In This Issue:

Articles, Research & Spotlights 

• Montana’s plan to improve pension funding and governance
• Efforts to undo Alaska’s pension reforms could cost close to $1 billion
• North Dakota’s potential pension reform
• State pension plans’ poor investment results in 2022
• Reason’s PRO Plan offers a modern approach to public retirement

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

Articles, Research & Spotlights

Two Bills in Montana Could Improve Pension Plan Design and Funding

Montana’s Public Employee Retirement System has $2.2 billion in unfunded liabilities, and if left unaddressed, funding issues are likely to continue. A new reform proposed in the state’s legislature would address some of Montana’s ongoing pension challenges, first by committing employers to make adequate annual contributions and second by setting the existing defined contribution retirement plan as the default benefit for new employees. In recent comments to the House Committee on State Administration, Reason Foundation’s Steven Gassenberger explained how House Bill 226 would reduce long-term costs by locking the state into eliminating its pension debt and reshaping its retirement offerings to fit the modern workforce better. Gassenberger also testified on House Bill 228, which would improve governance by setting stronger boundaries on what pension plan administrators can consider when making investment decisions.

Alaska Pension Bills Could Undo Previous Reform and Cost $800 Million

Following an effort to reopen a pension plan for public workers during last year’s legislative session, Alaska policymakers are again deliberating on several bills that could undo the state’s decision to close its defined benefit pension plans in 2006. Two identical proposals—House Bill 22 and Senate Bill 35—would allow public safety workers to retroactively switch from the existing defined contribution plan to a newly opened defined benefit plan. A Pension Integrity Project evaluation of these bills and an actuarial analysis of potential long-term costs find that this change would add more expensive debt to the plan’s already $5 billion in existing unfunded liabilities and could cost the state an additional $800 million over the next 30 years. Since public safety employees only make up around 10% of the system’s members, this proposal would be a costly move that would benefit a relatively small group.

Updates to North Dakota’s Pension Reform Effort

North Dakota lawmakers continue to discuss House Bill 1040, which would commit participating employers to make required annual payments in full and make the state’s defined contribution plan the only option for new hires. This backgrounder from the Pension Integrity Project responds to a recent statement from the North Dakota Public Employees Retirement System (NDPERS) that claims the adoption of proposed House Bill 1040 would require a drastic reduction to the plan’s discount rate. The system’s claim is inconsistent with other state plans that have undergone similar reforms, and there is no legal or financial requirement to change discounting like this when a pension plan is closed.

Updated 2022 Fiscal Year Investment Results for State Pension Plans

Investment returns are a crucial part of a pension plan’s funding of promised retirement benefits. While the ultimate success and cost of a public pension do not hinge on a single year of market results, each year that a pension plan falls below investment expectations adds to the growing—over $1 trillion nationally by the latest estimates—unfunded liabilities of state-run pension plans. An update to our October 2022 analysis compiles the investment returns reported by state pensions from the 2022 fiscal year. As expected, the research shows 2022 was a notably poor year of investment returns. All state-run pensions saw results that fell short of expectations, leading to significant growth in unfunded liabilities. Reason Foundation finds the median investment return achieved by the listed pension plans was -5.2% in 2022, well below the national average expected rate of return of 7.0%. Following an exceptional 2021, the latest investment results demonstrate that public pensions still have a steep hill to climb to get back to full funding.

PRO Plan: A Better Public Sector Retirement Plan for the Modern Workforce

Beyond the crippling growth of expensive unfunded liabilities, public defined benefit (DB) plans have failed to adjust to the evolving needs of today’s increasingly mobile workforce. Defined contribution (DC) plans aren’t without their shortcomings either, a common concern being that retirees can outlive their retirement savings. Both types of plans suffer from a lack of flexibility and personalization. The Pension Integrity Project’s Personalized Retirement Optimization Plan (PRO Plan) addresses these issues by structuring a guaranteed lifetime income on the foundation of an enhanced DC plan. In this commentary, the developers of the PRO Plan, Richard Hiller and Rod Crane, summarize the advantages of this approach to retirement for public employees.

News in Brief

Paper Proposes a Novel Discounting Method for Public Pensions

Discounting is how pensions calculate the future value of liabilities they have promised, and the rate used for this calculation has a massive impact on their funding. A new paper by Florida International University researchers identifies the problems with current discounting norms, namely their tendency to understate required contributions. They also acknowledge that discounting at a zero-risk rate—a method promoted by some to reflect the guaranteed nature of government pensions—likely overstates funding shortfalls and is too disconnected from financial reality. To strike a more appropriate balance between these two approaches, the researchers propose a new discounting method that applies a lower limit based on the lowest expected return among risky assets. A historical back-testing using this new discounting method going back to 2001 saw most plans (94%) exceeding these investment return expectations, resulting in funding improvements. The full paper is available here.

Quotable Quotes on Pension Reform 

“Divestment of these holdings would do nothing to stop climate change. The companies in question can easily replace CalPERS with new investors.”

—Marcie Frost, CEO of the California Public Employees’ Retirement System, on proposed legislation to force divestment from fossil fuel companies, in “Keep Politics Out of CalPERS, Reject Senate Bill 252,” Whittier Daily News, Feb. 8, 2023.

“Each year I’ve been in office, we have reduced the assumed rate of return…If we had the more rosy assumptions, we’d probably be 86, 87% funded…So the fact that we’ve had all this turmoil, had some market turmoil, and we’re basically where we were and probably much better if you had that, I think that’s a good sign. I think we’re going to be able to build from here…At the end of the day, we really want honest accounting. And we can fudge the numbers a little bit, but you know, so we’ve been reducing that assumed rate of return. I think that’s the conservative approach. I think that’s something that makes the most sense.”

