In This Issue: 

Articles, Research & Spotlights  

• A blueprint for protecting public funds from ESG and politicization 
• Arizona’s innovation for multi-employer pension plans 
• Challenges in inflation protection for Texas teachers 
• Retention trends in the public workforce suggest the need for portability 
• What U.S. pensions can learn from the U.K. margin call 

News in Brief 
Quotable Quotes on Pension Reform  

Articles, Research & Spotlights 

Reason’s New Blueprint for ESG-related Legislation

Reason Foundation’s Pension Integrity Project has developed an ESG Blueprint to help policymakers seeking sound and effective policies for managing public funds, particularly public pension funds. The website provides an overview of what ESG is, its potential impacts on public pension systems, and model legislation to strengthen the boundaries of fiduciary responsibility, ensuring that policymakers keep public funds out of political influence campaigns. Reason’s ESG blueprint is available here, and our full archive of ESG-related analysis is here. Recent pieces include:

Arizona Creates Prefunding Program for State Retirement System

Many state-run public pensions are multi-employer plans, meaning local cities and counties participate and contribute to a single fund and share liabilities. This allows smaller governments to reap the investment benefits of a larger asset-pooled plan, but it can also mean less flexibility in paying down the unfunded pension liabilities that are impacting annual budgets. State legislators in Arizona recently passed a bill that aims to improve this flexibility for employers participating in the Arizona State Retirement System (ASRS). As outlined by Reason’s Ryan Frost and Truong Bui, Senate Bill 1082 offers a vehicle for local governments to apply extra payments to a separate account, which can be used to offset rising contributions at a later time. This is an innovation that other state-run multi-employer plans should consider employing. 

Is Texas’ Definition of an “Actuarially Sound” Public Pension System Outdated?

With high inflation continuing to degrade the value of fixed pension benefits, there is significant attention being placed on the cost-of-living adjustment policies that are supposed to cushion the blow from retirees’ losses of purchasing power. In Texas, there is a strict hurdle set in law that must be achieved before giving retired public workers a so-called “13th check.” The state must be able to demonstrate that it is “actuarially sound.” Reason’s Steven Gassenberger explains the current understanding of this hurdle, noting that it would be prudent to adjust this standard with shorter debt-payment requirements. 

More Portable Retirement Plans Would Help Public Employers Attract and Keep Workers 

Increased rates of resignation in the post-pandemic world are a continuation of a decades-long evolution in the modern workforce, with the current generation of workers switching jobs at much higher rates. This phenomenon is even more pronounced among public workers and teachers. Examining some of the latest shifts in public employee retention, Reason’s Jen Sidorova offers ways that policymakers can shape retirement benefits to better fit today’s workers, including shorter vesting requirements and increased portability. 

The U.K.’s Margin Call Offers Warning Signs for Public Pension Funds in the U.S.

A sharp increase in bond yields recently put United Kingdom pensions in a difficult position where they needed to sell off assets, resulting in what was called a ‘doom loop’ scenario that prompted intervention from the Bank of England. Reason’s Swaroop Bhagavatula looks at how this market scare was associated with liability-driven investing (LDI), which is a strategy not often used by pensions in the United States. Still, there are some valuable lessons that can be applied, namely avoiding over-leveraging and maintaining adequate levels of cash to manage any major market shocks. 

News in Brief 

Paper Rediscounts Public Pension Liabilities 

A paper from economics professors Oliver Giesecke and Joshua Rauh of Stanford University asserts that public pension liabilities should be discounted in a way that reflects the guaranteed nature of these promised benefits, which would mean using zero-risk rates based on treasury yields. Their analysis of 647 state and local pension plans in 2021 finds that, while these plans report unfunded liabilities of just over $1 trillion and an aggregated funded ratio of 82.5%, rediscounting the same plans to the proposed specifications would mean unfunded liabilities of $6.5 trillion and a funded ratio of 43.8%. The full paper is available here, and an interactive dashboard of its results is available here. 

New Survey Asks Public Employees How The Current Market Has Impacted Their Retirement 

MissionSquare Research Institute has published results from a survey of 1,003 state and local government workers focusing on how current market turbulence has impacted the perception of retirement security as well as saving behavior. The survey indicates that most (84%) of respondents feel anxious about their personal financial security. Nearly half (48%) have reduced the amount they save for retirement, naming high inflation as the cause. Over half (58%) of the polled public workers indicated that the retirement plan offered to them was a factor in their decision to stay in the job, while 33% said that this made no difference. The full report is available here. 

Quotable Quotes on Pension Reform  

“In some cases, the [midterm election] campaign rhetoric not only dismissed the danger of climate change, it went so far as to mischaracterize a strategy we believe in strongly: examining the risk factors of the environment, of social inequality, and of good governance […] But let’s be clear: Applying the lens of ESG is not a mandate for how to invest. Nor is it an endorsement of a political position or ideology. Those who say otherwise are actually advocating for investors like CalPERS to put on blinders…to ignore information and data that might otherwise help build on the retirement security of our 2 million members.” 

—CalPERS CEO Marcie Frost quoted in “CalPERS CEO Pushes Back Against Politicization ESG Investing,” Pensions & Investments, Nov. 16, 2022 

“Regardless of your view on climate change or inclusion or human rights, Mississippi’s pension system, taxpayer dollars, and college savings programs are the wrong place to experiment with investment strategies that push balance sheets to the side. Moreover, many of the policies ESG promotes tie directly to higher costs for consumers, a weaker Mississippi job market, increased inflation, and smaller investment returns – all while undermining the free market and our economic liberty.” 

—Mississippi Treasurer David McRae in “Guest Column: Protecting Mississippi’s Finances,” The Vicksburg Post, Nov. 2, 2022 

“It does limit us…We, I believe, have been successful in trying to minimize any kind of cost that might bring to you, but eventually, it’s going to bite us in the butt if we continue. So we just have to be careful and prudent about it…Our bank list is getting short.” 

—Lamont Financial Services Founder Bob Lamb on Louisiana Treasurer John Schroder pulling the state’s investments from BlackRock over their ESG approach in “Pulling Louisiana’s Investments Could ‘Bite Us in the Butt,’ Adviser Tells Treasurer,” Louisiana Illuminator, Oct. 18, 2022 

Contact the Pension Reform Help Desk 

Reason Foundation’s Pension Reform Help Desk provides technical assistance for those wishing to pursue pension reform in their states, counties, and cities. Feel free to contact the Reason Pension Reform Help Desk by e-mail at pensionhelpdesk@reason.org.  

Follow the discussion on pensions and other governmental reforms at Reason Foundation’s website and on Twitter @ReasonPensions. As we continually strive to improve the publication, please feel free to send your questions, comments, and suggestions to zachary.christensen@reason.org. 

The post Pension Reform News: ESG blueprint, Arizona’s pre-funding, and more appeared first on Reason Foundation.

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

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

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

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

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

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

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

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

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

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

Contributions for Hypothetical ASRS Employer

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

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

The post Arizona passes prefunding program for state retirement system  appeared first on Reason Foundation.

The interactive map below shows the funded ratios for state-managed public pension systems from 2001 to 2022. A funded ratio is calculated by dividing the value of a pension plan’s assets by the projected amount needed to cover the retirement benefits already promised to workers. The funded ratio values for 2022 are projections based on a -6% investment return. 

Year-to-year changes in investment returns and funded ratios tend to grab attention, but longer-range trends give a better perspective of the overall health of public pension systems.

In 2001, only one state, West Virginia, had an aggregated funded ratio of less than 60%. By the end of 2021, four states—Illinois, Kentucky, New Jersey, and Connecticut—had aggregate funded ratios below 60%.

If investment returns are -6% or worse in the 2022 fiscal year, Reason Foundation’s analysis shows South Carolina would be the fifth state with a funded ratio below 60%. 

Over the same period, 2001 to 2021, the number of states with state-managed pensions with funded ratios above 90% fell from 33 to 20. If all plans return a -6% investment return assumption for 2022, Reason Foundation projects the number of states that have funded levels above 90% would shrink from 20 to six.  The six states with funded levels that would still be above 90% after -6% returns for 2022: Delaware, Nebraska, New York, South Dakota, Washington, and Wisconsin. 

Importantly, the -6% investment return assumption for the 2022 fiscal year used in this map may be too optimistic for some public pension plans. The S&P 500 lost 12% of its value over the 2022 fiscal year from July 1, 2021, to June 30, 2022. Vanguard’s VBIAX, which mimics a typical 60/40 stock-bond portfolio, was down 15% for the fiscal 2022 year ending in June 30, 2022. Thus, given the condition of financial markets this year, the public pension plans with fiscal years that ended in June 2022 are likely to report negative returns for the 2022 fiscal year.  

Another useful long-term trend to look at are the unfunded liabilities of state-run pension plans. Whereas a pension system’s funded ratio takes the ratio of assets to liabilities, unfunded liabilities are the actual difference between the pension plan’s assets and liabilities. Unfunded liabilities can be conceptualized as the pension benefits already promised to workers that are not currently funded by the plan. Again, the values for the 2022 unfunded liabilities map are a projection using an investment return of -6%. 

The five states with the largest unfunded liabilities are California, Illinois, New Jersey, Pennsylvania, and Texas. In fiscal year 2021, the unfunded liabilities of those states totaled $434 billion and would jump to $620 billion in 2022 with a -6% return.  

For more information on the unfunded liabilities and funded ratios of state-run pensions, please visit Reason’s 2022 Public Pension Forecaster.

Notes

ⁱ The state-funded ratios in this map were generated by aggregating (for state-managed plans) the market value of plan assets and actuarially accrued liabilities. Prior to 2002, Montana and North Carolina reported data every two years, therefore for 2001 figures from 2002 are used. Figures for Washington state do not include Plan 1, an older plan that is not as well funded.

ⁱⁱ The discount rate applied to plan liabilities will impact the funded ratio of a plan. Therefore, the map above can be best thought of as a snapshot of state-funded ratios based on plan assumptions by year. Overly optimistic assumptions about a pension plan’s investment returns will result in artificially high-funded states. Conversely, pulling assumptions downward, while prudent, will result in a worse-looking funded ratio over the short term.

ⁱⁱⁱ In addition to projections for fiscal 2022, some public pension plans in 29 states have yet to report their complete fiscal 2021 figures and therefore include a projection estimate for 2021 as well. Thus, 2021 projections were used for at least one plan in the following states: Alabama, Alaska, Arkansas, California, Colorado, Georgia, Hawaii, Illinois, Kansas, Louisiana, Massachusetts, Michigan, Missouri, Nebraska, New Hampshire, New Jersey, New York, North Carolina, Ohio, Oregon, Pennsylvania, Texas, Tennessee, Utah, Virginia, Washington, West Virginia, Wisconsin, and Wyoming.

The post Projecting the funded ratios of state-managed pension plans appeared first on Reason Foundation.

Through legislation and supplementary contributions over the past two years, state and local employers in Arizona dedicated an extra $2.67 billion in supplemental contributions to reduce the significant unfunded pension liabilities within state pension systems.

Similarly, Michigan policymakers have provided around $2.5 billion in relief payments for several of their underfunded pension plans in the recently enacted 2022 budget.  

These major payments mark a dedication to fulfilling promised retirement benefits, and they signal to taxpayers and public workers that these states are confident in the risk-reducing reforms enacted in recent years. 

Arizona 

Arizona lawmakers took their first meaningful leap into pension reform in 2016 by enacting major changes to the pension system for public safety workers. The bipartisan reform established a new risk-managed tier of benefits for new workers and more stable inflation protection for retirees. This comprehensive approach reduced the chances of the state facing unpredictable costs on promised benefits for incoming police and firefighters. In 2017, a parallel reform accomplished the same for the state’s corrections officer pension system. 

Now, with several years of results demonstrating the improved outlook of these systems, lawmakers are taking the next crucial step by making significant payments into the retirement funds to accelerate the paydown of unfunded obligations. Governor Doug Ducey’s 2021 state budget included $1 billion in extra appropriations dedicated to the public safety and corrections officer plans as part of a budget focused on tax cuts and debt reduction. Additional contributions totaling $500 million from local and state employers were also included.  

