The Arizona State Retirement System is a cost-sharing, multiple-employer plan where participating employer and employee contributions are pooled. All assets, approximately $50 billion, of the plan are shared, pooled for investment, and used to pay for promised pension benefits. Every employer in the state pays the same contribution rate, as a percentage, for each employee. All liabilities are pro rata owned by every employer, who all share in paying for the normal cost and unfunded liabilities of the plan.  

Under this fairly common contribution and liability structure, there is no way for any individual employer to “pay down” or accelerate the payment of their portion of unfunded pension liabilities. Any supplemental contributions from one employer would simply accrue to the entire employer pool.  

What the passage of the contribution prefunding program (CPP) brings is a novel way for government employers to set aside surplus funds to offset future required contributions, essentially allowing them to budget for lower ASRS payments in the future, while continuing to pay the full contributions now.  

The biggest benefit of the CPP is the ability for employer-prefunded contributions to earn the same investment return as the ASRS pension fund. ASRS will grant all pre-funded contributions an earnings rate equal to the actual annual rate of return on the ASRS pension investment portfolio, net of investment expenses. As an example of the return employers could expect to receive on their contributions to the program, ASRS has averaged an annual investment return of just over 9% since plan inception in 1975, although market outlooks in the near term posit a realistic return figure being somewhat lower.  

The growth of individual employers’ funds in the contribution prefunding program will help offset future unfunded accrued liability (UAL) cash requirements and help the employer keep budget stability during poor financial times. Instead of having to cut funding to other programs when pension contribution requirements increase, the employer can simply pull dollars from the CPP to offset that increase.  

The flexibility in this new program is also an important feature. The application of the money in the CPP is up to the employer, with three stipulations. One, for administrative reasons, the minimum prepayment contribution is $100,000. Two, the dollars must eventually be used to offset future pension contributions. And third, once ASRS reaches full funding and therefore has zero unfunded liabilities to be paid down, the plan will no longer accept additional funds into the CPP.  

Apart from that, the employer can choose exactly how and when to use their CPP balances. There is no requirement that the employer must use the funds within a certain time frame, allowing the employer to take advantage of the compounding returns from the ASRS investment portfolio. 

For an example of the possible employer savings from participating in the CPP, we use three hypothetical ASRS employers and assume each plan has a $100 million unfunded liability. For the purposes of this analysis, we assume: 

• Each employer’s payroll begins at $52 million and grows at 3% per year.  
• Employers have a payroll contribution of 8% to pay down the UAL.  
• Two employers choose not to contribute any dollars to the CPP. 
• The other employer chooses to contribute $20 million to the CPP in 2022. 
• The CPP employer wants to amortize (use the dollars in the CPP) over a 10-year period to help offset future contribution requirements.  
• CPP contributions are assumed to grow at ASRS assumed annual rate of 7%.  

For the employers who decided not to join the contribution prefunding program, their 10-year total contributions would be $48,245,443. For the employer who decided to contribute $20 million to the CPP, and use those funds to offset future contributions, their 10-year total contribution would be $40,248,304. The annual contribution amounts are seen in the chart below.  

Contributions for Hypothetical ASRS Employer

Under this scenario, the employers who neglect to join the CPP would pay roughly $8 million more over just that 10-year period. This is due to the compounding interest discussed earlier. The CPP employer’s $20 million, minus the amount used to offset each year’s contributions, is gaining 7% interest compounded annually.  

Senate Bill 1082 is a win for Arizona, the Arizona State Retirement System, government employers, and taxpayers. It is another important step forward in the successful and ongoing process of improving the state’s public retirement systems. With the wave of investment volatility and the costs of the average pension plan rising, these prefunding programs could allow employers some desirable flexibility and budget stability as it relates to pension costs. 

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However, despite funding developments from year to year, public pension plans remain subject to an uncertain economic climate, and the next downturn can quickly widen the unfunded gap.

While there are several answers for resolving the enormous debt accrued by pension plans, the standard solution employs a systematic plan to pay off the debt over many years. Usually, UAL is not paid off as a lump sum but is “amortized” over some time.

While the two most common amortization methods are level-dollar and level-percent, only the level-dollar method ensures predictable amortization contributions from year to year. It requires lower payment in the initial years of the schedule because it creates a predictable path to solvency by ensuring that specific amounts are paid each year.

When it comes to open and closed amortization schedules, this analysis graphically illustrates that closed amortization schedules ensure a timely repayment of UAL. Open amortization schedules, on the contrary, run the risk of keeping the amortization payment continually below the interest expense. This leads to perpetual negative amortization and makes it impossible for the pension plan to pay out UAL.

It is also important to keep the amortization period short. For longer amortization horizons, like 25 years, the interest exceeds amortization, leading to wasteful spending. Keeping an amortization schedule at 15 years ensures the intergenerational equity principle, that is, to pay off UAL within the average remaining working lifetime of active members of a pension plan.

The analysis that goes into calculating the amortization schedule relies on an assumption about the payroll growth rate and discount rate to be realized. Notably, the level-dollar amortization does not rely on an assumption about payroll growth, highlighting another advantage of the method. The discount rate, however, plays a critical role in the amortization of pension debt regardless of the method chosen. Setting the proper discount rate reduces the chance that the annual payments will not earn enough returns to pay off the debt eventually.

After thoroughly evaluating these policies, best practices for amortizing pension debt call for several recommendations, these include using level-dollar amortization, a closed schedule that does not exceed 15 years and setting appropriate discount rates. Plan sponsors should adhere to these principles to ensure the pension plan is equipped to fulfill its promises to existing retirees, as well as to assure the future robust functioning of the plan.

When adopting a particular amortization policy for a public pension, policymakers must consider a number of factors and tradeoffs. Time preference and budgetary constraints may prove influential forces in selecting from among the amortization method choices.

However, from the perspective of plan solvency and intergenerational equity, there are best practices that a pension plan can follow in adopting the best possible amortization policy.

(1) The level-dollar method is better than the level-percent method. Using level-dollar avoids actuarial assumption sensitivity, the potential for negative amortization, and requires lower total contributions over time compared to level-percent.

(2) Closed amortization schedules are better than open schedules. Using a closed schedule ensures the unfunded liability will actually be paid off. The open amortization approach violates the basic principles of intergenerational equity because the unfunded liability is never paid off.

(3) The length of an amortization schedule should not exceed the average remaining service years of the plan. This practice adheres the closest to the intergenerational equity principle. Today’s taxpayers, not future ones, should fund the pension benefits of today’s government employees. A good rule of thumb is to adopt schedules that are 15 years or less.

(4) The shorter the amortization schedule, the better. Shorter amortization periods may mean a higher level of contribution rate volatility, but they save costs in the long run and allow the pension plan to better recover from a significant near-term negative experience.

(5) Discount rates should appropriately reflect the risk of the plan’s liabilities. If the discount rate is too high, the recognized value of liabilities will be too low; thus, the value of unfunded liabilities that are amortized will be too low, and the plan will risk not having enough assets to pay promised pensions.

Plans that choose to adopt alternative policies to this gold standard can still make choices that aim for long-term solvency. Specifically:

(6) If using the level-percent method, adopt a closed design with a schedule of 15 years or less. Amortization schedules should always be closed, and the shorter the schedule, the better the policy.

(7) To avoid contribution rate volatility, use a layering method. Seeking to avoid spikes in amortization payments is an understandable budgetary goal, but it is best pursued by layering closed amortization schedules, rather than by using an open schedule.

Full Policy Brief: Best Practices for Pension Debt Amortization

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The defined benefit (DB) pension plans governments use across the United States rely on combining contributions from members and the state with long-term investment returns. This is because they are intended to be prefunded, which ensures that retiree pension expenses are covered fully in the long run. Prefunding benefits this way allows more benefit payments to flow out of the plan than contributions are flowing in without compromising the integrity or solvency of the system.

Analyzing a public pension system’s cash flow—the rates at which money is entering and leaving the fund—is one way to anticipate imbalances in pension plans that must be fixed to ensure long-term solvency.

This policy brief uses the Montana Public Employee Retirement System (PERS) as a case study to illustrate the principles and importance of conducting a cash flow analysis of public pension plans.

Having negative operating cash flow does not necessarily indicate an inherent problem with mature pension plans. However, it can reveal certain risks that should be properly managed. Adopting a funding policy that is responsive to unfunded liabilities would minimize insolvency risk, and using a more conservative return assumption—particularly one that is aligned with short-term market expectations—would help plans better align return assumptions with funding targets.

Full Policy Brief: The impact of cash flow on public pensions

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Which plan type does a better job of actually delivering benefits to the most people?  

It is important to understand the often-overlooked concept of benefit efficiency in concrete conditions. To demonstrate, a hypothetical retirement plan called PERS (Public Employee Retirement System) can serve as a stand-in. This hypothetical pension system uses common characteristics among public retirement plans that offer both DC and DB options. A full list of parameters used for this modeling is provided at the end of this piece. 

