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The retired firefighters, police officers, teachers and other state and municipal employees of Wisconsin are set to suffer yet another reduction in their monthly pension checks. On May 1, for the fifth year in a row, many of the 168,000 retirees and beneficiaries in the Wisconsin Retirement System (WRS) will begin receiving payments that are as much as 13 percent smaller than in 2012.

But it’s not just retirees who will have more trouble making ends meet in the Badger State. The 256,000 active employees in the WRS have been taking home smaller paychecks since July 2011. That is when Governor Scott Walker and the state legislature, as part of an effort to close a $3.6 billion state budget gap, mandated that public workers split the required contributions with their employers. Before that Wisconsin municipalities picked up most or all of their employees’ share of pension contributions.

At first glance, these reductions look similar: Both retirees and active employees will take home or receive less money than in years past. But there is a key difference. While current employees have recently begun to share their pension contributions with their employers, the retiree reductions are a direct result of a well-­constructed pension machine that increases or decreases payouts in tandem with the gains and losses in the WRS’s investment portfolio, which now has $84.6 billion in assets. Designed decades ago and unique among the 50 states, the ninth-largest public pension system in the U.S. features a mechanism that insulates Wisconsin from wide swings in funding by balancing both cost-sharing and risk-sharing between employers (that is, taxpayers) and employees.

Wisconsin’s multilevered retirement machine also awards pensioners an annual “bonus,” or dividend, when asset prices are rising that has reached as high as 17 percent (during the bull market in 1999). Retirees can also rest assured that their pensions are secure for the long haul despite any short-term gain or pain, because the adjustability feature keeps the WRS close to 100 percent funded. For their part, taxpayers can take comfort in knowing they won’t get hit with an increase because of a shortfall in the pension trust fund. Although the investment portfolio lost 26 percent of its assets in 2008, when the financial crisis exploded, taxpayer savings have been impressive: At the end of the 2013–’14 pension calendar year, the state will have shaved total pension benefits by $4 billion over five years.

“The Wisconsin Retirement System is fully funded, and the explanation is largely based on the design of the system,” says David Villa, who joined the Madison-based State of Wisconsin Investment Board (SWIB) as its first chief investment officer in June 2006. Villa is responsible for ensuring that the WRS achieves the top returns needed to deliver its 76 percent share of the system’s contributions (employers and employees split the rest).

It turns out that the Midwestern state best known for cheese and beer also has the best-designed and best-governed pension system in the U.S. The WRS’s ability to balance employer and employee gains and losses has sheltered Wisconsin from the pension problems that are running rampant in other states. Neighbor Illinois has only about 45 percent of the assets needed to meet future pension liabilities in its state employees’, teachers’ and university systems. In total, U.S. public pensions have a $757 billion underfunding hole, according to a June 2012 report by the Pew Center on the States.

The WRS was not immune to the financial crisis, losing $22.7 billion in 2008. So it’s a little ironic that although former Wisconsin public employees are still feeling the pain in the form of payment reductions, these very payment reductions are the reason state retirees are likely to continue to receive their benefits in the future.

The Wisconsin pension machine aligns the interests of its employees, taxpayers and investment office. Beyond the adjustable gears and switches that pass on investment gains and losses to Wisconsin retirees and tax savings to citizens is a system of governance that ensures employers and employees make every required contribution, in up and down markets. The third critical element is a bulletproof trust fund that prevents poaching by state officials in search of extra revenue. On top of it all is an investment process that is akin to the more risk-based investing used by top educational endowments and foundations.

“It’s one of the best-run, best-funded public pension plans in the country,” says Dale Knapp, research director of the Wisconsin Taxpayers Alliance, one of the WRS’s vigilant watchdogs. “It’s not something the legislature can get its hands on.”

“This is a good demonstration that defined benefit plans can work and they should not be written off,” adds Peter Gilbert, former CIO of the Pennsylvania State Employees’ Retirement System and the current investment chief for the endowment at Pennsylvania’s Lehigh University. “It’s critical to have the right design, and it’s critical that the employer funds the plan.”

In the wake of the financial downturn, state retirement systems have come under increasing attack by governors and legislatures desperate to balance budgets and stave off tax increases. Kansas, Louisiana and Virginia have replaced their defined benefit plans with cash balance or hybrid plans for new employees. Alabama closed its plan at the end of 2012 and replaced it with a new defined benefit scheme that will weaken future retirement benefits. Since 2000 nine state legislatures, including Florida, New York and Ohio, have enacted optional defined contribution plans for their public servants. Last year New York State Comptroller Thomas DiNapoli had to push hard to keep the new plan optional.

With so many states jeopardizing their retirees’ futures, it was little wonder that, in a bid to close a $3.6 billion budget hole in early 2011, then newly elected Wisconsin governor Walker successfully ended collective bargaining rights for unionized state workers and doubled their pension contributions, while cutting the pension cost to taxpayers in half (by requiring a 50 percent contribution by employees that had previously been bargained away). Although the budget gap was unrelated to the retirement system, which was fully funded, Walker set his cost-cutting sights on the defined benefit pension. In June 2011, under the governor’s direction, the Republican-led legislature ordered a yearlong study of the retirement system to determine whether a defined contribution plan for public employees would better serve the state’s needs. The legislature also wanted to examine whether employees should be permitted to opt out of making contributions.

“We have obviously in the past two years been pretty willing to be bold — that’s an understatement — about tackling issues out there,” Walker told Institutional Investor in December. “One of them we looked at was, could we change from a pension to a 401(k) system?”

In fear of losing their promised benefits, a record 15,265 WRS participants retired in 2011, nearly double the number that had retired the previous year. Their worries, however, proved unfounded. The pension system study, released last June, made a thorough accounting of all the ways in which the WRS was a model of excellence. Says Michael Huebsch, whom Walker appointed as secretary of the Department of Administration, the second-most-powerful role in Wisconsin government: “I summed it up to the governor: The system isn’t broken, and there’s no reason for us to tinker with it. And we’re not going to.”

In the midst of the ongoing political wrangling, which led to Walker’s June 2012 recall election and subsequent second victory, SWIB CIO Villa has been working hard to grow the WRS for its members. After all, their dividends depend on it.  Villa took aim at portfolio risk, earning a top-quartile ranking from San Francisco–based investment consulting firm Callan Associates. Calling himself the “chief risk guru,” Villa says, “If you can earn 50 basis points more on $80 billion while taking less risk, that pays a lot of $2,100 [monthly pension] checks.”

As a result of the devastating 2008 loss, the nine SWIB trustees, including Huebsch, in 2010 approved a new strategic asset allocation to reduce investment risk. This initiative lowered the fund’s reliance on equities and added a “best ideas” portfolio — a sort of internal hedge fund; SWIB launched a direct hedge fund portfolio in February 2011. With all the complex alternative-asset additions to the portfolio, and looking to cut costs, Villa has expanded the rigorously trained internal investment team to bring more investment duties in-house. Since 2007 in-house assets have grown from 21 percent to 55 percent; two thirds of that is in public market assets.

But Villa’s vision for his role goes beyond risk management and fund performance. The CIO, who comes from a family of teachers, has established a relationship with the nearby University of Wisconsin to draw upon the institution’s considerable resources. He established internships that make use of both the business school and its Applied Securities Analysis Program. An internal education program motivates investment staff to pursue a life of learning through academic research. “We’ve worked hard to strengthen the relationship with the university,” says Villa, who also set up weekly “office hours” visits from two economics professors.

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