In 2022, three separate pieces of legislation passed in the Arizona Legislature and were signed into law by Gov. Ducey, instantly eliminating another $1.17 billion in unfunded pension liabilities for the state’s public safety systems. House Bill 2862 made a supplemental payment of $1.07 billion, Senate Bill 1086 secured $40.8 million, and Senate Bill 1002 added another $60 million to be applied to unfunded pension liability.  

These significant payments reinforce the state’s commitment to the retirement promises made to public safety workers while reducing long-term costs to future taxpayers. Much like any other debt, paying down Arizona’s unfunded pension obligations faster will save tremendous amounts down the road. For some perspective on how much savings will be generated from these supplemental payments, the Pension Integrity Project estimated a $1 billion payment would save the state as much as $564 million over the next 30 years. 

Michigan 

Michigan’s pension systems have gone through numerous reforms over the past 25 years and it was the first state to institute a defined contribution plan for its public workers in 1997. After the Great Recession, the state reformed its underfunded public school and state police employee plans, ultimately passing a series of bills that have put the state’s pension funding outlook on solid ground. Most notably, a 2017 reform of the public school pension system established a hybrid plan for all new members that balances risks and costs equally between employees and the state, slowing the growth of runaway debts and costs. 

The 2022 Michigan legislative session included a wave of supplemental pension payments in its final 2022-23 budget (HB 5783), totaling around $2.5 billion, into three of its underfunded pension systems. Just over $1.7 billion of those funds were allocated to the public school employees’ pension system (MPSERS). The seven university employers in MPSERS received $300 million to pay down their unfunded liabilities, $425 million was allocated to the broader MPSERS plan to offset the costs associated with reducing the plan’s payroll growth assumption to 0%, and $1 billion was earmarked for distribution into the plan’s asset pool. Of note is that this payment is not to be used for any debt or normal cost payments.  

The municipal employee’s retirement system was also given $750 million to start a grant program that will award dollars to qualified local governments, with the goal of reaching a 60% funded ratio. $170 million of those funds, the largest individual chunk for any one governmental unit, will make its way to Flint where the city’s pension system is facing over $400 million in unfunded liabilities. The third system receiving funds is the state police pension system, which will have the plan’s entire unfunded liability paid off through a $100 million supplemental payment.  

Arizona and Michigan’s recent treatment of funding for pension systems is an example of the value of comprehensive pension reform. Other state and local governments should note their success in tackling the challenge of reducing pension debt. The clearest lesson to be learned from these successes is that when real risk-reducing reform is adopted, it makes it much easier for policymakers to work and reduce unfunded obligations. If lawmakers see that a plan has addressed the problems that created the funding shortfall, it can alleviate their reluctance to dedicate the necessary share of the budget to resolve the legacy costs of those problems.  

The post Reformed pensions in Arizona, Michigan receiving supplemental funding to pay down debt faster  appeared first on Reason Foundation.

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

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

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

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

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

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

Estimated Changes to State Pension Unfunded Liabilties, Funded Ratios

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

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

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

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

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

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

Webinar on using the 2022 Public Pension Forecaster:

The post Unfunded public pension liabilities are forecast to rise to $1.3 trillion in 2022 appeared first on Reason Foundation.

• Arizona state government accounts for nearly $473 million (5%) of the current unfunded pension liabilities held by the Public Safety Personnel Retirement System (PSPRS)—including $431 million in pension debt accrued by the Department of Public Safety (DPS).
• Unfunded pension liabilities accrue interest at the same rates as the PSPRS discount rate—currently 7.3% annually—making PSPRS unfunded liabilities among the most expensive taxpayer-backed debt held by the state. For comparison, the Arizona State Retirement System (ASRS) accrues interest at a 7.0% rate annually.
• Major reforms to PSPRS enacted by the legislature since 2016, along with several prudent policy and assumption changes made by the PSPRS Board of Trustees, have dramatically reduced the system’s risk, prompting dozens of employers, like Tucson, Flagstaff, and Prescott, to adopt various new funding tools designed to pay down their PSPRS debt faster, thus avoiding the high costs of pension debt accrual.

Paying Down Pension Debt Faster Is Prudent

• The proposed supplemental, one-time appropriation would pay down unfunded liabilities for state agency employers participating in PSPRS.
• Paying down debt associated with promised, constitutionally protected pension benefits faster is a time-tested way to save taxpayers money by avoiding interest costs.
• Actuarial modeling by the Pension Integrity Project at Reason Foundation finds that Gov. Doug Ducey’s proposed supplemental $611.3 million infusion into PSPRS would:
  • Yield between $137 million and $322 million in taxpayer savings over the next 30 years, depending on investment performance.
• A $1 billion infusion into PSPRS similar to that outlined in Senate Bill 1087 would:
  • Yield between $240 million and $564 million in taxpayer savings over the next 30 years, depending on investment performance.

Takeaway: The proposed “catch-up” payments for PSPRS’ unfunded liabilities would benefit taxpayers by reducing pension debt and producing long-term cost savings.

Paying Down PSPRS Debt Faster Is a Win for Taxpayers

The post Paying down PSPRS debt faster is a win for taxpayers appeared first on Reason Foundation.

The post Keeping politics out of public pension investing appeared first on Reason Foundation.

The post Expanding prefunding programs for the Arizona State Retirement System appeared first on Reason Foundation.

The concern even prompted a citizens initiative two years ago that would have frozen most new city spending until the debt is paid down, but voters rejected the idea of constraining spending on city programs to focus on pension debt reduction.

At the City Council’s direction, city staff are exploring a $1 billion bond package that would be dedicated toward paying down pension debt, but that would still leave upwards of $4 billion in remaining pension debt on the city’s balance sheet.

One way to tackle the remaining pension debt would be to look for smart ways to leverage assets, and Sky Harbor International Airport may present a unique opportunity to fund retirement benefits.

An airport lease could generate billions.

A new Reason Foundation report examines financial data for several dozen U.S. airports and, using data from a wide range of international airport transactions, estimates that a long-term lease (40 to 50 years) of Sky Harbor airport could generate between $1.5 billion to $2.9 billion in net proceeds to the city after all current airport debt is paid off.

For most in Arizona – or the entire United States, for that matter – the concept of “leasing an airport” may seem foreign, and in part it literally is.

Since the late 1980s, governments throughout the world have sold or leased their airports to investor-owned companies in a better position to manage, operate and invest in aviation infrastructure.

Today, most major global airports in Europe, Australia, Latin America and Asia are operated under majority private-sector ownership, allowing them access to expanded pools of capital for investment. Airports in London, Paris, and Sydney are among those that have tapped private financing for new terminals, while airports in Frankfurt, London and Bogota are doing the same for new runways.

For perspective, of the largest 100 global airport operators, 38 are fully or partially investor-owned, and those operators accounted for 49% of the nearly $100 billion in airport revenue in 2018. The sooner we pay down pension debt, the better.

San Juan International Airport in Puerto Rico was the first U.S. airport to complete a long-term lease, which has helped transform a formerly decrepit airport into a world class facility through expanded capital investment, as well as generating upfront revenue for additional infrastructure and other Puerto Rico needs. This is not to suggest that Sky Harbor is a poorly managed asset or that the city is letting it languish. The airport has seen significant expansion and modernization over the last decade and is generally well regarded among peers.

What a long-term public-private partnership lease could potentially offer the city is the opportunity to unlock value currently trapped within the airport that could be deployed toward the city’s other pressing fiscal needs.

Such an important transaction cannot be taken lightly, though, and if Phoenix were to pursue this opportunity, they must do so with the requisite due diligence to maximize value, ensure top-notch facility maintenance, and manage important operational and financial risks.

Thanks to recent reforms to the Arizona Public Safety Personnel Retirement System and the city’s adoption of a lower risk benefit design for new city workers, much of Phoenix’s future pension risk is contained, and new-hire benefits have a low risk of generating unfunded liabilities like those seen today. It’s the underfunding of pension benefits from past service that remain the problem, driving well over half of the city’s $400 million annual spending on pensions.

The sooner the city can pay down pension debt from past employee service, the sooner that hundreds of millions of funds are unlocked from the annual budget for Phoenix to deploy toward other public priorities and infrastructure needs.

Phoenix leaders would be wise to consider how leveraging Sky Harbor could eliminate pension underfunding and free up funds in the city budget, while maintaining an excellent experience for airport users.

A version of this column previously appeared in the Arizona Republic.

The post Leasing city airport could help Phoenix pay down pension debt appeared first on Reason Foundation.

That debt is ultimately borne by taxpayers, and like any debt, when unfunded pension liabilities rise, so do the costs of servicing it. As pension debt payments start to siphon money away from other government priorities, such as education and infrastructure, some lawmakers are now pushing for much-needed reforms.

In Texas, the state Legislature passed a major pension reform that tackles the Employees Retirement System of Texas’ nearly $15 billion in pension debt. The ERS serves more than 300,000 current and retired Texas government workers. But driven largely by rosy investment-return assumptions and a history of underfunding by the state, the system’s unfunded liabilities have skyrocketed. The ERS’s consulting actuary says the plan will be insolvent by 2061 even if it meets its lofty long-term investment return goals, and as early as 2047 if it doesn’t.

The reform legislation commits Texas to paying the bill for retirement benefits promised to workers by shifting the ERS to actuarially based funding and a fixed payoff schedule. The new law also enters all future employees into a new low-risk “cash balance” retirement plan that provides a guaranteed minimum 4% return on investment along with the portability of a 401(k). In short, the reforms would enable Texas to keep the promises made to current and retired workers but would stop making unsustainable pension promises to workers in the future.

The pension reform bill will become law this weekend if Gov. Greg Abbott doesn’t veto it, which he hasn’t indicated he will do. Texas will then join a growing list of states—including Michigan, Arizona, Pennsylvania and Colorado—that have created or expanded retirement plans that reduce financial risks for governments and can help avoid burdening future taxpayers with more unfunded liabilities.

Arizona and Michigan have enacted more than a dozen substantive pension reform bills over the past five years. Credit-rating agencies and national retirement experts have cited Arizona’s public-safety pension reforms. Moody’s Investors Service gave Michigan’s teacher retirement reform a “credit positive” review because the state and participating local governments “will no longer carry the entire burden of investment performance risk for new employee pensions.”

Pension reform need not be partisan. After gaining input and buy-in from unions for police officers, firefighters and other public employees, New Mexico Gov. Michelle Lujan Grisham, a Democrat, overhauled her state’s public-employee pension plan for workers who aren’t teachers. “We must make changes now—the alternative is to saddle New Mexicans with unacceptable risk,” Ms. Grisham said, urging fellow Democrats to pass reforms. In 2018, Colorado legislators bridged their differences in a divided government to pass comprehensive reforms that increased employee and employer contributions, reduced cost-of-living adjustments, raised the retirement age, and expanded the use of defined-contribution plans for future employees to address the chronic structural underfunding of the state’s main public pension system.

Public pension reforms aren’t politically easy. With Republicans in control of Florida’s state government and the Florida Retirement System $36 billion in debt, the state Senate passed a bill that would have closed the state pension plan to new hires. But the bill died in the House because lawmakers couldn’t agree on how to pay down the state’s pension debt.

Meaningful pension reforms are difficult to accomplish but will be increasingly necessary as state and municipal pension debt service eats up larger chunks of government budgets. State and local leaders seeking to make lasting improvements to government finances should look to Texas, Arizona and Michigan. These states are showing that it’s possible to create resilient retirement systems that can promote long-term financial security for taxpayers and public employees alike.

A version of this column originally appeared in The Wall Street Journal.

The post These States Are Leading the Way on Pension Reform appeared first on Reason Foundation.

Our latest analysis of the Arizona State Retirement System (ASRS), updated December 2020, shows that costs for the system could potentially rise by almost $20 billion under some bad market scenarios. Additionally, the findings reveal how the past two decades of underperforming investment returns, interest on pension debt, and inaccurate actuarial assumptions have driven pension debt ever higher, resulting in diverting more and more funding away from Arizona classrooms and other public priorities each year.

One such finding is that overly optimistic investment return assumptions have been the biggest contributor to ASRS debt—adding over $10 billion in debt since 2002.

Not only does Reason Foundation’s latest solvency analysis examine the factors driving the growth of ASRS’ unfunded liabilities, but it also presents a stress-test analysis to measure the impacts that future market scenarios could have on unfunded liabilities and required employer contributions.