—Florida Gov. Ron DeSantis, in “Gov. DeSantis Pushes for More Pension Spending in New Budget,” Florida Politics, Feb. 1, 2023.

Data Highlight

Each month we feature a pension-related chart or infographic of interest generated by our team of Pension Integrity Project analysts. This month, analysts Jordan Campbell and Steve Vu show the distribution of investment returns for state pension plans in 2022. You can access the graph and find more information here.

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 send your questions, comments, and suggestions to zachary.christensen@reason.org.

The post Pension Reform News: Montana’s proposed reforms, poor 2022 investment results, and more appeared first on Reason Foundation.

Chair Dooling and members of the committee:

Thank you for the opportunity to offer our analysis of House Bill 226 (HB226).

My name is Steven Gassenberger, and I serve as a senior policy analyst for the Pension Integrity Project at Reason Foundation. Our team conducts quantitative public pension research and offers pro-bono technical assistance to officials and stakeholders aiming to improve pension resiliency and advance retirement security for public servants in a financially responsible way.

We received our first invitation to provide research and feedback to legislative members in 2019 and have closely monitored and commented on the condition of Montana’s largest public pension funds since, including during recent consideration of HJ8 (2021) by SAVA this interim.

HB226 makes two updates to the PERS system:

1. Rearranges the way the state funds PERS-DB benefits.

Every year, PERS-DB actuaries calculate the contribution amount needed to keep the fund on track to achieve full funding within the established debt payment—or amortization—schedule. This figure is commonly called the actuarially determined employer contribution, or ADEC.

Rather than using an ADEC approach to funding retirement benefits, the state’s contribution rate has historically been set in statute, making payments into the fund controlled and predictable but often rigid and unresponsive to year-to-year needs. Only when system administrators find that the current statutory rate results in the system taking more than 30 years to become fully funded, is the statutory rate increase requested and legislatively adjusted. According to a 2020 Legislative Fiscal Division report the “…current funding policies leave the systems heavily reliant on investment earnings and unable to adjust contributions to maintain an actuarially sound basis in times of significant financial declines.”

HB226 commits the state and participating employers to fully funding benefits by a set date, regardless of investment performance or political trends. During an August 2020 hearing of the Legislative Finance Committee, PERS actuaries pointed out that “states are getting away from the old statutory funding method” and that “an actuary’s dream funding policy” is a system that adjusts “to keep up with how the plan is doing.” ADEC funding is a clear way policymakers can protect retirement benefits in bad times while finally tackling an important and expensive debt on behalf of taxpayers.

2. Sets the PERS-DC benefit as the default benefit for new employees.

Upon starting their career in public employment, new hires are offered a choice between the PERS Defined Benefit (PERS-DB) retirement benefit and the PERS Defined Contribution (PERS-DC)

retirement benefit. Currently, if an employee does not make a choice within their first year of employment, they are defaulted into the PERS-DB option. Both DB and DC plans can be adequate retirement options, but the DC plan (with its portability and steady benefit accrual) tends to be more advantageous for workers who do not continue to work with their public employer for multiple decades. Since most new workers fall into that category, it is best practice to make the DC option the default.

According to PERS data, regardless of the benefit chosen, 70% of all newly hired public employees will find other job opportunities outside of public employment within five years. An additional 15% will leave within ten years. Less than 10% of employees hired between the ages of 22 and 32 will stay in public employment for the 30 years required to earn an unreduced PERS-DB retirement benefit. As designed, the current PERS-DB default policy leaves the vast majority of public employees in a nonoptimal retirement plan, subsidizing the benefits for those employees who do stay 30+ years.

What HB226 does not do.

1. HB226 does not change the PERS-DB benefit at all.

When changes to a pension system are suggested, anxiety and fear over the loss of post-employment income increases. However, HB226 does not change the PERS-DB benefit for retirees, current members, or future employees who will choose the PERS-DB benefit option going forward. In fact, the switch to ADEC funding included in HB226 should make those retirees and current members breath a bit easier as the state would now be committing to making whatever payments are necessary to fulfill the pension benefits promised to them.

2. HB226 does not make PERS benefits more expensive.

When a system and its employers move from a statutorily set contribution rate to one determined by actuarial necessity, model projections of future contribution rates are likely to show an increase in contribution rates in the short term, with a gradual decrease over time. Some misinterpret this initial increase as an increase in cost when it is in fact a reflection of the true cost of offering a guaranteed life-time benefit payment. The alternative has been a relative increase in unfunded retirement benefits (i.e. pension debt), which now total over $2.2 billion according to PERS data. The lower statutory rate has not adequately recognized this growing unfunded liability, whereas the proposed ADEC contribution would. HB226 would not only make the employer rate more proactive going forward from a debt reduction perspective, but more transparent in its acknowledgment and mitigation of accrued yet unfunded retirement benefits.

The changes offered in HB226 would address how PERS is only optimal to a fraction of public employees at an ever-rising cost, and turn the system towards best practices in public retirement benefit design. Having retirement benefit options aligned with employee trends, and on a sustainable funding regimen, empowers public employees to choose the best retirement path for themselves and their families with confidence.

Thank you again for the opportunity to speak today, and I would be happy to answer any questions.

