Politics & Policy

Scott Walker Wins the Accountants’ Primary

Wisconsin’s rock-solid pension system makes him presidential material.

Wisconsin governor Scott Walker’s signature legislative achievement, Act 10, was one of the most polarizing and galvanizing pieces of state legislation in recent memory. The law, which severely weakens public-union powers and mandates public-pension sanity, is providing a blueprint for other Republicans around the country. Walker’s public-pension stewardship also demonstrates why he is on the short list of serious presidential contenders.

According to a Moody’s report last year, the funding gap for America’s 25 largest public pensions alone is approximately $2 trillion, equivalent to more than half of the entire federal budget. Other estimates that use lower discount-rate assumptions put the total closer to $5 trillion. There is increasing urgency about ways to address dangerously underfunded pensions, from local bankruptcies to federal bailouts to increased taxes. But there is one place where none of that discussion is necessary. That place is Wisconsin.

Although it’s not all attributable to Walker, Wisconsin’s public-pension system is the healthiest in the country, and the only statewide public pension that is fully funded. And Wisconsin does this with fewer accounting gimmicks than many other states, using a fairly realistic discount rate of 7.2 percent.

The nationwide public-pension problem is the product of several factors, including powerful public unions, outsized public-employee entitlements, the financial crisis that began in 2008, and historically low interest rates that push down discount rates and thus increase future liabilities. Back in 2000, more than half of the states had sufficient assets to cover current and future public-pension liabilities. But now states are 49 for 50 when it comes to promising more than they have allocated to fulfill those promises. And that says nothing about federal entitlements.

Even though Scott Walker inherited a strong pension system when he assumed the governorship in 2011, it has improved in both relative and absolute terms under his watch. According to Standard and Poor’s, in 2012, Walker’s first full year in office as governor, funded levels dropped for 38 states. That stemmed from a combination of increased benefits and lower returns on investments as a remnant of the financial crisis. The Wisconsin Public Employees Retirement System (WRS), the ninth-largest public pension in the country, was one of a handful that did not worsen.

How has Wisconsin’s public-pension system managed to stay the healthiest in the country, and how has Scott Walker contributed to that? One reason is its structure. As is true in many states, Wisconsin’s public-pension system is broken down into state and local components. WRS does not encompass Milwaukee County or the city of Milwaukee, which have separate pension systems. The Employees’ Retirement System of the County of Milwaukee (ERSM) was 85.7 percent funded on an actuarial basis and 90.8 percent funded on a market-value basis as of January 1, 2014. A separately funded and much smaller fund for Milwaukee County was only 47 percent funded on an actuarial basis as of January 1, 2014.

According to the National Conference on Public Employee Retirement Systems, which tends to provide an optimistic picture, the national average for public-pension funding is approximately 75 percent. That means Milwaukee’s pension system would still be one of the healthier pensions in the country if it were a separate state. Yet ERSM’s nearly $300 million funding gap is larger than all of WRS’s. So by excluding pension benefits from the largest county in the state, Wisconsin’s public-pension statistics are better than they otherwise would be.

More critical to Wisconsin’s clean balance sheet, however, has been its effective asset and liability management. Over the last several decades, public pensions — particularly with the growth of benefits and the need to juice long-term projected returns — have increasingly adhered to the David Swensen “alternative asset” view of pension-portfolio management. Swensen is the chief investment officer of Yale University’s endowment, and his seminal book, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment, advocated much higher long-term allocations to alternative assets, like private equity and hedge funds, to increase returns. That approach has become conventional among institutional investors with indefinite investment horizons. These investors have increased allocations to outside managers, particularly alternative-asset managers.

The effects of those trends have been notable in many respects, not the least of which has been minting Wall Street millionaires and billionaires who manage pension and endowment money. But there is a real cost in management fees, agency costs, and liquidity risks for public pensions in allocating funds to outside managers, and all of these were exacerbated during the financial crisis. While the alternative-investment industry still extols the virtues of its products, the reality is that alternative assets, particularly real estate and structured products, were huge catalysts for the financial downturn. Moreover, their inherently illiquid nature is precisely what spawns the fire-sale mentality that can exacerbate any financial crisis.

