In March 2022, over a third of the state and local government workers said they were considering quitting, according to a survey by MissionSquare Research Institute and Greenwald Research. This suggests that the worrisome trend of record resignations in the public sector could continue. In response to growing challenges in attracting and keeping valuable workers, lawmakers and government employers are eager to find solutions. Many policymakers are considering whether retirement benefits can be used to improve recruiting and retention. 

But addressing issues with retirement benefit design can be complicated because it is unclear how much value employees attribute to each benefit when they decide on accepting a job offer. Although government employers may assume that retirement benefits can help them attract a quality labor force, research is inconclusive. This topic deserves more attention in the face of ongoing recruitment challenges. One way to investigate further is to ask labor force entrants about their preferences directly. At least one survey suggests that younger public workers might not perceive retirement benefits as a highly motivating factor, contradicting conventional wisdom.

Because retirement benefits make up a large share of the compensation package, a change in the value of retirement benefits can influence employment decisions. The traditional belief is that—other factors being equal—a change in retirement benefits may lead to a change in employment attractiveness and, over time, changes in retention. When researchers study retirement benefits empirically, using data from pension plans, we assume workers’ actions change based on the shift in incentive (retirement benefit). But deriving such a conclusion requires an assumption that employees value retirement as much as other parts of their compensation package, including salary, health insurance, stability, etc. Is that assumption true? 

One way to get a better understanding is to implement a qualitative study tool that would reveal how employees value retirement benefits when compared to other deciding factors. Specifically: Ask prospective employees whether they find specific benefits meaningful enough to motivate their employment decisions. 

An April-May 2022 survey by MissionSquare Research Institute did that by asking 102 fellowship candidates from the national service program Lead For America to gauge their motivation toward public service, impressions of the application process, and other career aspirations. (Figure 1)

Figure 1. Ranking of workplace considerations 

Source: MissionSquare Research Institute

Given a list of eight benefits to public sector employment, personal satisfaction from the job and salary were ranked highest, and life insurance and retirement benefits ranked lowest. According to the respondents, health insurance benefits are still very important for young workers, ranking third in the survey’s list of priorities. Moreover, even nontraditional benefits such as tuition assistance, student loan repayment, employee assistance programs, and childcare assistance ranked higher than retirement benefits in the survey. 

This finding reveals important insight into how these Gen Z employees think about retirement benefits. If retirement benefits are not valued as much as other benefits, perhaps public sector employers are overinvesting in pensions at the expense of other components, like professional development programs and childcare. 

Public sector employers should prioritize understanding the work components that matter to their employees. MissionSquare’s small survey of young workers reveals that retirement benefits might not be a high priority for the incoming labor force. So perhaps that is not the right way to attract and retain valued workers. Judging by the responses of this young group of public workers, policymakers should further survey a broader sample of government workers because they may find similar results suggesting they should prioritize recruitment and retainment policies that improve personal satisfaction and general compensation.

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The goal of a hybrid plan is to provide an adequate benefit at an affordable cost—a fiscal policy that aligns with any retirement benefit. Reason Foundation’s Pension Integrity Project published best practices for hybrid plans earlier this year. As a compromise between defined benefit and defined contribution structures, hybrid plans, when implemented properly, offer policymakers a best-of-both-worlds blended approach.  

The key consideration for structuring a good DC portion of a hybrid is the actual contribution going into the account. In combination with the guaranteed DB portion, this contribution must be sufficient to help workers plan for and sustain a healthy retirement. Until recent changes were made in Georgia, this was a weakness of the state’s hybrid plan.  

Georgia’s state legislature recently approved a few changes to GSEPS that allow for a greater employer match in its DC portion. Specifically, the employer match contribution was increased from 3% to 5% of a worker’s pay. Moreover, plan members with six or more years of service will see an additional .5% per year, up to a maximum match of 9%. Employer matching contributions are subject to the plan’s vesting schedule; GSEPS vests 20% per year, reaching full vesting at five years of service. 

As a best practice, employee and employer contributions to the DC portion must be sufficient to provide an adequate retirement benefit. For hybrid plans, contributions should be designed in a way that ensures members would get at least a 60% income replacement after 30 years of employment. When designing a plan, policymakers should keep in mind that if roughly 30% of the replacement ratio is coming from the DB plan, the rest should come out of the DC portion. 

For Georgia, the combination of a pension plan and a fully matched 401(k) plan at the newly adopted levels will provide approximately 59% of an employee’s salary in retirement, according to the retirement system’s calculation. With Social Security benefits added, the total benefit could be 90% or more of a member’s final salary, assuming an investment return of 6% over 30 years and a 5% average contribution. For the sake of comparison, the nation’s average 401(k) matching contribution is approximately 3.5%, with only 10% of employers giving a matching contribution of 6% or more. 

In addition to providing an adequate benefit, the creation of a hybrid plan has allowed Georgia to reduce the growth of its pension liability. According to a study performed by the Georgia Department of Audits and Accounts, without the creation of GSEPS, the retirement system’s unfunded accrued liability (UAL) would be $67 million (or 1.5%) higher than it is today and would have necessitated higher employer contribution rates.  

Overall, Georgia’s recent change is a step in the right direction toward ensuring benefit adequacy for the state’s retirees. As it is now designed, the plan ensures that the existing liabilities are managed and a competitive retirement solution is offered. Georgia’s plan strikes a proper balance of risk between employees and employers, provides retirees with secure and predictable retirement, and offers the flexibility they need to get the most out of their retirement contributions.  

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CalPERS announced that its investment losses were -7.5% for its fiscal year, a further downgrade from the -6.1% returns reported a few months ago. These losses were in stark contrast to last year’s outstanding investment results when CalPERS posted 21.3% gains, which were mistakenly taken by many as a sign of stabilization.

Currently, the retirement system’s annual assumed rate of return—an estimate of the plan’s investment gains—is 6.8%. Through the years, CalPERS’ failure to meet its assumed rate of return has been the main driver of the system’s unfunded liability. With the latest investment losses applied, Reason Foundation estimates CalPERS’ debt is now $164 billion. This public pension debt roughly translates to over $4,000 in debt for every Californian.

Another marker of a pension plan’s financial health is the ratio of its debt to assets, also known as its funded ratio. After this year’s financial losses, CalPERS reported that its funded ratio plummeted from 81% in 2021 to 72% as of June 30, 2022, which means the pension system now has just 72 cents of each dollar needed to provide the pension benefits that have already been promised to current workers and retirees.

California’s public sector workers’ pensions are guaranteed by the state—meaning that state and local taxpayers are ultimately on the hook for CalPERS’ debt. When pensions are underfunded, like CalPERS is, the state must compensate for the debt through increased contributions. The 2022 fiscal year’s financial losses will likely cause state and local government contribution rates to rise in the next few years as governments, i.e., taxpayers, make up for the difference between the assumed rate of return of 6.8% and this year’s -7.5% loss.

The nonpartisan Legislative Analyst’s Office has determined that required public pension “contributions may increase 5%-12% of payroll over the next several years.” When a more significant chunk of state and local budgets is shifted to cover the rising costs of these pension benefits, other government services must be cut, or governments must pursue tax increases to maintain their current spending levels.

Recognizing that long-term investment forecasts are warning of lower annual returns in the coming decade, CalPERS has wisely lowered its assumed rate of return over the last several years. It has also created an asset liability management process that sets the ground for better balancing the cost of pension payments with expected future investment returns.

However, this year’s dismal financial returns, ongoing worries about a possible recession, the economic slowdown hitting California’s technology sector especially hard, and a state budget deficit that the Legislative Analyst’s Office says will reach $24 billion in 2023-24 are sending strong signals that further action is needed.

CalPERS should be even more proactive in accounting for these economic trends by further lowering its investment return expectations. Based on market expectations of asset growth for the upcoming decades, CalPERS should lower its expected rate of return to under 6.25%.

In addition, the pension plan’s leadership should encourage more government agencies and employers to take advantage of the California Employers’ Pension Prefunding Trust. Prefunding allows employers to generate investment income to pay the required contributions and reduces budget dependency on investment income. Moreover, it helps government employers during challenging financial times by offsetting their pension costs. This strategy would help pay down pension debt faster and stabilize some local government budgets.