Steven Gassenberger
Policy Analyst, Pension Integrity Project at Reason Foundation
steven.gassenberger@reason.org

The post Comments on Montana House Bill 226 (2023) appeared first on Reason Foundation.

Chair Regier and members of the committee:

Thank you for the opportunity to offer our brief perspective on House Bill 228 (HB228).

My name is Steven Gassenberger, and I serve as a policy analyst for the Pension Integrity Project at Reason Foundation. Our team conducts quantitative public pension research and offers pro-bono technical assistance to officials and stakeholders aiming to improve pension resiliency and advance retirement security for public servants in a financially responsible way.

We received our first invitation to provide research and analysis to legislative members in 2019 and have closely monitored and commented on the condition of Montana’s largest public pension funds since, including during recent consideration of HJ8 (2021) by SAVA this interim.

Over the last two decades, public pension systems in Montana and across the country have experienced a clear shift in their investment portfolios away from public assets like blue chip stocks to more private and opaque—and often, higher risk—“alternative” assets like private equity and hedge funds. An asset class comprising less than 6% of the Montana PERS portfolio in 2003 now accounts for nearly 30% of all assets held by the fund, making PERS and other public pension funds some of the largest, most active investors in the world.

Although it is reasonable and prudent at times for pension administrators to expand or contract the fund’s investments in various assets over time, the shift to private assets presents a new risk for policymakers and pension fund stakeholders—politicization of pension fund investments.

Nearly every lawmaker has heard at least one call for the state to invest in, or divest from, one particular company or industry sector based on political concerns of one type or another. Sometimes—like the recent calls by some pension systems to divest from Russian companies in the wake of the Ukraine invasion—geopolitics and other national security concerns may dictate certain shifts in investment strategy. Most investment or divestment calls, however, do not involve national security, but rather narrow political interests of various factions seeking to reward or punish particular industries via the investment policies of taxpayer-backed public trust funds.

Montana has two major pension systems that are underfunded by billions of dollars today, and both face a long-term challenge of hitting unrealistically high investment return assumptions in order to generate sufficient returns to fully fund promised pension benefits. Given such a difficult challenge, placing political constraints on pension fund investments would make the goal of fully funding earned benefits harder for administrators. By providing more explicit guidance and boundary setting to public trust fiduciaries with the intention of preventing politicized investment decisions, HB228 would improve governance and give stakeholders even more confidence in their system for future generations.

Thank you again for the opportunity to speak today, and I would be happy to answer any questions.

Steven Gassenberger
Policy Analyst, Pension Integrity Project at Reason Foundation
steven.gassenberger@reason.org

The post Testimony: Montana House Bill 228 (2023) appeared first on Reason Foundation.

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

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

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

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

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

The post The impact of cash flow on public pensions 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.

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.

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

Over the last two decades, the Public Employees’ Retirement System (PERS) and the Teachers’ Retirement System (TRS) have experienced a fiscal transformation. In 2002, PERS was nearly fully funded with less than $1 million in unfunded pension benefits while TRS held $384 million in pension debt. Two decades later, both plans combined find themselves nearing $5 billion in earned, legally protected, yet unfunded retirement benefits that will inevitably need to be paid out to public workers.

Financial reporting from both systems clearly shows that the changing global investment landscape over the last 20 years has left Montana’s public pension systems struggling to catch up. Unfortunately, the State’s current approach to addressing both the cost of earned retirement benefits and financing unfunded liability payments to address growing pension debt is leading to compounding interest and significantly higher long-term costs.

Montana House Bill 323 (HB323) of the 2021 legislative session attempted to address the state’s growing unfunded public pension liability through improvements on contribution and amortization policies. This legislation was a novel way to enhance the solvency and resiliency of the state’s largest public pension systems that would have improved upon the state’s current practices.

ADEC Policy Would Codify Current Variable-Statutory Rate Practice

Every year, plan actuaries calculate the amount that needs to be contributed to the pension fund to keep it on track to achieve full funding within the established debt payment—or amortization—schedule. This figure is commonly called the actuarially determined employer contribution, or ADEC.

Montana’s current pension funding policy does not directly use ADEC to determine annual state contributions as a matter of law, but the policy does take the ADEC contribution rate into account as a moving target of sorts, requiring periodic adjustments.

Table 1 – Make Up of PERS Contributions

Rather than using ADEC to calculate the state’s contribution each year, the Montana legislature has long adjusted the state’s contribution rate in statute upon request by system actuaries. The employer contribution rate stays fixed in state law until the systems’ actuary expects the current contribution rate will not allow the plan to pay off its unfunded liabilities within a 30-year timeframe (see Figure 1). As a result of low investment returns, growing unfunded liabilities, and the state’s reflexive adjustments to funding needs, state contribution rates toward TRS and ERS have nearly tripled over the last two decades.

By relying on the system administrators’ requests and adjusting rates in statute in reaction to past experience instead of automatically amortizing unfunded liabilities as they occur with an ADEC rate, Montana’s public pension funding policy risks systematically underfunding earned and accrued—and constitutionally protected—retirement benefits.

Figure 1 – How Montana’s Current Variable-Statutory Employer Contribution Rate Adjust
If a pension system actuary calculates an amortization period:

Unfortunately, reacting to the poor actuarial or market performance by increasing contribution rates or lowering assumptions alone is often not a comprehensive way to address the causes of growing unfunded benefits. HB 323 would have committed the state to a set timetable for fully funding benefits instead of allowing the debt to perpetuate.

