South Carolina’s looming pension crisis

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Years of ill-timed investments and a refusal to abandon questionable strategies have left South Carolina’s government pension plans on the ropes, with a massive funding gap that threatens promised benefits to future retirees.

The plans serve roughly one out of nine state residents, and the shortfall — $24.1 billion — is more than triple the Palmetto State’s annual budget. That’s left lawmakers and the state’s investment managers scrambling for a fix, as the burden grows for workers and taxpayers.

Teachers, firefighters and other government employees have been required to pump ever-rising amounts of money into the pension system, only to see their retirement plans become increasingly uncertain. Costs have soared for state and local governments, school districts and public colleges.

The pension shortfall is the “state’s biggest problem of the decade,” said Sen. Kevin Bryant, R-Anderson, co-chairman of the Joint Committee on Pension Systems Review.

How did we get here? First, state lawmakers repeatedly changed laws to encourage more aggressive pension investments, often at what proved to be the worst times to do so. Then, as the pot of pension money dwindled, the state’s investment managers chased increasingly expensive strategies. The result: South Carolina pays some of the nation’s highest costs among state pension plans, only to get results that were dead last over the 10 years ending in 2015.

“Our attitude from 2006 to 2013 was, we wanted to be on the cutting edge of (investment) diversification and financial theory, but we were on the bleeding edge,” said state Treasurer Curtis Loftis, who serves on the seven-member S.C. Retirement System Investment Commission. “We have lost so much money the state will be lucky to get out of it.”

Despite that poor track record, employees of the Retirement System Investment Commission collected $1.4 million in bonuses in 2013. Following criticism, the RSIC no longer pays bonuses, but the top 10 officials on its full-time staff still earn an average of $196,397 — $90,000 more than Gov. Nikki Haley is paid to oversee the state.

An in-depth Post and Courier analysis of financial reports, audits, studies, pension reform committee hearings and other pension plan materials found that:

  • For every dollar that should be in the pension funds to pay future benefits, the state has roughly 46 cents.
  • Government workers and their employers have seen five hikes in their pension plan contributions since 2012, and there’s no end in sight.
  • The pension plans collect about $2 billion yearly from workers and employers and pay out $3 billion in benefits. Pension investments need to earn $1 billion yearly just to keep the funds from shrinking.
  • In the five years before pension managers began wagering on expensive investment alternatives, yearly fees and costs averaged less than $27 million. Those costs have exploded, and over the past five years averaged more than $361 million.

Pensions like it’s 1999

It used to be different, before the high-octane investment strategies began. South Carolina’s pension plans were considered 99 percent funded in 1999, and on track to pay all promised benefits for decades to come.

That was the year the pension funds started investing in stocks, in hopes of pulling in even more income. A change to the state constitution and action by the General Assembly allowed those investments. In the previous five years, U.S. stock prices had nearly tripled.

By pouring money into stocks after prices had already soared, the pension funds arrived just in time for the bursting of the internet stock bubble and a deep, two-year tumble in market prices.

“We missed a significant portion of the dot-com bubble,” said the current S.C. Retirement System Investment Commission CEO, Michael Hitchcock. “The timing of what happened, it was not good by any stretch of the imagination.”

It was the first in a series of ill-timed pension investing decisions, some allowed by additional voter-approved changes to the state constitution, that resulted in the funds repeatedly buying stocks at high prices near peaks in the market.

Regular folks saving for retirement are typically advised not to try to time the stock market as it rises and falls, to avoid chasing investments that were last year’s winners, and to avoid paying high fees. The pension managers did the opposite, repeatedly, with state lawmakers’ encouragement.

Fund managers essentially kept doubling down, devoting larger chunks of the billions in pension funds to U.S. stocks right before market crashes that began in 2000 and 2007. They jumped into overseas stocks for the first time in 2007 when international markets peaked at values they haven’t since revisited.

Also in 2007, under then-Chief Investment Officer Robert Borden, the funds embraced expensive alternative investments, such as partnerships with hedge funds that wager on which assets may rise or fall in price, companies that try to buy and flip failing businesses for a profit, private real estate deals, and commodities such as cattle and gold.

Borden, who used to tool around Columbia in a yellow Lamborghini sports car, was pulling down a $485,000 state salary when he resigned in late 2011 for a job with a private investment group in North Carolina.

There were tales of state officials being wined and dined, once with a centerfold model, and partying with fund managers at posh New York City nightclubs. Loftis spread some of those tales, recounted in a 2012 New York Times story that observed: “It all sounds like one of those classic tales of a lot of public money meeting a little private greed, of locals wooed by big-city slickers.”

The RSIC’s next chief investment officer, Hershel Harper, collected a $300,000 performance bonus on top of his $300,000 salary in 2013, which was one of the rare years when pension investment returns exceeded the state’s target. That year, total RSIC bonuses cost the state $600,000 more than the entire annual budget of the State Ethics Commission.

A ticking bomb?

Despite Borden’s departure and several leadership changes at the RSIC, South Carolina has continued to pay some of the highest investment fees of state pension plans, while repeatedly falling short of investment goals and lagging behind even simple, inexpensive mutual funds.