During this economic uncertainty, many CalPERS stakeholders likely recognize that the problems that have kept so many public pension systems underfunded for the last few decades still exist. As a result, public pension plans—and thus taxpayers—are as vulnerable to financial shocks as they were in the past. California should prioritize solutions that minimize these risks in the future, making efforts to pay down its pension debt and making CalPERS more resilient and prepared to deal with the ups and downs of an uncertain economic future.

A version of this column first appeared in the Orange County Register.

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For some public sector workers, the portability of retirement benefits is becoming increasingly crucial to their career and employment decisions. With today’s workers proving to be less likely to stay in one position than previous generations, they need their accumulated retirement incomes to be retained even if they change jobs. To keep up with this shifting workforce environment and attract quality workers to government jobs, policymakers need to ensure that public retirement plans work for both short-term and long-term employees. 

About a third of all government sector workers said they were considering quitting earlier this year, according to MissionSquare Research Institute. To make matters worse for government agencies, young federal employees are leaving their jobs at a rapid rate, with nearly 10% of those under 30 quitting in the 2021 fiscal year, according to a survey of federal workers by the Partnership for Public Service. This contributed to roughly one million fewer state and local government workers in 2021 compared to 2020, according to Statista. The potential for public workers departing their jobs appears to be even worse for teachers, with around two-in-five teachers saying they’re planning to quit between 2022 and 2023, according to Bloomberg.  

While the transitory nature of public workers has been particularly noticeable over the last two years, this has been a long-developing trend. Even before the pandemic, millennials and Gen Z workers told pollsters like Gallup they valued mobility and the opportunity to work remotely. In addition, they put a lot of value on non-monetary aspects of employment, such as the ability to pick projects rather than specific jobs, mentorship, and easy-to-access technology in the workplace. 

Overall, these trends help show that fewer public sector employees are likely to spend a career with one employer than in previous eras. Recognizing the trends of the modern workforce is essential to recruiting and retaining good workers and to the success of a retirement plan, whose general purpose is to fit the retirement needs of its members.  

Public retirement plans should calibrate their benefits to provide a clear level of retirement security, even for those who do not stay with that employer for a decade or more. Security in retirement can be quantified and defined as a range. For example, a typical retiree would like to have 70% to 90% income replacement in retirement from all of their income sources. Any retirement plan’s most basic goal should be to provide enough income during retirement to maintain something similar to the retiree’s pre-retirement standard of living. As a rule of thumb, a well-designed retirement plan (or combination of employer-sponsored retirement plans, Social Security, and/or private savings) should replace approximately 80% of a worker’s final salary. This assumes retirees will have a lower cost of living with most of their major financial commitments, such as mortgages and childrearing, complete.  

Ensuring that these metrics are met is key in providing an adequate retirement plan, whether an employee stays for 30 years or just one year. Many public employers use retirement policies and plan designs to incentivize retention, with retirement benefits that increase in value as an employee accumulates years of service. While there is nothing wrong with rewarding public workers for sticking around, this too often results in inadequate retirement benefits for those who do not spend their entire careers in one position. To ensure that public employers are providing adequate retirement in a shifting job environment, there are a few key policies that should be evaluated and reformed. 

One way to adjust retirement benefits to match the modern workforce is for government employers to reduce or eliminate vesting periods, the number of years required in the plan before benefits are fully “owned” by the participant. Many defined benefit (DB) plans have long vesting periods before a participant is able to take advantage of the benefits portion of their compensation. Public defined contribution (DC) plans—while a completely different type of plan—can also have excessive vesting requirements that do not suit a mobile workforce. If an employee leaves before being fully vested, their transferrable benefits can be substantially reduced.  

Other potential solutions that government employers could consider are optional or default defined contribution plans, which have unique advantages in being able to meet career mobility realities. Since DC plans have individual accounts, they are easily transferable with the employee to a new workplace. Although DC plans do not guarantee a specific amount of retirement income, there are several ways to ensure that the appropriate contributions to the plan are made and retirement security is achieved.  

The structure of the workforce is changing with new trends in workers leaving sooner and more frequently. It is important to ensure that government employers meet the demands of public sector workers by introducing more portable retirement options and addressing the long vesting requirements of many plans. Policymakers should seek reforms that maintain valuable benefits for the career, 30-plus-year worker, while also helping the increasingly common worker who stays on a job for one-to-five years. By doing this, public employers can better serve the growing number of employees who are less likely to stick around for their whole careers. 

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When providing services in the EU, GDPR requires all publishers with websites and apps to receive user consent to visit the website or app before loading the platform for each unique visitor. The publisher must then provide an interface to manage how much data is kept, publish a dedicated cookie policy, host a separate privacy policy, and other exhaustive details.

The impact of GDPR has gone much further than changing protocols for website hosts. An analysis of 2017 and 2019 waves of CIGI – Ipsos’ international survey on attitudes towards the internet reveals that EU members might end up with slower improvements to UI (user interface) and UX (user experience) as compared to much of the world due to the unintended, real-world consequences from adopting privacy regulation as restrictive as the GDPR. For the purposes of this comparison, all countries that appear in the survey and fall under GDPR jurisdictions are labeled as GDPR. All other countries are labeled as ‘world.’

Self-reported difficulty using the internet for daily tasks, before and after GDPR.

Across the above metrics, many more non-GDPR residents reported an easier internet experience. If the label “easier” can be used as a proxy for improvement of content usability, then we may conclude usability is increasing in many parts of the world faster than it does within GDPR-regulated countries. Comparing GDPR countries between 2017 and 2019 showed some improvement, but it was not as drastic as it was for the rest of the world.

GDPR may be slowing down user experience improvements, but why would privacy legislation matter for daily internet activities?

The reshaping of digital interfaces to comply with GDPR has detrimental effects on both companies and end-users. Specifically, SMBs (small and midsized businesses) and startups suffer more because they lack the resources and staff to upgrade their systems and interfaces to comply with the law while maintaining daily operations. Some companies have shut down their services within the EU altogether because of concerns about compliance with the GDPR.

GDPR also may limit the accessibility of foreign content by European audiences, since many international firms simply do not have the resources or market incentives to adhere to the regulations. Two months after GDPR went into effect, 30% of the most popular U.S. news websites were forced to block access to the EU due to their inability to comply with the GDPR requirements, and some of these websites are still not available. The list included Pulitzer award-winning publishers like The Chicago Tribune.

These examples of domestic and international businesses eschewing the European market because of GDPR should not surprise those who are familiar with the law, as penalties are quite extreme for those who fail to comply with the regulation. For example, companies that fail to comply with GDPR may be punished with up to 4% of global sales or 20 million euros, whichever is higher.

Europe's situation is not without hope - policymakers can still look to reform GDPR to be more business and user-friendly. As states across the U.S. draft privacy regulations and talks about national data privacy legislation begin to grow, GDPR's unintended outcomes should not be ignored. European experience should be further analyzed in order to find a balance between reasonable protection of American privacy and our ability to use the internet now and in the future.

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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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However, the 2022 state budget passed by New York lawmakers also reversed several major pension reforms enacted in 2012. As a part of the new budget, the state reversed the 2012 law’s requirement that higher-salaried employees contribute more to their pensions. This change transfers more costs to future state budgets and taxpayers.

Vesting period changes that were in the 2012 pension reform bill will also be reversed, which will also undo some of the savings of the reform. But the vesting change could be a welcome one because the shorter vesting period will better align the NYCRF with the needs of a modern workforce. It is crucial to examine each of these reversals in more detail to understand what they will mean for NYCRF’s long-term perspective.

Reducing Pension Contribution Requirements

As part of a bipartisan agreement between legislators, the 2012 pension reforms established a progressive payment system for new state employees. As a result, public employees who earned a higher salary paid a higher percentage of their compensation toward the pension fund, which helped manage growing pension costs for government employers.

However, the 2022 budget passed by the legislature and signed by New York Gov. Kathy Hochul removes this feature, which will be a significant windfall for public employees with higher salaries. As previously noted, it also brings increased fiscal pressure on state budgets and taxpayers to make up the difference.

Public pension benefits are typically constitutionally protected, meaning the government—and taxpayers—must ultimately be the backstop if projected contributions to a pension system are not enough to cover the benefits promised to workers. Due to this rollback in progressive contributions for public employees, state and local governments will have to find taxpayer money to make these increased pension contributions. So, while the state budget measure puts more money in the hands of public employees now, it is a significant burden for taxpayers to carry now and into the future.