Switching to an ADEC Rate

Had it been enacted, the primary policy aspect of HB323 would have moved the state away from an employer contribution rate being set in statute—literally requiring an act of the legislature to change—to a rate that automatically adjusts every year to reflect the actuarially recommended ADEC amount.

For Montana PERS, negative deviations relative to current assumptions increase unfunded liabilities, often causing the funding period to exceed 30 years, requiring the legislature to periodically amend the statutorily fixed employer contribution rate. PERS actuaries also reset amortization payments to tackle the unfunded liability as part of their rate increase recommendation.

The highest level assessment of Montana’s current policy is that, absent any legal or policy requirement to use ADEC-based funding, the legislature and pension systems have demonstrated good stewardship over the years by trying to generally keep pace with ADEC rate levels over time. However, it appears your current policy is trying to “chase ADEC” instead of simply adopting a “set it and forget it,” true ADEC policy.

Stress Testing Montana’s Public Pension Systems

To understand the systemic challenges facing Montana’s pensions, it is valuable to examine the future of the plans under various stress scenarios. Reason’s forecast analysis of PERS shows that while the current contribution policy may keep the fund on track if investment returns match plan assumptions, it may prove insufficient if investments returns are lower or if the market is more volatile.

Figure 2 shows how the current 11.45% PERS employer contribution rate tracks closely with the ADEC rate under ideal investment return conditions. Figure 3 shows the projected funded status of PERS and reveals that both funding methods would help PERS achieve full funding by 2050 if the plan achieves its assumed rate of investment return.

Although the funding policies deployed in both scenarios shown in Figures 2 and 3 look similar, they differ in their ability to react to market conditions. Given the propensity of Montana’s public pension systems to increase holdings in volatile assets to achieve high investment return assumptions, it is likely the plan will fall short of its investment return assumptions. Figure 4 shows an ADEC scenario with underperforming PERS investments that achieve only a 6% average rate of return versus the current 7.65% assumption.

Figure 2 – PERS Employer Contributions Under Ideal Returns

Figure 3 – PERS Funded Status Under Ideal Returns

Figure 4 – PERS Employer Contributions When Returns are Weak

If the legislature continues the practice of maintaining a statutorily fixed rate, only increasing that rate after plan actuaries have identified a crisis, contribution rates are not expected to rise according to funding needs and the PERS funded ratio will likely decrease. Figure 5 shows that under Montana’s current practice, a 6% return would leave the plan at less than 50% funded in 2050.

The drop in funded status under weak investment conditions illustrates the need to adopt an ADEC policy, which would close the amortization period and eliminate current and future PERS unfunded liabilities in a relative 30 years (or whatever amortization window lawmakers choose) regardless of market performance.

Paying the ADEC rate makes contributions highly responsive to actuarial experience to make up for any shortfall (or surplus) over a predetermined time period. When comparing the state’s current PERS contribution practices to an ADEC policy, the current practice is more responsive than an entirely fixed statutory rate (a common, but poor practice in other states), but still less responsive than a true ADEC policy and less effective at fully addressing the unfunded liability within a set time period.

Figure 5 – PERS Funded Status When Returns are Weak

To give a clearer long-term perspective, the “All-in Employer Cost” combines 30-years of employer contributions with the ending unfunded liability. Such a perspective is important due to the legal protections afforded to earn pension benefits by the state constitution. The “All-in Employer Cost” calculation enables a clear comparison of the total long-term cost to government employers of one path relative to another.

The all-In cost in Table 2 illustrates the effect of adopting an ADEC policy, which closes the amortization period and eliminates current and future PERS unfunded liabilities in a relative 30 years if all assumptions prove accurate, saving taxpayers hundreds of millions. If plan investments underperform, an ADEC policy limits employer cost long-term in exchange for short-term appropriations. That major difference between how Montana funds public pension benefits today and the suggested funding policy under HB323 of 2021 is highlighted in Table 2 where PERS would be left with more unfunded benefits and the legislature with higher cost if the status quo is maintained.

Table 2 – PERS Employer All-In Cost

Addressing Current Unfunded Liabilities

The second major element of HB323 is how it would have adjusted the method by which the state and governmental employers address the current $5 billion in unfunded pension promises. Currently, unfunded retirement benefits are funded in a way that targets their full funding within 30 years.

As implemented however, the current policy has rates adjusting upward in response to actuarial experience not meeting expectations over a few years, leaving policymakers and employers with an unfunded liability that never truly reaches full funding.

Under HB323, all unfunded liabilities accrued before the measure is enacted would be set to amortize over the next 30 years, regardless of market performance, by assigning a clear due date and adjusting rates annually to meet that goal.

Addressing Future Unfunded Liabilities

Similar to paying the minimum on a large credit card bill each month, year after year, pension debt can continue to accrue through interest accrual despite contribution increases. In pension accounting, this concept is referred to as “negative amortization” which occurs when interest on pension debt exceeds annual amortization payments. Lowering the amount of time that debt is scheduled to be paid off reduces—and usually eliminates—negative amortization, better managing the cost to taxpayers and employers in the long-
term.

The final major element of HB323 is that it would have set all new unfunded liabilities to be amortized over 10 years, instead of the current 30-year target window, so any future unfunded liabilities are quickly amortized, greatly reducing the chances of perpetually growing pension debt.

PERS’ consulting actuary, Cavanaugh Macdonald, told the Legislative Finance Committee that a layered amortization policy like what is included in HB323 would be good for cash flow and an “actuary’s dream funding policy.” Layered amortization means all new UAL accrued in a given fiscal year is amortized over a short, fixed period such that each new year’s UAL is “layered” and paid down within the average service life of a typical public employee.

