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:

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To be clear, there is nothing fundamentally wrong with states offering a defined benefit pension plan to public workers, especially when the plan is properly funded and well-governed. But, as state leaders continue to explore workforce issues, it is becoming clear that many younger workers especially, be they educators or other state and local government employees, are not all interested in the one-size-fits-all retirement benefit.

In theory, the one-size-fits-all pension approach creates an environment where public educators and employees take lower pay over their entire 20-30 year careers in exchange for a predetermined and guaranteed pension check they can count on each month in retirement. Sometimes this check is a supplement to their Social Security benefit, other times employees have forgone contributing to Social Security and receive their pension check in lieu of a Social Security benefit.

The guaranteed pension check looms over every career opportunity that comes across a public employee or educator’s path. Most defined benefit systems currently being offered threaten to not only take away that guaranteed check but also take away the employer’s contribution toward an employee’s retirement savings if the worker leaves public employment before a set date. Most states require between 5 and 10 years to vest in the public pension system. The same dynamic leads some employees to leave their jobs immediately after becoming eligible to receive their full pension benefits, draining institutional knowledge from schools and other public sector jobs.

According to data reported by the New Mexico Educational Retirement Board (ERB), over two-thirds of newly hired educators will likely leave employment within five years or before initially vesting in their predefined retirement benefits. Data from the Teachers Retirement System of Louisiana shows less of a drop, with only about half leaving within five years. However, the same data show that Louisiana’s newly hired educators have only a 15% probability of staying in public education long enough to achieve a full, unreduced pension benefit.

These retention numbers are not unique. Of the public pension plans studied by the Pension Integrity Project at Reason Foundation, most public pension systems lose over half of all their new hires within 5 years. Generally, less than 20% of all new hires today will work with a public employer long enough to earn a full, preset pension check. If a system is what it does then most public pension systems that only offer a defined benefit pension plan are what they produce—a coercive and aristocratic benefit that garnishes the already limited compensation of new, shorter-term workers. In far too many cases, these public pension plans are also underfunded, saddling future generations of taxpayers with massive debt obligations.

Simply arguing that a defined benefit helps recruit and keep employees ignores the fact that each person who chooses to work for a public entity is unique and would be better served with more retirement options. Bottom-line, the one-size-fits-all defined benefit pension systems offered to most educators and public workers around the country can make working in the public sector much less attractive than private alternatives.

The post Outdated retirement benefits could be contributing to public employee hiring issues 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.

In the United States, public pension funds, which have an average investment return target of 7.25 percent, will likely struggle to meet those investment targets and could be severely impacted by plummeting interest rates. Without changes to pension plans’ assumed rates of return, many public pension systems will see an increase in debt.

Unfortunately, many public pension plan managers are not interested in adjusting their investment return targets to realistic levels at this time. Instead, they are seeking riskier, potentially higher-yielding investments in an effort to make up for depressed interest rates and hit their targets.

Fixed-income investments, like government and corporate bonds, have been a part of pension fund portfolios for decades. And, for several pension funds, fixed-income investments hover around 25 percent of their entire investment portfolios.

New Mexico’s Educational Retirement Board (ERB), which serves the state’s teachers, is one such plan that dedicates roughly a quarter of its portfolio to fixed-income assets. Within New Mexico ERB’s fixed income-investment allocation, 7 percent of funds go to emerging market debt, which is essentially sovereign bonds issued by countries classified by the World Bank as lower-to-middle-income to upper-middle-income. This includes countries such as Brazil, India, and Nigeria.

