In September, Oklahoma Governor Brad Henry and Treasurer Scott Meacham flew to New York to talk up the state’s strong economy with the three leading credit rating agencies. They were hoping to persuade Moody’s Investors Services, the most skeptical of the trio, to upgrade its rating on the debt of the energy-rich state. Doing so would save Oklahoma millions of dollars on future borrowings and allow the two politicians, both of whom are facing reelection campaigns this fall, to claim that
they had helped repair the state’s reputation as a poor, agrarian backwater. Skipping breakfast, the best friends from law school jumped into the back seat of a black SUV for the rush hour trip from the Waldorf-Astoria hotel in midtown to Moody’s office, near Wall Street.
There, sitting around a conference table, before an expansive view of lower Manhattan, first Henry, then Meacham took turns pitching Moody’s analysts. They boasted, among other things, that lottery revenues and high energy prices had strengthened the state’s rainy day fund, equal to 10 percent of its general revenues, so that it was full for the first time in its 21-year history.
So far, so good. Then, toward the end of the 90-minute meeting, the mood turned sour. Ted Hampton, an analyst who helps cover Oklahoma for Moody’s, began to grill the pair about the state’s biggest public pension plan, the Teachers’ Retirement System of Oklahoma, or TRS. Its assets were less than half of its liabilities, and current funding wasn’t nearly sufficient to amortize the unfunded liability of some $7 billion over 30 years, he noted: If not for that deficit — an amount about equal to the state’s annual budget — Oklahoma’s Aa3 rating, which puts it in the lowest quartile of states, would probably be higher.
What, Hampton wanted to know, were they planning to do about it?
“It was the first confirmation that it was impacting our rating,” says Meacham of the funding gap. An MBA and former banking executive, he had expected the question but had no ready answer — much less a solution. “I told them it was a matter of making the TRS a priority with the legislature,” he adds.
Not good enough. And with reason: Although Oklahoma enjoys a deserved reputation for fiscal conservatism at the state level, its pension systems, along with those of West Virginia, Indiana and Illinois, rank among the worst-funded in the nation. Altogether the state’s seven systems post an aggregate funding ratio — assets over liabilities — of just 60.5 percent, far below the 85 percent public plan average estimated by Wilshire Associates. Their total unfunded liability comes to approximately $10 billion — nearly $3,000 per capita. If not addressed, it could force the state to make, Meacham reckons, contributions of “staggering proportions” that would require Oklahoma to raise taxes or cut critical programs.
During the long, cramped return flight in the Sooner State’s twin-engine turboprop, Meacham resolved to jump-start the process of shoring up the beleaguered pension system. What he ended up doing, once he was ensconced in his office in the Oklahoma state capitol, was setting off a political firestorm that pitted him squarely against the pension system’s investment overseers as well as many in the state legislature, including some from his own Democratic party. While generating a rash of local headlines, he managed to raise uncomfortable questions about the kinds of investments state plans should make and the role elected officials should play in public investment decisions.
Oklahoma’s state treasurer has no direct role in administering or investing the state’s retirement pools. But he does have a bully pulpit and some bureacratic resources. Using his position as chairman of the state’s seven-member, nonpartisan Pension Oversight Commission, which monitors the state’s public pension systems, Meacham assigned his deputy, James Wilbanks, director of revenue and fiscal policy, to draw up a status report and recommend solutions. A draft emerged in February, titled “Crisis in the Oklahoma State Pension Systems.” It recommended that the legislature make a one-time infusion of $100 million into the TRS and consider issuing pension obligation bonds on the public market to shore up the system’s solvency.
More controversial, perhaps, the draft chided investment officials for allegedly endangering retirees’ welfare by taking excessive risks to make up for poor funding levels. Using loaded language, Meacham’s report took aim at the TRS’s higher-than-average equity allocation — 74 percent at the end of March — and at the Oklahoma Police Pension and Retirement System’s (OPPRS) lofty allocations to private equity and hedge funds — 5 percent and 23 percent, respectively (see table, page 32).
“The high-risk, high-reward nature of investing in private equity is the equivalent to betting a trifecta on a horse race with pension system funds,” the report stated. “If you bet on the winning horses, you can score a huge win; but if you pick the wrong horses, you stand to lose big.”
The draft report, written with minimal input from outside the treasurer’s office, peeved some state pension officials who learned about it only after it was leaked to the local press, prompting some to fret about Meacham’s grandstanding and fear-mongering. “I had no idea this was coming down until I saw the paper in my driveway,” says Tommy Beavers, TRS executive secretary. “Most of the 80-year-old widows now think they’re not going to get their retirement checks.”