Exploring PERS Before and After HB323

Combining the three major elements of HB323 – adopting ADEC funding policy, addressing the current unfunded liability, and addressing future liabilities going forward – the following figures compare PERS in its current state to PERS under a scenario where HB323 is adopted.

Assuming all investment and demographic assumptions prove accurate over the next 30 years, Figure 7 and Figure 8 compare PERS in its current state to PERS after the adoption of HB323.

Under the scenario in which actual returns match plan assumptions each year, HB323 would increase employer contributions over the next decade, but would also allow for a lower contribution after that. Additionally, the reform would slightly accelerate PERS’ path to full funding. Actual returns will not match plan assumptions year to year, however, and there is a good chance that long-term results will continue to land below the assumptions used. The true value of the proposed reform arises with a projection that does not meet the plan’s return assumptions.

Figure 7 – PERS Current State vs HB323 Employer Contributions Under Ideal Returns

Figure 8 – PERS Current State vs HB323 Funded Status Under Ideal Returns

Figures 9 and 10 introduce market volatility into the actuarial equation. The results show how, although the current funding policy maintains a lower contribution level, millions of earned retirement benefits will go unfunded and continue to drive up cost long-term.

Figure 9 – PERS Current State vs HB323 Employer Contribution Rate Assuming One Year of 0% Returns

Figure 10 – PERS Current State vs HB323 Funded Status

Figures 11 and 12 use PERS’ own experience to show how the plan will respond to future recessions like the one following the Dot.com boom of the late 1990s. If PERS reacts to a future recession as it has in past recessions, the system would continue to accrue unfunded liabilities and lawmakers and employers will remain responsible for expensive amortization payments under the status quo funding policy.

Figure 11 – PERS Current State vs HB323 Employer Contribution Rate Assuming ’01–’05 Returns

Figure 12 – PERS Current State vs HB323 Funded Status Assuming ’01–‘05 Returns

Switching Montana’s pension funding policy from reactive to proactive by committing to contributions toward the state’s public pension systems at rates determined by plan actuaries leads to long-term savings as displayed in Table 3. Depending on actual market results, a funding policy like HB323 of 2021 would save the state as much as $1.58 billion over the observed 30 years.

Table 3 – PERS Employer All-In Cost

The actuarial analysis shows that Montana’s current approach to funding PERS is the most expensive path forward and the changes proposed in HB323 could generate significant savings. This effect is even more prominent if the system experiences economic volatility similar to the last two decades.

Fiscal Considerations

During the 2021 regular session, many budget-aware stakeholders and legislators expressed concerns over the potential contribution increases associated with the state adopting policies like those in HB323. Table 4 compares the status quo with the proposed funding policy included in HB323 of 2021 from an employer cost perspective. In exchange for prudent, navigable increases in the short-term, employers would not only expect a drop in required contribution about 15 years out but a complete elimination of all unfunded actuarially accrued liabilities
(UAL), which are earned retirement benefits for which sufficient funds have not been set aside.

Table 4 – PERS Employer Annual Contribution and Final Unfunded Liability

The rise in employer contributions required under HB323 can be mitigated to some degree with technical adjustments, but not avoided entirely regardless of if the solutions found in HB323 are adopted or not. The over $5 billion in earned retirement benefits currently unfunded will need to be funded somehow, and the bill will come due one day. HB323 accepts that reality facing PERS and TRS and commits to honoring the state’s obligation in the interest of future Montanans.

The moderate upfront fiscal impacts pale in comparison to the savings Montana would see from avoiding interest and eliminating pension debt amortization payments. Actuarial modeling shows that maintaining the status quo ensures Montana will continue to allow hundreds of millions in retirement benefits to go unfunded if left unchecked. The funding policy included in HB323 would have driven down long-term costs by eliminating all unfunded liabilities in 30 years if all assumptions proved accurate. But when assumptions are off, as they often are, the policy would have remained anchored to a full funding target, minimized costs and financial risks for taxpayers and protected retirement nest eggs. Retirement benefit contribution rate hikes for local employers and municipalities are best seen as inevitable no matter what, but under the current policy paying off the systems’ unfunded liabilities are not inevitable. A policy like HB323 would ensure those funds truly guarantee the elimination of Montana’s pension debt over the long run.

Conclusion

Shifting to a shorter, layered amortization schedule would lead to the faster payment of unfunded pension liabilities. Although shortening the amortization schedule can lead to a temporary increase in the employer contributions immediately, it saves the state and taxpayers more long-term, while providing a more stable pension plan for public employees and educators.

Paying off unfunded pension liabilities faster results in less interest accumulated, leading to lower total costs over the long run. Paying down pension debt quickly reduces the risk that down markets will generate perpetual growth in unfunded liabilities. The technical adjustments made to the state’s public pension funding policy included in HB323 of the 2021 regular session would have used contributions today to set Montana’s two largest pension systems on a course toward long-term solvency and cost reduction.

The post How to address Montana’s underfunded public pension plans appeared first on Reason Foundation.

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

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

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

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

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

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

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

Makeup of Montana TRS Contributions

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

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

What Drives Montana TRS Pension Debt?