Temporary Overtime Costs Waiver

Usually, New York’s Tier 6 employees (those who joined the public pension system after April 1, 2012) had their pension contributions calculated based on their base and overtime pay. The new budget legislation removes overtime pay from the Tier 6 contribution rate calculation (applied to wages earned from April 1, 2020, through March 31, 2022), effectively lowering a member’s contribution rate.

However, the change does not affect the benefit calculation for the same workers. As a result, the workers’ contributions will go down for the time they were employed during the COVID-19 pandemic, while their pensions will remain unchanged. Tier 6 is now the largest tier in NYCRF. Since there are more than 325,000 members in Tier 6, the reduction in contributions will ultimately be a significant expense for the state.

Reduction in Vesting Requirement

The reversal of the 2012 pension reform will also lower vesting requirements from 10 years back to five years, which will also generate additional costs and pressures on state budgets. This particular rollback, while expensive, should improve the state’s ability to provide valuable retirement benefits to its public employees. Essentially, this change should allow more public workers to be eligible for a pension benefit because they will be able to qualify for a pension in half the time. New York state was an outlier in this regard, as most public pension plans only require around a five-year vesting period to become eligible for pension benefits.

While lengthy vesting requirements may reduce costs, they are a concern because they lead to large portions of employees being left without a sufficient retirement benefit, which is counter to the purpose of the state’s retirement plan.

Many modern employees are switching jobs and careers more frequently and sooner than their older counterparts. For example, on average, modern public-sector workers spend just 6.5 years on a job. So, expecting a 10-year commitment before someone vests into the public pension plan ends up excluding a large percentage of employees.

Overall, lowering the vesting requirement back to five years will allow more workers to retain their full retirement compensation, and it will be a valuable improvement for the state because it will align the retirement plan with existing shorter tenure patterns.

Thus, there are both negative and positive impacts from New York policymakers rolling back the pension reforms made a decade ago. While it is good to step back from the counter-productive 10-year vesting requirement, the reversal of a progressive employee contribution policy will transfer significant costs to taxpayers.

The post-pandemic economy, with its high inflation and uncertainty, may be pushing New York lawmakers to relax some of the state’s previous more fiscally conservative reforms. However, a recent Reason Foundation analysis of expected funding outcomes shows that public pension plans across the country are likely to see their unfunded liabilities increase. Lawmakers shouldn’t remove guardrails that were enacted to address growing budgetary pressures and runaway costs.

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Traditional investments, such as public equities and bonds, are not producing at historically-high investment return levels and many public pension systems have increased their investments in higher risk and potentially higher reward investment options, like private equity.

In the aggregate, for public pension plans, investments in private equity have grown to  represent 8.9% of their total holdings, a notable acceleration since 2018. According to The Wall Street Journal:

Government retirement funds are pumping record sums into private equity, defying concerns about risk and cost as they try to plug pension shortfalls. U.S. pension funds’ private-equity investments swelled to an average 8.9% of holdings in 2021 after three years of straight growth, according to analytics company Preqin. That amounts to roughly $480 billion of state and local pension fund assets tracked by the Federal Reserve, up from about $300 billion in 2018.

Some of the growth comes from blockbuster 2021 returns—54% for private-equity funds tracked by the data analytics firm Burgiss, not including venture capital, for the year ended June 30.

However, return experience from investments in private equity has differed significantly between pension plans. This inconsistency adds to uncertainty over private equity’s suitability for ensuring the security and sustainability of pension plans for teachers, firefighters, and other public sector employees. 

Private equity investments are not easy to value , which can make it difficult for public pension investors to make informed decisions on this key subset of assets. For example, private equity funds only report their results annually, creating a significant lag in information for their shareholders.

Also, since they are not publicly traded, these private equity valuations tend to contain more inaccuracies than other similar investment reports. The Securities Exchange Commission does not require a list of assets to be publicly available, which also makes it difficult for investors and the public to access all relevant information. 

The proposed reporting requirement from the SEC would force private equity funds to report quarterly instead of annually. These reports would require details about fee structure, manager compensation, and performance of securities. These private equity funds would also be subject to annual audits. 

This proposed level of reporting will lend itself to public plans who need to evaluate the risks they are taking on, and it will hopefully help public pension plans reduce situations where they are caught off guard by investment returns coming in way below their expectations. For example, The State Teachers Retirement System of Ohio's holdings in private equity have not met the high expectations set for this classification of investments. The plan’s assets returned an average of 6.7% annually over the past 5 years, lagging well behind the plan’s 10% benchmark.  

Another example is the Pennsylvania Public School Employees Retirement System (PSERS), which allocated more than half of its assets to alternative investments. Critics of PSERS’ investment strategy have suggested that the fund would have been better off investing in index funds or even stocks and bonds. The plan’s private equity return over the last 10 years was 7.7%, which is lower than the S&P 500's return during that period. 

Private equity firms are understandably pushing back on this increased regulation, feeling they're private entities who offer sufficient information to their willing investors and that the government regulations will not improve their sector. Other concerns from private equity firms include the worry that the quarterly reports may also leave less time for companies looking to right the ship, a significant advantage for new companies looking to use private equity funding.  

The stage is set for further discussions on how private equity is monitored and reported. With more and more public pension dollars tied to private equity performance, the increased focus by the SEC is notable.

In the meantime, public pension funds should be careful in developing an over-reliance on private equity, which should not be viewed as the solution to public pension debt and the perpetual underfunding of pension systems.

The race for higher yields and the increased volatility that comes with it can threaten the fiscal health of public pension plans, which puts taxpayers and public workers at risk. The costs of public pensions are rising for most governments and an overreliance on private equity is likely to exacerbate the growing challenges facing government budgets and taxpayers. 

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Five years ago, the Jacksonville City Council approved a pension reform package while enacting innovative changes, reducing debt by more than $585 million and adding over $155 million to pension reserves. A key element of the pension reform that led to reduced debt was closing the city’s three pension plans to new public employees in 2017. Since that change was put in place, over $715 million has been used to grow Jacksonville’s economy and invest in public services for its population. In addition, credit rating agencies, such as Moody’s, assign “grades” to governments’ ability and willingness to service their bond obligations, taking into consideration the jurisdiction’s economic situation and fiscal management. Since the pension reform reduced budgetary pressure, it improved the chances of the city getting a credit upgrade. 

The Jacksonville Daily Record reports:

Moody’s cited the closing of three pension plans to new employees as a factor for the rating improvement along with others:

• Material improvement in the city’s cash and liquidity position (issuer and non-ad valorem ratings.) 

• Significant reduction in the growth of the city’s pension obligations (issuer and non-ad valorem ratings).

• Material economic improvement reflected in tax base growth, lower unemployment and increased median family income (issuer and non-ad valorem ratings).

• Improved coverage from pledged revenues (special tax ratings).

Facing billions in unfunded public pension liabilities and increasingly expensive debt service payments, city leadership decided to stop adding risk to the budget by making the defined contribution plan the primary vehicle of a secure retirement for new hires beginning in 2017.

In addition, Jacksonville prioritized paying down the $2.86 billion in unfunded retirement benefit liability owed to current employees and retirees over the coming decades. While the city does not accumulate any pension debt from new hires, existing pension promises previously made to workers with defined benefit retirement accounts must be fulfilled. Overall, the pension reforms reduced the city’s risk, brought long-term costs under control, and improved pension funding policy overall.  

The 2017 pension reform is expected to lower unfunded pension liabilities and get the city’s pension plan closer to 100% funded in the coming years. Since getting existing liabilities under control makes the city more likely to honor its future debts, it inevitably has a positive effect on the city’s credit rating.  

When a city like Jacksonville receives a credit rating upgrade, it can issue bonds at a lower interest rate. This process is similar to an individual becoming eligible for lower interest rates as their credit scores improve. With lower interest rates available, the city can lower long-term costs and has more flexibility to invest in infrastructure projects and other public services.

“Roads and bridges and programs, parks, libraries, public health, and safety. All of that impacts our community and our citizens as they go about their daily lives. These things that we just sometimes take for granted that, you know, take a lot of money to keep in good working shape,” said Joey Grieve, the city’s chief financial officer, in a recent interview. 