That may be why, at a meeting in March to hammer out the final report, Meacham’s investment recommendations were beaten back by other members of the Pension Oversight Commission and by independent-minded trustees of the retirement systems. Robert Wallace, executive director of the Police Pension and Retirement Board’s fund, took particular offense at Meacham’s horse race analogy. The fund’s exposure to alternatives, which dates to 1993, is “proactive and a bit enlightened,” Wallace says, adding, of Meacham, “The chair of the pension commission is running for office, and this may be a political move.”
Meacham’s admonitions didn’t fare much better with the parsimonious legislature. In a contentious election-year special session in June, legislators declined to inject more money into the TRS. If anything, the legislature may have made matters worse when it chose to reduce the state’s surplus revenues by slashing the top state income tax from 6.25 percent to 5.5 percent over three years. The tax cuts will hurt state contributions to TRS by some $57 million through June 2010, Beavers says. The only pension-related victory Meacham can point to is the passage of a bill that requires the legislature to conduct an actuarial study of costs before benefits can be increased.
“We’re disappointed, and the legislature didn’t make a wise decision,” says Meacham. “But we’ll be back next year.” Whether he will return is an open question. This fall Meacham will be running his first campaign for public office. He faces Howard Barnett, a Tulsa financier who served as chief of staff to Oklahoma governor Frank Keating from 1999 to January 2003. Meacham’s success may depend in part on how far Governor Henry’s halo will extend. In July, Henry had an approval rating of 75 percent and polled strongly against his rival Ernest Istook Jr., a social conservative who has served seven terms in the U.S. House of Representatives.
Barnett criticizes Meacham’s efforts at pension reform as timid and simplistic: “Scott says there’s a simple answer, that more money must be placed in the system. I don’t think it’s that simple.” Barnett thinks the state would be better off shifting away from a defined benefit program. “Taking extra money and offering incentives for current members to convert to defined contribution plans has got to be part of the mix,” he says, adding that retirement benefit formulas might also be changed to reduce the unfunded liability.
Barnett adds that Meacham, tied closely to a governor who made tax cuts a priority in an election year, “failed to raise the roof” about the pension crisis. “If I’m elected, I’ll make this the cause célèbre,” he says.
In addressing the pension crisis, Meacham has raised his profile and bolstered his credentials as a defender of fiscal sobriety, a protector of public services like schools and highways. “I’m pro-education,” he says, noting that his mother worked for 30 years in the public schools as a first-grade teacher and principal in Chickasha, a town of 16,000 in western Oklahoma. “It’s all we talked about around the dinner table.”
Meacham was appointed to his post in June 2005, replacing Robert Butkin, who left to become dean of the University of Tulsa College of Law. After 13 years as a small-town banker, Meacham became Governor Henry’s director of the Office of State Finance in 2001. He continues to serve in the governor’s cabinet as secretary of Finance and Revenue. He is such a close adviser to Henry that many refer to Meacham as the governor, only partly in jest.
Yet even Democratic legislators convinced of Meacham’s sincerity question his political acumen. “He doesn’t understand political realities,” says State Senator Kenneth Corn, who serves on the Pension Oversight Commission and is, as chairman of the Senate Majority Caucus, the chamber’s third-ranking member. It didn’t help Meacham that the Oklahoma House of Representatives is controlled by Republicans and in the Senate the Democrats have only a slim majority.
Meacham’s pension fund campaign comes at a crucial time. Numerous states and municipalities are struggling under the burden of accumulated retirement promises and, like Oklahoma, are looking for ways to goose their investment returns.
Many state plans are moving into what Meacham and some financial observers consider riskier assets, such as private equity, hedge funds and other alternatives. Although only about one third of public systems invest in hedge funds, those that do have boosted their investments from $2.18 billion in 2002 to $17.2 billion in 2005, according to Greenwich Associates. The average state pension plan allocation to private equity rose from 3.6 percent in 2001 to 4.4 percent in 2005, reports Wilshire Associates.
The sweeping reform legislation passed by Congress in early August includes a provision that would let hedge funds manage significantly more public pension money. On the state level, last month New Jersey disclosed that it was readying a plan to shift about one quarter of its $72 billion in assets to private money managers, with a new emphasis on investments such as hedge funds, emerging markets and commodities. In June the board of the California State Teachers’ Retirement System (CalSTRS), the nation’s largest teachers plan, with some $145 billion in assets, decided to raise its target for alternatives from 6 percent to 9 percent. “We’re long-term investors; we’re willing to take more risk to get more return and be less concerned about year-to-year volatility,” says CalSTRS’s CIO Christopher Ailman.