Using these parameters and other turnover and mortality data, this piece will examine how a DB plan compares to a DC plan for a cohort of 1,000 employees by comparing their accumulated benefits over a potential lifetime (based on mortality rates). This analysis demonstrates that the DB plan does become optimal when compared to a DC plan for an individual around age 55-60 depending on the entry age. However, for a group of 1,000 employees and for certain entry ages like 22, the DB plan as a whole is never more valuable than the DC plan as a whole. 

For this hypothetical plan, only 33% of workers starting at age 22 remain in their jobs after five years, which is in line with expected retention rates for most public pension plans. For later entry ages, retention beyond the first five years goes as high as 50%. At the 30-years-of-service mark, only about 8%-to-12% of employees remain in their jobs, depending on the entry age. 

DB vs DC analysis for a group of employees 

To include a valuable comparison of how portable DB benefits are compared to DC benefits, the comparison of accumulated benefits will only be made for employees who leave the system. This analysis assumes that a person in a DB plan will try to attain their maximum possible benefit, meaning that if a PERS employee separates (in other words, take another job) at age 35, this comparison would be for their accumulated DC balance to the maximum possible DB benefits they could collect by waiting until the pension systems retirement eligibility. 

The first scenario looks at the cumulative benefits distributed between DC versus DB plans for a standard entry age of 22. Figure 1 shows the cumulative benefits of a DC versus DB plan for every new employee that leaves the system. The first thing that stands out is the stark increase in balances at age 60 for both the DC and DB plans.  

This increase is for two reasons: a spike in retirement rates and a spike in individual DB benefits. For retirement rates, about 940 people leave the system by age 60 and within just six years only two-thirds of them remain. Therefore, even though the individual DC balances grow steadily over time, the cumulative DC balances also spike because this analysis looks at cumulative balances for those who leave the system.  

As for the spike in individual DB benefits, it is a little more nuanced. The DB benefit becomes better than the DC benefit for an individual around age 56 when the person has worked for 34 years and is eligible for full retirement under the “Rule of 90” (see appendix). This relative value of a DB over a DC plan increases and peaks at age 60 where the maximum possible DB benefit at age 60 is 35% more valuable than the DC plan. This combined with increased retirement rates leads to a massive spike in cumulative DB balances around age 60.  

Despite the rise, the DB never crosses the DC plan in cumulative terms for this entry age. That is because the DB plan eventually becomes worse than the DC plan if the person waits too long to retire, specifically at a cutoff point around 70. While the annual benefits will increase for those working longer, a person may not live long enough to reap the full benefits, and thus it is no longer advantageous.  

Figure 1: Cumulative Benefits Distributed (Entry Age 22) 

This trend differs slightly but is still similar to other entry ages. In Figure 2, the ratio (vested DB benefits to vested DC benefits) is used to make a similar comparison of cumulative benefits for an aging workforce using different ages of entry. 

Figure 2: Ratio of Cumulative Benefits (DB/DC) for different entry ages 

At the entry age of 52, the defined benefit plan quickly becomes a better option when compared to the defined contribution plan due to early retirement eligibility. Of course, entering the workforce at 52 is not a typical scenario for most people and neither is staying at a job long enough to enjoy the comparative advantage of a defined benefit plan, as this analysis shows based on the retention rates.  

Conclusion 

The claim that a defined benefit plan is more efficient than a defined contribution plan, purely on a basis of cost, overlooks a larger and more meaningful perspective regarding benefit distribution. Most members of a DB plan do not stay at their jobs long enough to enjoy this “efficiency.”

Using the hypothetical PERS plan, fewer than 12% of employees make it to full retirement across all entry ages, yet the advantages of the DB retirement benefits seem to be tailored to this select group only. The vast majority of workers are better off with a defined contribution plan because the benefits they earn are not frozen when they leave for other employment. 

Additional notes on this analysis

Key Parameters 

1. Assumed Inflation – 2.25% 

2. Salary Growth Rate – 3.50% 

3. Vesting Period – 5 years 

4. Final Average Salary – 5 years 

5. Interest Credit – 6.5% 

6. Benefit Multiplier – 2.00% 

7. COLA – 0% 

8. Assumed Rate of Return – 7% for DB Plan, 6% for DC Plan 

9. Employee Contribution rate – 7% for DC and DB Plan 

10. Employer Contribution rate – 7% for DC and DB Plan 

Retirement Conditions 

1. Regular Retirement 

• Age 65 with 5 years of service 
• Age + years of service >= 90. Known as the rule of 90 

2. Early Retirement – Age 60 with 5 years of service 

This analysis assumes a 6% return for the defined contribution plan and a 7% return for the defined benefit plan. This is based on the NIRS assumption that the DB plan is managed by sophisticated fund managers and can therefore generate higher returns. This point was rebutted in the previous piece based on returns generated by pension funds vis-à-vis index funds to highlight the value of fund managers. This analysis focuses on benefit distribution, so the assumption of a higher DB return is used. 

The post Examining the populations best served by defined benefit and defined contribution plans appeared first on Reason Foundation.

Based on a -6% return for fiscal 2022, the aggregate unfunded liability of state-run public pension plans will be $1.3 trillion, up from $783 billion in 2021, the Pension Integrity Project finds. With a -6% return in 2022, the aggregate funded ratio for these state pension plans would fall from 85% funded in 2021 to 75% funded in 2022. 

The 2022 Public Pension Forecaster below allows you to preview changes in public pension system funding measurements for major state-run pension plans. It allows you to select any potential 2022 investment return rate to see how the returns would impact the unfunded liabilities and funded status of these state pension plans on a market value of assets basis.

The nation’s largest public pension system, the California Public Employees’ Retirement System (CalPERS), provides a good example of how much one bad year of investment returns can significantly impact unfunded liabilities, public employees, and taxpayers.

If CalPERS’ investment returns come in at -6% for 2022, the system’s unfunded liabilities will increase from $101 billion in 2021 to $159 billion in 2022, a debt that would equal $4,057 for every Californian. Its funded ratio will drop from 82.5% in 2021 to 73.6% in 2022, meaning state employers will have less than three-quarters of the assets needed to pay for pensions already promised to workers. 

Similarly, the Teacher Retirement System of Texas (TRS) reported $26 billion in unfunded liabilities in 2021. If TRS posts annual returns of -6% for the fiscal year 2022, its unfunded liabilities will jump to $40 billion, and its funded ratio will drop to 83.4%. The unfunded liability per capita is estimated to be $1,338. 

The table below displays the estimated unfunded liabilities and the funded ratios for each state if their public pension systems report -6% or -12% returns for 2022. 

Estimated Changes to State Pension Unfunded Liabilties, Funded Ratios

The first three quarters of the 2022 fiscal year clocked in at 0%, 3.2%, and -3.4% for public pensions, according to Milliman. The S&P 500 is down more than 20% since January, suggesting that the fourth quarter results will be more bad news for pension investments.

Considering the average pension plan bases its ability to fund promised benefits on averaging 7% annual investment returns over the long term, plan managers are preparing for significant growth in unfunded liabilities, and a major step back in funding from 2021. 

The significant levels of volatility and funding challenges pension plans are experiencing right now support the Pension Integrity Project’s position last year that most state and local government pensions are still in need of reform, despite the strong investment returns and funding improvements in 2021. Unfortunately, many observers mistook a single good year of returns—granted a historic one—as a sign of stabilization in what was a bumpy couple of decades for public pension funding. On the contrary, this year’s returns, as well as the growing signs of a possible recession, lend credence to the belief that public pension systems should lower their return expectations and view investment markets as less predictable and more volatile. 

State pension plans, in aggregate, have struggled to reduce unfunded liabilities to below $1 trillion ever since the Great Recession, seeing this number climb to nearly $1.4 trillion in 2020. Great results from 2021 seemed to finally break this barrier, with the year’s historically positive investment returns reducing state pension debt to about $783 billion. Now, state-run pension plans will again see unfunded liabilities jump back over $1 trillion, assuming final 2022 results end up at or below 0%. 

It is important not to read too much into one year of investment results when it comes to long-term investing. But during this time of economic volatility, policymakers and stakeholders should recognize that many of the problems that kept public pension systems significantly underfunded for multiple decades still exist. And many pension plans are nearly as vulnerable to financial shocks as they were in the past.

Going forward, state and local leaders should continue to seek out ways to address and minimize these risks, making their public retirement systems more resilient to an uncertain future. 

Webinar on using the 2022 Public Pension Forecaster:

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House Bill 55 (HB 55)—currently under committee consideration in the State Senate—would open a new tier in the pension plan that was closed to new entrants back in 2006. The legislation would make minor adjustments to employee contributions and retirement eligibility relative to the pre-2006 public pension system. While a defined benefit pension plan can be structured in ways to limit and share risk, HB 55 does too little to prevent growing unfunded pension liabilities, as discussed in the following sections.

In 2005, facing a massive drop in funding and growing annual costs, Alaska closed the state’s pension plan, the Public Employees’ Retirement System (PERS). Since that time, new workers were placed in the state’s Defined Contribution Retirement Plan (DCR), which has generally served as an effective retirement benefit for members (though potential improvements to the DCR design will be the subject of a future article). Alaska’s current defined contribution plan has the advantage of providing a competitive retirement benefit to public workers with a predictable and stable cost to state employers.