Jacksonville’s experience shows how sensible public pension reforms can positively impact the fiscal outlook of a major city while also improving public workers’ retirement security. The full effects of Jacksonville’s 2017 pension reform will be realized over decades, but it is clear from Moody’s credit rating upgrade that the reform has already contributed to improving the city’s finances. 

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Naturally, post-employment benefits would be a part of an individual’s consideration in accepting and staying in a job. Academic studies on this factor, however, have demonstrated mixed results. Some studies observed an increase in employee turnover after changes were made to their retirement benefits, while other studies have found changes to benefits had partial or no effect on workers’ behavior. In short, it is still relatively unclear how changes to retirement plans affect worker retention.

A new Reason Foundation working paper looks at teacher turnover rates in Alaska after the state closed its defined benefit pension plan in 2006. All new hires after June 30, 2006, were placed into the Defined Contribution Retirement (DCR) Plan. Since the public pension reform took place over a decade ago, there is now enough data to identify the behavior changes of Alaska teachers. 

To understand the effect of the 2006 change, the paper uses individual-level observations and conducts regression analyses of the data, measuring the likelihood of teachers leaving employment. Several important findings emerge from the analysis.

First, contrary to the aforementioned arguments against DC plans’ ability to retain employees, the paper documents that defined contribution plan enrollment did not increase teacher separation rates in Alaska. In other words, teachers who were enrolled in the defined contribution plan were not more likely to quit than colleagues that were enrolled in the defined benefit plan. 

Second, focusing on Alaska’s vested workers—or those who remained on the job for more than five years—shows that members in the DCR plan had a four times lower separation rate than DB plan members. These findings suggest that Alaska’s switch to a defined contribution plan may have even helped retain newer teachers. It is worth mentioning that Alaska public sector workers are not enrolled in Social Security. This means there is not a guaranteed ‘floor’ benefit for workers. Their retirement income is completely reliant on state-provided retirement and personal savings. Nonetheless, replacing the DB plan with a DC plan did not create additional teacher turnover for the state.

These findings raise questions as to the effectiveness of relying on pension plans to improve retention. As policymakers weigh different options in public retirement plans, it is important to understand the impact (or lack thereof) of retirement plan design on the decision-making of individual public workers. Alaska provides a unique perspective on this issue and suggests that not only are defined benefit plans ineffective retention tools but also that defined contribution plans may improve the retention of teachers in their first few years. 

The post Alaska’s public pension reforms didn’t result in higher teacher turnover rates appeared first on Reason Foundation.

In 2005, Alaska enacted one of the most radical retirement system reforms in the public sector by discontinuing enrollment into its defined-benefit pension plan and creating a 401(k)-style defined contribution plan for all new public workers hired after July 1, 2006. The pension reform represented a significant change in accrual patterns, a reduction in benefit generosity, and a transfer of investment risk from the employer to the employees.

Using individual-level data for all Alaska teachers in the Teacher Retirement System (TRS) before and after the retirement benefit change (2005–2017), we assess the effects of the reform on teacher mobility out of employment with the Alaska K-12 system. Using a panel of member-specific data, we examine the short-run and longer-run effects of a radical benefit redesign on the labor market behavior of public educators.

Contrary to expectations, we document a decrease in separations after the reform in the short-run while also showing weaker but still negative longer-term impacts of the reform on teacher separations from public sector employment as educators.

Working Paper: Effects of a Transition to a Defined Contribution Retirement Plan on Teacher Separations in Alaska

The post Working Paper: How shifting to a defined contribution retirement plan impacted teacher retention in Alaska appeared first on Reason Foundation.

The New York State Teachers’ Retirement System (NYSTRS) is scheduled to lower its assumed rate of return from 7.1% to 6.95%, beginning July 1, 2022. The pension system has nearly $120 billion in assets and is fully funded as of its latest actuarial valuation in January 2021.

While this drop in investment expectations is a lot less drastic than the one the NYCRF took (lowering the assumed rate of return from 6.8% to 5.9%), it is still a step in the right direction. Similar to the New York Common Retirement Fund, since 2014 NYSTRS has been gradually lowering its investment expectations from 8.0%.

The assumed rate of return (ARR) is the most critical component of properly evaluating the price of funding promised pension benefits. If the public pension fund fails to meet its investment target, the pension plan’s assets will not grow enough to pay for earned benefits, therefore accumulating unfunded pension liabilities. Lowering the investment expectation target makes it easier to meet plan assumptions over the long term and allows the pension plan to invest in less risky assets. Consequently, a lower assumed rate of return reduces a plan’s risk of accumulating pension debt.

NYSTRS’s new 6.95% rate will bring the plan’s assumed rate of return below the national average of 7%. This is a timely and wise decision because, between 2001 and 2020, the median actual rate of investment return for state public pension plans was only 5.7%. Any lowering of the ARR does come with a growth in employer contributions, but the total cost of NYSTRS’s assumed rate of return adjustment is to be announced by the pension board.

NYSTRS’s decision to drop its assumed rate of return comes on the heels of the pension system’s extraordinarily high 29% investment return in the fiscal year 2021. Many retirement plans are similarly seeing high investment returns for last year. However, pension and financial experts predict that investment returns going forward are unlikely to be as promising so adjusting investment return expectations now better matches what investment experts are predicting for the next few decades. More states should join New York in lowering their pension systems’ investment return assumptions.

The post New York teachers’ pension plan lowers investment expectations appeared first on Reason Foundation.

Table 1 and Figure 1 below show the results of a Monte Carlo simulation model based on NYCRF’s target asset allocation and reported expected returns by asset class. This analysis uses 10,000 simulations to generate both the probabilities of hitting certain returns and expected return distributions. Using forecasts of investment returns by asset class from BNY Melon, JP Morgan Chase, BlackRock, Research Affiliates, and Horizon Actuarial Services, the analysis matches the specific target allocation of asset classes set by NYCRF. These data indicate NYCRF’s probability of achieving a target return if all other economic and demographic assumptions are hit.

Table 1. Probability Analysis: Measuring the Likelihood of NYCRF Achieving Various Rates of Return

Graph 1. Probability Analysis: Probability Distribution of Return Outcomes

The results show that the pension fund’s new assumed rate of return is in line with 10-year forecasts from most market experts and better reflects the system’s investment experience from the last few decades. Even though New York’s new assumed rate of return of 5.9% will put the system’s rate well below the nation’s average of 7.2%, it is still slightly higher than the 5.7% average actual rate of return. over the last 20 years. It’s also important to note that two of the short-term forecasts used in this analysis still indicate that NYCRF may be wise to lower expectations even further.

Like many other public pension systems, New York has had a year of exceptional investment returns but the plan should not expect excellent returns moving forward.

Having realistic expectations of long-term investment outcomes plays a major factor in a pension system reaching its fiscal goals. When long-term investment returns are consistently below the rate a plan assumes it will achieve each year, asset growth will lag behind the levels needed to fund promised benefits. This leads to growth in unfunded pension liabilities and long-term costs for employees and taxpayers.

Going forward, public pension plans across the country should follow NYCRF’s lead and assess their near-term investment outlook and adjust assumptions accordingly. 

The post New York state’s new pension investment assumptions will help plan funding appeared first on Reason Foundation.

This investment performance is in stark contrast with last year when ERS had a negative 3.6% return (a loss) and TRS saw a modest 2.9% gain. The high investment returns are not unique to Georgia: Nationally, public pension plans have averaged investment returns of 27% for the fiscal year 2021.

The high returns are great news for ERS, a multi-tier public pension plan that enrolls all new employees to a hybrid defined-benefit (pension) and 401(k) plan. The structure of the hybrid benefit provides accountability and manages the burden that unfunded liabilities have on government budgets and taxpayers. According to the latest reporting, ERS now has $2.3 billion in unfunded liabilities and is 87.6% funded, a significant improvement from the previous year when it had $4.2 billion in unfunded liabilities and just 76.2% funded.

Strong investment returns are great news for Georgia’s teachers as well. Unfortunately, a year of good returns will hardly be the long-awaited salvation for TRS, which is the pension plan serving the state’s educators. As pointed out in a previous analysis, the teachers’ retirement plan faces several significant challenges that will require more than a single year of great investment returns to fix.

