Notes on the 2017 Massachusetts Investor Conference (Part 1)

The Massachusetts economy is experiencing its most robust expansion since the late 1980s. Third quarter GDP growth was clocked at 5.9%, according to Mass Benchmarks. Leading indicators anticipate 2017 fourth quarter GDP growth of 3.3% and 2018 first quarter growth of 3.0%. Massachusetts’ unemployment rate was 3.9%, below the national average of 4.1%. Job creation has been strong and broad-based, except for manufacturing. Early in the recovery cycle, hiring was concentrated among white collar workers, but more recently, blue collar workers have been the primary beneficiaries of continued job growth.

Despite the overall improvement, economic conditions remain difficult for selected communities, regions and demographic groups. The broadest measure of unemployment, U-6, was estimated at 7.6% for Massachusetts, nearly twice the rate of unemployment, but below the national average of 8.3%. Those with fewer skills and less education are far more likely to have trouble finding work. The state relies heavily on foreign-workers, especially for seasonal employment in areas like Cape Cod.

Real estate development has been booming in Boston, but much less so in other Massachusetts cities. Growth in Boston’s economy has put pressure on its infrastructure – housing is expensive, and traffic is congested. Inadequate infrastructure, such as water and sewer, and archaic zoning and land use regulations limit growth opportunities in cities outside of Boston.

One of the biggest risks to the continuing economic expansion in Massachusetts is “unforced” policy errors at the Federal level. A potential decline in Federal Medicaid reimbursements would put significant pressure on the Commonwealth’s budget. Other risks include geopolitical events, such as instability in important nations abroad and terrorist attacks, and the impact of rising interest rates.

Despite these risks, Massachusetts seems to be among the best positioned states to navigate the next economic downturn.

Governor Baker and Treasurer Goldberg. In July, the Massachusetts legislature passed a $40.2 billion budget for fiscal 2018 that cut spending from initially planned levels by $400-$500 million. The cutbacks were necessitated by a $400 million shortfall that arose near the end of fiscal 2017, which led to a $733 reduction in projected fiscal 2018 tax revenues. With these spending cuts, state spending in fiscal 2018 will be flat with 2017. The projected increase in fiscal 2018 tax revenues was reduced from 3.9% at the beginning of the budget negotiations to 2.9% in the final budget; but that is still higher than fiscal 2017’s 1.4% revenue increase.

The fiscal 2018 budget calls for a slight increase in spending on schools and local aid, but cuts spending in other areas. It factors in $250 million in Medicaid savings identified by the Governor, but a proposal that he offered to rein in the growth in Medicaid spending was rejected by the legislature due mostly to time constraints.

Although the governor’s proposals may change, his earlier proposals centered around tightening eligibility requirements (especially for those who have the option of getting health insurance from their employers), increasing the payments required from enrollees whose incomes are above the poverty line, instituting a work requirement (or obligation to look for work) for those currently unemployed; and pushing health care providers to reduce costs (in part through benchmarking).

On November 10, the Massachusetts Senate passed a health care reform bill that seeks to narrow cost differentials between large and small hospitals, reduce drug costs and commission a study for a single-payer system. The House must now pass its own version, which will then be reconciled with the Senate’s bill and sent to the Governor for his signature. Momentum for the bill’s passage has slowed, however, as the legislature has been mostly on break for the past few weeks, and Governor Baker has complained that the bill does not save the state any money.

The budget also raises $200 million by creating a temporary employer contribution to help pay for employees whose health insurance is covered by the Commonwealth. To ease the burden on business, future planned increases in the unemployment tax will be scaled back.

The budget was approved 140-9 in the House and 36-2 in the Senate. Governor Baker subsequently cut an additional $320 million from the budget through line-item vetoes. House Speaker De Leo said that in a tough fiscal climate, the legislature delivered a responsible budget that makes targeted investments and protects the state’s most vulnerable citizens. Senate President Stanley Rosenberg said it was the harshest state budget since the last recession.

Legislators rejected a proposal by the Governor to institute a hotel tax on residents who rent out rooms (via Airbnb and others) for more than 150 days. A ballot initiative has been proposed to amend the constitution of the Commonwealth to enact a 4% tax surcharge on residents with annual incomes over $1 million.