The findings show that ASRS has less than a 50 percent chance of meeting its set expected rate of return, and if it does not the system will fall even further behind. The growth of the public pension system’s debt can be seen in the chart below, which is pulled from the full solvency analysis.

With only 72.8 percent of needed assets on hand today, this underfunding not only puts taxpayers and public servants equally on the hook for servicing ballooning pension debt (the costs of which have increased massively since the early 2000s) but also undermines both the salary growth and retirement security needs of a significant portion of the workforce, particularly younger Arizona educators and state employees.

Challenges Facing ERS

1. Deviations from Investment Return Assumptions have been the largest contributor to the unfunded liability, adding $10.7 billion to the unfunded liability since 2002. ASRS assets have consistently returned less than assumed, leading to growth in unfunded liabilities.
2. Interest on Pension Debt has added $10.5 billion to the unfunded liability since 2002. • Accumulated interest on unfunded pension liabilities makes a pension more expensive. • Interest accrual on unfunded pension liabilities has frequently exceeded amortization payments, resulting in $1.2 billion in negative amortization (interest on the unfunded liability exceeding amortization payments).
3. Changes in Methods and Assumptions have revealed roughly $4.1 billion to the unfunded liability since 2002.
4. Undervaluing Debt through discounting methods has likely led to the tacit undercalculation of required contributions.

Challenge 1: Assumed Rate of Return

Unrealistic Expectations

The return assumption used by ASRS is exposing taxpayers to significant investment underperformance risk.

Underpricing Contributions

Using an overly optimistic investment return assumption leads to underpricing benefits and an undercalculated actuarially determined contribution rate.

Investment Returns Have Underperformed

ASRS actuaries have historically used an 8% assumed rate of return to calculate benefit cost to members and employers despite significant market changes, only lowering the rate to 7.5% in 2018. • 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 problem created by having an excessively high assumed rate of return.

New Normal: The Market Has Changed

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 around 8% in the 1990s to consistently less than 4% today. New phenomenon: negative interest rates, designates a collapse in global bond yields. The U.S. experiences 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. ASRS had yet to recover from the Great Recession, and now it will be dealing with high economic uncertainty and volatility in the wake of COVID-19.

Risk Assessment

Our risk assessment analysis shows that under likely market fluctuations, ASRS funding could decline significantly more.

If you assume ASRS will achieve an average six percent rate of investment return over the next 30 years plus experience one financial crisis in this time, analysis shows that the pension plans unfunded liability would equal $6.8 billion in the year 2050. Currently, the state assumes that the plan’s unfunded liabilities would be totally paid off by 2050.

This likely economic scenario would cost the state over $20 billion more in pension contributions than what they currently plan to spend on the plan.

Seeing as ASRS only averaged a 5.87 percent market valued investment return rate between 2000 – 2019, and that we have seen two major economic crises in the last 20 years, it is reasonable to assume the next 30 years will look somewhat similar.

An additional $20 billion in pension costs would put significant strain on the state budget.

Challenge 2: Amortization Methods

ASRS uses a 25-year, level-percentage amortization on a layered basis method to amortize newly accrued unfunded liability.

What is level percent of payroll amortization?

• Sets the amortization payment as a fixed share of total member payroll
• Often results in back-loaded pension debt payments, especially if payroll growth slows

What does amortizing unfunded liabilities using a layered-base approach mean?

• Any new ASRS unfunded liabilities in a given year are amortized over a 25-year period, meaning that there is no fixed-end date for the complete elimination of unfunded liabilities

What does a long amortization period mean?

• Professional actuaries generally recommend layering in periods 20 years or less in order to pay down unfunded liabilities faster, ensure sufficient contributions, and minimize the risk that pension debt is exposed to ongoing market risk
• Makes it more likely unfunded liabilities will never be paid off
• Often leaves debt payments each year short of the interest accrued on the debt (e.g. negative amortization)

Source: Pension Integrity Project analysis and forecast of ASRS Actuarial Valuation Reports and CAFRs. Figures are rounded.

Challenge 3: Uncovering Hidden Costs

Adjusting actuarial assumptions to reflect the changing demographics and new normal in investment markets exposes hidden pension cost by uncovering existing but unreported unfunded liabilities.

Here’s how actual experience has differed from actuarial assumptions:

New Member Rate Assumptions

ASRS new hire and rehire rates have differed from expectations resulting in a $543 million growth in unfunded liabilities from 2009-2014.

Withdrawal Rate Assumptions

ASRS assumptions on the rates of employer withdrawal have differed from expectations resulting in a $21 million growth in unfunded liabilities from 2009-2014.

Disability Rate Benefits

ASRS disability claims have been more than expected, resulting in a $14 million growth in unfunded liabilities from 2009-2014.

Active Mortality Rate Benefits

ASRS survivor claims for active members have been more than expected, resulting in a $13 million growth in unfunded liabilities from 2009-2014.

Age and Service Retirement

ASRS members have been retiring at younger than expected ages, resulting in a larger liability than expected and $7 million in growth in unfunded liabilities from 2009 to 2014.

Other Missed Assumptions

Other ASRS assumptions (not specified in financial documents) have differed from expectations resulting in a $285 million growth in unfunded liabilities from 2009-2014.

Inactive Mortality Rate Benefits

ASRS survivor claims for inactive members have been less than expected, resulting in a $154 million reduction in unfunded liabilities from 2009-2014.

Overestimated Payroll Growth

ASRS employers have not raised salaries as fast as expected, resulting in lower payrolls and thus lower earned pension benefits. This has meant a $2 billion reduction in unfunded liabilities from 2009-2014.

Overestimated Payroll Growth

However, overestimating payroll growth is creating a long-term problem for ASRS because of its combination with the level-percentage of payroll amortization method used by the plan.

This method backloads pension debt payments by assuming that future payrolls will be larger than today (a reasonable assumption). But when payroll does not grow as fast as expected, employer contributions must rise as a percentage of payroll. This means the amortization method combined with the inaccurate assumption is delaying debt payments.

Actual Change in Payroll v. Assumption

Source: Pension Integrity Project analysis of ASRS actuarial valuation reports and CAFRS.

Challenge 4: Discount Rate & Undervaluing Debt

The ASRS discount rate methodology is undervaluing liabilities.

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 ASRS — 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 ASRS 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.

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.

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

• Arizona Constitution—Article 29

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.

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

High pre-retirement withdrawal rates signal challenges in recruiting and retaining new public employees:

• 60% of new workers leave before 5 years of service
• 74% of new workers leave before 10 years of service
• Just 17% of ASRS workers remain in the system from start to finish to receive partial benefits at age 50
• Under 12% of ASRS workers remain in the system from start to finish to receive full benefits at ages 55 to 65 (depending on their age at hiring)

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. Adopt better funding policy, risk assessment, and actuarial assumptions. Lower the assumed rate of return to align with independent actuarial recommendations. These changes should aim at minimizing risk and contribution rate volatility for employers and employees.
2. 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. Reducing the amortization schedule would save the state billions in interest payments.
3. Review current plan options to improve retirement security. Consider offering additional retirement options that create a pathway to lifetime income for employees that do not stay in public service.

Potential Solutions

1. Adopt Better Funding Policy, Risk Assessment, and Actuarial Assumptions

Risk Assessment and Actuarial Assumptions:

• Look to lower the assumed return such that it aligns with more realistic probability of success
• Work to reduce fees and costs of active management
• Consider adopting an even more conservative assumption for a new hire defined benefit plan
• Require stress testing for contribution rates, funded ratios, and cash flows with look-forward forecasts for a range of scenarios Arizona Pension Analysis: ASRS 59 December 4, 2020

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

Current amortization time horizons are too long:

• ASRS’ 30-year layered level percent of payroll amortization policy leaves unfunded liabilities significantly exposed to additional market risk and should be shortened similar to PSPRS’ policies.
• The Society of Actuaries Blue Ribbon Panel recommends amortization schedules be no longer than 15 to 20 years.

The legislature could put maximum amortization periods in place and/or require a gradual reduction in the funding period to target a lower number of years:

• Other states have phased in changes by reducing the amortization schedules one year at a time
• The legislature could require that ASRS be funded on a certain time period under specific scenarios, such as alternative assumptions and/or stress test scenarios Arizona Pension Analysis: ASRS 60 December 4, 2020

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

ASRS is not providing a path for retirement income security to all Arizona public workers:

• For example, only 12% of public employees make it to the 30 years necessary for a full pension. This means the majority of members would be better served by having the choice of an alternative plan design built for portability and an increasingly mobile workforce, such as a Cash Balance, Hybrid or DC plan.

Employees should have a choice to select 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.
• Defined contribution plans can be designed to auto-enroll members into professionally managed accounts with low fees that target specified retirement income and access to annuities

Full Arizona State Retirement System Solvency Analysis  

The post Arizona State Retirement System (Arizona ASRS) Pension Analysis appeared first on Reason Foundation.

In This Issue:

Articles, Research & Spotlights 

• Study Says State, Local Retiree Healthcare Debt Totals $1.2 Trillion
• Testimony: Examining Solutions for the Florida Retirement System
• Nebraska Legislature Considering Stress Testing
• California Policymakers Should Address Pension Debt
• Why Paying Down Arizona’s Unfunded Pension Liabilities Makes Sense for Taxpayers

News in Brief

Quotable Quotes on Pension Reform

Data Highlight                                     

Contact the Pension Reform Help Desk

Articles, Research & Spotlights

New Study Shows State and Local Governments’ Other Post-Employment Benefit Debt Totals $1.2 Trillion

A new report by the Pension Integrity Project’s Marc Joffe provides a comprehensive assessment of other post-employment benefits (OPEBs) debt on an unprecedented national scale. State and local government provided other post-employment benefits include benefits such as retiree health care and dental care. The new study captures OPEB data for all states and most cities, counties and school districts in the U.S. — making it the most extensive effort yet to examine the subject. Notably, the report finds that just 15 governmental entities account for half the total national OPEB liability, which currently equals $1.2 trillion.

Testimony: Examining the Status of the Florida Retirement System

Florida policymakers have taken several steps to improve the financial security of the Florida Retirement System (FRS) over the past decade, but the pension plan still faces significant challenges. Recent adjustments to the plan’s assumed rate of investment return, for example, are still not enough to properly account for growing pension obligations and will likely lead to a pattern of insufficient annual payments into the pension system. Fortunately, the state legislature is showing interest in continuing the effort to reform FRS. The Pension Integrity Project testified on the changes needed for FRS to keep its promises to its retirees, noting the important role that data analysis and technical expertise should play in any reform effort.

Legislation in Nebraska Would Use Stress Testing to Assess Municipal Pension Sustainability

For years, the Pension Integrity Project has recommended pension systems use stress testing to recognize and help address a pension plan’s financial vulnerabilities that can arise from potential unforeseen economic events The Nebraska legislature has introduced a bill to require comprehensive annual stress testing on municipality-administered pension plans. In his recent testimony to the Nebraska Retirement Systems Committee, Reason’s Steven Gassenberger explains what the potential impact of the bill might be for Nebraska’s pension plans and how stress testing can better secure the affordability and sustainability of promised benefits to public workers. An additional, detailed commentary also evaluates how the current bill meets the objectives of pension reform.

California Should Prioritize Paying Down Public Pension Debt

Due to the COVID-19 pandemic and expected budget shortfalls, California Gov. Gavin Newsom decided to forgo properly funding the state’s pension plan by skipping a planned $2.4 billion supplemental pension payment last year. However, state revenues have greatly outperformed earlier estimates and California policymakers should reconsider reinstating the supplemental payment and recommit to paying down the state’s pension debt. Reason’s Marc Joffe details the ways unfunded liabilities are harming California’s economic growth and could worsen.

Quickly Paying Down Arizona Pension Debt Is a Win for Taxpayers

The Arizona State Senate has proposed a $300 million appropriation as a one-time supplemental payment toward the state’s public safety pension system. Reason’s Leonard Gilroy provides analysis on this proposal, explaining how the payment would reduce the system’s unfunded liabilities and help state and local employers reduce large interest payments that they are currently paying on pension debt. While the exact savings depends greatly on investment performance, Reason’s pension modeling analysis indicates that this one-time payment could save Arizona taxpayers up to $500 million over the next 30 years.