Going forward, it should not be assumed that Georgia’s pension plans’ high investment returns will continue. Experts predict the average investment return for public pension systems over the next few decades is likely to be less than TRS’ current target of 7.25%. Regardless of the high investment returns now, TRS should quickly lower this investment return assumption, which is above the national average of 7.0%. One year of excellent returns will not change the fact that TRS is most likely underestimating its unfunded liabilities.

Before the COVID-19 pandemic, there was a discussion of possible reforms to TRS. Among the proposals discussed were lowering assumed investment return rate assumptions, shortening the amortization schedule, and creating a new benefit tier.

The Pension Integrity Project at Reason Foundation pointed out that lowering the return rate assumption can improve a public pension system’s ability to keep promises by reducing the risk of insolvency and improving the long-term predictability of contribution rates. Shortening the time frame to pay off pension debt, in turn, can reduce the total long-term costs of the pension system. Creating a new benefit tier would not result in any changes to the benefits of current participants or increase state contributions, and it could lower the overall risk of plans’ underperformance.

A single year, or even several years, of exceptionally high investment returns, would be welcome news for TRS. Even a streak of high returns, however, will not change the harsh truth that TRS and many other public pension plans still face significant funding risks and unfunded liabilities going forward.

Georgia’s policymakers need to address these risks to protect taxpayers, employees, and retirees. Absent meaningful pension reforms to reduce financial risk and improve the solvency of the teachers’ retirement plan, the state will increasingly have to divert money away from other public priorities, such as K-12 education and infrastructure repairs, to pay its rising pension costs.

A version of this column was originally published by the Georgia Public Policy Foundation.

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The Pennsylvania Public School Employees’ Retirement System (PSERS), which serves the state’s teachers and school workers, is leaning on alternative investments at a much higher rate than most state plans. PSERS invested 62.6% of its assets in alternatives like real estate and private equity over the last decade. For context, the average pension plan invests about 20% of its assets into alternatives. Pension Integrity Project analysis of PSERS portfolio performance has indicated that this asset class has underperformed relative to hypothetical passive index fund investment. Despite the focus on alternative assets, our policy analysts found:  

“For the last five fiscal years, PSERS only outperformed Vanguard’s basic 60/40 stock-bond portfolio (VBIAX), net retail investor fees, once.”

Private equity investments lack transparency and are difficult to value. As opposed to publicly traded securities, limited partnerships used by private equity managers can’t provide frequent performance updates and, as a result, advise stakeholders after the end of each fiscal year. This leads to a lag in reporting important details. Moreover, shares of companies owned by private equity funds are not publicly traded, meaning that their values can only be estimated, which is subject to potential bias. Private equity firms are also not obligated by the law to publish their lists of assets in accordance with Securities and Exchange Commission rules. While this information can be found on Bloomberg Professional Terminal, it is not available to the general public. This lack of transparency should be concerning to employees and retirees who rely on these funds and taxpayers who contribute to them.    

For the Pennsylvania teacher system, the management fees associated with private equity investments that the plan had to pay over the past four years ($4.3 billion) are more than the total amount members paid into the plan during the same time ($4.2 billion). The pension plan recently announced that member contributions will have to be raised going forward because of long-term investment results below the plan’s benchmark. As a point of comparison, the New York State Teachers’ Retirement System, which has double the assets of PSERS, reported 36% less in total investment fees and expenses than PSERS.

Pennsylvania’s teacher retirement fund isn’t the only public pension to come under scrutiny because of private equity investment this year. When Ohio’s teacher pension eliminated an annual cost-of-living increase in 2017, it caused legislators, retirees, and plan members to pay greater attention to the fund’s investment transparency and the fees paid to private equity fund managers. The State Teachers Retirement System of Ohio (STRS), which has over 18% in alternative investments, has been paying about $303 million, or 0.40% of the assets the plan held in 2018, in fees associated with active investments in private equity and hedge funds. Reason’s senior policy analyst Marc Joffe found that:

“In Ohio, all five state pension plans tracked by the state’s Retirement Study Council reported returns on domestic public equities substantially exceeded their private equity returns.”

Pension funds shouldn’t rely on alternatives investment as a tool that will single-handedly save pension plans from investment returns below plan expectations. The race for higher returns can jeopardize the fiscal health of a pension plan and the financial future of the plan members. Coupled with high management fees, alternative asset investments are proving to be a risky gambit for most plans that are already seriously underfunded.

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The New York State Common Retirement Fund has nearly $270 billion in assets, making it the country’s third-largest public retirement fund. The plan’s new assumed rate of investment return of 5.9 percent will be the second-lowest investment return assumption among the country’s 130 largest state and local pension plans. The average assumed rate of investment return for state and local pension plans hovers around 7.2 percent.

A plan’s assumed rate of return is the most important assumption for a pension fund. If a fund realizes long-term investment returns below its assumed rate, the pension plan’s assets will not grow to the levels predicted and it will lead to growth in unfunded pension liabilities. It is significantly easier for a pension plan to meet a lower investment expectation over the long term, therefore a lower assumed rate of investment return greatly reduces a plan’s risk of accruing pension debt.

New York’s move to a 5.9 percent assumed rate of return (ARR) will put the system’s rate well below the nation’s average of 7.2 percent but the national average hardly reflects the realities of investment returns. In the last 20 years, the median actual rate of investment return for state public pension plans was only 5.7 percent.

For years, New York state policymakers have been proactively aligning the plan’s ARR with realistic market return expectations. The New York State and Local Retirement System (NYSLRS), which manages the Common Fund and pays out pensions to state employees, local employees, police officers, and firefighters, lowered its ARR from 8 percent to 7.5 percent in 2010, down again to 7 percent in 2015, and then down to 6.8 percent in 2019. While most public pension plans have lowered their assumed rates of return over the last decade very few have made as drastic and consistent changes as New York.

NYSLRS’s move to lower its assumed rate of return became public after the system released its investment gains from its fiscal year from April 1, 2020, to March 31, 2021, which came in at an astounding 33.5 percent. This is a stark contrast to its 2020 return of 4.4 percent—an illustration of the potential investment return volatility pension plans face from year to year.

In an interview with Bloomberg, New York State Comptroller Thomas DiNapoli said that the new assumption for investment returns will “help us weather whatever the next downturn will be.” He also mentioned that the pension plan could be in a better position long-term “because of the outsized returns that we’ve had in the past year.”

More states should be lowering their public pension systems’ investment return expectations to prevent further accumulation of unfunded liabilities. When pension plans keep their assumed rates of return too high and out of touch with long-term market realities, it hides the real cost of public pension benefits.

With many retirement plans are seeing high investment returns in 2021, now is a good time to adjust return rate assumptions to better match what investment experts are predicting for the next few decades. Following New York State’s lead would greatly reduce the risk of further public pension systems accruing more debt and could help put many pension plans back on track to solvency.

The post New York wisely lowers the state’s assumed rate of return for public pension investments appeared first on Reason Foundation.

State policymakers and pension managers in California, Connecticut, Maine, and New York are among those instructing their public pension plans to divest from certain industries, like fossil fuels, gun manufacturers, and tobacco products to help influence social change. On the other side of the political spectrum, Texas lawmakers have demanded the state’s pension plans not invest in companies that want to reduce or eliminate fossil fuel consumption. Both efforts are short-sighted.

Playing politics and focusing on the social impact of pension investments, rather than on the pension plans’ financial promises, can jeopardize employee benefits. If the goal of public pension fund managers becomes ensuring investments are perceived as things like “environmentally-friendly” instead of ensuring the pension plan has enough money to pay out the retirement benefits that have been promised to workers, investment returns will likely suffer.

Public pension plans in the United States are already chronically underfunded. The average state pension plan is only 72% funded. Total public pension debt across the country is nearing $1.5 trillion. Needless to say, most public pension plans are not in a position to take any additional financial risks by prioritizing social responsibility over investment returns.

Private companies are free to do what they want, but when governments gamble with public pension investments, other budget priorities and taxpayers are likely to suffer. After all, public pension benefits have legal protections that put taxpayers on the hook for unfunded liabilities that come with any failure to meet a plan’s investment expectations. If a pension portfolio consistently underperforms, it falls to the state or local government—thus taxpayers—to fund the gap with tax revenue.

Nonetheless, several public pension plans have been instructed to put significant efforts into achieving political goals.