The shortfall in state revenues seems at odds with the latest economic trends showing a sharp pick-up in the growth of employment and the economy. In early September, the Massachusetts Budget and Policy Center said that like the rest of the U.S., the Massachusetts economy has seen little or no wage growth. The Commonwealth has also experienced a decline in capital gains taxes and slowing sales tax revenues, perhaps because of the increasing popularity of shopping online.

Mass Benchmarks reported that the state’s economy slowed markedly in the 2016 fourth quarter and actually contracted slightly in the 2017 first quarter. But economic growth has picked up in the 2017 second and third quarters, which suggests that tax revenues will pick up in the months ahead.

In fact, tax collections, as reported at the latest Commonwealth Credit Review in October (with data through September), were up 2.6% year-to-date and 2.0% ahead of the benchmark level (i.e. budgeted amount). The increase was due to higher tax collections across all tax types (with net income tax revenues up 2.9% year-to-date and 2.0% over benchmark).

The Massachusetts economy is diverse and robust, thanks to its long-standing focus on enhancing its competitive advantage and capitalizing on economic opportunities. For years, the state has used the resources and intellectual capital of its world-class education institutions to convert ideas into products and products into businesses.

Governor Baker highlighted the strategic investments that Massachusetts is making – in housing, economic development, transportation and environmental policy – to strengthen communities, support the economy and position the Commonwealth to face future challenges

Massachusetts has invested in infrastructure to support its economic growth. The central artery tunnel (f/k/a the “Big Dig”) is the most visible example of such investment. More recently, the Mass Port Authority has undertaken projects to expand the number of international gates at Logan airport to meet increased demand and upgrade its container terminals to accommodate larger ships.

A housing bond bill is winding its way through the legislature and may be passed before the end of the current session. The bill provides $1.7 billion over the next five years to promote the development of affordable housing around the state, as well as the renovation and rehabilitation of existing housing stock.

With the help of Federal grants, Massachusetts is bringing high speed internet to communities that currently do not have it, mostly in the western part of the state.

The Baker-Polito administration has also promoted the establishment of a Seaport Advisory Council to encourage 78 coastal communities to strengthen their resiliency to superstorms and rising sea levels.

The Administration also continues its quest to improve the operation of the MBTA. For several years, the MBTA has focused on upgrading signals, switches and train cars to improve reliability, especially on the Orange and Red lines, the two busiest in the subway system. Governor Baker cited a July New York Times Op-Ed by Chicago Mayor Rahm Emanuel which credited that city’s subway system’s strong performance and favorable consumer ratings to its emphasis on reliability over expansion.

Education. Massachusetts’ schools have consistently ranked #1 in the country and among the top ten globally in English and math. The Commonwealth has opted out of the Federal government’s common core standard in favor of its own Massachusetts Comprehensive Assessment System (MCAS).

Massachusetts is also investing in vocational and technical schools to meet the needs of employers for entry level employees with adequate technical skills; but it seeks greater participation from employers in funding, curriculum development and offering jobs and internships.

The Commonwealth is also keenly interested in developing alternative pathways for college. It hosted a Digital Learning and Innovation Conference in September. It wants to provide education alternatives for those who must juggle work schedules and personal commitments to earn their degrees.

Pensions. The Pension Reserves Investment Management Board (PRIM) is a self-funded, quasi-state agency that manages the $70 billion Pension Reserves Investment Trust Fund (PRIT) on behalf of the Commonwealth. PRIT holds the assets of the Massachusetts State Employees, the State Teachers and Boston Teachers retirement systems, as well as the retirement assets of certain of the Commonwealth’s cities, towns, districts and agencies.

PRIM is managed by a nine-member Board of Trustees, chaired by State Treasurer Deborah Goldberg. It has four advisory committees and a staff of 41 professionals. Throughout its history, PRIM has been primarily an asset allocator that utilized external managers for nearly all PRIT’s assets. Over the past few years, it has begun investing more assets directly (for example in real estate and by taking minority positions in private equity deals) in part to reduce management fees. It is now considering managing more of PRIT’s assets internally.

