Reflections on Michigan’s Ongoing Pension Reform Project

After a major reform effort designed to restore the solvency of the state’s teacher pension system in 2017, the state of Michigan has continued its pattern of being a trend setter on pension reform during the 2018 legislative session.

Last summer, the legislature adopted a set of innovative changes to its public school employee retirement system (known as MPSERS) that included offering new teachers the option of either a risk-managed defined benefit pension plan with cost-sharing, or a defined contribution plan with access to annuities. While this legislation—which became Public Act 92 of 2017—made important changes and today offers a national model for robust pension reform, it did not address all of the challenges Michigan has been facing with its statewide retirement systems. At  the time, the legislature focused on what it could put together given existing fiscal and political constraints and took several large steps forward with the intent of working collaboratively over time to keep addressing problems.

Since then, the Michigan House and Senate have been engaged in a follow up round of legislation with several bills aimed at covering some of the issues left out of the original 2017 pension reform bill. Additionally, pension fund administrators made prudent adjustments to a key assumption that drives pension accounting.

The collective set of changes to state retirement systems was recently praised by Standard & Poor’s, which cited pension reform as a key factor in its recent decision increase the state’s credit rating from -AA to AA with a stable outlook. Hence, it is worth taking a step back to look back over the landscape of recently adopted legislation to see how the underlying process has driven such a successful collective outcome.

1. Moving to “Level-Dollar” Amortization of Pension Debt

Many public pension plans spread out their pension debt payments (unfunded liability amortization payments) over time by pegging them to the expected growth in payroll, and MPSERS has historically done the same. The logic is that as payroll grows it will reflect a broader capacity to make payments towards the debt by the state. However, this also means backloading debt payments as the expected dollar amounts in the future are much greater than today if payroll is assumed to grow at a considerable rate.

Unfortunately, this backloading method has contributed to structurally underfunding MPSERS over the past few decades. Payroll has been assumed to grow at 3.5% to 4% a year since the turn of the millennium. And yet, actual payroll has been effectively flat during that time, and in some years has contracted (largely due to a declining economy and population flight out of Michigan during the first decade of the century). As a result, the dollar value of amortization payments today are millions less than was expected by previous debt schedules.

In order to address this problem, the legislature unanimously adopted a bill sponsored by Rep. Tom Albert (House Bill 5355) to gradually reduce the MPSERS payroll growth assumption until it reaches zero. This innovative ratchet-down mechanism will avoid a fiscal shock from switching the level-percent amortization method to level-dollar overnight. When the payroll growth assumption reaches zero, MPSERS will effectively have level-dollar amortization method because payments will be spread out over the same expected payroll base. And as a failsafe, should Michigan experience a population boom that warrants maintaining a higher payroll growth assumption, the legislation allows for adjustment to the phase down schedule.

Particularly noteworthy is the nature of the political debate around HB 5355, relative to the rancor and heated debate of the 2017 MPSERS reform effort. The legislation that would become P.A. 92 passed by a thin 4-vote margin in both the House and Senate. By contrast, this pension reform — enshrined as Public Act 181 of 2018 — was passed with unanimous, bipartisan support in both chambers and signed shortly thereafter by Gov. Snyder. While there was some discussion over the fiscal effects of P.A. 181 during the process, this time around both chambers clearly recognized the long-term value of the policy and acted in singular accord to embrace it.

2. Lowering Assumed Rates of Return for Major State Pension Plans

In February 2017, Gov. Snyder’s Department of Technology, Management and Budget (DTMB) and the Office of Retirement Services — which oversees Michigan’s statewide retirement systems, including MPSERS and the State Employees’ Retirement System, MSERS — proposed lowering the assumed rate of return for the systems under their purview. (Research from Reason Foundation has long pointed out the need to make this change based on historic trends and capital market forecasts.) Funding was included in the package of 2017 reforms to pay for lowering the assumed rate of return on these systems from 8% to 7.5%.

However, it was widely accepted that the 7.5% assumed return was still reflecting considerable risk. In fact, P.A. 92 created a new defined benefit plan for teachers hired as of February 2018 that uses a maximum 6% assumed rate of return when determining normal costs.

Acknowledging the need for additional, prudent adjustments to the return assumption, this past spring Michigan took steps to further lower the assumed rate of return for MPSERS to 7.05% and for MSERS to 7%. The administrative change was driven by DTMB, but the legislature still needed to approve the change via the appropriations process (which was formalized in the budget signed by the governor in June).

3. Expanding Access to Annuities (in progress)

One of the provisions of SB401 was to require that ORS provide members of the state’s defined contribution plan access to annuities, specifically, the option of at least one fixed rate annuity and one variable rate annuity. However, due to debates over specific provisions at that time any further guidance was left out of the 2017 legislation.

This spring, two bills have been introduced to expand on that section of the law created by SB401. HB5230 and HB5231 have passed the House and made it through the Senate Finance Committee (as of May 2018). Specifically, the bills would ensure DC plan members can purchase annuities while still participating in the plan (rather than just rolling their account balances into annuities at the end of their career), require a competitive bidding process for the provision of annuities, set standards for the annuity providers selected by the Treasury Department, require certain reporting standards, and require the annuity provider to offer participant-specific education and tools to understand the use of annuities as part of retirement income.

4. Regularizing Certain Retirement Benefits

The legislature enacted three additional bills this year that, while narrowly limited in scope, will bring additional rationality to certain benefit structures:

• Public Act 335 and Public Act 336 made adjustments to the judicial and state employees retirement systems that sync the actuarial assumptions used to calculate certain optional benefits with the assumptions used by the plan actuary today.
• Public Act 328 of 2018 cleared up certain language with respect to community college students, formally establishing that they are not required to contribute to MPSERS if they are working for their school on a part-time basis.

Conclusion

Taken as a whole, Michigan policymakers have made considerable strides towards improving the retirement security of state workers, teachers, and other public education employees over the current biennium. The state has created a new choice-based plan design for teachers, lowered the assumed rate of return in steps from 8% to 7%, put in place a phase in towards a 6% assumed return over time, adopted an effective level-dollar amortization policy, and set the stage for members of its defined contribution plan to have a stronger path towards retirement security. This impressive and sweeping set of achievements was not accomplished with one singular bill, though, and the process as a whole is a testament to making incremental change through more narrow debates so that the collective reform effort is not drowned by competing priorities.