Last month, for example, the Maine State Senate passed a bill that requires the state’s retirement system to divest from fossil fuels by 2026. In April, Rhode Island’s public pension funds announced that they are scheduled to reduce investments in fossil fuel assets by 50%. Rhode Island State Treasurer Seth Magaziner cited building “a cleaner and more climate-resilient world” as a motivation behind this divestment.

Similarly, last year, New York announced its state public pension plans would prioritize divesting from oil and gas companies by 2025.

Political leadership in California has also voiced support for fossil fuel divestment in an attempt to advance “California’s climate leadership.” This is especially concerning for California since the state’s largest public pension system, the California Public Employees’ Retirement System’s (CalPERS’) own consultants found the plan missed out on almost $3.6 billion in investment returns when it undertook a similar socially motivated move by divesting in tobacco stocks back in 2001.

Last month, Texas passed a law that prohibits the state’s pension plans from investing in companies that “discriminate” against the oil and gas industry. This is the opposite of Texas’ supposed free-market mindset and creates the same risks for taxpayers as blue state’s divestment policies. As many companies are attempting to move away from fossil fuel consumption, this policy will surely leave Texas pension investors in a tough position as they try to maximize investment returns for their underfunded pension plans.

There is a precedent of these socially motivated investments resulting in financial losses. In addition to the aforementioned losses associated with California’s divestment from tobacco stocks, Connecticut’s pension systems lost $25 million after a push to invest in local businesses. In Kansas, it is estimated that the state pension fund lost upwards of $200 million after in-state investment program borrowers defaulted on their loans.

Private companies are completely free to set their own social responsibility policies, but governments have obligations to citizens, taxpayers and public workers. Generating investment returns that can help provide promised retirement benefits to workers without overburdening taxpayers ought to be a top priority for public pension plan management. Using funds contributed by public employees and employers to achieve other socially motivated political goals, rather than serving the pension funds’ primary purpose of providing a secure retirement to workers is irresponsible and dangerous. Such policies risk the retirement income of public servants and the tax dollars of citizens who are on the hook to pay if pension funds are unable to earn what is required to fully fund pension benefits.

Policymakers and pension boards should avoid making political statements with pension funds and instead focus on fulfilling the promises they’ve made to retirees without saddling future taxpayers with pension debt.

The post Public Pensions Shouldn’t Prioritize Political and Social Goals Over Investment Returns appeared first on Reason Foundation.

This debt is putting a strain on schools and taxpayers in the state.

The latest analysis by the Pension Integrity Project at Reason Foundation, updated this month (February 2021), shows that deviations from the plan’s investment return assumptions have been the largest contributor to the unfunded liability, adding $897 million since 2002. The analysis also shows that failing to meet investment targets will likely be a problem for TRS going forward, as projections reveal the pension plan has roughly a 50 percent chance of meeting their 7.5 percent assumed rate of investment return in both the short and long term.

In recent years TRS has also made necessary adjustments to various actuarial assumptions, exposing over $400 million in previously unrecognized unfunded liabilities. The overall growth in unfunded liabilities has driven Montana’s pension benefit costs higher while crowding out other education spending priorities in the state, like classroom programming and teacher pay raises.

The chart below shows the increase in the Montana Teacher Retirement System’s debt since 2002:

Left unaddressed, the pension plan’s structural problems will continue to pull resources from other state priorities.

The full Montana TRS solvency analysis also offers stress-testing designed to highlight potentially latent financial risks the pension system is facing. Reason Foundation also highlights a number of policy opportunities that would address the declining solvency of the public pension plan. A new, updated analysis will be added to this page regularly to track the system’s performance and solvency.

Bringing stakeholders together around a central, non-partisan understanding of the challenges the Montana Teacher Retirement System and Montana Public Employee Retirement System are facing—complete with independent third-party actuarial analysis and expert technical assistance— is crucial to ensuring the state’s financial solvency in the long term. The Pension Integrity Project at Reason Foundation stands ready to help guide Montana policymakers and stakeholders in addressing the shifting fiscal landscape.

Makeup of Montana TRS Contributions

Montana law (MCA 19-20- 608 & 609) dictates that if the TRS funded ratio is below 90%, employer contributions should contribute an additional 1% of compensation, increasing by 0.1% each year up to 2% or the TRS funding ratio is above 90%.

The supplemental rate applicable to the university system (MUS-RP), is currently set at 4.72%.

What Drives Montana TRS Pension Debt?

1. Deviations from Investment Return Assumptions have been the largest contributor to the TRS unfunded liability, adding $897 million since 2002.
2. Changes to Actuarial Methods & Assumptions to better reflect current market and demographic trends have exposed over $400 million in previously unrecognized unfunded liability.
3. Deviations from Demographic Assumptions including deviations from withdrawal, retirement, disability, and mortality assumptions — added$332 million to the unfunded liability over the last 15 years.
4. Extended Amortization Timetables have resulted in interest on TRS debt exceeding the actual debt payments (negative amortization) since 2002, adding a net $39 million in the unfunded liabilities.

Challenge 1: Assumed Rate of Return

Investment Return History, 2001- 2020

Investment Returns Have Underperformed

TRS actuaries have historically used an 8% assumed rate of return to calculate member and employer contributions, slowly lowering the rate to 7.5% over the past two decades in response to significant market changes.

Average long-term portfolio returns have not matched long-term assumptions over different periods of time:

Note: Past performance is not the best measure of future performance, but it does help provide some context to the challenge created by having an excessively high assumed rate of return.

New Normal: Markets Have Recovered Since the Crisis—TRS Funded Ratio Has Not

The “new normal” for institutional investing suggests that achieving even a 6% average rate of return in the future is optimistic.

1. Over the past two decades there has been a steady change in the nature of institutional investment returns.
   • 30-year Treasury yields have fallen from near 8% in the 1990s to consistently less than 3%.
   • New phenomenon: negative interest rates, designates a collapse in global bond yields.
   • The U.S. just experienced the longest economic recovery in history, yet average growth rates in GDP and inflation are below expectations.
2. McKinsey & Co. forecast the returns on equities will be 20% to 50% lower over the next two decades compared to the previous three decades.
   • Using their forecasts, the best-case scenario for a 70/30 portfolio of equities and bonds is likely to earn around 5% return.
3. 3. The Montana TRS 5-year average return is around 6.6%, well below the assumed 7.5% return assumption.

Expanding Risk in Search for Yield

Probability Analysis: Measuring the Likelihood of TRS Achieving Various Rates of Return

Probability Analysis: Measuring the Likelihood of TRS Achieving Various Rates of Return

TRS Assumptions & Experience

• A probability analysis of TRS historical returns over the past 20 years (2000-2020) indicates only a modest chance (26%) of hitting the plan’s 7.5% assumed return.
• Horizon’s long-term capital assumptions adopted by TRS project a 47% chance of achieving their current investment return target.

Short-Term Market Forecast

• Returns over the short to medium term can have significant negative effects on funding outcomes for mature pension plans with large negative cash flows like TRS.
• Analysis of capital market assumptions publicly reported by the leading financial firms (BlackRock, JP Morgan, BNY Mellon, and Research Affiliates) suggests that over a 10-15 year period, TRS returns are likely to fall short of their assumption.

Long-Term Market Forecast

• Longer-term projections typically assume TRS investment returns will revert back to historical averages.
  • The “reversion to mean” assumption should be viewed with caution given historical changes in interest rates and a variety of other market conditions that increase uncertainty over longer projection periods, relative to shorter ones.
• Forecasts showing long-term returns near 7.5% being likely also show a significant chance that the actual longterm average return will fall far shorter than expected.
  • For example, according to the BlackRock’s 20-year forecast, while the probability of achieving an average return of 7.5% or higher is about 49%, the probability of earning a rate of return below 5% is about 21%.

Important Funding Concepts

Employer Contribution Rates

• Statutory Contributions: TRS employers make annual payments based on a rate set in Montana state statute, meaning contributions remain static until changed by legislation.
• Actuarially Determined Employer Contribution (ADEC): Unlike statutory contributions, ADEC is the annual required amount TRS’s consulting actuary has determined is needed to be contributed each year to avoid growth in pension UAL and keep TRS solvent.
• Variable Contribution Rate: Not as rigid as statutory contributions but not as responsive as actuarially determined contributions, Montana’s current tradition of legislating contribution increases only after years of poor performance requires political action in times of volatility, with rate increases requested only when forecasts show that the period to fully amortize the current legacy unfunded liability exceeds 30 years.