Even though emerging market debt carries much higher yields that are attractive to pension funds, those benefits can be outweighed by enormous risks since several of these countries have defaulted on their debt in the past. Due to this risk, public pension investment allocations to emerging market debt have historically been used sparingly in pension fund portfolios. However, in recent months, pension fund managers have signaled a growing appetite for allocating more assets to this asset class. The reasons for this change could be:

1. Smaller Contraction and Sharper Rebound – According to the International Monetary Fund (IMF), the developed world’s economy will, on average, contract about 5.8 percent in 2020 and rebound about 3.9 percent in 2021. Those numbers are almost reversed for the emerging markets where the economic contraction is expected to be about 3.3 percent in 2020 with a rebound of 6 percent in 2021. This means that on average, the emerging markets are forecast to be a key driver of economic growth post-pandemic.
2. Search for Yield – With the downward pressure on interest rates in the US, Europe, China, and elsewhere, the search for higher yields will be paramount for pension funds seeking to hit their investment return targets without lowering investment return assumptions.
3. Backstop from IMF – Given the risk of debt defaults as discussed earlier, emerging market investment was always severely limited in pension funds. With the coronavirus pandemic continuing, the IMF has provided partial guarantees to several emerging markets in debt relief. This response has made this debt much more attractive.

There are still a lot of risks associated with emerging market debt. For starters, each of the economic forecasts and scenarios above may not materialize fully. For example, the economic rebound may not be as strong as expected, or the IMF may not guarantee as much debt as investors expect. Each of these scenarios would be a blow to the attractiveness of emerging market debt.

On top of that, these emerging market countries have significant currency risks that could be made worse through recent trends in declining exports. In other words, many public pension funds are still taking significant financial gambles by investing in emerging market debt.

As long as public pension funds across the country continue to maintain unrealistically high annual return targets of around 7.25 percent, and as long interest rates in developed economies continue to plummet to zero—and below zero, we can expect emerging market debt to continue to gain traction with plans willing to take significant risks in 2021 and beyond.

The post With Interest Rates Low, US Pension Funds Make Risky Investments In Emerging Market Debt appeared first on Reason Foundation.

During an August Investments and Pensions Oversight Committee (IPOC) meeting, the Educational Retirement Board’s administrative leadership spoke to state legislators about the long-term funding prospects of the plan and laid out three options they believe could get ERB back on track to being fully funded by 2050.

These suggestions were to increase employer contribution rates, transfer the pension plan’s reported $9 billion in unfunded liabilities to the state’s general ledger through a bond offering, or decrease retirement benefits offered to ERB members.

Legislators and ERB seem to have come to an agreement on a plan to increase employer contributions and ERB has already drafted legislation to do so.

The bill is set to be introduced by State Sen. Mimi Stewart (D-Albuquerque) in the 2021 legislative session. The proposed bill increases the annual statutorily-set ERB employer contribution rate from 14.15 percent to 18.15 percent, increasing one percent a year over four years.

In its latest presentation to IPOC on December 10, the New Mexico Educational Retirement Board’s administrators used the plan’s latest valuation report to walk policymakers through its current $9 billion shortfalls and 60 percent funded status by way of highlighting the fact that there is currently no path for ERB to fully fund retirement benefits. Plan administrators warned that, historically, ERB has had the ability to pay benefits in perpetuity, but for the first time in its history, ERB is expected to exhaust that ability soon absent changes to current funding policy.

The employer contribution rate is the amount of funding that the state is required to contribute to the plan each year. This funding increase recommendation is the latest legislative attempt by ERB to ensure the retirement benefits of state-employed educators are fully funded and available to retirees over the long-term.

Previous well-intentioned efforts to increase retirement eligibility requirements, increase member contributions, and tie retirees’ cost-of-living-adjustments (COLAs) to ERB’s funded ratio (all of which focused on the member’s influence on the funding formula) have made a small impact on the resiliency and long-term solvency of ERB.

Figure 1 below displays the funding history of the plan.

Figure 1: History of the New Mexico Educational Retirement Board’s Solvency

Actuarial analysis of ERB’s latest proposal suggests that the increased employer contribution rate, while a positive step, would only make a difference in the plan’s long-term sustainability if all actuarial assumptions are met over the next 30 years.