Opening a new tier in the previously closed PERS defined benefit pension system, as proposed in HB 55, would move the state away from its current risk-free retirement design for new public safety hires. Today, employers bear no further liability once their DCR contributions are made to the employee’s retirement account and this proposal would expose the state to the same types of unfunded liabilities that prompted closing the pension 15 years ago. Notably, the state still has $4.6 billion in unfunded PERS liabilities today despite having no flow of new plan entrants for 15 years.

House Bill 55 does include a few tweaks to the proposed new PERS tier (relative to the pre-2006 pension) that proponents suggest are intended to lower the financial risk to the state. Below is a list of these adjustments, as well as comments on these proposed changes based on the Pension Integrity Project’s experience and analysis:

1. Setting a minimum retirement age of 55 if members have 20 years of service. 
   • The legacy PERS pension had a 20-years-and-out feature, which meant that a firefighter hired at 21 could retire at 41 with his/her fully accrued retirement. 
   • “55-and-20” would improve upon that by setting a minimum retirement age, but at the same time, age 55 is also a fairly low bar as a minimum age.
2. Raising employee contribution rates from 7.5% in the legacy pension to a min 8% and max 12%.
   • While these employee rates are higher, they still fail to share the risk of unexpected costs of the plan with employers.
   • The employee rate cap also means all future underperformance beyond that limited contribution increase is placed on the backs of state and local employers and their budgets. 
   • Because the plan’s assumptions and funding design are flawed, a long-term risk of insufficient contributions still exists.
3. Suspending the post-pension retirement adjustment if the plan falls below 90% funded, and completely removing the annual Alaska cost-of0living adjustment.
   • These are both prudent cost-control measures relative to the previous policies.

To date, HB 55 has faced minimal actuarial scrutiny and there is no publicly available long-term actuarial forecasting or stress testing to justify such a financially profound policy decision. Public pension systems operate over generations, but state legislators have only been presented with minimal five-year cost projections based on an assumption that the proposed pension tier would do the impossible: get 100% of its assumptions 100% right, 100% of the time.

While the five-year cost analysis—performed by the PERS consulting actuary, Buck Global—is limited in its scope and rigor, it does raise some major concerns that should alarm state policymakers. The report states, “Adverse plan experience (due to poor asset returns and/or unexpected growth in liabilities) or changes to more conservative assumptions will increase the plan’s unfunded liabilities, which results in higher Additional State Contributions.”

It also notes that:

“[t]he impact of HB 55 on projected Additional State Contributions depends on how large the unfunded liabilities become. If the Actuarially Determined Contribution rate for HB 55 members’ pension and healthcare benefits exceeds 9%, then HB 55 will lead to larger increases in Additional State Contributions compared to what would have happened without HB 55…By shifting active P/F members (and all future P/F hires) from DCR to DB, the State will be taking on greater risk of higher contributions in future years.” (emphasis ours)

Given that the limited actuarial analysis that exists warns that the proposed reintroduction of a pension plan would also be committing Alaska to unpredictable long-term costs in the future, it is crucial for state decision-makers to first consider the implications of HB 55 over multiple decades, not just a few years.

Examining the Actuarial Impacts of the Proposed HB 55 Pension Tier

Recognizing the need for a long-term perspective on funding and costs, the Pension Integrity Project has prepared preliminary modeling of the proposed new HB 55 tier; it is important to note that these results do not include potential impacts on the legacy PERS tier and its current $4.6 billion in unfunded liabilities.

The results of our analysis indicate that, despite efforts to manage risk relative to the pre-2006 pension system available to first responders, HB 55 would still expose the state to obligations that are likely to cost much more than initial estimates indicate.

Pension Integrity Project modeling of House Bill 55 finds that the new pension plan would require a total of $743 million in employer contributions over the next 30 years, but this assumes that the fund:

1. Meets its current actuarial assumption (7.38%) each and every year—which is virtually impossible—and;
2. Never faces any unfunded liabilities along the way.

A complete evaluation of the potential costs of this bill needs to also include scenarios in which investment returns do not match the pension plan’s expectations. What is more, it is important for state policymakers to understand how the proposed plan would respond to market stresses.

With that in mind, our analysis below applies a scenario in which two economic recessions occur over the next 30 years (one in 2023 and another in 2038), and investment returns for other years come in at 6%— in line with the average 10-to-15 year forecasts in a survey of 39 financial experts.

The stress scenario applied to the new pension proposed in HB 55 would result in unfunded liabilities that would require higher contributions from state employers. Instead of the $743 million paid in employer contributions over the observed 30-year window if all current actuarial and demographic assumptions are met, Alaska would be responsible for paying $887 million instead due to the need to service growing unfunded liabilities.

Figure 1 breaks down the ranges of annual contributions both employees and employers could expect under the proposed plan. As explained above, HB 55 includes the potential for increases in employee contributions, depending on need. Predictably, the market stress scenario used in this analysis would bring rates up for employees. Market stress would also require more of the state. While employer contributions are set at 10% in the proposed plan, these rates would also need to go up to meet the demands of unfunded pension liabilities.

Failure to answer the call for higher employer contributions in this scenario would result in the accrual of expensive public pension debt. Alaska does not have a set policy to enforce these necessary contribution increases and the proposed reform does not establish one. With that in mind, we are left to assume that contribution rates would remain static, thus passing these unfunded obligations—debt—onto future generations and weighing on state and local government budgets perpetually.

Figure 1: Market Stress on Employee and Employer Contributions Under Proposed HB 55 Tier

A great deal of the risk the state would be taking on is also hidden with discounting policy. The proposed plan would discount liabilities at PERS’ current 7.38% rate. Considering most state pension plans across the country are adjusting their investment return rate expectations down to, or below, 7%, this would place the new Alaskan defined benefit discount rate on the higher end of investment expectations, meaning a good portion of the state’s potential risks and costs could be hidden.

Adjusting the discount rate of the plan down to 6% reveals that a stress scenario could result in actuarially required contributions rising more than 7% over the currently reported and expected rate, totaling 17% of payroll annually within 20 years.

The stress scenario also reveals the risks of pension debt that would still exist under the proposed reform. While the pension plan would accrue no unfunded pension liabilities under a scenario in which plan assumptions are met, recessions and overall returns that fall below the plan’s overly optimistic assumptions would create significant funding shortfalls.

Applying the two-recession stress scenario shows that the new plan could go from no unfunded obligations to having as much as $302 million in pension debt by the end of the modeled 30-year window (see figure 2).

Figure 2: Unfunded Liability Forecast of New Pension Plan Proposed in HB 55

This issue would not be exclusive to long-term perspectives, either. The proposed HB 55 pension tier would be immediately susceptible to accumulating significant unfunded liabilities due to the decision to allow current DCR plan members to transfer their defined contribution plan assets into the new pension as if they had been in the new pension the entire time. This practice would essentially use these funds to have existing members buy into guaranteed pension benefits in the middle of their careers. This policy would also represent a large and immediate new exposure to market risks for Alaska.

Proponents of the bill argue that this is a cost-neutral way to allow members to switch a defined benefit pension midstream, but this again is relying on a very improbable 7.38% rate of return. If market outcomes end up diverging from the plan’s very optimistic assumption, the funds transferred will end up being inadequate to provide the promised pension benefits, with the responsibility for the shortfall once again falling to the state.

The immediate threat of this problem surfaces in our actuarial analysis. Modeling of the new pension shows that a single recession year in 2023 could immediately generate unfunded liabilities and go from fully funded to 71% funded after just one bad year of losses.

This type of scenario should be very familiar to Alaska legislators. The state’s funding woes that precipitated the 2005 pension reform began after 2001 losses, where they saw the pension fund go from $50 million overfunded to $1.5 billion underfunded in just one year, dropping from the pension system being 100% funded to just 75% funded. According to this analysis of HB 55, those same risks that existed in PERS before its closure would still largely exist in the newly proposed plan.

Figure 3: Funding Forecast of New Pension Plan Proposed in HB 55

Had a long-term actuarial forecast been requested to accompany this legislation, and had there been a review of the financial outcomes of HB 55 in underperforming investment scenarios, Alaska policymakers would clearly see that the proposed HB 55 pension tier for first responders resembles nothing like the supposed “low-risk” or “risk-free” pension described by bill proponents.

By allowing the transfer of funds held in members’ defined contribution accounts immediately into the new pension system at an unreasonably high discount rate, the “new” pension tier would, within the first few months of existence, become a somewhat mature pension plan—with all the attendant financial risks of traditional defined benefit pension systems.

The national trend since the Great Recession of 2007-2009 has been for states to adopt greater risk controls in their traditional public pension systems and move towards a variety of plan design options with the goal of avoiding re-exposing state and local budgets to the risks of worsening unfunded pension liabilities over the long-term.