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

Challenge 1: Assumed Rate of Return

Investment Return History, 2001- 2020

Investment Returns Have Underperformed

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

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

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

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

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

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

Expanding Risk in Search for Yield

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

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

TRS Assumptions & Experience

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

Short-Term Market Forecast

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

Long-Term Market Forecast

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

Important Funding Concepts

Employer Contribution Rates

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

All-In Employer Cost

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

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

Baseline Rates

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

Risk Management

Stress Testing TRS Using Crisis Simulations

Stress on the Economy:

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

Methodology:

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

Scenario Comparison of Employer Costs

How a Crisis Increases TRS Cost

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

Unfunded Liabilities Under Crisis Scenarios

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

TRS Solvency Under Crisis Scenarios

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

All Paths to a 7.5% Average Return Are Not Equal

Long-Term Average Returns of 7.5%

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

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

Challenge 2: Deviations and Changes to Actuarial Assumptions and Methods

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

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

Actuarial Assumption and Methods

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

Salary Increase Assumptions

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

Withdrawal Rate, Service Retirement, and Mortality Assumptions

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

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

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

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

Overestimated Payroll Growth

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

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

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

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

Challenge 3: Insufficient Contributions & Debt Management Policies

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

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

Challenge 4: Discount Rate and Undervaluing Debt

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

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

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

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

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

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

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

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

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

Sensitivity Analysis: Pension Debt Comparison Under Alternative Discount Rates

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

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

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

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

Recruiting a 21st Century Workforce:

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

Retaining Employees:

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

A Framework for Policy Reform

Objectives

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

Pension Resiliency Strategies

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

Potential Solutions

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

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

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

Rethink amortization in two steps:

Step 1: Address the Current Unfunded Liability

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

Step 2: Develop a Plan to Tackle Future Debt

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

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

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

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

Improve risk assessment and actuarial assumptions.

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

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

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

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

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

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

Montana Teacher Retirement System (TRS) Pension Solvency Analysis

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

My name is Steven Gassenberger, a policy analyst with the Pension Integrity Project at Reason Foundation, and I’m joined by my colleague Geoff Lawrence, Reason Foundation’s subject matter expert on drug policy. We are a national 501(c)(3) public policy think tank that offers pro-bono research and technical assistance to public officials and other stakeholders to help design and implement policy solutions in a variety of areas, including public employee retirement security and the emerging regulatory framework governing controlled substances.

The Pension Integrity Project’s quantitative team used decades of publicly reported data from Montana’s two largest public pension systems to build detailed actuarial models that we use alongside stakeholders to spotlight the long-term solvency challenges and financial risks facing both the teacher and public employee pension systems.

Our actuarial modeling suggests that, if not addressed, three issues will lead to a steady increase in costs borne by taxpayers as well as the growing degradation of these important pension systems.

First, investment underperformance relative to each system’s assumed rates of return has added over $2.1 billion in unfunded liabilities to MTRS and MPERS over the last 20 years. This underperformance has required the legislature to continually increase state contributions to these plans over time.

Second, the amortization policies for both MTRS and MPERS are perpetuating debt across generations by using excessively long amortization periods. MPERS specifically uses an amortization policy which resets the period used to calculate actuarially required contributions each year to a 30-year term commitment, passing the bill to future taxpayers.

Third, only 23 percent of new teachers and 14 percent of newly hired public employees will remain in full-career employment with the state long enough to each a full pension benefit according to each system’s comprehensive annual financial reports.

In a nutshell, the state of Montana has two underfunded pension plans serving a very small number of workers relative to total hiring.

Despite recent steps taken to increase contributions and a decade of historic market gains, neither system has seen any significant improvements. This highlights the fact that markets alone simply will not restore these systems to fiscal health and that other structural mechanisms are likely at play.

Future contributions will be needed to make up for those not given in the past. House Bill 670 offers one new way to address that need. By directing revenue from recreational marijuana sales to help pay down current unfunded liabilities faster than currently scheduled, House Bill 670 is likely to save taxpayers long-term interest payments on pension debt and ensure promises made to generations of state workers are managed responsibly.

Having engaged public pension and drug policy design and implementation with stakeholders in a diverse array of states, we have seen a variety of desired uses of marijuana tax proceeds get intractably complicated by the difficulty of accurately forecasting revenues. Historical data regarding the size of the marijuana market and its determinative trends simply do not exist. Estimates have been developed using household surveys of marijuana use and anonymous, crowdsourced data collected on the internet, but true, observable market data are largely unavailable due to marijuana’s previously illicit nature.

As a result, several states that have built marijuana tax revenues into their budget for ongoing publicly funded programs, like K-12 education or road maintenance, have been frustrated when their revenue projections are inaccurate.

House Bill 670 avoids those pitfalls by allocating uncertain tax revenues to pay off a long-term obligation and fund a rainy day account, which is consistent with the principles of sound public finance when considering the use of one-time revenues, or in this case, highly volatile tax revenue streams. Or perhaps more simply put, HB 670 would pay for obligations already on the books, while avoiding adding future obligations via new programmatic spending.

States should not appropriate marijuana tax revenues to fund ongoing programs until a track record of receipts has been established over a period of two to five years. House Bill 670, as well as some other measures being considered by this committee, would follow in the footsteps of Nevada, which successfully allocated all proceeds from its retail marijuana tax to the state rainy day fund for its first two years of operation. Dedicating marijuana tax revenues to pay down long-term debts, such as those found within public employee pension plans, can help improve the state’s financial position while avoiding the trappings that often come with building inconsistent revenue sources into a budget.

The post Testimony: Legislation in Montana Would Use Marijuana Tax Revenue to Pay for Pensions appeared first on Reason Foundation.

The Montana Public Employee Retirement System (MPERS) has seen a significant increase in public pension debt in the last two decades. In the year 2001, the public pension plan, which serves state workers, was overfunded by almost a half of a billion dollars and had almost 120 percent of the assets they needed on hand to pay promised benefits.