News in Brief

S&P Global Ratings Expect Growing Issues for Pension Plans in Upcoming Fiscal Year

Many of the financial difficulties that emerged during the 2020 recession will continue to affect state and local pensions. S&P Global Ratings has released a new study of five potential trends affecting pension systems in 2021 and beyond, warning that the market turmoil last year will continue to affect investment returns. The study is available here.

National Conference on Public Employee Retirement Systems Releases Yearly Study of Pension Trends

The National Conference on Public Employee Retirement Systems (NCPERS) releases a yearly study exploring the retirement practices of the public sector. In general, they find that the market effects of the COVID-19 related recession were less severe than expected. Although they note, the pandemic has introduced new capabilities for the public to listen to their public pension board meetings through video recordings and phone calls. The study is available here.

Equable Institute Releases Explainer on Pension Data Sources

As a particularly quantitative field of analysis, pension finance discussions rely heavily upon high-quality data sources. Equable has released a new primer detailing commonly-used sources of pension data, as well as an evaluation of the strengths and limitations of each source. This is an excellent tool for those interested in seeking and understanding the metrics that best explain trends in public pension funding policies. The primer may be found here.

Quotable Quotes on Pension Reform

“All too often, what cities, in general, have experienced is that these assumptions have been overly optimistic, with the systems’ earnings being overestimated and cost of benefits underestimated, resulting in a level of unfunded liabilities that the city is required to pay.”

—Paul Payne, St Louis Budget Director, cited in “Nearly nine years after reform, city poised to reverse some fire pension changes,” St Louis Post-Dispatch, January 19, 2021

“This is one of the major reasons why our budgets went up and taxes, in turn, have gone up. We have an opportunity right now to make a financing decision that saves the town and taxpayers significant money. This means year-after-year savings for taxpayers for the next 25 years.”

—Shari Cantor, West Hartford Mayor, discussing growing pension liabilities in  “Mayor: New pension measures could save West Hartford taxpayers for years,” West Hartford News, February 1, 2021

“We put in millions of dollars every year from our General Fund that usually pays for other services, for parks and recreation, for road repair, for other services to our community from there. So, the more we put into our pension payments from our General Fund the less services we can provide to Tucsonans.”

—Regina Romero, Tuscon Mayor, cited in “Tucson invests for pension payments,” Arizona Public Media, February 12, 2021

Data Highlight

Each month we feature a pension-related chart or infographic of interest generated by one of our Pension Integrity Project analysts. This month, Quantitative Analyst Jordan Campbell investigates the relationship between public pension investments and declining bond yields. Read more about the tool here.

Contact the Pension Reform Help Desk

Reason Foundation’s Pension Reform Help Desk provides information on Reason’s work on pension reform and resources for those wishing to pursue pension reform in their states, counties and cities. Feel free to contact the Reason Pension Reform Help Desk by e-mail at pensionhelpdesk@reason.org.

Follow the discussion on pensions and other governmental reforms at Reason Foundation’s website and on Twitter @ReasonPensions. As we continually strive to improve this publication, please feel free to send your questions, comments and suggestions to alix.ollivier@reason.org.

The post Pension Reform Newsletter: New Analysis of Other Post Employment Benefit Debt, Florida Considers Pension Reform, and More appeared first on Reason Foundation.

Funded ratios are a simple and useful metric that can help to assess the financial health of a pension plan. Calculated by dividing the projected value of a pension plan’s assets by the cost of its promised pension benefits, funded ratios can reveal if a pension system is on track to be able to pay for the retirement benefits that have been promised to workers.

Over time, changes in a pension plan’s funded ratio, also referred to as a pension’s funded status, can show the rate at which the plan’s debt is growing.

In 2001, West Virginia was the only state where public pension plans had an aggregate funded ratio of less than 60 percent. However, 18 years later, in 2019, nine states faced aggregate funded ratios below 60 percent.

In that same time period, the number of states with funded ratios below 70 percent (but above 60 percent) grew from three to 14. Together, these numbers show that, as of 2019, 23 states had less than 70 percent of the assets on hand that they need to be able to pay for promised future retirement benefits.

Perhaps even more alarming is the fact that over the last two decades, the number of states with fully-funded pensions fell from 20 to just one. As of 2019, South Dakota was the only state without any public pension debt.

The interactive map below shows the change in each state’s aggregated pension plan funded ratio from 2001 to 2019. Because many states administer multiple public pension plans we combined the pension liabilities and actuarial value of assets of all the pension plans in a state to calculate their aggregate funded ratio for the data visualization.

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

Previous analysis has shown that the average state-level funded ratio, using the market value of assets, dropped from 97.7 percent in 2001 to roughly 73.6 percent in 2019. This decline of 24.1 percentage points is cause for concern for workers, taxpayers, and lawmakers.

As public pension debt grows, so does the cost of saving for retirement benefits. Public pension underfunding not only puts taxpayers on the hook for growing pension debt but could jeopardize the retirement security of teachers, public safety officials, and other state employees. Left unaddressed, pension debt will also continue to pull resources from other public priorities like road repairs and K-12 education in most states.

The post Public Pension Plans’ Funded Ratios Have Been Declining for Years appeared first on Reason Foundation.

Issue No. 75 – December 2020

This newsletter from the Pension Integrity Project at Reason Foundation highlights articles, research, opinion, and other information related to public pension challenges and reform efforts across the nation. You can find previous editions here.

In This Issue:

Articles, Research & Spotlights 

• Best Practices for Public Retirement System Design
• An In-Depth Look at the Arizona State Retirement System
• Lessons from West Virginia’s Municipal Pension Reform
• How to Include Lifetime Income Options in Defined Contribution Plans

News in Brief

Quotable Quotes on Pension Reform

Data Highlight                                      

Contact the Pension Reform Help Desk

Articles, Research & Spotlights

The Gold Standard in Public Retirement System Design Series

The Pension Integrity Project has launched a new, ongoing series outlining best practices for public retirement system design. The series provides guidance to help states structure attractive retirement systems that meet the needs of both employees and taxpayers. It will also provide policy suggestions for states that are struggling with pension debt. The first two briefs in the series have been released. The first brief explores best practices in defined benefit pension system design and explains how risk-sharing can increase plan solvency, provide better accountability to retirees, and lessen the burden that unfunded liabilities have on taxpayers. The second brief details how defined contribution retirement plans can be designed to manage financial risk while also supporting the retirement security goals of today’s evolving and dynamic public sector workforce.

» Best Practices in Incorporating Risk Sharing Into Defined Benefit Pension Plans

» Best Practices in the Design and Utilization of Public Sector Defined Contribution Plans

Assessing the Financial Health of the Arizona State Retirement System

In 2002, the Arizona State Retirement System (ASRS) had a $1 billion surplus of public pension assets. Less than 20 years later, the public pension system has nearly $16 billion in unfunded pension liabilities. A new solvency analysis by the Pension Integrity Project at Reason Foundation finds that investment returns falling below assumptions as well as interest accrued on pension debt have been the biggest contributors to the growing unfunded liability. If left unaddressed, this growing debt could cause the state to divert even more funding away from education, road repairs, and other public priorities.

West Virginia’s Municipal Pension Reforms Offer Lessons for States and Cities

In the wake of the Great Recession, then-West Virginia Gov. Joe Manchin signed a law reforming West Virginia’s municipal pension plans. A decade later, the local public pension plans have seen funding improvements due to the establishment of a pension oversight board and the option for new hires to shift to a statewide retirement plan. In this commentary, policy analyst Marc Joffe examines the details of the 2009 pension reform and notes how this effort can serve as an example for other states and cities to follow.

Lifetime Income and Defined Contribution Plans Are Not Mutually Exclusive

One common criticism of defined contribution retirement plans has been that they lack a lifetime income offering for their members. However, annuities that include lifetime income have long been flexible options that can provide a stable income for a retiree’s life and many defined contribution plans in higher education have had this valuable option for decades. Richard Hiller, a senior fellow with the Pension Integrity Project, details the best approaches for lifetime income options in defined benefit plans and discusses how annuity options can effectively meet the needs of public employees and employers.

 News in Brief

Milliman Releases 2020 Public Pension Funding Study

According to Milliman’s annual funding study, the average state pension plan was funded at 70.7 percent as of June 30, 2020, down from 73.4 percent a year earlier. The report finds that while aggregate plan assets only rose slightly from $3.82 trillion to $3.84 trillion, aggregate pension liabilities grew from $5.07 trillion to $5.27 trillion. The COVID-19 pandemic has affected public pensions through market volatility, which has affected asset values. The pandemic also prompted some agencies to furlough government employees, which resulted in lower-than-planned contributions.

State of Pensions 2020

An updated report by Equable Institute summarizes many of the financial risks facing public pension plans during the COVID-19 pandemic and economic recession. These risks include investment returns below assumed rates, growing unfunded liabilities, and falling tax revenue. Despite a decade-long bull market leading up to 2020 and the COVID-19 pandemic, the aggregate funded ratio for all statewide pension systems is near its lowest point in modern history.

Are Texas Teacher Retirement Benefits Adequate?

A new report from Bellwether Education Partners and TeacherPensions.org examines the Teacher Retirement System of Texas (TRS) and finds those plan members who accrue fewer than 27 years of service in the plan will leave with inadequate retirement savings. As a solution, they argue that TRS should offer a guaranteed return (cash balance) plan, which would allow teachers to leave the public employee workforce at any stage with the full value of their contributions and investments.

Internal vs. External Management for State and Local Pension Plans

As pension plans have increased investments in alternative assets, the high fees associated with external asset managers have garnered public scrutiny. Several large plans, such as the California Public Employees’ Retirement System (CalPERS), Wisconsin Retirement System, and Public Employees’ Retirement System of Nevada have developed internal asset management teams to reduce fees. A new brief by Jean-Pierre Aubry and Kevin Wandrei of the Center for Retirement Research at Boston College investigates the impact of external asset managers and finds that lowering the number of asset managers does positively affect the plan, but only if the correct managers are cut.

 Quotable Quotes on Pension Reform

“Fundamentally, achieving a 7 percent average annualized return isn’t the hardest part. The challenge as a public pension plan is to do so while attaining an acceptable and appropriate level of risk and diversification, amortizing an unfunded liability of over $14 billion, and honoring our commitment of lifetime income to over 140,000 members and beneficiaries.”

—Thom Williams, Hawaii Employees’ Retirement System executive director, quoted in “Hawaii’s Public Pension Fund Rises 5.38 Percent in Q1 Fiscal 2021,” Chief Investment Officer, November 19, 2020

“Some of the implications of low interest rates are already clear. For example, a balanced portfolio of half stocks and half bonds has historically earned a return of 8.2 percent, or about 5 percent after inflation. My guess is that a more plausible projection is an inflation-adjusted return of about 3 percent… public and private pension plans are probably more underfunded than current estimates suggest.”

—N. Gregory Mankiw, Harvard Economics professor, quoted in “The Puzzle of Low Interest Rates,” The New York Times, December 4, 2020

“All we’re doing is passing along to the citizens of Du Quoin what the state is calculating, [in terms of additional pension obligations]. This is not self-inflicted… I don’t like it. But in this case, you have to weigh funding your public safety or you have layoffs to pay for pensions.”

—Guy Alongi, Du Quoin mayor, quoted in “City Council Eyes 15 Percent Property Tax Hike to Fund Pensions,” Du Quoin Call, December 6, 2020

“We could come back and say we told you this last year, we told you this the year before…and in addition to those factors we’re now in a pandemic.”

—Ash Williams, the chief investment officer of Florida’s State Board of Administration, quoted in “COVID-19 Pandemic Puts Squeeze on Pension Plans,” Wall Street Journal, December 9, 2020

Data Highlight

Each month we feature a pension-related chart or infographic of interest curated by one of our Pension Integrity Project analysts. This month, quantitative analyst Anil Niraula has provided an interactive chart that tracks the fiscal year 2019-2020 investment returns for state pension plans across the nation as they report their official returns. You can find the tool here.