It’s common for elected officials to participate in pension fund investment decisions, usually in their role as pension trustees. In California, for instance, State Treasurer Phil Angelides, who will face Arnold Schwarzenegger in the gubernatorial race this fall, sits on the boards of the California Public Employees’ Retirement System and CalSTRS, the nation’s two biggest public pension funds.
In Oklahoma the treasurer has no direct role in the management of the state’s pension systems. As chairman of the Pension Oversight Commission, though, he can make recommendations on all aspects of pension management. The commission includes one representative from both the State House and Senate, three ex-officio members — including the treasurer as chairman — and two appointees of the governor.
Elected officials involved in pension systems have been criticized for being overzealous corporate activists or for trying to steer pension assets into environmental and other politically popular areas, such as urban development, that may not offer the best returns. There’s also the risk of cronyism and the possibility of sleaze. Ohio’s “Coingate” scandal, centered on the state’s $21 billion Bureau of Workers’ Compensation, has led to four misdemeanor ethics convictions against Governor Bob Taft, a guilty plea by the bureau’s former CFO, Terrence Gasper, to charges that he accepted bribes, and the indictment, on more than 50 counts of corruption, of Thomas Noe, a coin dealer who raised more than $100,000 for President Bush’s reelection bid. In February an Ohio grand jury accused Noe of stealing from the $50 million he managed for the bureau from 1998, when he received the funds, to 2003. His trial is slated to start on October 10. (In May, Noe pleaded guilty to federal charges that he illegally gave more than $45,000 to the Bush-Cheney campaign in 2003.)
Meacham isn’t alone in his conservatism. Zvi Bodie, a professor of finance and economics at the Boston University School of Management, reckons Meacham’s criticisms are wise from an investment and public policy perspective. “By investing in risky assets, all they’re doing is subjecting future generations to extra risk,” says Bodie. He notes that no one has asked taxpayers if they want to take extra risk that could make future payments higher or lower. “It’s doubtful to me that they would want to take that risk.” In a corporate pension fund, in contrast, it’s clear the shareholders are liable, and that is reflected in the price of the stock, he says.
What most galls Meacham, who is also a certified financial planner, is the police fund’s private equity exposure. The asset class suffers from “illiquidity, a lack of information and an inherently more drastic risk profile,” he says. “That makes it ill suited to the public.”
At the March meeting, though, Meacham’s attempt to get the Pension Oversight Commission to recommend in its final report that the police fund cut its private equity allocation target from 10 percent to 5 percent was opposed by all other members of the commission. The report said that several systems “are moving into aggressive, highly volatile investment categories.”
Yet in advocating specific investment targets, Meacham may have overreached, says Jonathan Forman, a University of Oklahoma law professor who counts both the treasurer and the governor as former students. “It’s not unreasonable for the treasurer to weigh in on these issues, but it’s of concern when the state interferes with fiduciary decisions. This is tampering,” says Forman, who also serves as vice chairman of the Oklahoma Public Employees Retirement System (OPERS) board of trustees. “We’re independent of the governor and the treasurer. He can’t say, ‘Buy this’ — although the legislature could pass legislation that mandated investments in certain investment classes.”
Meacham says the Pension Oversight Commission makes recommendations, not investment policy.
When the teachers’ retirement system of Oklahoma opened its doors in 1943, it was already in the red. Thousands of teachers were granted past-service credits that were not funded. Teachers contributed 4 percent of their annual compensation, which didn’t begin to cover the growing liabilities of the fund. The state didn’t start making regular contributions until 1957, when it allocated 78 percent of gross-production taxes levied on natural gas that was extracted in the state. School districts didn’t kick in any money to the retirement system until 1989. Liabilities rose steadily, but gas taxes proved an unstable revenue source. When natural-gas prices slumped, state revenues dedicated to the system plunged, from $140 million in 1994 to $109 million in 1995.
“When we had a pay increase for teachers or changed the benefit formula, the gas tax didn’t know it was supposed to go up correspondingly,” quips TRS executive director Beavers.