Unfortunately, House Bill 55 does not resemble those types of prudent retirement reforms. Considering the serious levels of risk that Alaska could be taking on with HB 55, policymakers should seriously consider going back to the drawing board on more effective methods of managing and sharing risk. Once risk policies that are more in line with modern reforms are agreed upon, a rigorous long-term actuarial analysis should be performed on those proposals to ensure lawmakers aren’t entering into the risky retirement commitments that created debt and fiscal challenges for Alaska in the past.

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A Horizon Actuarial Services report released in Aug. 2021 surveyed firms like JPMorgan, BlackRock, and BNY Mellon to find that long-term investment returns are expected to decrease across the main asset classes that public pension plans invest in. The Horizon report states:

“Over the last five years, expected returns have declined for all but a few asset classes. The steepest declines have been for fixed income investments such as US corporate bonds and Treasuries, where return expectations have fallen more than 100 basis points since 2019. These declines were driven by recent monetary and fiscal policy interventions, and may have significant implications for multiemployer pension plans.”

Some public pension plans have made the prudent decision to reduce their investment return assumptions in light of this cautionary market outlook. Notably, the New York Common Retirement Fund lowered its assumed rate of return 90 basis points, which takes the assumed rate of return from 6.8% to 5.9%. This 5.9% expected return fits between Horizon’s 10- and 20-Year forecasts of 5.38% and 6.25%.

To get a better sense of the investment outlook for state pension plans, we created a tool that runs a simulation of the investment performance of a hypothetical public pension portfolio over 30 years. It displays the growth of $1 in assets; a distribution of the compound annual growth rate for those 30 years; and the simulation estimated probability of hitting several return assumptions.

The tool utilizes assumptions on asset returns, volatilities, and correlations pulled from BlackRock, BNY Mellon, Horizon Actuarial Services, JPMorgan, and Research Affiliates to simulate portfolio returns. Specifically, the model uses a Monte Carlo simulation with 10,000 simulations of the portfolio over 30 years. Users can select which capital market assumptions they want to run the model with. Additionally, users can select between the national average pension asset allocation, a 60/40 stock-bond portfolio, or a custom portfolio. Step-by-step directions on how to use the tool can be found below.

It is important to note that while this tool uses the latest assumptions from reputable financial advisors, they are still mere speculations on market performance. Additionally, while this approach for portfolio simulation is commonly used in the financial industry, it does not account for the time-variant nature of asset correlations. In times of financial stress, for example, assets can be more tightly correlated than they are in normal market conditions—aggravating portfolio losses. This was true during the Great Recession from December 2007 to June 2009 and could be true in a future crisis as well.

How to Use the Tool

1. To run the portfolio simulation with the preloaded settings, simply hit the “Run Simulation” button in the top right.
2. To modify the inputs, select the “Control Panel” button in the top left.
3. The user can modify both the asset returns, volatilities, and correlations by firm (both Horizon’s 10-year and 20-year assumptions are included) via the “Capital Market Assumptions” dropdown.
4. Asset allocation can be switched between the national average for state pension plans or a 60/40 stock-bond split. Additionally, asset allocation can be customized via the “Custom” button. Note that the portfolio must equal 100% to run the simulation.
5. Once selections are completed, click “Run Simulation” to see the results.

Outputs

1. Assets: Displays the 25^th percentile to 75^th percentile (middle 50 percent of the data) of asset growth for $1 for the 10,000 simulations over 30 years.
2. Distribution: Displays the distribution of compound annual growth rates for the 10,000 simulations over 30 years. Opposed to the arithmetic return, the compound annual growth rate (or geometric return) better represents the long-run growth of an asset. Also displayed are two lines: (1) the median simulation return and (2) where 7% return sits in the distribution which is often used as the assumed rate of return for public pension plans.
3. Return Probability: Displays the probability of the portfolio reaching various assumed rates of return given the results of the 10,000 simulations.

The post Modeling how public pension investments may perform over the next 30 years appeared first on Reason Foundation.

The 2021 Horizon Actuarial Services survey shows that despite the historic positive investment performance that public pension plans have seen in the last year, not much has really changed in terms of future and long-term investment outlook. In fact, financial advisors seem to have further reduced their capital return assumptions to offset the recent favorable gains. Below are a few of highlights from the survey.

Compared to last year, the long-term expected investment returns decreased across the main asset classes that public pension plans invest in. The report says:

“Over the last five years, expected returns have declined for all but a few asset classes. The steepest declines have been for fixed income investments such as US corporate bonds and Treasuries, where return expectations have fallen more than 100 basis points since 2019. These declines were driven by recent monetary and fiscal policy interventions, and may have significant implications for multiemployer pension plans.”

The chart below, taken directly from the report, shows each asset classes’ decline in the last few years.

The survey also says that the likelihood that pension plans will meet high investment return targets is falling. For a hypothetical pension fund, the probability of meeting a 7% return target given average market returns over the next 20 years dropped to 38% from about 45% last year, Horizon says. The most conservative market returns gave pension plans less than a 20% chance of meeting 7% investment returns over 20 years.

Short-term investment outlooks seem to be worse than long-term prospects, which still aren’t great. The Horizon table below shows that 10-year expected returns are markedly lower than 20-year expected returns. This means the probability that plans achieve certain benchmarks are also significantly lower for the next decade. Again, this is for a hypothetical multi-employer pension fund.

  Source: Horizon Actuarial 2021 Survey of Capital Market Assumptions

The individual assumptions from each of the 39 advisors are plotted below.

Overall this Horizen survey further supports financial experts’ predictions about a depressed investment market in the next 10 to 20 years.

Despite 2021’s excellent investment returns, policymakers should not lose sight of the fact experts are saying the long-term investment prospects look bleak. Now is the time for cities and states to consider needed reforms that would properly manage the investment risks facing their public pension plans.

The post Horizon survey predicts bleak future for public pension investment returns appeared first on Reason Foundation.

A single year, or even several years, of above-average investment returns would be welcome news for public pension plans. But, a year or two of great returns will not resuscitate the public pension plans at risk of financial insolvency. Public pension plans with growing debt are in need of structural reforms that protect taxpayers, employees and retirees. A key component of these reforms is setting realistic assumptions about future investment returns.

For the last 20 years, state and local pension plans’ assumed rates of return have been far too optimistic. The distributions of average (geometric mean) assumed investment returns and actual returns from 2001 to 2020 demonstrate this. The figure below shows the distribution of the average assumed investment return rate versus actual investment returns for 200 of the largest state and local pension plans in the United States. The median assumed rate of return over the last 20 years was 7.7 percent per year, the median actual rate of investment return for these public pension plans was 5.7 percent.

This two percent difference helps to explain the nearly 30 percent drop in the average pension plan funded ratio over the same period. In recent years, many pension plans lowered their assumed rates of return. As visualized below, the distribution of state and local pension plan assumed rates of return (blue) are moving closer to the distribution for the 20-year average (orange). 

Although progress has been made there is still a significant gap between the assumptions for investment returns and actual returns from the last two decades. For public pension plans, falling short of investment return expectation, even by a small percentage, can add millions to billions in pension debt over time.

In short, state and local governments are betting that the next few decades will not be like the last two. Policymakers should continue to lower overly optimistic assumed rates of return. By doing so, they can reduce the risk of future growth in unfunded pension liabilities, protecting taxpayers and government workers.

The post Public Pension Plans Need to Put a Year of Good Investment Returns In Perspective appeared first on Reason Foundation.

Legislation currently under consideration in the South Carolina State Senate would offer newly hired state employees a choice between two new risk-managed retirement plan options—a modern defined contribution plan or a modern pension plan. The new defined contribution plan would limit risk to the state and taxpayers and allow more workers to accrue a stable, predictable retirement benefit. The new pension plan that would be offered under the legislation would regulate costs better than the current plan does and would not be as vulnerable to market volatility.

A new Reason Foundation analysis of South Carolina Senate Bill 176 finds that, as originally drafted, the bill could produce some long-term cost increases of roughly 5 to 10 percent, depending on market conditions, while shifting to the new plan design (note: cost increases are relative to the costs of an underpriced SCRS pension plan). If slightly amended,  the legislation could also put in place a realistic and resilient approach to paying off the pension plan’s debt. Adding actuarially based legacy pension funding to the bill would transform the bill into an effectively cost-neutral overhaul to the pension system.

This analysis examines Senate Bill 176’s impact on the long-term solvency of the South Carolina Retirement System (SCRS). None of the changes modeled in this analysis impact current member benefits.

Full Analysis of Senate Bill 176 

The post Analysis of South Carolina Senate Bill 176 appeared first on Reason Foundation.

The New Mexico Educational Retirement Board (ERB), the public pension plan serving educators in the state, is descending into insolvency and putting the retirement benefits of teachers at risk. In the year 2001, ERB had less than $1 billion in public pension debt, but in the two decades since, this number has risen dramatically. The latest, official numbers reveal that the New Mexico Educational Retirement Board now has $7.9 billion in unfunded pension liabilities.

Reason Foundation’s latest solvency analysis, updated this month (November 2020), shows that the past two decades of underperforming investments, insufficient contributions, and undervaluing debt, have driven benefit costs higher while crowding out other programs and priorities clamoring for public funding in New Mexico.