Contact the Pension Reform Help Desk

Reason Foundation’s Pension Reform Help Desk provides information on Reason’s work on pension reform and resources for those wishing to pursue pension reform in their states, counties, and cities. Feel free to contact the Reason Pension Reform Help Desk by e-mail at pensionhelpdesk@reason.org.

Follow the discussion on pensions and other governmental reforms at Reason Foundation’s website and on Twitter @ReasonPensions. As we continually strive to improve the publication, please feel free to send your questions, comments, and suggestions to alix.ollivier@reason.org.

The post Pension Reform Newsletter: Best Practices for State Pension Systems, Tracking Annual Investment Returns, and More appeared first on Reason Foundation.

In This Issue:

Articles, Research & Spotlights 

• Pension Reform for the “New Normal” Economy 
• The Growing Unfunded Pension Liabilities in Texas
• Pension Debt Is Pulling Funding Away from Michigan’s Schools
• Evaluating Arizona’s Public Safety Personnel Retirement Plan After Its Reforms
• Modernizing Police Retirement Plans
• Transit Agencies Are Strapped with Pension Debt 

News in Brief
Quotable Quotes on Pension Reform
Data Highlight
Contact the Pension Reform Help Desk

Articles, Research & Spotlights

Pension Reform for the “New Normal” Economy—Examining Colorado’s Successful Model

The pension reforms Colorado made in 2018 have put the state on track to have its Public Employee Retirement Association (PERA) fully funded in 30 years—a position that, unfortunately, many other public pension plans across the country are not in. A new Pension Integrity Project policy brief by Zachary Christensen compares how PERA would be able to respond to economic and market turbulence before and after the reforms implemented via Senate Bill 200 of 2018. The study shows that after the reforms, PERA is in a much-improved position to handle the current and future market shocks, due largely to the introduction of automatic adjustments. Colorado’s reform efforts can be a useful example for other pension plans across the country that need to make changes to adapt to the new economic and investment environment.  

New Texas ERS and TRS Pension Solvency Analyses

Since 2001, unfunded liabilities for the Teacher Retirement System of Texas (TRS) have grown by more than $50 billion. Over the same time period, unfunded liabilities for the Employees Retirement System of Texas (ERS) have grown by nearly $12 billion, resulting in ERS’ funded ratio falling from 105 percent to 70.5 percent. What’s more, Texas has reached its constitutionally set cap on annual contributions for ERS and is quickly approaching this limit for TRS. Achieving unrealistically high investment return targets in an increasingly volatile market—a strategy that failed to prevent growing pension debt despite a decade-long historic run-up in the market—is unlikely to be the savior of the retirement systems now. New analysis of TRS and ERS by the Pension Integrity Project examines the factors behind this recent growth in unfunded liabilities and suggests reforms Texas can use to close the funding gaps, including strategies to pay down pension debt faster, adopt more prudent actuarial assumptions and build more resilient and financially sustainable retirement systems for the future.

Examining How Much Money Pension Debt Takes Away From Michigan’s Classrooms Each Year

In 2018, nearly a third of state funding for the Detroit Public Schools district went to its pension plan, the Michigan Public School Employees Retirement System (MPSERS). Returns that deviated from assumptions and missed payments have created over $40 billion in unfunded liabilities, debt that crowds out other school spending each year. While the normal cost per pupil (the cost of actual retirement benefits earned that year) was $252 in 2018, Detroit schools paid $2,202 per student for MPERS Debt, implying that each student would have an additional $1800 of funding if the plan had been fully-funded. Reason’s Truong Bui, Marc Joffe and Leonard Gilroy have created a data visualization of the cost of Michigan’s public-school pension debt on a per-student basis, which allows the viewer to compare funding and contribution numbers between districts in the state. 

Arizona Public Safety Personnel Retirement System Solvency Analysis

As a result of a 2016 pension reform effort, the Arizona Public Safety Retirement System (PSPRS) is on track to sustainable financial sustainability. The reform, for which the Pension Integrity Project played a major technical assistance and stakeholder engagement role, provided increased retirement security, lowered costs for employers and taxpayers, and provided new retirement choices to allow new public safety personnel to better match an evolving set of worker preferences. In this newly published analysis, Reason’s analysts examine the effects of Arizona’s 2016 reforms and identify the challenges that remain for PSPRS.

Adapting Police Retirement Plans to Serve an Evolving Workforce

As the national conversation on the role of policing continues, Reason’s Richard Hiller notes the need to rethink police retirement plans as the profession evolves. Due to a variety of factors, law enforcement officers tend to join and retire at younger ages, often around the age of 50 or 55. Despite the relatively early retirement, vesting periods for pension benefits guarantee that many officers may not even meet their goals. For example, Arizona’s plan for public safety workers showed only 54 percent of new hires remaining in service after five years, when they would vest in their pension benefit, which encouraged stakeholders to establish more plan options to fit the need of more public servants. Hiller urges policymakers to adapt pension plans to better account for the increased mobility in the workforce. 

Transit Agencies Have At Least $49 Billion in Retirement Debt 

As the COVID-19 pandemic continues to keep workers at home, many of the nation’s mass transit agencies are also struggling with growing pension funding shortfalls. In the best of times, transit agencies rely heavily on subsidies to operate. As tax and farebox revenues plummet during the pandemic, transit agencies have been urging Congress to provide a large bailout. However, as Reason’s Marc Joffe finds, the nation’s largest transit agencies have at least $49 billion in retirement system debt, so Congress should examine whether any potential bailout would be used to pay for pension contributions and debt rather than providing mass transit services for commuters who need them. 

News in Brief

ESG Investing and Public Pensions: An Update

While pension funds have been engaged in social investing for decades, the rise of environmental, social, and governance (ESG) investing has prompted the Department of Labor to set clear guidelines for fiduciaries. Jean-Pierre Aubry, Anqi Chen, Patrick M. Hubbard and Alicia H. Munnell of the Center for Retirement Research (CRR) have examined the impact of ESG investing in a new research brief and found that any form of social investing is not appropriate for public pension funds. Because ESG investing lowers potential investment returns and has an unclear effect in achieving its social goals, the report recommends against plans swapping to this framework. The brief is available here. 

2020 Public Plan Investment Update And COVID-19 Market Volatility

With 2020 financial reports now available for most public pension plans, Jean-Pierre Aubry of the Center for Retirement Research compiled an overview of the impact of COVID-19 on plan performance so far, finding that most plans fell below actuarial expectations. According to the report, while in 2019 plans outperformed their average assumed return of 7.2 percent with an average return of 8.9 percent, the average 2020 return was just 5.8 percent. The brief argues that plans may need to hold U.S. Treasuries, which rise in value during market shocks and can be easily liquidated if needed to pay contributions. The brief is available here. 

Impact of COVID-19 on Pension Plan Actuarial Experience and Assumptions, Including Mortality

COVID-19 has been responsible for over 225,000 deaths in the US so far. As a result, the American Academy of Actuaries has released a brief detailing the changes that the pandemic has posed to actuarial assumptions, including mortality tables. Due to the advanced age of most COVID-19 victims, the pandemic’s effect on mortality appears unlikely to have a significant impact on unfunded liabilities for most public pension plans. “While the excess mortality associated with the pandemic could have an impact on certain plans, other workforce demographic and economic implications appear to be far more financially significant,” the report finds. The brief is available here. 

Quotable Quotes on Pension Reform

“My point here is not to deprive current retirees of benefits they were promised or to take away benefits already earned by current employees. But it’s time for honest, independent assessments of the long-held assumptions that investment returns can be sufficient to fund COLAs indefinitely while also paying off today’s combined trillion-dollar unfunded liabilities.”
— Girard Miller, finance columnist, writing in “Public Pensions’ New Inflation Dilemma,” Governing, Sept. 15, 2020

“One of the issues you have is the liability can change. So even if you issue pension obligation bonds, there’s always a chance that those divisions don’t stay at 100 percent funded. That’s when problems arise. That’s when you suddenly have the bond payment and the pension payment.”
— Dean Bott, Grand Traverse County finance director, quoted in “Grand Traverse Pavilions Seeks Bonds to Cover Pension Debt,” Record Eagle, Oct. 4, 2020

“Private equity isn’t my favorite asset class. It helps us achieve our 7 percent solution. I know we have to be there. I wish we were 100 percent funded. Then, maybe we wouldn’t.”
—Theresa Taylor, chair of CalPERS board’s investment committee, quoted in “Marching Orders for the Next Investment Chief of CalPERS: More Private Equity,” The New York Times, Oct. 19, 2020

Data Highlight

Each month we feature a pension-related chart or infographic of interest curated by one of our Pension Integrity Project analysts. This month, Quantitative Analyst Anil Niraula visualizes the changes in funded status for state pension plans across the nation. Use or read more about the tool here. 

Contact the Pension Reform Help Desk

Reason Foundation’s Pension Reform Help Desk provides information on Reason’s work on pension reform and resources for those wishing to pursue pension reform in their states, counties and cities. Feel free to contact the Reason Pension Reform Help Desk by e-mail at pensionhelpdesk@reason.org. 

Follow the discussion on pensions and other governmental reforms at Reason Foundation’s website and on Twitter @ReasonPensions. As we continually strive to improve the publication, please feel free to send your questions, comments and suggestions to alix.ollivier@reason.org.

The post Pension Reform Newsletter: Modernizing Police Retirement Plans, Transit Agencies Strapped With Debt, and More appeared first on Reason Foundation.

Four years after the Arizona Public Safety Retirement System (PSPRS) adopted major stakeholder-driven reforms to stem a precipitous increase in unfunded pension liabilities resulting from faulty plan design, the system now appears to be on a sustainable financial trajectory, according to a new stress test analysis prepared by the Pension Integrity Project at Reason Foundation.

The historic reform—for which the Pension Integrity Project played a major technical assistance and stakeholder engagement role—brought together the legislature, police and fire associations, taxpayer organizations and others to address the serious problems facing the public pension system.

Our newest analysis of Arizona PSPRS, updated this month (October 2020), shows that the 2016 reforms have already achieved many of the goals set by stakeholders, including providing increased retirement security for members and retirees, reducing long-term costs for employers, taxpayers, and employees, and providing new retirement design choices to allow new public safety personnel to better match an evolving set of worker preferences.

While actual results will depend on market outcomes, the most likely expected scenario is that the reforms will save PSPRS employers approximately $141 million over the studied 30-year window. This is welcome news for the state and the many local governments who have struggled to manage the rapidly growing costs of the pension system in the last 15 years. Additionally, while the benefits of a low-risk tier for new members will ultimately take decades to fully realize, this change will reduce risk incrementally with every new hire going into the future.

The system still faces challenges as it works to remain on a path back from its current 50 percent funding ratio. Not only does the latest solvency analysis examine the factors still driving the growth of PSPSRS’ unfunded liabilities and assesses the positive impacts of reforms to the system, but it also presents a stress test analysis to measure the impacts that future market scenarios could have on unfunded liabilities and required employer contributions. The analysis also provides a number of policy suggestions that, if implemented, would add to the already positive reforms that Arizona stakeholders have implemented.

New, updated analyses will be added to this page periodically to track PSPRS’s performance and solvency as new data and information become available. The analyses will continue to examine the primary factors driving historical changes in unfunded liabilities and offer stress testing designed to highlight potentially latent financial risks the plan is facing.

Arizona Public Safety Personnel Retirement Systems (PSPRS) Pension Solvency Analysis

The Pension Integrity Project at Reason Foundation offers pro-bono consulting to public officials and other stakeholders to help design and implement policy solutions aimed at improving public pension plan resiliency and promoting retirement security for all public employees. We stand ready to help motivated policymakers and stakeholders understand the issues, and we maintain up-to-date actuarial models for both the Arizona State Retirement System and the Arizona Public Safety Personnel Retirement System, which allows us to test the potential actuarial and fiscal impacts of a wide variety of potential policy changes

The post Arizona Public Safety Personnel Retirement System Solvency Analysis appeared first on Reason Foundation.

The most common justification given by plan managers is that pension assets are invested for the long-term and the market drop will not affect funding in the long-run. However, this attitude ignores the far-reaching effects that even one year of poor returns has on the funding status of troubled retirement systems.