The Pension Integrity Project at Reason Foundation modeled the proposal and found that if implemented, ERB’s 2050-projected unfunded liability would decrease by nearly 40 percent, decreasing from $34.2 billion in debt to $20 billion. The ERB proposal, however, would still ultimately result in the plan’s accrued benefits being only 66 percent funded in 2050.

In short, the proposed changes could be a good, small reform and the plan’s funded status would marginally improve if all actuarial assumptions are met over the next 30 years, but ERB would still have significant structural problems and remain far short of full funding.

From a solvency perspective, the impact of increased contributions on ERB is clear: the more contributions the better. However, our analysis also finds that when accounting for potential future market underperformance, absent addressing the systemic issues driving the growth of unfunded benefits, ERB’s funding issues are bound to worsen.

To be sure, increasing contributions to address growing unfunded liabilities is a good policy step for many public pension plans, but often more changes are necessary to fully address the fiscal stress pension debt puts on employees, retirees and taxpayers.

Figure 2 illustrates this important finding by comparing the current state of ERB, where all actuarial assumptions governing the plan—including ERB’s current 7 percent investment return rate assumption—are accurate each year, to a less optimistic forecast that shows the condition of ERB after 30 years of more conservative investment returns and two recessionary periods.

Figure 2: The Effect of a 4 Percent Employer Contribution Increase on ERB’s Funded Ratio

In the event that all of the plan’s assumptions are consistently accurate over the next 30 years, additional state funding would improve ERB solvency. But the proposal to increase contributions does nothing to address the current unfunded liabilities or the system’s exposure to market volatility.

Additionally, ERB funding improvement relies on the theory that the system’s investment return rate assumption of 7 percent, among others, will either be met or exceeded in the near-term, which ERB administrators and consultants say they believe is a reasonable assumption.

When assumptions are missed, especially the plan’s investment return rate assumptions that serve as the only other funding source outside of members and taxpayers, ERB’s unfunded liabilities would grow despite increased contributions from the state. Thus, in the overall picture, the proposed contribution increases wouldn’t prevent the further accrual of unfunded retirement benefits by public educators, who, for their part, have honor the obligation their side of the agreement entered in when first hired.

Figure 3 shows the projected increase of ERB unfunded liabilities under various economic and investment return scenarios.

Figure 3: The Effect of a 4 Percent Employer Contribution Increase on ERB Unfunded Liabilities Under Lower Investment Return Rates

A less lucrative investment portfolio and recurring recessions over the next 30 years, which most economists expect, would likely result in significant drops in ERB’s funding regardless of the proposed employer contribution increase.

Increasing the contribution rate is a good idea but without also addressing the volatility inherent in the ERB investment portfolio and adjusting how the state is paying off its debt and unfunded liabilities, ERB will remain less and less resilient to economic and stock market shifts over time and will continue to accrue ever higher unfunded liabilities.

The proposed contribution increase would certainly be beneficial from a solvency perspective, but ERB’s situation requires far more substantive adjustments to how unfunded liabilities are tackled and how the plan reacts to underperforming investment results if it is going to ensure retirement benefits for New Mexico’s teachers and educators are sustainable and financially resilient to market shocks over the long-term.

During New Mexico’s recent PERA reform effort, state policymakers simultaneously increased employer contributions while also addressing systemic design flaws like the guaranteed cost-of-living adjustments that were untethered to actual inflation and reducing PERA’s long-term exposure to market risk by lowering investment return assumptions.

Elsewhere, in 2018, the state of Colorado not only increased employer and employee contributions to its main public pension system but also established an automatic adjustment feature— automatically increasing annual pension contributions and lowering the pension plan’s cost-of-living adjustments if certain funding thresholds are not met. The city of Fort Worth soon followed suit, enacting a similar automatic adjustment policy for its public workers’ pension system.