An August 2020 New Mexico ERB investment committee report showed annualized returns of 5.7 percent for the last five years, falling well below the plan’s return target of 7.25 percent. In fact, investment returns failing to meet unrealistic expectations has been the largest contributor to the public pension plan’s unfunded liability growth, adding $3.3 billion in debt since 2001.

Reason Foundation’s analysis finds that the New Mexico Educational Retirement Board has less than a 50 percent chance of meeting its 7.25 percent investment return assumption in the next 10 years. If the plan continues to fall short of this unrealistic goal, the analysis shows it could add $10 billion to $20 billion in long-term pension costs, depending on a variety of market scenarios.

Today, ERB has only 63 percent of the assets needed to fully fund the pension system in the long-term. This underfunding not only puts taxpayers on the hook for growing debt but also jeopardizes the retirement security of New Mexico’s educators. Left unaddressed, ERB’s structural problems will likely lead to more education funding crowd out, more debt for future generations, and less retirement security for the state’s educators.

The solvency analysis looks at the primary factors driving unfunded liabilities for ERB over the past few decades and offers stress-testing designed to highlight potentially latent financial risks the pension system is facing. It also provides a number of policy suggestions that, if implemented, would address the declining solvency of the public pension plan.

A new, updated analysis will be added to this page regularly to track ERB’s performance and solvency.

Bringing stakeholders together around a central, non-partisan understanding of the challenges ERB faces—complete with independent third-party actuarial analysis and expert technical assistance—Reason Foundation’s Pension Integrity Project stands ready to help guide New Mexico policymakers and stakeholders in addressing the shifting fiscal landscape.

New Mexico Educational Retirement Board (ERB) Pension Solvency Analysis

The post New Mexico Educational Retirement Board Pension Solvency Analysis appeared first on Reason Foundation.

Bad assumptions, missed payments and underperforming investments have created over $40 billion worth of debt—unfunded liabilities—that cost students and school districts more and more money each year.

Use the tool below to select any K-12 public school district in Michigan that contributes to the Michigan Public School Employees Retirement System (MPSERS) and see how unfunded liabilities are taking millions from that school district’s K-12 classrooms on a yearly basis.

Using data for the 2017-18 fiscal year, you will see that each student in the state has a staggering amount of pension debt tied to them and that normal pension system costs (what school districts contribute each year to pay for current employees’ future retirement benefits) are dwarfed by high debt payments for yesterday’s workforce.

Find the full interactive dashboard here or simply use the tool below.

To see the data for your school district use the expandable sidebar on the left side of the tool below.

We recommend viewing this interactive dashboard on a desktop for the best user experience. Please note that the tool will automatically sleep after a certain idle time and can be restarted by simply refreshing the page.

Reason Foundation’s Pension Integrity Project finds that in 2018, Detroit Public Schools spent $2,202 per student on MPSERS debt, which equals nearly 27 percent of the district’s per-pupil foundation grant from the state. Detroit Public Schools’ total retirement costs ate up $111,047,484 of the over $700 million budget in 2018.

In stark contrast, the normal cost—the cost of actual retirement benefits earned that year—was only $252 per Detroit Public Schools student. This means that if the state would have made full pension contributions and maintained realistic investment return assumptions for the last two decades, there would be almost $1,800 in additional funding for each of Detroit Public School students during that year. Instead, more and more money is being taken out of classrooms each year to pay for over $40 billion in MPSERS debt.

Lansing Public Schools had similar contribution rates, spending $2,428 per pupil and $25,403,305 in total MPSERS costs in 2018. These contributions ate up 32 percent of the school district’s per pupil grant and over 15 percent of the school district’s total budget. If MPSERS was not in debt, Lansing Public Schools would only have needed to contribute $274 per student to fund retirement benefits.

If they are left unaddressed, historical problems and a lack of accountability within the retirement system will continue to threaten promised pension benefits and jeopardize school funding.

During the current coronavirus pandemic, decreased state revenues and increasingly volatile stock markets add to these concerns. It is crucial that going forward, even during times of fiscal crisis, that Michigan makes its full MPSERS payments and maintains responsible funding policies.

The post Examining How Much Money That Pension Debt Takes Away From Michigan’s Classrooms Each Year appeared first on Reason Foundation.

On the aggregate level, public pension plans’ average investment returns over the last two decades have fallen short of their return assumptions. And this year’s recession has exacerbated this trend. While the stock market has, in many ways, recovered since April any market setback can have major and long-lasting effects for pension funds. Early reports of the current fiscal year’s investment performance from a number of pension plans show that 2020 investment return results will fall well below most pension plans’ assumptions, which adds to the growing trend of long-term results not matching expectations.

Assuming pension plans achieve a conservative 3 percent return in fiscal year 2019-2020, Reason Foundation Pension Integrity Project’s calculations show that the 20-year aggregate average rate of return would be only about 5.9 percent, falling far short of the current weighted average assumed rate of return of 7.25 percent.

In a perfect world, a defined benefit plan’s investment returns would perfectly match its assumed rate of return (ARR) so that the accumulated normal cost contributions and investment earnings would be enough to cover the promised benefits. However, the reality is far from perfect. Declining interest rates over the last three decades have made it harder for public pension plans to match their ARRs, which have remained relatively high.

To visualize how a state pension plans’ historical performance has stacked up against their assumptions, Reason Foundation created this interactive visualization.

Interactive Data Visualization Tool: State Pension Challenges — Investment Performance vs. Return Assumption

The first two charts below display historical annual returns, the ARR, and the rolling average return over the last two decades for the selected plan as compared to the national average.

Below you can see the results, excerpted from the tool, for the largest public pension plan in the nation, the California Public Employees Retirement System (CalPERS), with an estimated 3 percent return selected for the 2019-2020 fiscal year.

The last two charts show a snapshot of investment performance vs. assumed rate of return among 115 state pension plans in our database, in a year selected by the user. Users can see if their selected pension plan’s 15-year performance fell above or below expectations for any particular year, as well as how that result compares to other state plans.

Interactive Data Visualization Tool: State Pension Challenges — Investment Performance vs. Return Assumption

We recommend viewing this interactive chart on a desktop for the best user experience. 

Please note that the interactive tool will automatically sleep after a certain idle time and can be restarted by simply refreshing the page.

The post Public Pension Investment Performance Has Historically Fallen Short of Return Assumptions appeared first on Reason Foundation.

While the coronavirus pandemic and economic downturn are making the need for budget-saving actions very real, Colorado policymakers should understand the long-term costs of shorting PERA contributions in 2020.

A major part of the 2018 pension reform—which had significant bipartisan support—was a direct annual distribution of $225 million into the pension fund from the state budget. The purpose of this additional infusion of cash was to make up for several decades of significant shortfalls in investment returns and pension contributions, among other factors that have been a drag on PERA’s funding. As a part of the current Joint Budget Committee (JBC) proposal, the state would suspend this funding assistance for two years, picking it back up in the summer of 2022 and continuing (as originally planned) into perpetuity.

The JBC is also considering putting a pause on newly established automatic adjustments, which were instrumental in setting up guard rails to ensure retirement security for Colorado’s public workers. A major piece of the 2018 reform effort included a feature that adjusted pension contributions in the case of payments being insufficient according to PERA’s actuaries. As part of their budget-balancing recommendations, the JBC is advising the state suspend what would have been an automatic increase of 0.5 percent in 2020 contributions.

Lastly, the committee is proposing a permanent reduction in Amortization Equalization Disbursement (AED) and Supplemental Amortization Equalization Disbursement (SAED) payments into the State Division. These additional payments have been a part of the state’s commitment to paying off growing funding shortfalls since 2004 and 2006 respectively, and are currently an essential part of PERA’s plan to reduce long-term costs and reach full funding within a 30-year window. The proposed action from the JBC would cut this payment to the State Division in half, dealing a major blow to the long-term solvency of the state’s pension system.

Analysis of the changes proposed above illustrates the long-term costs of taking a short holiday on SB 200 reforms and a permanent one on the aforementioned supplemental contributions. When evaluating the true long-term cost of any pension-related action, it is important to consider two factors:

• First, one must calculate the difference in contributions, both in the short-term and the long-term (for this analysis, a 30-year window is used to evaluate the long-term).
• Second, it is essential to forecast the unfunded liability that will exist at the end of the long-term period.

Adjusting contributions, as the JBC proposal suggests, usually changes a plan’s path toward full funding. Forecasting these proposed contribution pauses and reductions will clearly result in a plan that is less likely to reach full funding within the advised 30-year timeframe.

Adding both the combined 30-year employer contribution with the ending unfunded liability equals what we call the “All-in Employer Cost,” which allows us to compare the total cost to government employers of one path relative to another. Using this method, we have mapped the contributions and ending All-in Costs for PERA’s school and state divisions both before and after the effects of COVID-19 on the plan’s assets and liabilities (this analysis assumes a 2020 recession and recovery similar to that of 2008). Then, we map out the changes in the total costs of the plan under the proposed 2020 response. The results show that, while the proposal would alleviate immediate budget needs, the changes would generate significant additional long-term costs, a result that would be even more exacerbated by yet another recession or continued failure to meet lofty return assumptions.