In Illinois, where the state’s Teachers Retirement System (TRS) is only 41 percent funded, Dave Urbanek, the spokesman for TRS, says that they are “prepared for an eventuality like this” and “our [systems’ leadership] priority is to protect assets, so we’ve been in what we call a ‘defensive posture’ for the last several years.”

In reality, the Illinois TRS’ “defensive posture” portfolio is not that different from many other pension systems in terms of diversification and funds committed to “safe” assets like public equities.

Similar rhetoric has been heard from the State Retirement System (SRS) of Illinois.  Tim Blair, the system’s executive director, says that “we [the system] outperform in down or choppy markets, compared to our peers.” He also adds that “there’s absolutely no danger whatsoever of missed benefit payments.”

Although the rhetoric might sound reassuring, and it is in fact important to know that there will be no immediate interruptions with pension payments, this is not addressing the continued fiscal decline of a pension system that is currently just 38 percent funded. This means the fund has enough to cover only 38 cents of every dollar of benefits it has already promised to current and retired workers. When it comes to Illinois, such optimism is particularly surprising in light of the state’s recent request for a federal bailout of its poorly-funded pension systems.

Like Illinois, the leadership of the better-funded—86.4 percent funded—North Carolina Teachers and State Employees Retirement System (NC TSERS) cite a “conservative” investment strategy as grounds to believe that the pension systems “will survive the COVID-19 economic downturn better than other states.” Nonetheless, the asset allocations in the pension portfolios of both systems have what has become a rather standard market exposure—committing about a third of assets in public equities.

While Illinois’ teacher plan and NC TSERS have vastly different funded ratios, they have relatively similar asset allocation, meaning they are likely to see similar year-to-year results in terms of actual rates of return. However, there is a clear difference in how the systems will be able to recover because of the vastly different current asset-to-debt ratios.  NC TSERS has been responsive to changing market conditions and lowered its assumed ratio of return to 7 percent.

Nonetheless, as the Reason Foundation’s Pension Integrity Project noted in a recent analysis, NCTSERS is more likely to hit returns closer to 6 percent over the next 20 years. This is considerably lower than its long-term assumed investment return of 7 percent. The underperformance of assets could lead to unexpected additions to unfunded liabilities and increases in contributions from the state. Even if the pension plan meets it’s targeted assumed rate of return (ARR) on average in a 30-year window, the timing of returns impacts the plan’s ability to reach a 100 percent funded target. Low returns this year could throw the plan off the trajectory of being fully funded within its targeted timeframe.

To the west, both the Arizona State Retirement System (ASRS) and Iowa Public Employee Retirement System (IPERS) reassured the public that they have enough money in their systems to cover outgoing benefits without any disruption. But neither public pension system addressed the existing—and growing—underfunding issue or what a recession could mean for their pension systems’ long-term solvency. The funded ratio for ASRS is currently 71 percent, which is around the national average funded ratio for public pension plans, whereas IPERS is currently 84 percent funded.

A number of other public pension plans around the country have encouraged patience amid the ongoing coronavirus pandemic and fiscal crisis. The California Public Employee Retirement System (CalPERS) leadership called for the public to “resist ‘resulting bias’ (by) looking at recent results and then using those results to judge the merits of a decision.” Like other systems, CalPERS emphasized that it is a long-term investor, which requires them to “think differently.” The system, which is currently 71 percent funded, will certainly see a jump in unfunded liabilities in light of this year’s market downturn.

Texas Teachers Retirement System (TRS) Chief Information Officer Jase Auby said that although the system is expecting a negative 8.3 percent return for 2020, the long-term “plans (for handling down markets) are working exactly as we intended.” The system, sitting at the national average assumed return of 7.2 percent, will have to show significant investment gains in the next few years to bounce back from this year’s losses. This outcome appears to be increasingly unlikely in an environment of “new normal” low investment returns. A lower-yield investment environment has already impacted plans across the country even before the current market downturn.

Generally, public pension funds in most states are too fragile in the face of market crashes. They often lack the resiliency to climb back to full funding after suffering setbacks during a recession and, as a result, they are often not ready to face whatever the next unforeseen event that will challenge them in the coming years or decades. This problem is most evident in looking at how the country’s public pension plans, on average, still had not fully recovered from the Great Recession of 2008 when the coronavirus pandemic and economic downturn arrived in 2020.

Although some public pension plans across the country have gradually lowered their investment return assumptions, most are still too high, which keeps them exposed to both year-to-year volatility and long-term market underperformance. Pension plans are long-term investors, but they should not depend fully on historic norms by assuming that markets are going to revert to the same investment earnings experienced in the 1980s. This reversion to the mean is unlikely to be achieved because of structural changes in the economy and resulting slower economic growth.

More than 10 million people in the United States rely on the benefit payments promised by public pensions. Furthermore, taxpayers depend on their governments to avoid exorbitant costs as they are managing these benefits. This creates a delicate balancing act, but it is possible to provide secure and affordable retirement benefits to public workers.

The previous two decades of declining public pension funding and the damaging effects of the current market turmoil demonstrate that policymakers need to take a closer look at the policies that are intended to ensure the long-term sustainability of these pension plans. They should seek better ways to prepare funds to face multiple market shocks over the next 30 years and they need to find methods to soften the blow of downturns and one bad year of returns.

Overall, public pension plans remain vulnerable in the face of underperforming investments. This won’t be the last market downturn of our lifetimes. Based on historical patterns, public pension systems should assume the next financial crash will happen in 10-to-15 years rather than 20-to-30 years from now. In order to improve pension resiliency, public pension plans must first adopt lower investment expectations. This does not necessitate changes in investment strategies, but by setting a lower target for average investment returns, public pension funds would be better able to weather market shocks and avoid any insurmountable underfunding of their systems.

Public pension managers are understandably urging their members to remain calm and explaining that there will be no disruption of benefit payments in the face of the current notable level of societal and market turbulence. In the short-term, it is largely true that retirees will continue to see their retirement checks as promised. The long-term outlook for some of these public pension plans, however, is beginning to look even worse and is calling out for pension reforms.

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Some will, of course, argue that U.S. public pension systems are resilient already today due to several factors, including:

• Their long-lived investment horizon and long-term focus (e.g., the “stay calm, we’re long term investors, we plan for this” argument) 
• A belief that long-term investment returns will revert to the historical mean
• The multiyear smoothing techniques employed in reporting investment returns, that then feed back into contribution rate calculations (which limit contribution rate volatility from the stakeholders’ perspective) 
• They continue to reliably provide constitutionally protected benefits regardless of the whims in the market

Yet while there are some legitimacy and merit to every one of those commonly heard arguments, the instance of any one of them being true—or all, for that matter—is not sufficient to leap to an assumption of those pension systems being resilient in any real fiscal or policy-relevant way.

That’s because these are no longer theoretical arguments that require faith. We can look to our recent past to help guide better thinking. In the aftermath of the Great Recession, the conversations among professional actuaries, their public pension system clients and policymakers tended to revolve around what, in retrospect, appears to be an utterly faith-based argument with the following two core components:

1. Accepting a belief that despite the severity of the Great Recession and its impact on state and local budgets and pension funding, public pension funds were large and sophisticated institutional investors that planned for downturns and could “invest their way out” of what at that time was over $1 trillion in aggregate pension unfunded liabilities over the next 20-30 years.
2. Accepting a belief that absent a crystal ball for investment returns, the concept of “reversion to the mean” is an acceptable benchmark by which to assume where long-term investment forecasts will land. After all, if your public pension plan has averaged a 9% investment return over the last 40 years, which many have, then would it not be reasonable to do so again into the future when it comes to long-term expectations?

But how did such faith play out in real life, having now over 10 years of experience to look back on? We’ve essentially had a lost decade in U.S. public pension solvency, for all practical intents and purposes. 

Public pension underfunding—the gap between assets and liabilities—skyrocketed during the Great Recession, jumping from $0.1 trillion at the end of fiscal year 2007 to $1.1 trillion by the end of fiscal year 2009. At the time, pension managers certainly recognized that they had their work cut out for them—and some systems made fairly minor assumption and plan design changes around the edges in an attempt to course-correct financially—but were mostly confident that they could chip away at this shortfall over time. Unfortunately, the experience that followed did not match their optimism. During a historic bull run in the equity markets, state public pension funds effectively made no progress on closing this funding gap, with national unfunded liabilities reaching $1.2 trillion by the end of fiscal year 2019, immediately prior to COVID (see Figure 1). 

Figure 1: Historical U.S. Public Pension Assets, Liabilities and Funded Ratio (2001-2019)

Source: Pension Integrity Project analysis of state-level pension data.

That’s not to say there was no progress at all. Aggregate funded ratios fell dramatically after the 2008 financial crisis but improved slightly over the following decade at the state level, going from a low of 63 percent in 2009 to an improved—but still woefully insufficient—74 percent in 2019. Another twenty years like the last ten would have theoretically pulled national levels closer to full funding, but even the most optimistic of market analysts would see the folly in that expectation given the roller coaster that is today’s volatile market. 

Now, in the aftermath of losses caused by COVID-19, state and local governments will be facing the challenge of taking yet another significant hit to pension assets before they were even able to fully recover from the last drop. According to our estimates, 2020 unfunded liabilities are likely going to jump to between $1.5 trillion to $2.0 trillion, depending on investment returns in the current fiscal year, nearly wiping out a decade of gains since the last downturn. 

This weak recovery and the likely 2020 loss of what little progress was made suggest that the “invest your way out” mindset is likely built on false hope. If public pension funds didn’t invest their way back to significantly improved funding after a decade long bull market, then why on earth would we think we’d be able to invest our way out now? How many times does Lucy pull the football until Charlie Brown stops trying to kick it, at least when it comes to improved pension solvency?

Now in fairness to savvy pension administrators and actuaries, it’s not that there’s been no progress at all. Public plans have steadily lowered their assumed rates of return over the last decade on an aggregate basis, from roughly 8 percent down to approximately 7.2 percent today. That is undeniably a positive thing on its own terms, to be clear, in that it reflects a growing awareness that the future may portend less in terms of market returns than in the past. But at a time when the implied risk premium—the difference between assumed rates of returns held by pension funds and a “risk-free” rate, such as the yield on 20-Year Treasuries—appears to be at an all-time high (in excess of a whopping 600 basis points, as shown in Figure 2), it seems almost self-evident that additional prudent steps to lower public pension discount rates further are warranted. 

Figure 2: State Plans’ Average Return Assumption vs 20-Year Treasury Rate

Source: Pension Integrity Project analysis of state-level pension data.

Similarly, it’s not that plan directors and policymakers have done nothing at all. States like Michigan, Arizona, Colorado, Pennsylvania, and New Mexico have enacted smart reforms since 2015 that advanced reasonable ways to share risk more equitably between employers and employees and aimed to bend the long-term liability curve downward over the long run—and along with it, governmental appropriations. But most states made relatively smaller adjustments to their pension benefit structures and systems around the edges in the wake of the Great Recession, like meager adjustments to contribution rates, retirement ages, and the like. 

Moving Beyond the False Hope of “Invest Your Way Out” 

Perhaps the biggest “loss” in the lost decade for pensions was the lost opportunity for policymakers to more proactively address the problem. Looking forward, policymakers face a fundamental choice: do they revert to the “invest your way out” faith that has so poorly served them to date, or do they aim for a new operating principle, a new North Star, for underfunded pensions? 

The latter is the prudent choice for policymakers moving forward given the severity of expected challenges to come in the near term. We should all want to see public pension funds achieve their long-term investment targets. It is, after all, in the best interest of all stakeholders. But that has not been happening consistently across shorter-term time frames, and that was the case prior to COVID-19. The strongest of pension funds still have to deal with unexpected situations like disasters and pandemics that are unforeseen (and we’re all getting a daily clinic in processing data and understanding forecasts and their foibles these days, which certainly has some high-level parallels with the vagaries of actuarial “what if?” projections).

It is time to admit that the hope-and-roll-the-dice model is failing state and local budgets. This policy outlook is disingenuous to employees, and it disrespects the sanctity of the pension promises made to retirees. Faith in “reversion to the mean” or “investing our way out” seems misplaced from a public policy perspective when daily we’re seeing news about negative oil prices, skyrocketing unemployment, a near-zero federal funds rate, global supply chain challenges, emerging corporate bankruptcies, and a lack of any clarity about where the future goes from here in terms of public health, economy, or many other factors. 