PRIM’s mission is to maximize the total return on PRIT’s investment portfolio to ease the pension funding burden on Massachusetts’ taxpayers. It seeks to achieve a total return on the investment portfolio that is equity to the investment return assumption used to calculate the Commonwealth’s unfunded pension liability. Currently, its total return target is 7.5%.

As of October 31, PRIT’s total annualized returns (gross of fees) have exceeded the core benchmark by 150 basis points for one-year performance, 100 basis points over 5-years and 20 basis points over 10 years. Its long-term targeted fund allocations are 40% in global equities, 22% in fixed income (core and value-added), 14% in real assets (real estate and timberland), 11% in private equity and 13% in portfolio completion strategies (i.e. funds designed to achieve specific retirement objectives such as beating inflation, protecting against volatility and meeting the longer payouts required by increased longevity). 42% of the portfolio currently qualifies as “alternative” assets.

Project SAVE is a PRIM program designed to enhance the overall returns of the portfolio by reducing costs. It produced $127 million in savings during its first phase. A large portion of the savings was achieved by eliminating middle men and pursuing direct investments. For example, PRIM re-engineering its hedge fund program by shifting from a fund-of-funds approach to direct hedge fund investments and employing hedge fund replication strategies. It has developed alternative strategies for harvesting risk premiums and uses hedging to mitigate equity risk. As noted, it now pursues direct investments in real estate and private equity co-investments (i.e. taking minority positions in operating companies alongside the primary private equity investor). Phase II of Project SAVE, now underway, will consider whether PRIM can achieve further cost savings by managing some of its funds internally.

The Commonwealth’s pension system covers about 325,000 employees, retirees and beneficiaries. As of January 31, 2017, its actuarial liability was $91.6 billion, of which $39.6 was unfunded, which equates to a funding ratio of 56.7%. Net of employee contributions and including administrative and other expenses and transfers, the annual (i.e. net normal) cost of the pension program was $642 million. However, the Commonwealth expensed $2.66 billion in fiscal 2017 in total for post-employment benefits. The difference of $2.0 billion is a catch-up payment for the unfunded actuarial liability (UAL).

After falling to less than $5 billion in 2000, the UAL ballooned to $21 billion in 2009 due to investment losses suffered during the 2008 financial crisis. In 2010 and 2011, the Commonwealth enacted pension reform that 1) reduced post-retirement benefits to plan members hired after April 1, 2012 and 2) increased the latest date for the elimination of the UAL to 2040.

The Commonwealth then had to establish a funding schedule, incorporating key actuarial assumptions such as mortality, the rate of increase in average salaries and projected returns on PRIT assets, that would eliminate the UAL by the 2040 target date. Without running through the specifics of the formula, it decided for budgetary purposes to fund only a portion (~70%) of this annual required contribution (ARC), but would then increase its payment by about 9% annually until fiscal 2036. Under this schedule, the Commonwealth’s annual payments would catch up with the ARC in about six years, and exceed it thereafter. The fiscal 2018 post-retirement appropriation, covering both normal costs and the catch-up payment, was set at $2.39 billion.

Investment returns are obviously important to the calculation of the UAL. More than half of the $11.25 billion increase in the UAL since 2009 was due to the reduction in the investment return assumption in three steps from 8.25% to 7.5%. (Of the remainder, nearly 25% increase in the UAL was due to changes in mortality assumptions; 13% to plan amendments and the rest to other actuarial adjustments.)

There is still pressure to reduce investment return assumptions. Two other large pension plans, CALPER and CALSTRS, have committed to reducing their investment return assumptions to 7.0% from 7.5% over the next few years. Yet, the Commonwealth’s 7.5% assumption is equal to the current national average. According to an informal poll of public sector actuaries taken in April 2017, current investment return assumptions most commonly range from 7.00%-7.75%. Although PRIT’s investment returns have averaged only about 5% annually over the past decade, it has achieved returns in excess of 7.5% annually over a longer-term horizon (20+ years).

The Commonwealth calculates that eight percentage points of the decline in the funding ratio since 2009 is due to changes in assumptions and plan provisions. Consequently, much of the decline represents the use of more conservative assumptions. If the market holds up and PRIM can at least meet its performance benchmarks, this will help Massachusetts reduce its UAL over time.

Link to:
Notes on the 2017 Massachusetts Investor Conference (Part 2)

December 16, 2017

Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246

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