Figure 1: Baseline Forecasts of PERA Contributions and All-in Costs (State and School Divisions)

Source: Pension Integrity Project actuarial forecast of PERA State and School Divisions. Values are rounded and adjusted for inflation. The “All-in Cost” includes all employer contributions over the 30-year timeframe, and the ending unfunded liability accrued by the end of that timeframe.

Most of the contribution reductions—and therefore most of the added long-term costs—come from permanently halving AED and SAED contributions in the State Division. This result is very visible in forecasts of State Division’s funding under a scenario of multiple recessions over the next 30 years. Figure 2 shows that, assuming actual long-term returns that match PERA’s pre-COVID expectations, after the 2018 reforms the fund was structured to withstand two individual recessions over the forecasted timeframe. Despite two 2008-like hits to the fund’s assets, the State Division would still be able to rebound and reach full funding by 2047.

Figure 2: Baseline Forecast of PERA Funding After 2020 & 2035 Recessions (State Division)

Source: Pension Integrity Project actuarial forecast of PERA State Division. Scenario assumes 2020 & 2035 recessions and recoveries similar to 2008 and the plan’s assumed returns in other years.

But a permanent reduction in AED and SAED payments would put the State Division on a much different path, as displayed in Figure 3. The proposed recommendations would significantly alter the long-term forecast of the fund so it would no longer reach full funding within the prescribed 30-year window under a scenario of two recessions and it would still be saddled with significant amounts of unfunded liabilities after that period. These results suggest that a permanent contribution reduction would negatively affect PERA’s resiliency to turbulent and unpredictable market conditions.

Figure 3: Forecast of PERA Funding After 2020 & 2035 Recessions and JBC Recommendations (State Division)

Source: Pension Integrity Project actuarial forecast of PERA State Division. The scenario assumes 2020 & 2035 recessions and recoveries similar to 2008, the plan’s assumed returns in other years, and contribution reduction recommendations according to the Colorado Joint Budget Committee.

Colorado policymakers are right to anticipate and plan for significant budget difficulties in the upcoming year. A recession will have wide-reaching impacts on how the state government operates in both the short- and long-terms. Significant market losses will surely affect PERA, and consequently the costs and security of retirement plans for public workers. While weighing policy options to alleviate these upcoming budgetary pressures, it is critical to understand not only the short-term savings but also the long-term costs that are attached to various proposals. If pension contribution policies are adjusted it would result in the addition of significant long-term costs and a public pension plan that is no longer en route to full funding within the prescribed 30-year window.

The post Colorado Considers Reducing Pension Contributions in Response to Budget Concerns appeared first on Reason Foundation.

The primary culprit of growing public pension debt has been the across-the-board investment underperformance of pension investments relative to plans’ own investment return targets. This lower yield, higher risk investment environment has become the “new normal” for public pension plans. Most financial advisors suggest that investment return expectations for equities and fixed income products over the next 10-to-15 years will be lower than it has been over the past 30 years. However, in defiance of this clear trend, pension plans have been slow to adjust their investment return expectations. Now, with the economy headed downward, the implications of further inaction could be severe.

In a 2012 poll, 38 of 39 leading economists agreed, “By discounting pension liabilities at high-interest rates under government accounting standards, many U.S. state and local governments understate their pension liabilities and the costs of providing pensions to public-sector workers.”

This observation is even more germane today, with ever-growing costs of servicing and paying down pension debt. Unrealistic investment return assumptions produce a plethora of cascading effects downstream. For example, setting a high investment return target can result in undercalculating contribution requirements to the extent that even making 100 percent of actuarially-required contributions into a plan will still fall short of reducing its unfunded liabilities. When annual pension contributions fail to cover even the interest payments on past pension debt it is called negative amortization.

Failing to meet a plan’s assumed rate of return has long-term consequences. The Pension Integrity Project at Reason Foundation finds that overly optimistic investment return assumptions caused over 50 percent of the $6.3 billion unfunded liabilities that the Teachers’ Retirement System of Louisiana (TRSL) added between 2000 and 2019. Another roughly 10-to-15 percent of TRSL’s debt percent comes from negative amortization.

Unfortunately, this debt inducing combination is not unique to Louisiana and has been experienced by many state and local pension plans across the nation.

Keeping investment return targets higher than recommended — 7 percent or lower should be viewed as the “new normal” — can bring government’s short-term relief because it allows them to reduce the amount of money they put into the system in a given year. If the plan assumes investment returns will cover the costs, employer and/or employee contributions can be lower, the theory goes. But in the long-term, overly optimistic assumed rates of return cause mounting pension debt that increases with shortfalls in either of the pension plans’ core two revenue sources: investment returns and contributions. If, for example, pension trustees are wrong on the expected investment returns, then the deferred normal cost—which is usually shared between employees and employers—gradually multiplies into additional unfunded pension liabilities, which are usually borne solely by taxpayers.

Furthermore, overly optimistic investment return expectations misalign with liability durations and undermine retirement plans’ future cash flows. This is mainly due to America’s aging population and the number of mature state pension plans expecting to pay out a significant amount of their pension benefits to retirees over the next 10 years. This means that large portions of current pension assets will be used to pay for retiree benefits and will not be around to be invested over the next 10-30 years to make up for the lower investment returns over the next decade. Adjusting return assumptions per mid-term projections, as opposed to the long-term, should help curb investment losses and better align assumptions with the average timing of pension payouts.

Adjusting assumed rates of return is a tough political decision and will not come without costs for state and local governments. Lowering rates increases pension contributions in the short-term.  However, adjusting to the new normal should be done sooner rather than later to help pension trustees avoid paying costly compounding interest on pension debt. This would drastically reduce the long-term financial burden for taxpayers by stabilizing contribution requirements. It would also improve the solvency of retirement systems and help governments keep the pension promises they’ve made to public employees.

Each state and local government pension plan has its own unique set of problems. In an economic downturn, budget trade-offs are always a large part of the equation. Properly estimating promised pension liabilities and adopting strong funding policies designed to pay off legacy unfunded liabilities as fast as possible to minimize the risk of new debt materializing are in the best interests of active and retired public employees, as well as taxpayers.

The post Public Pension Plans Weren’t Meeting Investment Expectations Long Before the Coronavirus appeared first on Reason Foundation.

Long before the COVID-19 pandemic disrupted financial markets, public pension plans’ investments were underperforming expectations with regularity. Across-the-board investment underperformance relative to a plan’s assumed rate of investment return has been the primary culprit of the nation’s growing pension debt. Even before the recent economic downturn, it was clear this lower yield, higher risk environment should be considered the “new normal” in public pension investment returns and that plans like the Teachers’ Retirement System of Louisiana need to adjust.

Our updated analysis recently published by the Pension Integrity Project at Reason Foundation found investment underperformance over the past 20 years accounts for over 50 percent of the $6.3 billion worth of unfunded liabilities plaguing the Teachers’ Retirement System of Louisiana (TRSL). Another roughly 10-to-15 percent of unfunded liabilities come from negative amortization — annual pension contributions failing to cover even the interest payments on past pension debt.

According to 2019 capital market assumptions done by Horizon Actuarial Services, TRSL had less than a 40 percent chance of achieving investment returns at, or above, its 2019 target rate of 7.55 percent. And the plan has only a 55 percent chance of reaching that threshold over the next 20 years — and those were the odds before the market downturn of March 2020.

When public pension systems fail to meet their investment return targets, it piles debt onto an already underfunded retirement system.

Lower investment yields also mean that most public plans are going to assume increasing risks to try and maintain their higher target return rate assumptions. In 1996, TRSL investment volatility stood at just 9 percent. Based on 2019 capital assumptions, TRSL is likely to experience roughly 12 percent year-over-year volatility in portfolio returns in the next 10 to 20 years. It is clear that in response to underperformance, Louisiana plan investors are welcoming higher risk.

Although the long-term economic effects of COVID-19 remain unclear, the “new normal” analysis of the previous decade’s recession gives a glimpse at the fate many public pension plans face after the pandemic.

After the financial crash of 2007-08, several state pension systems—including pension plans in Kentucky, Connecticut, Illinois, and New Jersey—were so underfunded that even the longest economic recovery in history, over a decade of economic growth, did not appear to help them dig out of their deep underfunding trenches. Now that the bull market has come to a grinding halt, it is more important than ever to adjust target rates and avoid further insolvency.

Policymakers should be proud that the tough decisions they made over the past several sessions to fill the multibillion-dollar state budget hole has better prepared Louisiana for the COVID-19 crisis. But they again face serious state and local budget problems, including questions regarding the long-term solvency of TRSL.

A changing investment reality and the “new normal” for pension plans is here. For Louisiana, the new normal means it is time to take proactive steps to secure the pensions that have been promised to workers and to get TRSL in a financial position that allows it to better weather the fiscal storm we’re entering.