A 2015 study by the Maryland Public Policy Institute compared pension funds in states paying the highest fees (South Carolina was No. 2) with states paying the lowest, and said those paying the lowest fees had higher multi-year investment returns. Jeff Hooke, a senior fellow at the institute and one of the report’s authors, said the state’s investment policies suggested either a lack of mathematical understanding or “a decision process not driven by the best interests of the pensioners and taxpayers.”

Edward Siedle, a former Securities and Exchange Commission lawyer who unsuccessfully sought a contract to review South Carolina’s pensions, was blunter. In a Forbes.com commentary, he called the state’s pensions a “ticking megaton alternative investment time-bomb South Carolina pension officials created in secret with Wall Street technical assistance.”

Hitchcock, the current retirement system CEO, has heard all the criticism but said he and his staff are constantly working to improve results. As state employees, he said, they have a vested interested in the success of the pension plans.

“I have 14 years in the big (main pension) system and 15 in the National Guard system,” he said. “This is my retirement we’re investing in, and that’s how we treat it.”

Hitchcock landed his now-$245,000 job just over two years ago, after serving as chief counsel and assistant clerk of the state Senate. Another lawyer, Robert Feinstein, became the RSIC’s managing director of public and private markets in late 2015. His pay, $253,866, is the highest of the RSIC staff.

Geoffrey Berg, the chief investment officer, was promoted to that role temporarily in the fall of 2015 and the position was made permanent in September after a national search for the best candidate. Berg holds an MBA in finance from the University of Iowa and joined the RSIC in 2009 after two years in private industry as an analyst.

While Hitchcock and his staff search for a solution, ultimately, it’s up to taxpayers to make up the difference and close the pension funding gap, because they underwrite the costs of government. Modestly paid state, school district and local government employees have also felt the pinch, as they have been required to contribute more and more each year.

For someone with a $40,000 salary, about average for a state employee, required pay deductions to the main pension fund now consume more than a month’s pay each year.

Michelle Nichols, who teaches math and science at Moultrie Middle School in Mount Pleasant, said there’s a feeling of helplessness among workers covered by the plans.

“It’s kind of like with health insurance — what can we really do about it?” she said. “A lot of times people work (second jobs) during the school year, like waitressing. I tutor.”

Jarrod Bruder, speaking for a coalition of law enforcement associations, told the South Carolina Joint Committee on Pension Systems Review: “We all understand the losses that were endured during the 2008-09 financial crisis, but we are simply at a loss when it comes to understanding how our state continually under-performs our peers.”

Local impacts

Many state pension plans now face funding challenges, largely because of investment losses related to the Great Recession. But South Carolina’s pension woes are different than those faced by some states.

South Carolina hasn’t chronically underfunded its pensions, as has Illinois, which has the nation’s largest shortfall. And unlike California, where the average annual pension for a retired teacher in 2013 was $47,000, South Carolina does not offer generous benefits to most workers.

South Carolina’s retirees over the past decade, in the largest pension plan that serves most workers, received an average annual starting retirement benefit of slightly more than $17,000.

What South Carolina has is the distinction of paying some of the highest costs in return for some of the worst results.

Greg Mennis, director of Public Sector Retirement Systems at The Pew Charitable Trusts, told the state’s pension review committee in October that South Carolina’s dramatic shift toward alternative investments since 2007 is a big reason its returns “lag nearly all other state pension funds.”

Alternative investments hold the lure of potentially big gains, and the certainty of high fees.

Investment costs paid by the pension funds ballooned from $22 million in 2005 to $467 million in 2014. Loftis has called this an enormous transfer of wealth from “South Carolina’s working class to wealthy money managers.”

Costs have since declined, but that’s mostly because some fees are based upon performance, and South Carolina’s pension investments lost money in the 2016 fiscal year, which ended June 30.

One reason for poor performance — another example of bad timing — is that South Carolina’s pension managers moved money out of U.S. stocks right around the time prices hit bottom in March 2009, in favor of more alternative investments intended to protect the funds from big drops in stock prices.

During the five years that followed, the stock market soared. South Carolina pension plans did post some large returns, but Georgia’s pension plan, focused on low-cost stock and bond funds, did even better.

One key difference: South Carolina paid $156 in expenses for every $10,000 invested in 2014, while Georgia paid $13.

Nevada has a larger state pension fund than South Carolina, worth $35 billion, and most of Nevada’s pension money is invested in low-cost funds that track the broad stock and bond markets. One state employee with a few support staff runs the office that invests pension money. South Carolina’s Retirement System Investment Commission, by comparison, has 51 employees and an annual budget of more than $17 million.

In the last fiscal year, Nevada paid $18 million in fund fees — $229 million less than South Carolina — while posting better investment returns than the Palmetto State, as it has done for the past decade.

A Legislative Audit Council report examined South Carolina’s pension funds last year, and said that during a decade of investing through mid-2015, a low-cost Vanguard index fund of stocks and bonds would have produced higher returns than the state’s pension plans at a much lower cost.

Index funds mimic the performance of selected stock and bond market benchmarks, such as the S&P 500, by proportionally buying all the stocks or bonds in the index. They are known as passive investing, and are known for low costs, because there are no fee-collecting fund managers trying to pick winners and losers.

