Over the past month, Michigan and Pennsylvania lawmakers joined a handful of other states in passing meaningful pension reform. It’s high time for the rest of the nation to follow their lead.
Unfunded pension liabilities today are pushing many cities close to bankruptcy; state pension plans are similarly in dubious fiscal health.
State public pension funds are now underfunded by nearly $5.6 trillion, according to Unaccountable and Unaffordable 2016, recently published by the American Legislative Exchange Council (ALEC). This represents a$900 billion increase from a comprehensive report by State Budget Solutions in 2014. The combined price tag for all unfunded public pension liabilities in the United States is $17,427 for every man, woman and child.
This $5.6 trillion estimate is substantially higher than reported by official state financial statements because it assumes a risk-free rate of return rather than the overly optimistic returns used by far too many state pension funds. This pension study by ALEC analyzed more than 280 state-administered pension plans and found the simple, unweighted, average discount rate to be 7.37 percent. This far exceeds the risk-free rate of 2.344 percent.
Overestimating future returns leads to artificially lower annual required contributions and dramatically underestimates actual pension liabilities. In short, assuming a higher rate of return exaggerates the future value of existing pension fund assets. Over time, underfunding stemming from this inaccurate portrayal of the fiscal situation leads to a combination of diminished essential services, broken pension promises and higher taxes. If a plan is properly funded, the vast majority of annual pension payouts will come from investment earnings on accumulated assets. Underfunding results in these payouts relying far more on current year tax revenue, either creating an impetus for higher taxes or diverting resources from government services.
According to public finance scholars Robert Novy-Marx and Joshua D. Rauh, “The states use discount rates that are unreasonably high.” As former Social Security Administration deputy commissioner Andrew Biggs and economist Kent Smetters have explained, “No matter how well a pension plan manages its investments, it cannot generate 8 percent returns with certainty.” Faced with unrealistically high expectations, state pension fund managers often embrace overly aggressive investment strategies that expose taxpayers to additional risk. In addition to expecting unrealistic investment returns, many state governments fail to make their annually required contributions (ARC). Pew Charitable Trusts, a nonpartisan think tank, defines the ARC as “the minimum standard set by government accounting rules.” Unfortunately, several states have reduced their annual contributions, either failing to make full ARC payments, or skipping payments altogether. According to a Pew Charitable Trusts report, only 21 states made their full annual required contributions in 2013.
Unlike the GASB-influenced Consolidated Annual Financial Reports (CAFRs) and actuarial valuations, State Budget Solutions uses a more reasonable valuation to determine the unfunded liabilities of public pension plans. Given many plans’ assumed rates of return are too high and invite risk, State Budget Solutions uses a more prudent rate of return, rather than the loftiest goals of money managers. This study uses a rate of return based on the equivalent of a hypothetical 15-year U.S. Treasury bond yield. Since this is not presently offered as an investment instrument, the number is derived from an average of the 10 and 20 year bond yields. This year’s number is averaged from March 2015 to March 2016. The resulting rate is 2.344 percent, which is considered a risk-free rate. As the Society of Actuaries’ Blue Ribbon Panel recommends, “The rate of return assumption should be based primarily on the current risk-free rate plus explicit risk premium or on other similar forward looking techniques.”
Prudent valuation provides the best insight into the real unfunded liabilities states face. It is important for states to adopt this model because states must first understand their true liabilities so they can keep their promises. By failing to measure liabilities accurately, any attempt at a solution will be hindered.
Top Five States With Highest Unfunded Liabilities
- California $956 billion
- Illinois $363 billion
- Texas $360 billion
- New York $348 billion
- Ohio $331 billion
Five States With Lowest Funding Ratio On Public Pension Plans
- Connecticut 22.8%
- Kentucky 23.4%
- Illinois 23.8%
- New Jersey 26.9%
- Michigan 27.5%
Thankfully, legislators in Michigan and Pennsylvania recently passed meaningful pension reform.
In Michigan, SB 401 brought meaningful pension reform to the state. According to the legislative analysis of the bill, “the new plan will close the Michigan Public Employees’ Retirement System (MPSERS) hybrid pension plan. That plan has been in place since 2010. The plan will close to new employees on February 1, 2018. This plan will be replaced with an optional hybrid plan that contains the same benefit calculations, but will include a 50/50 cost share between employers and employees.” The legislation also says the assumed rate of return will be a less optimistic 6 percent annually.
The bill also replaces the current defined contribution (DC) plan with a new DC plan, which mirrors the current plan for state employees. This new plan will contain an automatic employer contribution equal to 4 percent of the participant’s compensation plus a 100 percent matching contribution capped at an additional 3% of a participant’s compensation. The current optional plan offers a 50 percent employer match capped at 3 percent of employee compensation. Perhaps the greatest defense to the taxpayer is the trigger added to the plan. If the actuarial funded ratio falls below 85 percent for two consecutive years, the hybrid plan will closed to new employees. Public school employees hired after Jan. 31, 2018, may choose between the new hybrid pension plan and a DC plan.
In Pennsylvania, Governor Wolf and legislators worked in a non-partisan basis to craft meaningful reform that will provide existing employees and retirees a path to a more secure retirement. Future employees will no longer rely on a pure defined benefit (DB) system, but rather a choice between three retirement savings options. The available options will include two DB/DC hybrid retirement plans and a DC retirement plan.
Pennsylvania’s unfunded pension liability is currently $212 billion using the ALEC risk free rate of return assumptions (using rosier assumptions, the unfunded liability is still a whopping $76 billion). Without reforms, the pension debt would have continued to increase, creating dire challenges for the state budget, taxpayers and retirees. Honoring pension promises while protecting taxpayers requires reform. As former Utah Senator Dan Liljenquist, author of the ALEC publication Keeping the Promise: State Solutions for Government Pension Reform, study has rightly noted, pension reform is a not a partisan problem, but a math problem. The time is now for governors and state legislators to pass legislation that will keep the promise for taxpayers, government employees and government retirees.