the lawsuit. Kentucky Attorney General Daniel Cameron, however, recently joined as a new plaintiff along with additional allegations concerning the Kentucky Teachers Retirement System (KTRS). 

Between 2000 and 2009, the Kentucky Retirement System (KRS) lost half of its assets. Cameron’s complaint alleges that, given the massive losses KRS sustained in 2009, the fund managers sought a quick fix by gambling with “alternative investments.” According to Cameron, KRS employees bought risky investments from hedge funds in a last-ditch effort to rapidly fund the system, which had already been failing for years. When the funds’ performance didn’t meet their expectations, they allegedly attempted to cover up any indication of wrongdoing. 

Along with accusing KRS employees of misconduct, the plaintiffs claimed that the CEOs of Blackstone and KKR benefited from significant financial gain from a relationship with KTRS, while selling the system faulty funds. These “alternative investments” were marketed by KKR & Co. and Blackstone Group, among others, to underfunded pension systems across the country. They referred to the strategy as an “absolute return strategy,” promising annual returns of 7.75 percent in addition to reduced risk. The funds were generally hedge funds that invest in other hedge funds and, although they promised higher returns, studies have shown these “alternative investments” fail to perform and include large management fees which reduce any existing profits.

Last week, an attorney representing the Blackstone Group responded to accusations, indicating that the fund’s shortfalls existed long before their collaboration with the Blackstone Group and stating, “As we’ve demonstrated repeatedly, these claims have absolutely no merit… We delivered more than $150 million in net profits to Kentucky pensioners and exceeded by nearly three times the benchmark set by KRS itself.” Kelly also expressed his surprise in learning that the attorney general’s office would actively pursue a case already addressed by the state’s supreme court. 

Meanwhile, Krista Locke, deputy communications director for the attorney general’s office promised that their “goals in pursuing this litigation are straightforward: to protect the pensions of hardworking government employees and to safeguard taxpayer dollars”. 

Although the case remains in its early stages, the question remains whether KRS employees violated their fiduciary duties by choosing risky investments. The case’s outcome will also determine whether Blackstone Group and KKR are forced to spend millions in payouts, a decision that will undoubtedly be hotly contested.

The term “ESG” – Environmental, Social, and Governance-based investing – was first used in an International Finance Corporation 2005 report Who Cares Who Wins and developed a widespread use in the following years. Currently, there is over $20 trillion in ESG assets under management and is a growing sector. 

One of the key issues with ESG investing is that while it is seen as the right thing to do ethically, it is not clear whether it is the right thing financially. The performance of ESG-related investments has been widely questioned, and in a 2019 IMF report, it was found that there were comparable returns to traditional means of investment. Additionally, many institutions have created and formed standards around ESG, like the Sustainable Accounting Standards Board (SASB) and the Global Reporting Initiative (GRI). These actions have led to no prevailing standard. There is variation in many aspects of ESG and it has led to the sector being complex and not uniform. 

All investment firms certainly overlap in their ESG definitions, but some go further than others in their commitment to describing exactly what that means and how they’re incorporating ESG into their decisions. On the base level, all firms describe ESG integration as the practice of incorporating ESG information into investment decisions – only some elaborate further.

Some firms, such as Schroders, acknowledge the haziness surrounding the precise definition of ESG. They explained that often “the most commonly used terms include “sustainable,” “responsible,” “impact,” and “ESG investing.” These are often used interchangeably to cover a wide spectrum of goals and strategies. Although ESG is distinct from SRI, there is some obvious overlap that many firms hesitate to distinguish between. Instead of pinpointing a solid definition, some firms, such as Shoroders, chose to view ESG as a spectrum where “At one end of the scale, ethical screens eliminate companies engaged in controversial activities, reflecting asset owners’ values and should have little expectation of improved investment returns. At the other end, sustainability analysis can, when approached thoughtfully and integrated with more traditional analysis, improve insights and enhance performance. Each approach has different objectives, requires different skills and demands different tools.” 

Some firms, in lieu of defining ESG, dive deep into detail on how they will integrate ESG into their work. Most often, these firms include some form of “pillars” to convey their related corporate priorities. BlackRock, for instance, described three main themes around which they integrate ESG into their investment teams and strategies. The first is investment processes and they expect all active funds and advisory strategies to integrate ESG. They tasked portfolio managers with this task. Secondly, they use material insights in their ESG investments, and lastly they aim for transparency in their investments. Although BlackRock included a long description for how they integrate ESG into their work, they didn’t define ESG itself.

J.P. Morgan followed a similar approach of incorporating multiple elements into their ESG definition. Rather than choose their own pillars, they deconstructed the ESG acronym and individually defined “environmental,” “social,” and “governance.”

ESG has become a popular topic recently due to the possibility of restrictions being put into place by the Labor Department. The Labor Department Secretary, Eugene Scalia, said in June that the new proposed limitations would “remind plan providers that it is unlawful to sacrifice returns, or accept additional risk, through investments intended to promote a social or political end.” 

At the end of June, word was coming out of Washington that there could be a second stimulus plan coming. President Trump and Treasury Secretary Mnuchin both voiced optimism that the second round of COVID-19 relief would be imminent. Sure enough, it is reported that next week the second plan, the HEROES Act, will be introduced to the Senate after passing the House approximately a month earlier. Part of this massive relief plan is the Emergency Pension Plan Relief Act of 2020. Simply put, it is a bailout for single and multiemployer pension plans. 