All-In Employer Cost

• The true cost of a pension is not only in the annual contributions, but also in whatever unfunded liabilities remain. The ”All-in Employer Cost” combines the total amount paid in employer contributions and adds what unfunded liabilities remain at the end of the forecasting window.

Quick Note: With actuarial experiences of public pension plans varying from one year to the next, and potential rounding and methodological differences between actuaries, projected values shown onwards are not meant for budget planning purposes. For trend and policy discussions only.

Baseline Rates

• The variable contribution rate used as the baseline funding policy in the following analysis responds to changes in market conditions in lieu of the slower-paced statutory rate increases anticipated under current state law.
• The variable baseline rate factors in statutorily required appropriation from the state of a fixed amount of $25 million for the fiscal year beginning July 1, 2013 which is used to calculate the amortization period and subsequent variable rate. The variable baseline rate does not include conditional decreases tied to the TRS funding period.

Risk Management

Stress Testing TRS Using Crisis Simulations

Stress on the Economy:

• Market watchers expect dwindling consumption and incomes to severely impact near-term tax collections – applying more pressure on state and local budgets.
• Revenue declines are likely to undermine employers’ ability to make full pension contributions, especially for those relying on more volatile tax sources (e.g., sales taxes) and those with low rainyday fund balances.
• Many experts expect continued market volatility, and the Federal Reserve is expected to keep interest rates near 0% for years and only increase rates in response to longer-term inflation trends.

Methodology:

• Adapting the Dodd-Frank stress testing methodology for banks and Moody’s Investors Service recession preparedness analysis, the following scenarios assume one year of -24.0% returns in 2020, followed by three years of 11% average returns.
• Recognizing expert consensus regarding a diminishing capital market outlook, scenarios assume a 6% fixed annual return between crisis scenarios.
• Given the increased exposure to volatile global markets and rising frequency of Black Swan economic events, we include a scenario incorporating a second Black Swan crisis event in 2035.

Scenario Comparison of Employer Costs

How a Crisis Increases TRS Cost

• Discount Rate: 7.5%
• Assumed Return: 7.5%
• Actual Return: Varying
• Amo. Period: Current

Unfunded Liabilities Under Crisis Scenarios

• Discount Rate: 7.5%
• Assumed Return: 7.5%
• Actual Return: Varying
• Amo. Period: Current

TRS Solvency Under Crisis Scenarios

• Discount Rate: 7.5%
• Assumed Return: 7.5%
• Actual Return: Varying
• Amo. Period: Current

All Paths to a 7.5% Average Return Are Not Equal

Long-Term Average Returns of 7.5%

Sensitivity Analysis: Normal Cost Comparison Under Alternative Assumed Rates of Return

Amounts to be Paid in 2020-21 Contribution Fiscal Year, % of projected payroll

Challenge 2: Deviations and Changes to Actuarial Assumptions and Methods

Failure to meet actuarial assumptions, and delay in updating those assumptions, has led to an underestimation of the total pension liability.

Adopting more prudent actuarial assumptions and methods necessitates the recognition of additional unfunded liabilities.

Actuarial Assumption and Methods

TRS unfunded liabilities have increased by a combined $400 million between 2002-2020 due to prudent updates to actuarial assumptions and methods such as lowering the assumed rate of return.

Salary Increase Assumptions

TRS employers have not raised salaries as fast as expected, resulting in lower payrolls and thus lower earned pension benefits – a common case for many state-level pension plans. This reduced unfunded liabilities by $266 million from 2002-2020.

Withdrawal Rate, Service Retirement, and Mortality Assumptions

Due to misaligned demographic assumptions, TRS unfunded liabilities have increased by a combined $332 million between 2002-2020.

This likely stems from a combination of one or more of the following factors:

Actual withdrawal rates before members have reached either a reduced or normal retirement threshold have been lower than anticipated.

TRS members have been retiring earlier than expected, receiving more pension checks.

Overestimated Payroll Growth

Overestimating payroll growth may create a long-term problem for TRS in combination with the level-percentage of payroll amortization method used by the plans.

This method backloads pension debt payments by assuming that future payrolls will be larger than today (a reasonable assumption).

While in and of itself, a growing payroll is a reasonable assumption, if payroll does not grow as fast as assumed, employer contributions must rise as a percentage of payroll.

This means the amortization method combined with the inaccurate assumption is delaying debt payments.

Challenge 3: Insufficient Contributions & Debt Management Policies

Over the past two decades employer contributions to TRS have fallen short of the amount plan actuaries determined would be needed to reach 100% funding in 30 years.

State contributions towards paying off pension debt are less than the interest accruing on the pension debt.

Challenge 4: Discount Rate and Undervaluing Debt

The discount rate undervalues the total amount of existing pension obligations.

1. The “discount rate” for a public pension plan should reflect the risk inherent in the pension plan’s liabilities:

• Most public sector pension plans — including Montana TRS — use the assumed rate of return and discount rate interchangeably, even though each serve a different purpose.
• The Assumed Rate of Return (ARR) adopted by Montana TRS estimates what the plan will return on average in the long run and is used to calculate contributions needed each year to fund the plans.
• The Discount Rate (DR), on the other hand, is used to determine the net present value of all of the already promised pension benefits and supposed to reflect the risk of the plan sponsor not being able to pay the promised pensions.

2. Setting a discount rate too high will lead to undervaluing the amount of pension benefits actually promised:

• If a pension plan is choosing to target a high rate of return with its portfolio of assets, and that high assumed return is then used to calculate/discount the value of existing promised benefits, the result will likely be that the actuarially recognized amount of accrued liabilities is undervalued.

3. It is reasonable to conclude that there is almost no risk that Montana would pay out less than 100% of promised retirement income benefits to members and retirees.

• The Contract Clause in the Montana Constitution is similar to the U.S. Constitution’s Contract Clause. There is little basis to conclude Montana TRS has the kind of liability risks implied by a high discount rate.

4. The discount rate used to account for this minimal risk should be appropriately low.

• The higher the discount rate used by a pension plan, the higher the implied assumption of risk for the pension obligations.

Sensitivity Analysis: Pension Debt Comparison Under Alternative Discount Rates

Changes in the Risk Free Rate Compared to TRS Discount Rate (2000-2020)

Change in the Risk Free Rate Compared to TRS Discount Rate (2000-2020)

Challenge 5: The Existing Benefit Design Does Not Work for Everyone

• More than 70% of TRS members do not work long enough to earn a full pension
• The turnover rate for Montana teachers suggests that the current retirement benefit design is not effective at encouraging retention in the near-term, and may be pushing out employees at the end of their careers.
• 59% of new teachers leave before 5 years
• TRS members need to work for 5 years before their benefits become vested.
• Another 9% of new teachers who are still working after 5 years will leave before 10 years of service
• 23% of all members hired will still be working after 30 years, long enough to qualify for full, unreduced pension benefits

Recruiting a 21st Century Workforce:

• There is little evidence that retirement plans—DB, DC, or other design—are a major factor in whether an individual wants to enter public employment.
• The most likely incentive to increase recruiting to the public workforce is increased salary.

Retaining Employees:

• If worker retention is a goal of the TRS system, it is clearly not working, as nearly 70% of employees leave within 5 years.
• After 15 to 25 years of service there is some retention effect, but the same incentives serve to push out workers in a sharp drop off after 30 years of service or reaching the “Rule of 80” threshold.

A Framework for Policy Reform

Objectives

• Keeping Promises: Ensure the ability to pay 100% of the benefits earned and accrued by active workers and retirees
• Retirement Security: Provide retirement security for all current and future employees
• Predictability: Stabilize contribution rates for the long-term
• Risk Reduction: Reduce pension system exposure to financial risk and market volatility
• Affordability: Reduce long-term costs for employers/taxpayers and employees
• Attractive Benefits: Ensure the ability to recruit 21st Century employees
• Good Governance: Adopt best practices for board organization, investment management, and financial reporting

Pension Resiliency Strategies

1. Establish a plan to pay off the unfunded liability as quickly as possible. The Society of Actuaries Blue Ribbon Panel recommends amortization schedules be no longer than 15 to 20 years.
2. Adopt better funding policy, risk assessment, and actuarial assumptions. These changes should aim at minimizing risk and contribution rate volatility for employers and employees.
3. Create a path to retirement security for all participants. Consider offering members that won’t accrue a full pension benefit access to other plan design options (e.g., cash balance, DC, hybrid, etc.)