To make its contributions more stable, the state in 1999 switched the source of dedicated revenues from gas taxes to a percentage of individual and sales taxes. Oklahoma now allocates 4.5 percent of these revenues to the teachers’ system, a ratio that will rise to 5.0 percent in 2008. Yet funding is far below what’s necessary to restore the plan to fiscal health, and tax cuts going into effect in 2007 will make tax receipts lower than they otherwise would be. Since 1970, total contributions have shortchanged the system by $2.9 billion.
“We’ve never been close to fully funded,” complains Beavers.
At current contribution rates, if actuarial assumptions prove correct, the system won’t reach full funding until 2048, says the plan’s actuary, J. Christian Conradi, who works in the Dallas office of Gabriel, Roeder, Smith & Co.
Oklahoma’s other pension systems were established later and given funding streams tied more closely to actuarial needs. At OPERS, set up in 1964, employees and the state contributed a total 15.5 percent of payroll until 1999; after that a financially strapped state government cut its contributions to 13.5 percent. That’s a primary reason for its underfunding, according to the Pension Oversight Commission. The police system, set up in 1980, receives a combined 21 percent of payroll from employees and the state. Both systems also receive a cut of the state insurance premium tax.
Today Oklahomans face some daunting numbers. It’s particularly true for the TRS, the state’s oldest and biggest system, with 125,000 active and retired members. On June 30, 2005, when the most recent data became available, the system reported assets of $7 billion versus liabilities of $14.1 billion — a funding ratio of 49.5 percent. Only West Virginia and Indiana teachers report worse funding levels. OPERS, the state’s other major plan, is marginally better off, though still in dismal shape: With 68,000 active and retired members, it has assets of $5.5 billion versus liabilities of $7.6 billion, a funding ratio of 72 percent. OPPRS, which covers 6,000 active and retired police officers, has assets of $1.4 billion and $1.8 billion in liabilities, a ratio of 79 percent.
The prognosis is difficult. The obvious solutions — increasing contributions and cutting benefits — are tricky in Oklahoma because current contributions, as a percentage of payroll, are well above the national average; in this year’s budget debate, politicians clearly put a much higher priority on tax relief than on paying down the state’s unfunded liability.
Meacham says that restoring the state’s pension systems to health will require a thorough restructuring and rationalization of funding streams. These are now a hodgepodge of taxes — sales, corporate, personal income and insurance. He also thinks that a portion of rainy day funds should be dedicated to plugging pension deficits and that the legislature should consider alternative financing schemes, such as pension obligation bonds.
Legislators acknowledge the funding problems even as they resist Meacham’s solutions. Twice in the past three years the legislature voted down the issuance of pension obligation bonds. “We believe trading soft debt for hard debt will really get us into fiscal trouble,” says State Senator Corn.
Ironically, Oklahoma has been a model of fiscal conservatism — except where its pension plans are concerned. A statewide majority vote is needed to issue general obligation debt. Although deficit spending is specifically prohibited, the constitution and case law say nothing about pension debt. “There’s been a disconnect between traditional debt and unfunded liability pension debt,” says Tom Spencer, OPERS’s executive director. “This legislature has an insatiable appetite to cut state revenue every year and to raise benefits to the retirement system. It would be like paying off the credit card expenses with a loan and then running up new charges.” The legislature will have to make “a serious move this year or next,” Corn says, to shore up the retirement systems.
Meacham and his team fear the political and economic risk that would result from a sharp downturn. “Our concern is taking on that much risk with a public pension system, where one of the key foci needs to be on protecting assets,” says revenue and fiscal policy director Wilbanks. Although the state’s coffers are flush now, thanks to oil royalties, Oklahoma has a history of booms and busts. “When oil goes down, we’ll be scraping for every nickel to pay for basic services,” says Wilbanks.
The treasurer would prefer less-volatile pension investment strategies that could possibly result in a better state credit rating. Although Standard & Poors and Fitch give Oklahoma a AA bond rating with a stable outlook, Moody’s relatively lower rating increases its borrowing costs by 7 to 10 basis points, according to one municipal bond analyst. An upgrade wouldn’t affect the cost of the state’s current debt, which totals about $1.6 billion, one of the lowest levels in the country. But if the state were to issue $1 billion to $2 billion in pension obligation bonds, as Meacham wishes, he figures it would save $7 million to $20 million annually in interest costs.
Meacham says he’ll keep pressing the issue with the legislature next year. He will also have to face the credit agencies in New York. “When we go to New York, we’ll talk about the positive reforms that were enacted and that we’ll continue to persevere on pensions,” he says.
Of course, all this assumes he wins in November.