The Emergency Pension Plan Relief Act of 2020 (EPPRA) would double the Pension Benefit Guaranty Corporation (PBGC) maximum benefit level. Currently, the maximum is 100% of the first $11 of the monthly benefit rate, plus 75% of the next $33 of the monthly benefit rate, times the years of credited service. This means a 30 year employee receives $12,870 annually, or $17,160 for a 40 year employee. Under this act, those limits would be raised to $24,300 and $32,400. The act also reinstates cuts that have been made by firms that were about to deal with insolvency. Furthermore, cuts made by the Multiemployer Pension Reform Act (MPRA) of 2014 wouldn’t be in effect either. The major problem with the entire act is that all of these benefit cuts are being rolled back without a reciprocal increase in contributions by those who have pension plans. Most of the funding would come from the federal government.  Other things done in the EPPRA are the authorization of composite plans — a multiemployer plan that combines defined benefit plans and defined contribution plans, — accounting relief, special partition relief and an extension of funding improvement and rehabilitation periods 

While it is essential that the American economy is guided back on the right course, this shouldn’t be an excuse for handouts as a stop-gap measure to remedy underlying problems. The burden taken on by the federal government will end up being paid off by the nation’s population. Pension fund relief and reform is not something that is taken lightly. Conscientious work and deliberations should be had so the problem can be addressed comprehensively and effectively.

The fate of the EPPRA is unclear at this moment, but however it must be noted that the pension fund issue has caught the eye of elected officials in both parties. This means that no matter the outcome of the EPPRA, it is expected that new pension legislation will come to the House and Senate floors soon.

Earlier this month, the Rhode Island Supreme Court ruled on a case with significant long-term implications for Providence’s critically underfunded pension system. The court reversed a 2012 city pension reform act, effectively prohibiting cities in Rhode Island from executing pension reform without the consent of pensioners. City leaders voiced their disappointment regarding the outcome, some suggesting that the city may have no choice but to consider declaring bankruptcy. 

Providence’s pension system, which serves over 3,200 retirees, has been a subject of great concern for policymakers for decades. The City’s retirement fund remains only 26.3% funded, with its unfunded obligations exceeding $1.3 billion. As of November 2019, Providence’s pension fund, along with 20 other municipal plans across the state, sat in “critical” status. According to Rhode Island General Treasurer Seth Magaziner, pension funds underfunded by at least forty percent receive this classification. 

In 2011, Providence’s then-Mayor, Angel Taveras, pushed for city-wide reform to recover from what he referred to as “pension abuse.” Mayor Taveras believed Providence could save $16 million annually by freezing COLAs. Cost of living adjustments, or COLAs, change a pension recipient’s monthly retirement benefit to account for increasing prices and to ensure that their purchasing power remains the same. In Providence, however, generous COLAs contributed to the city’s looming economic collapse. The most frequently used example of Providence’s generous COLAs is Fire Chief McLaughlin, who retired in 1992 with a tax-free disability pension when his salary was $63,500. He received a compounded 6% COLA and, by 2013, his pension soared to $196,800. 

Mayor Taveras’s administration passed an ordinance that suspended cost-of-living adjustments until Providence’s pension fund reached a 70% funding level. Taveras argued the freeze was only a temporary change to the pensions of public employees. Retiree groups and unions agreed to a 10-year suspension, however, the fund was not projected to reach the targeted level of funding until 2036. A lower court ruling previously upheld the freeze, until earlier this month when the Rhode Island Supreme Court presided over the case. 

The Court ruled that “if the pension plan for city employees and retirees is changed by the courts, it can’t be changed again by the City Council” unless changes are agreed upon by pensioners. The majority opinion was written by Chief Justice Suttell, who concluded that each plaintiff definitively proved that they were entitled to the full benefits they were promised by the city. Additionally, the court decided that the suspension of COLAs could not be considered temporary because, according to William B. Fornia, an expert in actuarial science as it relates to municipal pensions, testified that over half of the plaintiffs whose COLAs were frozen will have died by the time the retirement system achieved 70% funding. Following the Supreme Court’s decision, Fire Chief McLaughlin and others with high earning COLAs could potentially receive huge payouts. 

City leaders voiced their disappointment about the decision and their concerns for the financial security of Providence. City Council President Sabina Matos released a statement expressing that “the outcome of today’s Rhode Island Supreme Court decision is at a minimum disappointing. At a time with so much fiscal uncertainty, this decision augments the need to be creative with our pension obligations while not sacrificing the City’s duty to pay debts and provide basic needs and services.” Providence Mayor Elorza also warned about the decision’s implications for the good of Providence and the sacrifices that the City now expects to make. He wrote: “Today’s Supreme Court decision will ensure that the unsustainably generous pensions that were doled out in the past will continue to be an albatross over our city for decades to come. This decision will force the city to make very difficult decisions about how to pay for ballooning pension payments at the risk of short-changing critical needs like public education, social services and infrastructure investments.” City officials urged other Providence leaders to think creatively in their suggestions for expanding revenue streams, given that the wellbeing of the City hangs in the balance. 

The decision will immediately cost Providence several million dollars in payouts. In the future, public employees will be able to cite this case as a precedent to prohibit changes to their pensions and city leaders are now barred from unilaterally executing changes to the pensions of current and former city workers. Whereas the original reform saved millions, the City of Providence must now decide whether to declare bankruptcy as its only escape from mounting debt. City leaders certainly face pressure to devise a solution as quickly as possible.

Enacting larger reform to implement a more responsibly-managed retirement system will be essential to Providence’s recovery and the financial well-being of its public employees for decades to come.