Adding an automatic adjustment policy to increased contribution proposals would not only improve the trajectory of ERB funding but could also insulate the system from unpredictable market returns in the future. Such a policy would allow annual contributions to respond more freely to changing conditions and ensure that if any future investment returns come in below expectations, they do not derail the public pension system’s trajectory towards full funding.

The best way for New Mexico lawmakers to address the problem of contributions not adjusting to market volatility and performance would be for the legislature to contribute annually to ERB at an actuarially determined employer contribution (ADEC) rate.

Every year, ERB’s actuaries calculate the amount of funding the pension plan needs from all sources to avoid any growth in unfunded pension liabilities. Currently, the state does not rely on this ADEC value to determine its annual contributions, as many pension plans across the country do. Instead, ERB relies on a fixed percentage of payroll set by law at the discretion of legislators. The result of this policy has been chronic underpayments, adding to the system’s long-term solvency concerns.

Figure 4 illustrates this problem, showing that state contributions into the fund have been below actuarially required amounts for nearly 20 years.

Figure 4: Actual vs Required ERB Contributions

ERB would benefit from adjusting its funding policy to match the many other states that rely on the actuarially-determined amount to set annual contributions. This change in policy, like the proposed automatic adjustment feature, would protect the post-employment security of New Mexico educators from the unpredictable future of the market.

Figures 2 and 3 above also include scenarios modeling an ADEC-based policy, which shows ERB’s funded ratio rising to nearly 100 percent and its unfunded liabilities being nearly eliminated in 30 years.

The ERB-backed state funding increase proposal represents a commitment to securing the retirement of New Mexico educators.

However, despite the contributions increases moving ERB off the path of insolvency, the proposal’s success relies heavily on the ability of ERB to achieve expected returns. Because of this, the retirement security of the 12 percent of New Mexico educators who serve their communities long enough to earn an unreduced ERB retirement benefit, will continue to be exposed to a great deal of risk and ERB will still need additional adjustments in the future.

Adopting more risk-averse investment return assumptions and funding policies to prevent the further growth of unfunded benefits, while establishing a plan to pay off the plan’s existing unfunded liability as quickly as possible would directly address the systemic underfunding that has created the challenges facing ERB today.

The post Contribution Increases Could Help New Mexico’s Teacher Pension Plan, But More Changes Are Necessary appeared first on Reason Foundation.

In an August presentation to the New Mexico Investments and Pensions Oversight Committee, the state’s Educational Retirement Board (ERB) administrators warned that without significant employer contribution increases, there may need to be benefit reductions for the pension plan’s active and new members. They said these cuts would help the plan, which serves all of the state’s K-12 educators and some higher education employees, reach full funding in a 30-year period.

Reason Foundation’s latest analysis shows that New Mexico Educational Retirement Board had $8 billion in unfunded liabilities in 2019, up from only $650 million in unfunded liabilities in 2001. The majority of this growth in unfunded liabilities stems from investment returns that fell below investment return rate assumptions and insufficient contributions on the part of the state.

At this time, it will take the New Mexico Educational Retirement Board 47 years to pay off its accumulated debt. According to the Society of Actuaries (SOA), the recommended payoff period for public pension debt is 15-to-20 years.

These numbers do not take into account the fact that ERB reported a negative .97 percent return for its last fiscal year. Estimates show that this negative return could add an additional $1 billion of debt to the pension system.

The director of ERB discussed a variety of ways these pension cuts could play out, including a reduction of the benefit accrual rate for future service, which would mean workers receive fewer retirement benefits for the same employee contributions. Also discussed was a 0.5 percent cap on cost-of-living adjustments (COLAs) until the plan is projected to reach 100 percent funding within 30 years.

While it is good that ERB is highlighting the urgency of the pension plan’s financial troubles, cutting benefits without addressing structural and funding policy issues undermining the sustainability of the pension plan would be an inadequate approach to solving a nuanced problem.