The post Failing to Meet Investment Expectations Drives the Teachers’ Retirement System of Louisiana Debt appeared first on Reason Foundation.

Despite a decade-long bull market—and even before the arrival of the COVID-19 pandemic-related market turmoil of March 2020—many “defined benefit” (DB) pension plans covering U.S. state and local government employees have continued grappling with growing unfunded liabilities. And the primary culprit of growing pension debt, according to analyses by the Pension Integrity Project at Reason Foundation, has been the across-the-board investment underperformance of pension assets relative to plans’ own return targets.

This unwelcome emergence of the “new normal” lower-yield investment environment is characterized by low dividend yields, ultra-low interest rates, subdued economic growth, subpar inflation, and increased market volatility/risk. Furthermore, most financial advisors now portend muted, compared to the past 30 years, investment returns for institutional investors over the next 10–to-15 years.

But, despite the mounting evidence and informed projections of the “new normal” lower-yield environment, many public pension plans postpone adjusting their investment risk policies and long-term rate of return (and discount rate) targets to the new realities.

The implications of inaction could be severe. If, for example, pension trustees are wrong on the expected investment returns (and on the discount rate), then they will continue gradually adding more unfunded pension liabilities (i.e. pension debt) and weaken their cash flow, which is crucial for managing annual benefit payouts. Furthermore, leading economists agree that when state and local governments discount their pension liabilities at high rates, they understate the contributions needed to pre-fund promised pension benefits. And putting off pension payments further degrades cash flow and leads to long-term fiscal disaster.

Each state and local government pension plan is unique with its own set of problems, and budget trade-offs are a large part of the public finance equation. And yet, faced with such headwinds, policymakers and pension trustees must acknowledge the evidence supporting the changing investment reality and the “new normal” for pension plans. Doing so sooner rather than later, by taking proactive steps, will position these state and local public pension systems to better secure promised pensions, and weather any economic, capital market, or other fiscal storms along the way.

Introduction

Over 16 million state and local government employees across the U.S. participate in “defined benefit” (DB) pension plans that rely primarily on regular contributions (both from employers and employees) and asset returns in order to pre-fund promised pension benefits for teachers, law enforcement officers, judges, and other public service workers. As much as 63 percent of overall pension revenue between 1989 and 2018 came from investments alone, according to the National Association of State Retirement Administrators (NASRA).

It is, however, now clear that over the past decade the capital markets have drastically changed; sustainable double-digit yields are long gone. Public pensions lost a significant portion of their assets in the aftermath of the dot-com crash in the early 2000s (when most public pensions were 100 percent funded), and then again during the 2007–08 financial crisis.

This chain of asset losses, followed by muted returns, plunged many jurisdictions into a spiral of unfunded pension liability accruals and debt payments. With pension liabilities growing faster than assets, costs of underfunding are claiming a disproportionate amount of tax revenues, escalating funding concerns for elected leaders. According to an analysis by Fitch Ratings, from 2001 to 2017 public pension liabilities and assets grew at compound annual rates of 5.2 percent and 3.4 percent, respectively.

At press time, it is premature to offer more than informed speculation on the potential impacts of the recent market turmoil—with the S&P 500 Index dropping by 30 percent by mid–March of 2020 below its records just a month ago—brought about by the global response to the COVID-19 pandemic. However, it is safe to say that because most U.S. public pension funds had still not yet fully recovered from the Great Recession by 2020—despite a decade-long bull market—they will hardly withstand another such crisis without suffering a major blow to their asset levels and long-term solvency prospects.

Similarly, most leading financial advisors project subdued capital market returns in the next 10-to-15 years. As The Group of Thirty Steering Committee and Working Group on Pensions recently pointed out: “[t]he ongoing fluctuations in asset prices and the likely ‘new normal’ future of low real asset returns for a protracted period of time create major uncertainties for individuals, policymakers, and pension fund professionals.” But despite the mounting evidence of changed capital market realities and a likely need to curb investment expectations amid this “new normal” in the global capital markets, many U.S. public pension administrators (or in some cases, policymakers) continue to maintain assumed investment returns in the 7 percent-to–8 percent range.

Defenders of maintaining unrealistic asset return assumptions tend to make a few common arguments:

• Public plans’ average returns over the last three decades have actually exceeded the assumed returns.
• Public plan return assumptions take the long-term view, so short-term volatility should be of no serious concern.
• Investment risk decreases over time, so the long-term view justifies the high assumed returns.

In the following sections, we will explore these and other arguments in the context of the “new normal” lower-yield environment and its implications for the future of public pension finance and unfunded pension liabilities across U.S. jurisdictions.

Full Policy Brief: The “New Normal” In Public Pension Investment Returns

The post The “New Normal” In Public Pension Investment Returns appeared first on Reason Foundation.

Any time annual investment returns fall below the assumed rate of return (ARR), a plan must find ways to make up the shortfall between expected and actual assets. Sustained experience below a plan’s ARR results in growing pension debt, which has been a significant contributor to the funding shortfalls in public pension plans across the nation.

In response to decades of investment performance below expectations, most public pension plans have been gradually adjusting their assumed rates of return down to more realistic levels.

This map (click to zoom) shows the changes in assumed rates of return held by state pension systems from 2001 to 2018, along with the national average rate for comparative purposes. And this visualization highlights the different ways states have responded to the ubiquitous challenge of lower long-term returns. [Note: for cases of states with multiple public pension plans, the analysis uses each plan’s accrued liability to weight the state’s combined assumed rate of return.]

As an example, North Carolina lowered its ARR well before most other states. As a result, they experienced fewer unexpected costs over the studied timeframe, which helped them become one of the nation’s healthiest states in pension funding — with a 90 percent funded ratio at this time.

Colorado, on the other hand, was slow to adjust its ARR. Market returns below the state’s expectations were the largest contributor to Colorado’s pension debt over the past two decades, adding $8.4 billion in unexpected costs. Now, the state only has 60 percent of the funding needed to cover the retirement promises already made to its public servants.

States have been lowering their assumed rates of return across the board, but most maintain assumptions that are still too high. Many financial advisors believe that investors can expect to see continued overall investment performance that is below the levels experienced in the past. With this in mind—and the unignorably turbulent market results as of late—state policymakers should consider reducing the risk of future pension debt accrual by lowering their ARR even further.

The sooner government pension plans adopt more conservative return assumptions, the better off they will be down the road. More importantly, acting early can help ensure that promised pension benefits will be available for their public workers.

Map: State Pension Plans’ Assumed Rates of Return 2001-2018 (png)

Map: State Pension Plans’ Assumed Rates of Return 2001-2018 

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PERA currently holds over $6.7 billion in unfunded liabilities, and plan administrators have warned that deteriorating cash flow trends may create major financial challenges down the road in underperforming markets, necessitating increased contributions today to avoid benefit payout issues down the road.

The bill, sponsored by State Sen. George Muñoz and Rep. Phelps Anderson, passed with bipartisan support and was backed by a diverse array of labor associations and other stakeholders, including the PERA Board of Trustees, New Mexico Municipal League, New Mexico Counties, AFSCME Council 18, Americans for Prosperity-New Mexico, Communication Workers of America, New Mexico Professional Firefighters Association, Fraternal Order of Police, National Association of Police Officers, Albuquerque Fire Department Retirees’ Association, and the Albuquerque Police Officers Association.

The legislation largely codified into law a set of recommendations made by Gov. Lujan Grisham’s Pension Solvency Task Force last fall. The reform was backed by PERA’s Board of Trustees and administration, who—commendably, in our estimation—took their fiduciary responsibilities seriously and offered a strong case for reform in the interest of improving PERA’s solvency and reducing long-term taxpayer financial risks and costs. 

In the wake of the Solvency Task Force’s report, and throughout the 2020 legislative session, the Pension Integrity Project at Reason Foundation provided actuarial and policy analysis to legislators and an array of other stakeholders. 

While we believe that additional reforms—primarily shifting away from legislatively-set PERA contribution rates, paying down pension debt faster, improving actuarial assumptions, and expanding plan design options to expand choice—will still be needed in additional phases of reform to ensure long-term solvency, Senate Bill 72 was an important step in the right direction for New Mexico, both from a pension finance and bipartisan consensus-building perspective. 

The Problem

“We are avoiding the cliff if we do this,” Sen. George Muñoz told his Senate colleagues prior to the vote on SB 72. “At the end of the day, this fund has to be solvent.”

Indeed, PERA currently holds $6.7 billion in unfunded pension liabilities, most of which have materialized in the decade following the 2008 financial crisis (see Figure 1). 

Figure 1. PERA Historical Solvency, 1990-2019

Source: Pension Integrity Project analysis of PERA valuation reports, and CAFRs.

As the Pension Integrity Project described in a September 2019 report, investment shortfalls, negative amortization and changes to actuarial assumptions have been the primary drivers of PERA’s unfunded liabilities over the past decade (Figure 2).

Figure 2: Origins of PERA’s Unfunded Liability, 2010-2019

Source: Pension Integrity Project analysis of PERA valuation reports, and CAFRs.