Such faith in the future may have been a way to justify inaction in the past, but it is too shaky a foundation to base modern pension public policy on. If policymakers care about both taxpayers and retirees, then they should not play fast and loose with things like maintaining 7+ percent assumed investment return assumptions when those are ultimately based on faith in a “reversion to the mean” over the next 30 years, an outlook not justified by 10- to 20-year capital market forecasts. It would be vastly more prudent to hope for the 30-year returns to revert to the mean, while actually planning for a world in which they do not. In short, hope for the best, but plan for the worst.

Just as we need to build resilient public infrastructure systems that can handle and reduce the severity of unexpected weather disasters, we need to rebuild our public sector retirement systems in the US in a way that embraces the concept of pension resiliency. 

This means adopting assumed rates of return tied to short-term forecasts and abandoning rates framed around long-term forecasts—not because we don’t believe the funds can achieve that, but because it’s a prudent way to build shock absorbers against certain risks, especially when taxpayers are exposed to such prominent financial risks associated with underfunded pensions. 

This also means abandoning 30-year amortization periods to pay down future unfunded liabilities and containing pension debt payments to shorter (15-year or less) periods. This means using discount rates divorced from assumed rates of investment return to get a more realistic picture of the true liabilities that are going to be paid out to beneficiaries no matter what happens in the market, and then budgeting for that much larger, yet less risky, number. This means acknowledging that things like promising automatic 3 percent cost of living adjustments in an era of persistently low inflation ultimately undermines the financial health of the plans offering them. 

In terms of the lost opportunity over the last decade, we should have been using the time between recessions to build a new generation of retirement systems at the state and local levels that look like much more like the federal government’s hybrid retirement plan, for example, or perhaps those fully funded public pension plans in places like Wisconsin, South Dakota and many Canadian provinces that have flexible benefit mechanisms built-in and keep contribution rate volatility fairly low. Entering a recession with $1.2 trillion in unfunded liabilities at still-too-high discount rates is a glaring signal that it’s time for a different approach.

Five Guiding Principles of Pension Resiliency

Resiliency may be the proper aim for pension funds today in terms of policy direction, but the US did not accumulate between $1 trillion to $2 trillion overnight, nor will it dig out from its pension debt challenges very quickly either. With pensions having been tacitly underpriced for so long, trying to squeeze additional pension contributions out of increasingly strained state and local budgets is going to be a tall order. 

Things are likely to get worse before they get better. If, for example, pension plans started adopting more realistic accounting of their obligations by lowering their assumed returns, as the Pension Integrity Project would generally recommend to most, costs will necessarily rise as a result. 

But the sooner plans embrace the financial and market realities they are actually living in—as opposed to seeing them as the way they would like them to be—the sooner they will recognize the true costs they face, and the sooner policymakers can begin to reckon with pension plan designs that have unintentionally left their systems too exposed to market shocks and volatility. Under that mindset, they can begin to fortify weak areas of the system to prevent the current situation from ever happening again. 

This leads to five principles of pension resiliency to help guide the redesign process for US states and local governments:

(1) Resilient retirement systems rely on a governance structure designed to minimize the role of politics

Make no mistake, while the primary factors that drive unfunded pension liabilities—things like missed investment returns, negative amortization, demographic experience (like mortality) deviating from assumption—are technical in nature, the primary problems that have faced US public pension plans are driven by politics and the pension plan’s position in the political process. Policymakers (often with term limits) make long-term policies for pension plans while generally lacking any real expertise or understanding of the deep technical aspects. And there is often direct or indirect political pressure exerted by public employers on pension trustees to avoid making changes to contribution rates and assumptions that would result in higher annual employer contributions in the near term. 

Worse, policymakers sometimes choose to set contribution rates in statute based on what they want to pay, as opposed to what the actuaries calculate is required to contribute each year to continue making pension funding progress. Some states (most notably, California near the turn of the century) have taken pension fund surpluses and, in the interest of raw politics, have used them to grant retroactive benefit increases to employees. Some states vest in the legislature the authority to statutorily grant “13th checks” and other supplemental benefit increases at their discretion depending on fiscal conditions in the pension plan, which risks spending down investment gains as they materialize instead of banking them to create a cushion that will likely be needed down the road when the next downturn hits. In other states, policymakers have a strong say over the pension fund asset portfolio, in other policymakers routinely try to substitute their political sensibilities over the pension plan’s investor team regarding different companies or sectors to invest in, or more commonly, to divest from.

By contrast, a resilient retirement system is one that is built to be politician-proof, except of course for the important role of public oversight and holding plans accountable. Major decision points facing US pension plans today—for example, the investment return assumption, the payroll growth assumption, the selection of a discount rate, the selection of contribution rates, and more—can be either entrusted to pension boards directly or—better yet—automated, tied to external benchmarks and contingency plans, and then set into motion and left to operate. 

(2) Resilient retirement systems can take many forms but are designed to manage risk through autocorrecting features and policy guardrails

The Pension Integrity Project has been involved in the design of some major reforms of pension systems in recent years in states like Arizona, Michigan, Colorado and New Mexico that involved the introduction or expansion of innovations like cost-sharing mechanisms (e.g., 50/50 cost-sharing between employers and employees), automated changes in contribution rates or COLA levels, the use of more conservative assumptions (like Michigan capping the allowable assumed rate of return on the newest tier of its teacher pension plan at no higher than 6 percent), the use of graded pension multipliers that increase depending on service tenure (as in the new public safety tier in Arizona), and tying assumptions to certain external benchmarks (like regional inflation).

These efforts take inspiration from states like Wisconsin, which maintained full funding through a smart plan design that promises a core base benefit with the potential for an annual “annuity adjustment” up or down depending on the market performance of the pension fund. Employees of the Badger State have the expectation that benefits can be modified to a certain extent in the interest of maintaining full funding. South Dakota utilizes a similar approach that relies on adjusting benefit levels to keep the employer and employee contribution rate held steady. 

Even Wisconsin and South Dakota pale in comparison in some ways to several Canadian provincial pension funds, which should serve as the basis for any new public pension benefit tiers in the United States. For example, US state legislators might understandably be envious of the Ontario Teachers’ Pension Plan, as just one example. This plan is 103 percent funded at a 4.60% discount rate, uses 50/50 employer/employee cost-sharing, uses a robust benefit adjustment mechanism tied to an objective decision framework, and has had employer/employee contribution rates hover in the 8-13 percent of payroll zone since the mid-1970s.

Another key innovation in recent years is the expansion of choice and alternative plan designs.  We live in a world of more retirement plan design options than just pure defined benefit pension plans or pure defined contribution plans—including cash balance plans and hybrid plan designs. Rather than force all workers into a one-size-fits-all plan design approach, employers could offer a choice between a guaranteed return plan (like a cash balance or defined benefit pension plan) which would be attractive to those envisioning longer employment tenures, and a more portable plan design option(s) (e.g., hybrid or defined contribution retirement plan) geared towards workers that may not serve a full career in the same public service position. Arizona’s public safety plan, Michigan’s teacher plan, and the Commonwealth of Pennsylvania’s new hybrid plans for civilian workers and teachers all offer good examples.

(3) Resilient retirement systems are those that use realistic assumptions and are disciplined in maintaining full funding of their pension plans

Building off the previous principle—and in recognition of the many factors that drove $1.2 trillion in aggregate public pension underfunding in the US in the first place—to the extent that employers offer a guaranteed return plan option like a defined benefit pension or cash balance plan, it is essential that those plans be built on a foundation of realistic actuarial assumptions and rigid funding discipline reliant on making full actuarially determined contributions each and every year.

(4) Resilient retirement systems create a pathway to lifetime income for employees while avoiding intergenerational equity disparities, public service crowd-out, and runaway taxpayer costs

No matter what kind of resilient retirement plan designs are offered moving forward, it is critical that they all be designed to meet one core objective that respects every public worker for the time they serve the public—creating, even if just for a relatively short duration of their public service—a pathway to retirement security. If they are a traditional career worker in their 50s participating in a pension system, then that pathway is fairly clear. But if they are a 26-year-old starting a new public sector career that may not last long, then a professionally managed defined contribution plan design with strong contribution rates may serve the same purpose from the perspective of advancing retirement security.

(5) Resilient retirement systems assess—and plan for—downside risk 

Most charts and figures related to pension funding and solvency that public pension plans show to US policymakers are based on the plan’s own adopted economic and demographic assumptions holding true and accurate, creating a path dependency of sorts on assumptions. In recent years, enhanced accounting standards and required financial disclosures have increased the amount of attention given to alternative scenarios that deviate from assumptions, and states like Virginia and Hawaii have adopted laws requiring routine risk assessment. 

These are encouraging moves and over time will prompt much more active discussions related to pension risk management, but risk assessment alone is only part of the answer. Risk assessment needs to be accompanied by strong contingency planning and “what if?” thinking. For example, as mentioned earlier the South Dakota Retirement System regularly conducts a risk assessment process to understand if there will be a likely need for any benefit flex in order to maintain current employer contribution rates. At that point, the system undertakes a deeper contingency planning analysis to determine the scope and scale of the changes likely needed to get ahead of the problem, allowing the plan to provide substantive guidance to policymakers on the many aspects of needed reform.

Conclusion

In the world of investments, past performance is no guarantee of the future, but those managing pension plans cannot ignore the implications of the past decade and the current market shock. The fact that pension funds have experienced very little recovery since 2009 and are now facing yet another significant loss suggests that the design and assumptions in many public pension plans may not be well-suited for the current setting of market turbulence. 

The Pension Integrity Project has for years suggested plans use stress testing to assess their ability to maintain solvency. Now, every single plan is experiencing a real-world stress event. When the dust settles on the immediate economic impacts of the COVID-19 pandemic, pension stakeholders and policymakers should use this moment of clarity to recalibrate not only expectations, but the overall guiding principles of retirement security. 

In the interest of retirement security for public workers and fiscal stability of state and local budgets, policymakers need to consider restructuring pension plans to reflect the principle of resiliency. In short, plans need to be structured to better withstand the market shocks that appear to be emerging more frequently in the modern era. There are already several examples of reforms and plan structures that can serve as roadmaps to policymakers seeking to fortify their government’s public employee retirement system against the increasingly volatile ups and downs of the market. Judging by the past couple of decades, the resiliency of retirement systems will largely decide how effectively—and at what cost—these plans will be able to continue serving their members and the public.

The post Seeking Pension Resiliency appeared first on Reason Foundation.

Yavapai County: A 14x Increase in Pension Costs 

Yavapai County is no stranger to the increasing costs of public pensions. According to the Pension Integrity Project’s analysis of financial documents, the county’s total payments to ASRS and PSPRS have skyrocketed from about $587,000 per year in 2001 to over $8 million in 2018, with $5.5 million going to ASRS and $3 million going to PSPRS. This analysis does not account for additional costs derived from the Corrections Officers Retirement Plan (CORP) or the Elected Officials Retirement Plan (EORP), which means the costs have grown even more than displayed here (though at a much smaller scale for CORP and EORP relative to ASRS and PSPRS).

An increase in costs this large has far-reaching effects in local governments—Yavapai County is paying more than 14 times more in aggregate ASRS and PSPRS contributions relative to what it used to less than two decades ago. This is reflective of the overall statewide trend. The total combined annual contributions into ASRS and PSPRS have risen to nearly $2 billion, a big jump from the $128 million in payments in 2001. Though there are certainly varying degrees of severity—some municipalities like Prescott and Bisbee have explored bankruptcy in the recent past in large part due to the rising costs of servicing pension debt—governmental units across Arizona are facing similar challenges to Yavapai, and local policymakers all across the state are weighing a range of options between reducing services, raising taxes or reprioritizing spending to keep up with the higher price tags attached to ASRS and PSPRS.

Why Pension Costs Are Growing 

To some degree, increased dollar values dedicated to these pension payments is expected—as the state’s population grows, state and local governments need more employees, which generates higher overall pension liabilities over time. But in this case—and the case with many underfunded pension systems in the US today—the disparate rates of growth between payroll and pension payments indicate that there is something outside of growing employment that is the main source of increased costs.