Potential Solutions

1. Establish a Plan to Pay Off the Unfunded Liability as Quickly as Possible

Current amortization policy for TRS targets time horizons that are too long:

• TRS targets a 30-year window to pay off unfunded liabilities.
• The longer the unfunded liability amortization period, the greater chance that market risk drives unfunded liabilities higher.
• The Society of Actuaries Blue Ribbon Panel recommends amortization schedules be no longer than 15 to 20 years.

Rethink amortization in two steps:

Step 1: Address the Current Unfunded Liability

• Segmenting accrued unfunded liabilities from any gains or losses in future years can allow policymakers to set the past debt on a direct and fiscally realistic course to being fully funded.
• Prevents the need to revisit the issue in subsequent sessions.

Step 2: Develop a Plan to Tackle Future Debt

• Adopting “layered” amortization for future unfunded liabilities. would ensure that any new pension debt accrued in a given year is paid off much faster—preferably 10 years or less—than the current 30+ year period.
• Covering future pension losses with consistent annual payments over a decade or less would align TRS amortization policy with actuarial best practice.

2. Adopt Better Funding Policy, Investment Policy, Risk Assessments and Actuarial Assumptions

Current funding policy has created negative amortization and exposes the plan to significant risk of additional unfunded liabilities.

• Establishing TRS contribution rates in statute, and requiring political intervention with uncertain outcomes, makes it difficult in practice to respond quickly to changing economic circumstances.
• This policy is in contrast with the more common funding method based on normal cost and the amortization cost that pays down unfunded liabilities over a predetermined, closed period.
• Given the volatility of their amortization policy, it will likely take more than 30 years to amortize current unfunded liabilities, exposing TRS to major financial risks over that period.
• Options to consider include:
  • Requiring employers and future employees that accrue defined benefits to make contributions on a pre-defined cost sharing basis (such as a 50-50 split) as actuarially determined
  • Using short (10-year or less) periods to pay off any new, annual unfunded liabilities that might accrue

Improve risk assessment and actuarial assumptions.

• Look to lower the assumed return such that it aligns with more realistic probability of success.
• Adjust the portfolio to reduce high risk assets no longer needed with lower assumed return target.
• Work to reduce fees and costs of active management.
• Consider adopting an even more conservative assumption for a new hire defined benefit plan.
• Require regular stress testing for contribution rates, funded ratios, and cash flows with look-forward forecasts for a range of scenarios.
• While pension plans can, and some do, implement a limited risk assessment under current financial reporting, an independent risk assessment/stress test review using a range of pre-built stress scenarios is the ideal approach.

3. Create a Path to Retirement Security for All Participants of TRS

Montana TRS is not providing a path to retirement income security for all educators

• For example, only 23% of teachers make it to the 30 years necessary for a full, unreduced pension. This means the majority of teachers could be better served by having the choice of an alternative, more portable plan design—such as a cash balance, hybrid or defined contribution retirement plan.

Employees should have options when selecting a retirement plan design that fits their career and lifestyle goals

• Cash balance plans can be designed to provide a steady accrual rate, offer portability, and ensure a path to retirement security.
• Montana has a long history of managing cash balance plans through municipality, county, and district systems.
• Defined contribution plans can be designed to auto-enroll members into professionally managed accounts with low fees that target specified retirement income and offer access to annuities.

Montana Teacher Retirement System (TRS) Pension Solvency Analysis

The post Montana Teacher Retirement System (TRS) Pension Solvency Analysis appeared first on Reason Foundation.

Executive Summary

Since 2007, state pension plans across the country have experienced approximately 200 reforms to various aspects of retirement benefit design, funding policy, amortization policy, and more. While these changes are all made to increase the solvency of the plans, little is known about why states choose some reforms over others or why they choose to reform at all. The financial stakes involved in public pensions are enormous; these plans were facing an unfunded liability of $1.2 trillion before COVID-19, which is expected to increase further with the latest fiscal year reporting.

This brief analyzes several different factors that impact the likelihood of state policymakers making changes to a pension plan. The variables that had the largest and the most consistent effects were passing a prior law or having several states pass a law in the same year; both variables increased the likelihood of passing a pension reform. Fiscal and workforce variables also frequently mattered, but they had smaller effects and the specific variables that were significantly varied from model to model. Often, higher funded ratios made a state less likely to pass a reform, while higher pension contribution ratios made a state more likely to pass a reform. Larger states tended to pass reforms. Those with larger public sectors were more likely to pass reforms, but those with more union members were less likely.

Given these results, pension funding, policy diffusion, and workforce variables should be analyzed to forecast future potential reforms, with reforms being much more likely in states with a recent history of reform or during a time when other states are also reforming their pension plans. The political factors within a state should not be expected to impact change. Finally, these variables should be considered in the context of time; those that are more likely to change quickly, such as pension funding variables, may become more important than those that are less likely to change quickly, such as union membership.

The results from the models show several factors that are more than likely to shape pension reform. First, policy diffusion, or the effects of earlier reforms on future reforms both within and outside of a state, is the most important factor with respect to adoption. Not only were these variables almost always significant, but they also had the largest effects. States that have already passed reforms should be seen as being more likely to pass subsequent reforms. Pension reforms also appear to be motivated by peer pressure; the larger the number of states that pass reforms in a year, the more likely it is that additional states follow.

Full Policy Study: Determinants of Public Pension Reform 

The post What Factors Impact Public Pension Reform? appeared first on Reason Foundation.

In a recent paper, researchers at the Center for Retirement Research (CRR) used Survey of Income and Program Participation (SIPP) data to look at whether the amount of pension savings, the funded status of a pension plan, or a worker’s Social Security eligibility had any effect on state and local workers’ decisions over whether or not to participate in a supplemental defined contribution (DC) retirement savings plan.

Supplemental defined contribution plans are a vehicle of personal savings that provide additional retirement income, often through a pre-tax arrangement with an employer or third-party financial firm. This is a great tool for public sector workers who are looking to bolster their retirement income. Although specifics and enrollment requirements of supplemental plans vary from state to state, across the board they offer participants more control over their investments than traditional defined benefit plans.

The Center for Retirement Research study found that employees whose pensions are less generous than the national average are more likely to participate in a supplemental retirement plan, but the statistical effects of this are small in magnitude. They did find that members of poorly funded pension plans are no more likely to participate in a supplemental savings plan than members of well-funded plans. Social Security participation also does not seem to have an effect on savings as employees without Social Security did not participate in an outside savings plan at a higher rate than individuals who are not elidable for Social Security benefits.

The authors also found that decreases in required employee contributions to a pension fund are predicted to increase an employee’s participation in a supplemental savings plan. Simply put, if the employee is required to put only a small amount of their paycheck toward their pension plan they are more likely to invest more of that paycheck into another savings vehicle. When it comes to interpreting these findings, it is important to note that decreases in employer pension contributions do not necessarily translate into pension funding issues, so those motivations are not straightforward. Contribution rates can change for a variety of reasons, including a plan reaching full funding.

The authors share a few concerns about their findings.

First, there is evidence that state and local workers are commonly unaware of how much saving is taking place through their pensions (see also Kelley 2014, Stalebrink 2014, Chen 2018).

Second, the authors note that because workers whose pensions are among the worst-funded are no more likely to save than workers whose pension plans are the best-funded, they may be financially unprepared if future benefit cuts are enacted to shore up a pension system.

Third, Social Security participation not having any effect on supplemental savings may be a sign that ineligible workers may be less prepared for retirement than those that are eligible for social security benefits.

It is important to note that defined contribution supplemental plans are available to only some public sector workers and as a result, these findings might be in part driven by the availability of supplemental plans from state to state.

This research highlights the fact that public sector workers are not prepared to adjust their savings in response to the poor funding of their pension plans. In addition, this has again highlighted that the public is relatively unaware of how the fiscal health of their plan impacts their pension checks. Financially-unprepared workers in combination with uncertainty around future benefits could create a highly volatile fiscal climate for future retirees. Pension plans across the country should prioritize getting their funding on track to alleviate some of this uncertainty.

The post Do Public Workers Set Aside Additional Retirement Savings When Their Pension Plan’s Debt Grows? appeared first on Reason Foundation.