Rather than jump to benefit cuts, the state legislature could explore more substantive reforms that could put ERB on a realistic debt payoff period, just as the legislature did last year when it passed reforms to the New Mexico Public Employee Retirement Association (PERA), the state’s other major public pension system.

PERA has consistently maintained a higher funded ratio than ERB while also paying out higher benefits, but last year unpromising financial forecasts prompted the legislature to enact plan changes to help improve the system’s solvency. These changes included a shift to a flexible COLA that adjusts based on fiscal conditions and a “shared sacrifice” of an equal employer and employee contribution rate increase.

According to PERA’s own projections, these changes will raise the plan’s chances of reaching full funding by 2043 from 38 percent to 47 percent and will save the state from accruing an estimated additional $15 billion in unfunded liabilities during that period. These changes increase retirement security for employees and retirees, and ERB should look to implement similar reforms.

ERB has not been completely inactive in trying to ward off insolvency. In April 2020, the plan reduced its assumed rate of return on investments from 7.25 percent to 7 percent. This change will limit the opportunity for new debt to accrue as a result of investment shortfalls.

In the last 20 years, ERB has averaged a 5 percent investment return and their return for this last fiscal year was negative .97 percent. And, well before the COVID-19 pandemic and recession arrive, financial experts were saying a lower yield investment environment would plague public pension plans for the foreseeable future. The below chart compares ERB’s assumed rate of return to actual investment returns since 1995.

Figure 1 – New Mexico ERB Returns vs Assumptions

Source: Pension Integrity Project Database with data compiled from New Mexico ERB Valuation Reports

State law has also contributed to ballooning unfunded liabilities as annual pension contribution calculations for ERB are set in state statute rather than by plan actuaries who calculate the actual amount required to fully fund benefits each year. Over the last 20 years, actual contributions have shorted ERB of $1.4 billion in payments.

This is funding that will eventually need to be recouped via either higher contributions or higher than expected investment returns. It would behoove state policymakers and taxpayers to make pension reforms sooner rather than later. Every year that passes without this money in the pension fund means more lost investment revenue, making the retirement plan more expensive for employers, members, and ultimately taxpayers.

The chart below displays the gap between the actuarially determined contributions and the actual contributions made by the state each year since 2001.

Figure 2 – New Mexico ERB Employer Contribution Shortfall

Source: Pension Integrity Project Database with data compiled from New Mexico ERB Valuation Reports

These structural problems are the main contributors to ERB’s growing debt and the increasing likelihood that pension benefits will be reduced.

State policymakers should begin to address these challenges with meaningful and lasting pension reforms based on informed analysis, just as they have done for New Mexico’s Public Employees’ Retirement Association. If meaningful action is taken quickly, the pension benefit cuts the plan is currently warning about and considering could be avoided.

The post As Debt Grows, New Mexico Pension Plan Considers Retirement Benefit Reductions for Teachers appeared first on Reason Foundation.

In This Issue:

Articles, Research & Spotlights 

• A Look at CalPERS’ New Investment Policy 
• Evaluating New Mexico’s Pension System After Recent Reforms
• Could Public Pension Garnishment and Forfeiture Laws Play a Role in Criminal Justice Reforms? 
• The Risk-Free Origin of Public Pension Investment Strategies
• Why Public Pension Reforms Need to Refocus on Plan Objectives

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

Articles, Research & Spotlights

The Potential Risks and Rewards of CalPERS’ New Investment Policy

The California Public Employees Retirement System (CalPERS) recently announced its strategy to increase the solvency of the plan, which currently sits at just 71 percent funded. The new approach, labeled “More and Better Assets,” embraces a new two-pronged investment strategy that combines a push towards higher earnings and riskier assets, with the ability to leverage the fund to retain liquidity when market opportunities present themselves and borrowing costs are low. As Reason Foundation’s Ryan Frost and Leonard Gilroy note, the strategy means that the plan will be taking on higher levels of investment risk, but Ben Meng—CIO of CalPERS—indicates that it will increase the probability of hitting the system’s assumed 7 percent return rate from 39 percent to 45 percent.