As states have become more sensitive to burgeoning pension costs in recent years, and with increasing regulatory scrutiny and media attention on possible fee abuses by investment managers, more public-pension systems have been moving away from the standard investment approach. For instance, CalPERS, which manages the California Public Employee Retirement System and is the largest public pension in the nation, announced last year that it would no longer allocate its funds to outside hedge-fund managers. The news shook the investment-management world because CalPERS is often the leader in setting public-pension trends, but in this case it is significantly behind what Wisconsin has been doing for years. In 2007, the state managed 21 percent of its pension investments directly. Today, it manages 57 percent. The results are fewer fees that decrease returns, more coherence in overall portfolio management, and fewer alternative investments that can be very risky.

The State of Wisconsin Investment Board also allocates less to private equity than other pensions do. Less than 7 percent of the WERS assets are allocated to private equity, and when the board does invest, it looks for smaller funds. John Drake, the senior investment officer of Wisconsin’s Investment Board, spoke last year about how smaller private-equity firms can be better. He said, “Our peers have done large strategic accounts. We have been going down market. . . . We like the alignment of interests down there.” Translation: Larger private-equity firms make plenty of money from fees and do not rely on the performance of their investments as much as smaller firms do.

By comparison, more than 10 percent of the assets under management at CalPERS and its sister CalSTRS (California States Teachers’ Retirement System) are invested in private equity. Washington allocates 23 percent of its assets to private equity, Oregon 18.6 percent, Michigan 18.8 percent, and the Pennsylvania Public School Employees’ Retirement System 20.5 percent, according to the financial-data firm Preqin. Pennsylvania’s and Michigan’s pension systems are less than 65 percent funded, but Oregon’s and Washington’s are both over 90 percent funded. So high allocations to alternative assets are neither necessary nor sufficient for pension health, but they do increase risk and diminish liquidity. Wisconsin has managed to avoid those dangers.

Then there is the management of the liability side of the balance sheet, which is where Scott Walker has left his biggest mark. In 2008, according to the National Association of State Retirement Administrators, Wisconsin spent 1.3 percent of all state and local spending on public-employee pensions, less than half the 2.9 percent average nationwide. Since then, however, it has improved those numbers further, reducing pension payments to retirees by $3.2 billion. And remember, this is Wisconsin, a state that has not voted Republican in a presidential election since 1984 and is far from homogeneous in its political views.

Walker’s Act 10 has made it likely that Wisconsin’s health will continue in the long term, and it has already reaped massive long-term savings. The act does many things, including increasing the required annual contributions of public employees (including Milwaukee public employees) to up to 50 percent of their pensions, or roughly 5.8 percent of salaries. It requires employee contributions of at least 12.6 percent of health-care costs. It prohibits public unions from engaging in collective bargaining on anything except wages, which are capped by cost-of-living calculations. (The act does, however, include a collective-bargaining exemption for police and firefighters because of the public-safety role that they play.)

Perhaps most important, public unions are now prohibited from automatically deducting union dues from employee paychecks, and they must annually recertify their union status by collecting the votes of at least half their membership base. To the labor circle, that is the existential threat that makes Scott Walker Public Enemy No. 1.

While Walker’s signature legislative achievement has rankled the unions, the oft-forgotten carve-out for firefighters and police officers has become somewhat of a blueprint for other Republican governors across the country. It also gives Walker a retort to the charge that he is against middle-class workers. In Milwaukee particularly, where Walker was the Milwaukee County executive before he ran for governor, he enjoys widespread support among union members, especially police and firefighters.

Republican governors from other states have taken note. First-term Illinois Republican governor Bruce Rauner, for instance, just proposed $2 billion in public-pension cuts but excluded firefighters and police officers. “Those who put their lives on the line in service to our state deserve to be treated differently,” he said. Michigan governor Rick Snyder included a carve-out for police and firefighters in a right-to-work bill last year.

That approach preserves the natural alliance that Republicans have with law-enforcement employees and firefighters, who often lean more to the right than their union leadership. Combined with aggressively tackling the stranglehold that public unions have long had over their members’ collective voices and the public coffers, the Walker formula seems increasingly to be a winning one. It could eventually take him to the White House.

— Brett Joshpe, CFA, is an attorney in New York City and the principal of Joshpe Law Group LLP. He is also a co-author of the book Why You’re Wrong About the Right.


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