To illustrate this point, the total payrolls for ASRS and PSPRS have nearly doubled since 2001. Pension costs, on the other hand, are now 14 times the amount they were in 2001 for ASRS and 17 times the amount for PSPRS employers.

This trend is also visible in annual contribution rates, which are expressed as a percentage of covered payroll. [Note: For the purpose of this analysis, we will consider ASRS as an example since they represent the largest pool of pension liabilities and constitute the majority of overall public pension contributions statewide; however, a similar analysis can be performed for PSPRS.] Employers participating in ASRS have seen their required contributions to the pension plan—excluding contributions to the health and disability plans—go from just under 2 percent of payroll in 2002 to nearly 11 percent over the last sixteen years, a nearly six-fold increase. [Note that the total required contribution for all ASRS post-employment programs, including the health plan, was 11.5 percent of payroll in 2018]. This means that employers like school districts are having to dedicate a significantly larger portion of their budget to pension costs, diverting resources away from the classroom and making it increasingly difficult to adjust teacher salaries and fund other priorities like technology and student enrichment programs.

Notably, since 2001, there have been no major increases in retirement benefits for ASRS members and retirees that would prompt a commensurate ramp-up in costs. In other words, the overall benefits promised to teachers and state and local public employees has remained relatively static over the past two decades, but costs have gone up significantly.

So, what is driving up the costs of Arizona’s pension plans? A deeper analysis of ASRS and PSPRS contributions reveals that Arizona’s escalating pension debt is the primary culprit. Over the past two decades, ASRS has precipitously accumulated an unfunded liability of $15.6 billion, with most—but not all—of the shortfall stemming from underperforming investments. This growing shortfall requires greater annual payments into the fund, so the system can eventually get back to full funding.

Due to slow adjustments to assumptions and a forecast of lower overall returns when compared to previous decades, investment returns below expectations are likely to apply continued pressure in the form of more pension debt and, consequently, higher annual contributions. Using forecasts of future ASRS and PSPRS contributions under various one-year return scenarios, it is clear that investment underperformance can play a significant role in even more prohibitive costs for all Arizona municipalities.

Just one year of returns at 6.5 percent—about one percentage point below the assumed rate—would require an additional $2.4 million in 2022 contributions for both ASRS and PSPRS combined. Assuming contribution shares stay relatively similar, Yavapai would be facing an additional $11,406 in 2022 pension expenses under this scenario, with over 76 percent of that ($8,737) coming from added ASRS costs.

Breaking Down the Pension Costs: Funding Benefits Earned Today v. Paying Pension Debt

Splitting annual pension contributions into the amount needed to prefund benefits (also known as the normal cost) and the amount needed to amortize (or pay off) pension debt demonstrates the influence unfunded liabilities are imposing on ASRS and PSPRS contributions. Where no pension debt amortization payments were necessary in 2001, debt payments now make up a third of the annual $1 billion cost for ASRS and two-thirds of the annual $857 million contributed into PSPRS. Splitting contributions by these two categories shows that the main driver of increasing pension costs is, in fact, the significant amount of debt accrued by the system. The following charts illustrate how normal cost and amortization payments have each contributed to growing ASRS and PSPRS costs.

The rising contribution rates reflect that previous economic and demographic assumptions that influence pension math have not held, and that the pension promises made to public employees are going to be much more expensive going forward—hence, the rise in the “normal cost” of prefunding future benefits. What’s worse, it took the ASRS board of trustees many years to change outdated actuarial assumptions—primarily the assumed rate of return—creating a large fiscal hole related to current pension liabilities that needs to be filled through additional pension debt payments.

Effectively, employers and members of ASRS are having to pay for both increases at once. This interaction, with pension debt amortization payments driving up pension costs, is ubiquitous among all Arizona governments, from Maricopa County with its 4,000,000 residents to the city of Bisbee with its population of just over 5,000. These amortization payments create significant difficulties for local governments, as they are required to allocate funds that are several multiples of what they used to be just a few years ago. Taxpayers and public employees also bear the brunt of this issue, via increased taxes and pension contributions, all with no improvement (or often a reduction) in services and benefits.

Conclusion

State and local policymakers owe it to their constituents to continue to build upon the reform efforts undertaken with PSPRS in recent years and expand them to ASRS. Through a multi-year effort, public safety employees and employers collaboratively made great strides in addressing the system’s most immediate needs through reform, while not sacrificing the value and attractiveness of the plan. There are still more reforms that could be considered, however, including improvements to funding and amortization policies. Likewise, several issues associated with ASRS continue to put the retirement security of Arizona workers at risk. Stakeholders for both systems need to foster a comprehensive and collaborative effort to manage the growing costs of the retirement plans, preferably one that is based on sound research and common understanding.

Notes on Methodology:

Contribution amounts for Yavapai County are given in ASRS and PSPRS GASB 67 reports going back to 2016. Contributions before 2016 are calculated by applying the average contribution share from 2016-18 to total statewide contributions. Forecasted 2022 contributions use Pension Integrity Project actuarial modeling. Contributions for Yavapai use the County’s average share of the state’s total contributions from 2016-18 and apply this share to the forecasted total contribution under different return scenarios.

Pension Debt Drives Rising Costs for Arizona Municipal Governments: Yavapai County

The post Examining Yavapai County and How Pension Debt Drives Rising Costs for Arizona Municipal Governments appeared first on Reason Foundation.

City of Bisbee: A 16x Increase in Pension Costs

The City of Bisbee is no stranger to the increasing costs of public pensions. According to the Pension Integrity Project’s analysis of financial documents, the city’s total payments to ASRS and PSPRS have skyrocketed from about $100,000 per year in 2001 to over $1.6 million in 2018, with $202,000 going to ASRS and $1.4 million going to PSPRS. This analysis does not account for additional costs derived from the Corrections Officers Retirement Plan (CORP) or the Elected Officials Retirement Plan (EORP), which means the costs have grown even more than displayed here (though at a much smaller scale for CORP and EORP relative to ASRS and PSPRS).

An increase in costs this large has far-reaching effects in local governments—Bisbee is paying more than 16 times more in aggregate ASRS and PSPRS contributions relative to what it used to less than two decades ago. This is reflective of the overall statewide trend. The total combined annual contributions into ASRS and PSPRS have risen to nearly $2 billion, a big jump from the $128 million in payments in 2001. Though there are certainly varying degrees of severity—some municipalities like Prescott and Bisbee have explored bankruptcy in the recent past in large part due to the rising costs of servicing pension debt—governmental units across Arizona are facing similar challenges to Bisbee, and local policymakers all across the state are weighing a range of options between reducing services, raising taxes or reprioritizing spending to keep up with the higher price tags attached to ASRS and PSPRS.

Why Pension Costs Are Growing 

To some degree, increased dollar values dedicated to these pension payments is expected—as the state’s population grows, state and local governments need more employees, which generates higher overall pension liabilities over time. But in this case—and the case with many underfunded pension systems in the US today—the disparate rates of growth between payroll and pension payments indicate that there is something outside of growing employment that is the main source of increased costs.

To illustrate this point, the total payrolls for ASRS and PSPRS have nearly doubled since 2001. Pension costs, on the other hand, are now 14 times the amount they were in 2001 for ASRS and 17 times the amount for PSPRS employers.

This trend is also visible in annual contribution rates, which are expressed as a percentage of covered payroll. [Note: For the purpose of this analysis, we will consider ASRS as an example since they represent the largest pool of pension liabilities and constitute the majority of overall public pension contributions statewide; however, a similar analysis can be performed for PSPRS.] Employers participating in ASRS have seen their required contributions to the pension plan—excluding contributions to the health and disability plans—go from just under 2 percent of payroll in 2002 to nearly 11 percent over the last sixteen years, a nearly six-fold increase. [Note that the total required contribution for all ASRS post-employment programs, including the health plan, was 11.5 percent of payroll in 2018]. This means that employers like school districts are having to dedicate a significantly larger portion of their budget to pension costs, diverting resources away from the classroom and making it increasingly difficult to adjust teacher salaries and fund other priorities like technology and student enrichment programs.

Notably, since 2001, there have been no major increases in retirement benefits for ASRS members and retirees that would prompt a commensurate ramp-up in costs. In other words, the overall benefits promised to teachers and state and local public employees has remained relatively static over the past two decades, but costs have gone up significantly.

So, what is driving up the costs of Arizona’s pension plans? A deeper analysis of ASRS and PSPRS contributions reveals that Arizona’s escalating pension debt is the primary culprit. Over the past two decades, ASRS has precipitously accumulated an unfunded liability of $15.6 billion, with most—but not all—of the shortfall stemming from underperforming investments. This growing shortfall requires greater annual payments into the fund, so the system can eventually get back to full funding.

Due to slow adjustments to assumptions and a forecast of lower overall returns when compared to previous decades, investment returns below expectations are likely to apply continued pressure in the form of more pension debt and, consequently, higher annual contributions. Using forecasts of future ASRS and PSPRS contributions under various one-year return scenarios, it is clear that investment underperformance can play a significant role in even more prohibitive costs for all Arizona municipalities.

Just one year of returns at 6.5 percent—about one percentage point below the assumed rate—would require an additional $2.4 million in 2022 contributions for both ASRS and PSPRS combined. Assuming contribution shares stay relatively similar, Bisbee would be facing an additional $1,570 in 2022 pension expenses under this scenario, with 80 percent of that ($1,251) coming from added PSPRS costs.

Breaking Down the Pension Costs: Funding Benefits Earned Today vs. Paying Pension Debt

Splitting annual pension contributions into the amount needed to prefund benefits (also known as the normal cost) and the amount needed to amortize (or pay off) pension debt demonstrates the influence unfunded liabilities are imposing on ASRS and PSPRS contributions. Where no pension debt amortization payments were necessary in 2001, debt payments now make up a third of the annual $1 billion cost for ASRS and two-thirds of the annual $857 million contributed into PSPRS. Splitting contributions by these two categories shows that the main driver of increasing pension costs is, in fact, the significant amount of debt accrued by the system. The following charts illustrate how normal cost and amortization payments have each contributed to growing ASRS and PSPRS costs.

The rising contribution rates reflect that previous economic and demographic assumptions that influence pension math have not held, and that the pension promises made to public employees are going to be much more expensive going forward—hence, the rise in the “normal cost” of prefunding future benefits. What’s worse, it took the ASRS board of trustees many years to change outdated actuarial assumptions—primarily the assumed rate of return—creating a large fiscal hole related to current pension liabilities that needs to be filled through additional pension debt payments.

Effectively, employers and members of ASRS are having to pay for both increases at once. This interaction, with pension debt amortization payments driving up pension costs, is ubiquitous among all Arizona governments, from Maricopa County with its 4,000,000 residents to the city of Bisbee with its population of just over 5,000. These amortization payments create significant difficulties for local governments, as they are required to allocate funds that are several multiples of what they used to be just a few years ago. Taxpayers and public employees also bear the brunt of this issue, via increased taxes and pension contributions, all with no improvement (or often a reduction) in services and benefits.

Conclusion

State and local policymakers owe it to their constituents to continue to build upon the reform efforts undertaken with PSPRS in recent years and expand them to ASRS. Through a multi-year effort, public safety employees and employers collaboratively made great strides in addressing the system’s most immediate needs through reform, while not sacrificing the value and attractiveness of the plan. There are still more reforms that could be considered, however, including improvements to funding and amortization policies. Likewise, several issues associated with ASRS continue to put the retirement security of Arizona workers at risk. Stakeholders for both systems need to foster a comprehensive and collaborative effort to manage the growing costs of the retirement plans, preferably one that is based on sound research and common understanding.

Notes on Methodology:

Contribution amounts for Bisbee are given in ASRS and PSPRS GASB 67 reports going back to 2016. Contributions before 2016 are calculated by applying the average contribution share from 2016-18 to total statewide contributions. Forecasted 2022 contributions use Pension Integrity Project actuarial modeling. Contributions for Bisbee use the City’s average share of the state’s total contributions from 2016-18 and apply this share to the forecasted total contribution under different return scenarios.

Pension Debt Drives Rising Costs for Arizona Municipal Governments: City of Bisbee

The post Examining the City of Bisbee and How Pension Debt Drives Rising Costs for Arizona Municipal Governments appeared first on Reason Foundation.