New Mexico Enacts Bipartisan Reform to Improve PERA Security

The New Mexico Public Employees Retirement Association (PERA) has amassed over $6 billion in unfunded pension liabilities over the past two decades, but recent reforms placed the pension plan on a better path toward debt elimination and full funding. Earlier this year, state lawmakers and the governor prudently addressed a number of PERA’s problems with significant reforms to contributions and benefits. The changes could generate $700 million in long-term savings and improve the probability of reaching full funding by the year 2043 from 38 percent to 47 percent. This in-depth analysis looks at the primary factors driving PERA’s unfunded liabilities over the past few decades, the benefits of the 2020 pension reform law, and provides stress testing analysis designed to highlight ongoing financial risks and remaining opportunities to improve the plan.

States’ Varying Approaches to Police Pension Garnishment and Forfeiture

Only 15 states will revoke or garnish a police officer’s pension benefit if the officer is convicted of serious crimes or misconduct. While the effectiveness of pension garnishment and forfeiture laws is difficult to quantify, allowing courts the ability to modify public employee benefits may be important in attempts to prevent further taxpayer dollars from going to public employees who have abused and disgraced their positions. Reason’s Ryan Frost offers a snapshot of pension garnishment and forfeiture policies across the nation and reflects upon what this could imply for broader government and police reforms.  

The Surprisingly Risk-Free Origin of Public Pension Investment Return Assumptions

While CalPERS has a target assumed rate of return of 7 percent today, it was once as low as 2.5 percent. Throughout the history of the public pension administration, investment expectations and strategies have evolved in response to shifting market landscapes. In a new commentary on these trends, Reason’s Marc Joffe explores the history of the nation’s largest public pension plan, finding that investments were relatively low-risk for much of the history of CalPERS. Since the early 1990s, however, the system’s assumed rate of return has consistently been above risk-free rates. 

Public Pension Systems Need to Revisit and Clarify Their Objectives

When examining the effectiveness of public pension plans, dialogue often focuses on metrics such as contribution rates or funded ratios. But any evaluation of a public pension plan’s effectiveness should also consider the larger principles and objectives that the system has adopted, such as affordability for taxpayers and providing a secure and portable retirement income for retirees. Pension Integrity Project Senior Fellow Richard Hiller writes about the need for policymakers to revisit goals associated with employee outcomes, workplace recruiting and retention needs, and taxpayers’ costs so they can more accurately structure pension plans to meet their overarching purposes.  

News in Brief

How Exposed Are Retirement Savings to Market Risk?

During the stock market volatility earlier this year, nationwide retirement assets fell by $14.2 trillion dollars. While the market has largely recovered those losses since, this year’s market movement highlights some of the challenges in managing secure and predictable retirement benefits in an unpredictable world. In a new brief, Anqi Chen and Nilufer Gok at the Center for Retirement Research analyze the impact of the pandemic-related recession, discuss the importance of protecting worker retirements from market turmoil and the need for plans that manage and share risk between employees and employers. The brief can be found here. 

An Update on Teacher Salaries Versus Benefits 

While average teacher salaries in the U.S. rose by 19.3 percent from 2010 to 2020, the average cost of teacher retirement plans soared by 126.45 percent, concludes a new analysis by Chad Aldeman of TeacherPensions.org. Overall teacher compensation rose by 28.5 percent over the same time period. These findings suggest that pension contributions are taking up a growing share of education-related budgets and pension costs for retired employees is hindering the ability to improve current teacher compensation. Aldeman warns that without further reforms, growing pension costs will take a larger proportion of school district budgets in the future. The analysis can be found here. 