Today, the pension plan is only 74 percent funded and has $2.1 billion in debt.

The latest analysis by the Pension Integrity Project at Reason Foundation, updated this month (February 2021), shows that deviations from the plan’s investment return assumptions have been the largest contributor to MPERS’ unfunded liability, adding $1.3 billion since 2001. The analysis also shows that failing to meet investment targets will likely be a problem for MPERS going forward as projections reveal the pension plan has roughly a 50 percent chance of meeting their 7.65 percent assumed rate of investment return in both the short and long term.

Negative amortization has also added $587 in unfunded liabilities to the plan since 2002. Negative amortization is experienced when interest on debt exceeds actual debt payments in any given year.

The overall growth in unfunded liabilities has driven Montana’s pension benefit costs higher while crowding out other taxpayer priorities and programs in the state.

The chart below, from the full solvency analysis, shows the increase in the Montana Public Employee Retirement System’s debt since 2001:

This underfunding not only puts taxpayers on the hook for growing debt but could jeopardize the retirement security of Montana’s state employees. Left unaddressed, the pension plan’s structural problems will continue to pull resources from other state priorities.

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

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

Montana Public Employee Retirement System (MPERS) Pension Solvency Analysis

Reason Foundation’s previous solvency analysis of the Montana Public Employee Retirement System is available below:

• January 2021 Montana Public Employee Retirement System Pension Solvency Analysis

The post Montana Public Employee Retirement System (MPERS) Pension Solvency Analysis 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.

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

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

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

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

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

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

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

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

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

The post Map: Comparing State Pension Plans’ Assumed Rates of Return appeared first on Reason Foundation.

After recovering from the dot.com economic bubble bursting in the early 2000s, PERS was nearly fully funded, holding less than $1 million in unfunded liabilities in 2002, while TRS maintained near $384 million in pension debt at that time.

Today, both plans, combined, find themselves nearing $4 billion in debt. TRS has only 68 percent of assets on hand, and PERS has 73 percent of assets needed, to pay out the benefits promised to public workers.

The Pension Integrity Project at Reason Foundation’s preliminary analysis of the current state of pension solvency in Montana shows that if the plans’ problems are not addressed, they will lead to a steady increase in costs borne by taxpayers and a growing degradation of pension solvency. 

One significant issue: Investment returns underperforming, relative to the plans’ assumed rates of return, have added over $1.07 billion in unfunded liabilities to TRS and PERS, leading both to statutorily increase state contributions. 

Additionally, the amortization policies for both TRS and PERS are also perpetuating debt across generations by using excessively long amortization periods. PERS, specifically, uses an amortization method that resets the period used to calculate actuarially required contributions each year to a 30-year term commitment, passing the bill onto future generations.

Although recent steps taken to align assumptions with real-world experiences is the source of nearly a quarter of the total unfunded liability, those actions should be seen as positive steps towards recognizing the true cost of a public pension. Without exposing these hidden costs, TRS and PERS would have continued their history of missed investment return assumptions and low funded ratios, likely experiencing continued growth in unfunded liabilities and required employer contributions over time. 

Restoring TRS and PERS to fiscal health will require blending the rigorous actuarial analysis and risk assessment needed to deconstruct the components of the problem with a comprehensive solution-building strategy focused on engaging and considering the objectives of all stakeholders.

Montana Public Employee Retirement System Solvency Analysis

Montana Teachers’ Retirement System Solvency Analysis

The post Assessing the Financial Sustainability of Montana’s Largest Public Pension Systems appeared first on Reason Foundation.

Chattanooga’s actuaries estimate the city will save $227 million by 2040 as a result of the COLA restrictions, allowing the plan to improve its funding level by curbing the outflow of payments to retirees instead of driving up inflows of contributions from today’s taxpayers.

This decision will likely be welcomed by other jurisdictions looking to modify COLAs, though it is far from uncontroversial.

The 6th Circuit held that the CFPPF COLA was not explicitly included in the provisions of the law that outline vested benefits. A benefit is considered vested if the state or municipal statute creates a contractual relationship between the government and the pensioner, and it is unconstitutional for states to pass any law impairing contracts. However, since the COLA was not a vested right — according to the 6th Circuit — it could be amended.

In the U.S., pension benefits were originally considered gratuities that could be rescinded by the government. But the Kern v. City of Long Beach decision in 1947 found that pension benefits constituted a contractual relationship because “the mere fact that [pension benefits are] dependent on certain contingencies does not prevent a contract from arising.

Under this reasoning, also called the “California Rule,” an employee agrees to the pension benefits in place when they were hired, just as they agree to a salary, and they are entitled to those benefits as if they were a contract. Since then, many state courts across the U.S. have followed similar logic, with the exception of decisions such as US Trust Co. v. New Jersey, where the US Supreme Court held that it is acceptable to impair contractual obligations, but only to “serve an important public purpose.”

However, the 6th Circuit did not need to apply US Trust logic in its decision because it found the COLA was not a contract in the first place. This decision follows similar cases of COLA reductions — including Berg v. Christie and Tice v. South Dakota — which also predicated their arguments on a presumption against statutes creating contractual obligations.

The importance of this line of argumentation cannot be understated. According to the 6th Circuit, pensions are deferred compensation, but, like most other policies, they should not be set in stone before first clearing the hurdle of “unmistakable” legislative intent.