In suburban Philadelphia, one county switched all of its half-billion dollars in pension investments to low-cost funds that track the overall performance of selected financial markets. Josh Shapiro, chairman of the Montgomery County Commissioners, has been thrilled with the results.

“We’ve hit the assumed rate of return, we’ve saved millions of dollars in fees, and we’re beating the former active approach consistently,” he said. “Why South Carolinians would want their money going to Wall Street, when they could be using the money to shore up the pension fund, makes no sense.”

Hitchcock said index funds may sound appealing, but they are less likely to generate a 7.5 percent annual return on investments. That is the expected rate of return that South Carolina mandates, though many in the investment business believe that goal will be a long shot in the coming decade.

“It certainly is cheap and easy to invest in index funds, but the problem is that we have a 7.5 percent rate of return to hit,” Hitchcock said. “Unfortunately the cheaper, easier solution of 60-40, stocks and bonds, won’t get you nearly what you need.”

Pension changes

In 2012 the General Assembly passed significant rule changes aimed at shoring up the pension fund, mostly by demanding higher contributions from participants and reducing retirement benefits for future employees.

Those changes kicked off five years of increases in the funding that workers and their government employers must contribute. Future benefit payouts were also reduced, by capping cost-of-living benefit increases for retirees at an amount — 1 percent raises — that’s unlikely to keep pace with inflation.

In addition, a generous pension fund just for members of the General Assembly was restricted to lawmakers elected prior to the November 2012 election. In that plan, part-time lawmakers have collected average annual pension benefits larger than those seen by most government retirees. Lawmakers elected prior to November 2012 are still covered.

The rising contribution demands have impacted budgets at school districts and cities across the state:

  • Government contributions to the pensions totaled $1.26 billion for 2016, nearly double the amount contributed in 2006.
  • Employees contributed $302 million more over that span.
  • For a police officer earning $50,000, the Police Officers Retirement System now collects $4,620 deducted from the cop’s wages plus $6,920 paid by the government that employs them.

“Here, where the rubber meets the road at the local level … the fix is being borne by the public employees and the taxpayers of the community,” said Eric DeMoura, administrator for the town of Mount Pleasant. “The condition of the retirement system is a serious concern of ours.”

Most government workers contribute 8.66 percent of their pay, up from 6.5 percent before the 2012 reforms.

Their employers — ultimately the taxpayers — pay even higher rates. When mandatory contributions increased again this year, South Carolina awarded state workers 3.25 percent raises, their largest in a decade, partly to compensate for rising pension costs faced by the workers.

So taxpayers funded the pay hikes and workers gave part of their raises to the pension fund.

Future pensions?

Despite the 2012 pension reforms, the funding gap has increased. In the past two years, the pensions paid out more money than they took in, due to poor investment results. That means the amount available to invest is shrinking.

Now some state officials wonder if the pension plan will survive for future employees, current employees wonder when demands for larger pension contributions will end, and taxpayers are feeling the pinch.

“I think we passed the tipping point — I believe the system has to be altered,” Loftis said. “To fix the plan now is going to be an outrageously expensive proposition.”

Loftis predicts future state and local employees will have 401(k)-type retirement plans, not pensions. That’s something many private companies have done, shifting the retirement burden to employees.

That wouldn’t solve the funding problems, but it would eliminate future uncertainty after all the currently covered employees retire over the next four decades or so.

Loftis said he’s hopeful the new RSIC leadership will make a difference. “It does take a bit of time to turn things around, but I am confident they are on the correct path,” he said.

Legislation expected in January will likely include a costly plan to stabilize the funding shortfall ahead of potential changes to the system, such as the 401(k)-style plan predicted by Loftis.

“In order to put a stop to the growing pension debt … there simply needs to be an infusion of money to offset the unfunded liabilities, we all know it,” said state Rep. Bill Herbkersman, R-Bluffton, co-chairman of the Joint Committee on Pension Systems Review.

Options available to repair the pensions for the long term boil down to a combination of these three: Further restricting benefits to slow the money going out; increasing contribution rates again to boost the money coming in; and earning better returns on investments.

Hitchcock said the RSIC is adjusting the pension investment mix, and taking a close look at the performance of the many outside fund managers that collect fees to invest the pension fund’s money. One change put more money into stocks around the end of 2015, after watching U.S. stock market values more than double since the pension fund pulled some money out of stocks in 2009.

The Legislative Audit Council recommended that the General Assembly cap the amount of pension fund money that can be shoveled into expensive alternative investments. Hitchcock opposed the recommendation, saying it would limit the RSIC’s ability to chase higher returns. State lawmakers opted against the change.

As with Social Security on the national level, the projected inability to pay full benefits is many years away, and lawmakers tend to focus on immediate concerns.

Bryant, the Joint Committee on Pension Systems Review co-chairman, said pension funding will compete for attention and budget dollars against the state’s crumbling state transportation infrastructure.

“They want this pension fund funded, and they want our roads funded,” Bryant said about his constituents’ concerns. “Everything else is just behind those two.”

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