Quotable Quotes on Pension Reform

“Employers and employees will likely face higher payroll contribution rates in years ahead, but the pandemic recession itself is only modestly amplifying that trend. What the recession is provoking, however, is a near-term issue of whether public employers will yield to a temptation to put off actuarially required contributions to their pension funds.”
—Girard Miller, finance columnist, writing in “Public Pensions and the COVID-19 Fiscal Dilemma,” Governing, July 7, 2020

“Today’s Supreme Court decision will ensure that the unsustainably generous pensions that were doled out in the past will continue to be an albatross over our city for decades to come. This decision will force the city to make very difficult decisions about how to pay for ballooning pension payments at the risk of short-changing critical needs like public education, social services and infrastructure investments.”
— Jorge Elorza, mayor of Providence, quoted in “R.I. Supreme Court Deals a Huge Blow to Providence in Pension Case,” Boston Globe, June 30, 2020

“It’s even more important in challenging economic times to act responsibly in addressing long term liabilities. A total of more than half a billion dollars is a good start toward closing the $50 billion long-term gap.”
— Dale Folwell, state treasurer of North Carolina, quoted in “New laws could boost North Carolina’s state health plan, pension system,” The Center Square, July 10, 2020

Data Highlight

Each month we feature a pension-related chart or infographic curated by one of our Pension Integrity Project analysts. This month, Marc Joffe displays the long history of assumed rates of return for CalPERS compared to 10-year U.S. Treasury rates, showing the assumed rates have been slow to adjust downward with market changes in recent decades. Find the data visualization and more detail here. 

Contact the Pension Reform Help Desk

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

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

The post Pension Reform Newsletter: New Investment Policy for CalPERS, Pension Forfeiture Laws, and More appeared first on Reason Foundation.

Because most public pension funds failed to recover from the Great Recession—despite a historic, decade-long bull market—they won’t be able to quickly recover from the current recession and future market events absent major reforms.

This is why New Mexico’s bipartisan effort by Gov. Michelle Lujan Grisham and the state legislature to enact Senate Bill 72 was a particularly well-timed move. Signed in March, this legislation was designed to improve the solvency of the state’s Public Employees Retirement Association (PERA) pension plan. These changes sought to better shield the plan from the types of uncontrollable market risks that manifested just weeks later as the COVID-19 pandemic reached the US.

New stress testing shows that such efforts might save New Mexico employers and taxpayers as much as 28 percent in total pension costs over the next 30 years. These results show that because of the reform, PERA will certainly be better off in the event of future worst-case recession scenarios.

New Mexico’s SB 72 Reform

SB 72  was a bipartisan reform designed to begin tackling PERA’s solvency challenges – which included over $6.7 billion in unfunded liabilities. The legislation was effectively the end product of a process launched by a gubernatorial task force that began examining the system in the summer of 2019.

Among the core provisions of SB 72 were:

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

After conducting an actuarial analysis of PERA’s funding, the Pension Integrity Project at Reason Foundation notes that absent SB 72 the plan’s unfunded liabilities would likely have nearly doubled to over $12 billion in the next 30 years.

This would have put greater stress on both public budgeting priorities and PERA cash flows compared to the pre-reform situation. With the passage of SB 72, PERA is more likely to eliminate its pension debt entirely by roughly 2047.

Still, under current economic conditions—and accounting for future “Black Swan” market-impacting events that may occur more frequently in the future— policymakers need to understand that improvement is by no means guaranteed.

This analysis, derived from a larger Pension Integrity Project risk assessment that involves Dodd-Frank-style stress testing to gauge PERA’s resiliency to future down-market scenarios, will reveal what PERA’s pension costs and overall solvency would have looked like both with and without the provisions of SB 72.