Because “there was no unmistakable evidence of [Chattanooga’s] intent to be bound to the fixed COLA,” the Court found, the ordinance does not create a contract. City code says pensioners’ benefits “will be increased,” but the term “will” only imposes a duty to comply until the statute is changed, according to the ruling.

The court also found that if the purpose of a COLA is to prevent the erosion of pension benefits due to inflation, fixing the value at 3 percent, as many other pension systems do, contradicts the purpose of a COLA. Inflation has only averaged 1.7 percent in the past decade. A COLA above the rate of inflation amounts to an additional benefit increase.

The logic of the court is clear and understandable — but is it not consistently held across the country. Rulings in Heaton v. Quinn and Byrne v. Montana sided with the pensioners in similar cases where a state or municipality sought to curb COLAs in order to try and improve the solvency of a pension fund. After all, it is difficult not to sympathize with pensioners. The very logic behind a COLA is predicated upon fluctuating economic conditions and ensuring the preservation of the purchasing power of money.

Perhaps more importantly — separate from logic of the court —freezing or reducing COLAs alone may not be sufficient to ensure the solvency of pension systems. Thus, while it can be an important element of reforms to prevent pension crises in the near-term, such changes in isolation may paper over greater risks in the long run.

Simply reducing COLA payments today in order to kick the can on meaningful, structural reforms is not real pension reform. On the flip side, COLA reductions — to the degree they are legally allowed and do not undermine retirement security — could be one piece of a larger pension reform package. After all, should a pension fund become insolvent there might not be a monthly pension check to get a COLA on in the first place.

The post Federal Court Upholds Chattanooga COLA Adjustments appeared first on Reason Foundation.

Of the three long-term measures, the trust fund solvency is perhaps the most relevant indicator to evaluate how pensions and other post-employment benefits (OPEB) can affect a state’s finances. The measure is defined by combining three metrics:

(1) Total primary government debt/state personal income

(2) Unfunded pension liability/state personal income

(3) OPEB/state personal income

By directly incorporating pension liability and OPEB in its calculation, the trust fund solvency measure provides a more complete picture of a state’s ability to finance its long-term obligations than the long-run solvency measure, which covers only a portion of the pension liability and OPEB. It should also be noted that the trust fund solvency measure counts not only pension plans that states offer to their employees but also those plans that states administer but don’t directly contribute to, like municipal plans. The study’s rationale is that municipalities tend to ask for state aid when their state-administered/locally-funded plans face financial distress, which presents a “contingent liability” on the states.

Perhaps most importantly, the study uses market valued liabilities for pension plans instead of just taking a state’s reported accrued pension liabilities at face value with their own adopted discount rate. In the discussion of the trust fund solvency measure, the study gives a short but solid argument in favor of market valuation of pension liabilities, which uses a discount rate that reflects the risk of the plan’s liability rather than the expected returns on the plan’s assets:

First, according to economic theory, the value of the plan’s liability is independent of the value of the plan’s assets, much as the value of a homeowner’s mortgage is independent of the value of his or her personal savings. Economic theory holds that a stream of future cash flows (in this case, a stream of future pension benefit payments) should be valued based on the certainty and timing of those payments. State pension plans come with a legal guarantee of payment, but there is no guarantee that the plan’s assets will return 7.5 percent each year. GASB 27 implies that securing a promised stream of future benefits based on uncertain investment returns without any risk is possible.

Market valuation using a risk-free discount rate* shows that states’ pensions, and consequently states’ fiscal condition, are in much worse shape than the official numbers indicate. According to the data from the study, the average unfunded liability/state personal income ratio under market valuation is 30 percent, more than four times higher than the 7 percent ratio calculated under the GASB standards.

Table 1 and Table 2 below show the top and bottom 10 states in terms of trust fund solvency and general fiscal condition.

While there is no strong correlation between trust fund solvency and general fiscal condition, states at the bottom of the fiscal condition ranking tend to also rank low in trust fund solvency. States such as Illinois, Kentucky, Hawaii, California, New Jersey, and Connecticut have large unfunded pension liabilities relative to personal income and also have poor overall fiscal health.

The most interesting state in the rankings is perhaps Alaska, which ranks 1st in fiscal condition but 50th in trust fund solvency. A major reason is that the study assigns significantly larger weights to short-term solvency measures than to long-term ones. Specifically, cash and budget solvency criteria each receive a weight of 35 percent, while the three long-term criteria are each weighted only 10 percent. The rationale is that a state’s ability to meet immediate financial needs and to absorb negative financial shocks in the short run is probably more important than its long-term solvency. As a result, Alaska’s abundant liquid financial resources relative to near-term obligations greatly offset its poor trust fund solvency.

The fiscal condition ranking provides a valuable benchmark to evaluate states’ fiscal health, which concerns not only conventional government debts but also often-overlooked pension and OPEB liabilities.

Users of the ranking, however, should note two limitations. First, the ranking is only relative. Since an appropriate discount rate reveals that most states’ pensions are badly underfunded, even highly ranked states may have serious trouble meeting future pension commitments. Second, the overall fiscal condition ranking should not be viewed in isolation of the sub-rankings, as the low weights assigned to long-term solvency (a subjective methodological choice), including the trust fund solvency, may mask a state’s long-term financial problems.

*In principle a discount rate should reflect the risks of a plan’s liabilities, and as a proxy for this the authors applied a discount rate of 3.2 percent (15-year Treasury bond yield) to all liabilities on a fixed basis.

The post Ranking of State Finances Offers Insight on Public Pension Debt appeared first on Reason Foundation.