First, the good news: The condition of Wichita Employees’ Retirement System is nowhere near as dire as Kansas Public Employee Retirement System, or KPERS. But the city is having to make much higher contributions to keep the plan funded. These contribution rates are likely to increase, as the plan relies on unrealistic assumptions.
Wichita has two employee retirement plans, one for police and fire, and another for other employees. The two plans are nearly equal in size, and both experience the same problems.
As a result of low investment returns, the city finds itself saddled with higher retirement plan costs. In 2009, the city’s contribution to Wichita Employees’ Retirement System was $3,887,085. For 2011, it is $7,695,317, an increase of 98 percent in two years. In reality this increase, as large as it is, is not nearly enough to fund the plan if realistic assumptions and accounting was used.
In the words of report authors, the Wichita Employees’ Retirement System plan experienced a “large increase to the unfunded actuarial liability.” In plain language, the plan’s investments did not earn enough in 2011 to meet expected future expenses. This is termed, again by plan authors, an “unfavorable experience.”
The reality is worse than reported, as Wichita uses a valuation method called “asset smoothing.” This technique smooths out uneven investment returns. It means that the recent years of investment losses are not fully incorporated into the official statistics. Again, from the report authors: “Under the asset smoothing method used in the valuation process, a portion of this investment loss is deferred to future years.” Private sector pension plans can’t do this.
As of December 31, 2011, the actuarial value of the plan’s assets — determined using the asset smoothing technique — was $513.3 million. The market value was $458.8 million, or 10.6 percent less. Also, a measure called “Portion of Actuarial Liabilities Covered by Reported Assets” has declined from 90.1 percent in 2009 to 73.9 percent in 2011.
The effect of this unrealized loss on the plan is severe. If these losses were recognized, the city would have to increase its contributions to the plan by a large amount, write the authors: “If the deferred losses were recognized immediately in the actuarial value of assets, the funded percentage would decrease from 93% to 83% and the actuarially determined contribution rate would increase from 12.6% to 17.9%.” (It’s important to remember who pays for these contributions: Wichita taxpayers.)
A chart in the report shows the expected city contribution rate for future years. It rises rapidly, from about 10 percent now to over 16 percent in 2015. This assumes that the plan earns 7.75 percent investment returns.
The ongoing problem
The Wichita retirement plan uses an assumed rate of return of 7.75 percent. Calculations as to how much the city needs to contribute are based on this assumption. The problem is that this rate is simply too high.
In the private sector, pension plans use much lower assumed rates, such as the rate of return on high quality corporate bonds. This might be somewhere between five percent and six percent. If the Wichita retirement plans were re-evaluated using this assumption, the unfunded liability would explode, and the contributions the city would need to make would be much greater, perhaps by one-third. That’s because of the long time frame of pension fund investments, where small changes in rates of return have a large dollar impact.
Solution going forward
The ongoing problem is that city and state pension plans operate under unrealistic assumptions. This means that Wichita is taking on too much risk in the form of future promised benefits that it isn’t presently paying for.
It’s also easy for cities and states to promise generous retirement benefits without paying for them. The solution is to simply stop this practice and adopt what most of the private sector has: Defined contribution plans like 401k plans.
The city has done this, partially, as new employees (not police and fire) are initially in a defined contribution plan. But employees can later decide to move to the defined benefit plan — the type that causes so much trouble for state and local governments. As it turns out, almost all eligible Wichita employees choose to enter the defined benefit plan.
Government employee representation groups are strongly in favor of defined contribution plans. Last year, in its message to its followers, Kansas National Education Association (KNEA, the teachers union) wrote this about defined-contribution plans: “First, they claim that a DC plan gives the employee control over their own retirement. And if you have lots to invest and have the time and knowledge to do so effectively, that might be true. Of course, even if you do, you can end up like the folks who found Enron to be a great investment or trusted Mr. Madoff. The fact is most of us are not prepared to do our own analysis and investment.”
(While KNEA is writing about KPERS, the state employee retirement plan, the principles apply to the Wichita plan.) There’s quite a bit of misinformation here. But before that, a huge irony is that this information is aimed at Kansas schoolteachers, and their union assumes they are not intelligent enough to plan for their own retirement.
In fact, planning for retirement is quite easy and simple. All one needs to do is select low-cost index stock and bond mutual funds, of which there are many. These funds, over the long time horizon appropriate for retirement investing, beat the performance of all managed funds, meaning funds managed by professionals who attempt to analyze markets and earn greater than average returns through an active trading strategy. This is not disputed by anyone except by those who sell actively-managed mutual funds.
“The evidence is clear. Low-cost index funds regularly outperform two-thirds of actively managed funds, and the one-third of actively managed funds that outperform changes from period to period. Even the very few professional investors who have beaten the market over long periods of time — Berkshire Hathaway’s Warren Buffett and Yale University’s David Swensen, for instance — are quick to advise that investors are likely to be much better off with simple low-cost index funds than with expensive actively managed funds.” (Burton G. Malkiel, ‘Buy and Hold’ Is Still a Winner. Also, see the author’s book The random walk guide to investing: ten rules for financial success.)
Generally, most investors would select just one or two funds in which to place their contributions. Over time, investors may want to change the balance or characteristics of the funds they invest in. This again is easy to do. In fact, large mutual fund companies like Vanguard have index funds that automatically shift the balance between stocks and bonds as investors move along towards retirement.
The idea that the teachers union believes that professionals like schoolteachers are not capable of becoming informed and making these decisions is laughable if it weren’t the actual belief of the union. Suggestion: An actually useful and productive role for the teachers union would be to help their members learn to invest for their retirement. Cities like Wichita could do the same.
The problem cited about Enron and Madoff is that some people placed all or nearly all their investments with these two firms. That’s a bad strategy for anyone to follow with their retirement investments. Using index funds will not expose investors to the risk of losing all their money.
The claim by the KNEA that “lots to invest” is required is false. The companies that manage defined-contribution retirement plans accept new employees into the plan no matter how little they have to invest, and they accept their periodic contributions each pay period no matter how small. Scale — the amount available to invest — is not an issue, contrary to the assertions of the teachers union.
One claim made by KNEA is true: defined contribution plans give workers control over their retirement savings. This is a benefit. If a worker has a low tolerance for risk, they can keep their contributions in cash (actually treasury bonds would be the choice for these people). Others who wish to take an active role in the retirement investing can do so, as most plans offer funds that have targeted goals such as real estate, growth stocks, short-term bonds, long-term bonds, etc.
But in KPERS — and the Wichita plan — all members are invested in the mix of investments that the plan trustees decide on. These investments are largely in stocks and bonds, a fact possibly lost upon Jane Carter of Kansas Organization of State Employees. She asked her members “Do you really want to take your retirement security and gamble it on the stock market?” The reality is that KPERS is invested in the stock market, and those returns are essential to funding KPERS benefits. The investments that the trustees choose may not be suitable for each individual member. But KPERS members have no choice.
The point is that the individual is in control, and can choose investments that match their goals.
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