As one indicator of the challenges facing PERA administrators and trustees, even though in 2019 the S&P 500 index—a composite index capturing the 500 largest U.S. publicly traded companies—reached an all-time high (see Figure 3), PERA’s funded status continued its steady decline.

Figure 3. PERA Funded Status vs. S&P 500 Index, 1990-2019

Source: Pension Integrity Project analysis of PERA valuation reports, CAFRs, and Yahoo Finance data.

Though PERA’s investment returns averaged 9.2 percent over the past 10 years, the average return falls to 5.9 percent when extended back 20 years. Worse, pension coffers became so depleted in the aftermath of the 2008 financial crisis that they failed to produce consistent material asset gains during the proceeding record-setting bull market. Put simply, PERA experienced a lost decade of investment gains during a market boom, making reducing unfunded pension liabilities and growing pension assets in absolute terms very difficult. 

To their credit, PERA administrators responded to the new normal low-yield investment economy by lowering the assumed rate of return from 8 percent to 7.25 percent in 2010, uncovering hundreds of millions in previously unrecognized (on an accounting basis) unfunded pension promises. Yet, using a range of industry-standard capital market assumptions, a Pension Integrity Project analysis of PERA’s investment portfolio suggests that PERA has between a 12 percent and 47 percent probability of consistently meeting its 7.25 percent investment return expectation in the next 10-to-20 years. 

Another major challenge is that for years PERA has been systematically underfunded due to a flawed funding policy whereby the state legislature establishes employer contribution rates in statute. The results have been the consistent failure to appropriate 100 percent of the actuarially determined employer contributions (ADEC) calculated by PERA actuaries each year as being necessary to keep the plan solvent.

Figure 4 shows the divergence between the total ADEC rates and the total annual statutory contribution rates each year since 2010, both in annualized and average terms. 

Figure 4. PERA Projected Total Statutory vs. ADEC, 2010-2020

Source: Pension Integrity Project analysis of PERA valuation reports and CAFRs. Contribution rates shown are for employers and employees combined.

As one example of contribution rate insufficiency, last year’s statutorily set employer and employee contributions for all PERA divisions combined equated to 26.84 percent of total payroll, which fell short of the ADEC rate by as much as 5.73 percent of payroll, or $145 million. 

Senate Bill 72: The First Steps Towards PERA’s Long-Term Solvency

Several provisions were included in SB 72, but the two core reforms that serve as the foundation for long-term solvency were: 

• Raising the statutorily-set employer and employee contribution rates each by 2.0 percent of payroll over four years, with a two-year delay for county and municipal employees and employers, and
• Transitioning from a static, fixed 2.0 percent cost-of-living adjustment (COLA) most current and legacy members receive—regardless of any actual change in consumer prices in the economy—to a profit-sharing model for retirees with a 3.0 percent cap and 0.5 percent floor, where COLA granted in any year is dependent on both investment performance and the plan’s funded status.

By embracing the “shared sacrifice” approach between employees and taxpayers in terms of equal contribution rate increases, along with adopting a prudent benefit adjustment mechanism designed to not pay out automatic, fixed-rate benefit increases at a time when the plan is declining in solvency, SB 72 represents a smart and collaborative balancing of interests between taxpayers, public employees and current retirees. 

“Will there be a little sacrifice from everybody? Sure […] But the sacrifice we make now will pale in comparison if we wait,” PERA executive director Wayne Propst recently told the Santa Fe New Mexican. 

To make the adjustments easier for those most affected by the transition, Senate Bill 72:

• excludes retirees over 75 and employees earning less than $25,000 per year from its provisions, 
• switches from a compound to simple 2 percent COLA (the so-called “13th check”) for the three years before the new COLA mechanism takes effect, and 
• discontinues the current seven-year waiting period for new retirees by reinstating a two-year COLA waiting period that had been removed in previous legislation.

Regarding the transition from a fixed-rated COLA to a profit-sharing model, under SB 72 the new COLA would only exceed the minimum 0.5 percent annual increase if smoothed asset returns exceeded a “COLA hurdle rate” to be set by PERA’s actuaries. The 3 percent COLA cap instituted by the new reforms would rise to 5 percent if PERA were to reach full funding.

Analyzing the Effects of SB 72 on PERA’s Pension Solvency

PERA administrators expect the passage of SB 72 to generate $700 million in long-term savings and eliminate all unfunded liabilities over the next 25 years if all assumptions are met. According to the latest projections published by PERA actuaries during the legislative process, the new reforms will improve PERA’s probability of reaching full funding by 2043 from 38 percent to 47 percent. 

From a fiscal standpoint, SB 72 sets New Mexico on the path to reducing PERA’s unfunded pension liabilities through increased contributions (Figure 5) and a transition to a more sustainable COLA mechanism. Shedding pension debt would undoubtedly make New Mexico more financially flexible in its public funding priorities and spare future state taxpayers hundreds of millions of dollars in pension debt payments.

Figure 5. PERA Employer Statutory Contribution Projections

Source: Pension Integrity Project actuarial forecast of PERA’s funding under the current baseline and SB 72 scenario. SB 72 scenario assumes that the state pays all newly established statutorily determined contribution rate each year, which fall over time because of lower normal cost for Tier II (i.e. post-2013) members. Projections assume a 0.5 percent/1.0 percent/2.0 percent reduction in both employer and employee contribution rates upon PERA reaching 80 percent/90 percent/100 percent funded status. Model assumes all actuarial assumptions are met and the current amortization policy is maintained.

Figure 6 examines how SB 72 will eliminate—or at least significantly contain—PERA’s unfunded liabilities over the next 30 years, especially in the event of sustained investment underperformance. Absent SB 72, unfunded liabilities would have continued to grow, likely surpassing $12 billion in the next 30 years—more than double the 2019 reported level—which would put much greater stress on both public budgeting priorities and PERA cash flows compared to today.

Figure 6. PERA Unfunded Liability Projections Before and After SB 72

Source: Pension Integrity Project actuarial forecast of PERA’s funding under the pre-SB 72 baseline and SB 72 scenario. Modeling assumes PERA meets all actuarial assumptions every single year going forward.

It is apparent from the Pension Integrity Project stress testing analysis shown in Figure 6 that SB 72 makes a major leap in risk reduction. In the event of a 100 basis point underperformance relative to the assumed investment return—in other words, hitting a 6.25 percent average return instead of the assumed 7.25 percent rate over the next 30 years—SB 72 would shield taxpayers from a quadrupling of current unfunded liabilities and avoid over $15 billion in additional unfunded liability. 

This risk reduction is important given the less optimistic near-term capital market forecasts. Leading financial advisors that provide forecasts for diversified institutional pension portfolios—for example, Horizon Actuarial Services, LLC, which surveyed over 30 such advisors in 2019—estimate that returns will average around 6 percent over the next decade. 

Modernized COLA Designed to Protect Retirees From the Threat of Inflation

The profit-sharing COLA structure included in Senate Bill 72, along with other COLA changes, helps increase the likelihood of PERA achieving full funding in the coming decades. But more importantly, SB 72 offers PERA a more sustainable approach while continuing to provide robust protection against inflation for retirees. 

Actuarial modeling by the Pension Integrity Project finds that the new COLA created under SB 72 is likely to produce annual benefit increases in the 1.3 percent to 2.5 percent outcome range over the 2023-to-2049 period (see Table 1).

Notably, we find there is a 50 percent chance the SB 72 COLA for current and future retirees below age 75 would average at least 1.71 percent annually through 2049, on par with the PERA actuary’s latest projection of a 1.61 percent average COLA. The Pension Integrity Project’s modeling suggests a 39 percent probability that the new COLA under SB 72 would meet or exceed the previous fixed 2.0 percent COLA rate over the same period.

Table 1. Average COLA & Inflation Projections

Source: Pension Integrity Project actuarial and stochastic forecasts of PERA’s funding under current baseline and SB 72 scenario. And Horizon Actuarial Services, LLC., “Survey of Capital Market Assumptions” (2019 Edition)

Conclusion

Senate Bill 72 was a necessary and crucial first step towards improving the financial health of PERA and ensuring the sustainable delivery of public employee retirement benefits for state and local workers. 

More importantly, the bipartisan and labor-supported effort established an important precedent in New Mexico and elsewhere for collaboratively seeking pragmatic solutions on a challenging public finance issue that is often intractable politically and fraught with emotions and fear. 

This is important because it is rare that one reform ever “solves” all the challenges facing a typical pension system. In this case, other fundamental changes will still be needed to strengthen PERA against volatile global markets, including paying full actuarially determined contribution rates, adopting more conservative actuarial assumptions, and increasing paths to retirement security for the growing share of the workforce unlikely to work the full 30 years in public service needed to receive an unreduced pension benefit.

Senate Bill 72 created a solid platform to begin the critical work of improving PERA’s long-term solvency.

The Pension Integrity Project looks forward to continuing our technical assistance and research support for all PERA stakeholders focused on creating sustainable benefit costs for taxpayers and long-term retirement security for New Mexico public employees.

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