The power of the 'case method'
If you felt some tremors on 25 October, the cause may have been the animated debate at the University of Toronto’s Rotman school of management about the right financial policies for the Public Sector Employee Retirement System (PERS). The participants in the debate were the 55 attendees to a colloquium organised by the Rotman International Centre for Pension Management (ICPM). The attendees came from a variety of professional and academic backgrounds.
The PERS case was specifically written for the colloquium in order to create a dynamic forum for exploring the current financial challenges facing public sector defined benefit (DB) plans in the developed world. The Dutch pension fund PGGM provided technical support with its balance sheet valuation model based on ‘fair value’ principles.
The PERS situation: After considerable reflection, the virtual Alyson Green had decided to throw her hat into the ring to become the next CEO of the state’s fictional public employee retirement system (PERS). The state’s governor, whom she knew of old, had been very persuasive. It was his perception that, with the retirement of PERS’ long-serving previous CEO, the organisation needed new, vigorous leadership. With her strong track record as a private sector ‘turn-around’ specialist, he thought that Alyson fitted the bill perfectly.
PERS’ board of trustees must have agreed with the governor’s assessment, as they decided that Alyson was the strongest of the three finalists for the job. Now six weeks on the job, she had started to make serious preparations for her first board meeting, only two weeks away. As she felt that this first meeting would offer a unique opportunity to establish a few key strategic priorities for PERS, it was important for her to develop her own view on what they should be.
The PERS debate: An important starting point for the debate was that in its most recent annual peport, PERS had reported balance sheet assets and liabilities at $50bn (e41.8bn) each. However, the case description raised doubts about whether the two figures are really comparable. While the $50bn asset value was based on market valuations, the $50bn liability value was not, as it was calculated using a 4% real return discount rate at a time when the term structure of default risk-free real interest rates was in the 1%-2% range.
The first specific question participants were asked to address was whether the fact that PERS has $50bn in assets (at market) and had accrued pension payment obligations with a market value (in an insurance sense) of $74bn (ie, well-above the reported $50bn ‘liability’) was a serious issue for PERS, requiring immediate attention. Specifically, is this an issue that the new PERS CEO Alyson Green should put on the agenda of her first meeting with the PERS board of trustees? The majority of attendees thought it was a serious issue, but there was also a significant minority who were of the view that this situation did not constitute a serious issue requiring immediate attention. Both groups were invited to state their reasons. These views are summarised in the table (left).
After an hour of general discussion and debate, participants were split up into seven smaller working groups and asked to provide Alyson Green with advice about what she should convey to the board about the PERS funded status, and what PERS should do about it. With the assistance of the PGGM model, the case study had shown that the asset-side of the PERS balance sheet could be shored up by a higher contribution rate, while the liability-side of the balance sheet could be reduced by making pension benefits dependent on the balance sheet funded ratio. Thus advice for Alyson could involve some combination of raising contributions, making benefit payments contingent on the health of the PERS balance sheet, and changing investment policy. In a more radical vein, even moving to a collective arrangement with both capital accumulation and annuitisation components could be contemplated.
In the report back, most groups recommended Alyson should clearly explain the current financial situation of PERS in her first meeting with the board. They also suggested that Alyson convey the view that PERS needed to move to a formal ‘policy ladder’ involving variable contributions, variable benefits, and a variable investment policy. The groups providing Alyson with this advice realised that this would be a difficult message to ‘sell’ to the various PERS stakeholder groups. Three of the more creative ‘selling-the-message’ suggestions provided to her were:
o Brief the governor fully on the current situation, and develop a two-pronged strategy with him. The ‘inside’ strategy would engage representatives of the various stakeholder groups, and see if an acceptable solution to all (or most) could be brokered. The ‘outside’ strategy would see the governor create a public forum to explain the current situation to all concerned, and to seek a satisfactory solution through a public process;
o Engage a credit rating agency to get an independent opinion on how PERS’ current financial situation could impact the state’s credit rating, and how moving to a more fiscally prudent ‘policy ladder’ involving variable contribution rates, variable benefits, and a variable investment policy could improve that credit rating;
o Lie. In other words, exaggerate the seriousness of the problem to the extent that the various stakeholder groups are forced to engage in finding a solution.
One group disagreed with these PERS strategies recommended by the other groups. In the opinion of the disagreeing group, the best solution was to stabilise the pension system by (a) moving the contribution rate to full-cost (20.2% of pay), (b) moving the investment policy to 100% inflation-linked bonds, and (c) making up the annual benefit payments shortfall on a pay-go basis out of general tax revenues.
The entire three-hour process, led by professor Alexander Dyck of the Rotman School, was a powerful learning experience . Most were persuaded that the PERS situation did indeed warrant an immediate, forceful response of some sort, and that its situation in fact reflected the current reality of most public sector DB plans around the world. The challenge is to create tipping points that lead to ‘immediate, forceful responses’. In the Netherlands, the pension regulator has already been the catalyst for change, which is now occurring.
In California, the governor has tried to create change, and failed. He has promised to try again. The virtual Alyson Green and her PERS board of trustees are plotting their strategy for change as you read this. More importantly, so are some of the colloquium participants!
Keith Ambachtsheer is director of the Rotman International Centre for Pension Management at the University of Toronto, and adjunct professor of Finance www.rotman.utoronto.ca/icpm