Persistent Economic Volatility 

In June the Federal Reserve Bank of Atlanta projected that U.S. GDP could contract by as much as 53 percent in the April-June period. Capital markets have felt the whipsaw. In the previous quarter, the S&P 500 index dropped by 20 percent, with both equities and fixed incomes underperforming.  While the S&P 500 index fully rebounded by the end of June, the global economic outlook remains very uncertain. For example, massive economic disruptions related to COVID-19 remain, and state and local budgets have only just begun to enter what is expected to be a period of financial distress that rivals or exceeds that of the Great Recession.

It is likely that the current financial environment could fuel potential investment losses for many public pension plans this year and maybe years to come. Investment shortfalls will result in the accrual of additional unfunded liabilities, which drive up long-term costs for both employers and employees. Further, recent increases in unemployment rates mean that individual consumption and incomes could be depressed for some time, which is expected to translate into lower state and local tax revenues over the next several years. Lower revenues can undermine governments’ ability to make full pension contributions.

Stress Testing Meathods

As a way to stress test a pension plan’s financial resiliency the Pension Integrity Project has applied a risk assessment methodology that, similar to the process used to test bank solvency under Dodd-Frank, simulates a one-year market downturn followed by a rebound. Similar to methodology used by Moody’s Investors Service, for the first year the test assumes pension plan experiences a significant investment loss equaling twice the expected portfolio volatility (as measured by standard deviation). The analysis then assumes a follow-up three-year market recovery with 11 percent average returns each year.

The results were found by analyzing 2019 capital assumptions, PERA’s asset allocation, applying the custom stress testing technique, and the assumption that PERA’s portfolio returns a -19.8 percent return in 2020, followed by three years of 11 percent average returns. The test also assumed that long-term investment returns eventually average out to 6 percent (less than PERA’s 7.25% return target) once markets rebound, as a way to reflect a more realistic target given the “New Normal” diminishing capital market outlook. It is worth emphasizing that the assumptions for stress testing scenarios are for informative purposes only, and are not meant to be interpreted as Reason’s projections of the actual fiscal year 2020 outcomes for PERA or any other pension system. You can find an interactive tool that shows how a variety of investment return scenarios would impact public pension plan funding across the nation here.

Given the relative frequency of economic downturns over the past two decades, the assessment also includes scenarios incorporating a second Black Swan crisis event in 2035. In the interest of reflecting some degree of appropriation risk—the risk politicians fail to fully fund pension contributions on a sound actuarial basis during a recessionary period amid budget deficits—scenarios that contemplate a hypothetical five-year employer pension contribution freeze are also included.

Overall, four separate stress testing scenarios below were evaluated, both pre- and post-SB 72:

1. 2020-23 Crisis + Average 6.0% Long-Term Returns
2. 2020-23 Crisis + 2035-38 Crisis + Average 6.0% Long-Term Returns
3. Scenario 1 + 5-Year Employer Contribution Freeze
4. Scenario 2 + 5-Year Employer Contribution Freeze

State statutes currently establish the PERA contribution rate. This means that the rate is fixed by politicians and does not automatically adjust to keep up with the actuarially determined employer contribution rate (ADEC) needed to keep the system on track to full funding. For the purposes of examining stress and resiliency across scenarios most effectively, the four pre- and post- SB 72 crisis scenarios assume that the state pays the actuarially prescribed contribution amounts (ADEC) each year. Using the more responsive ADEC method allows one to see the progression in contribution rates and make a more informative comparison of multiple scenarios.

Stress Testing Results

The true cost of a defined benefit pension plan over a period is not only in the total annual contributions over that time but also in any unfunded liability the plan accrues. This unfunded liability has to be paid off at some point. Making progress on paying down pension debt will ensure that pension costs are kept in check, thereby securing promised benefits. Thus, for conceptual purposes, an “All-in Employer Cost” concept that combines the total amount paid in employer contributions and adds what unfunded liabilities remain at the end of the forecasting window (adjusting both for inflation) to get a sense of the total scope of taxpayer obligations over time will be used.

PERA modeling results show that absent SB 72, employers’ “all-in cost” for PERA through 2049 would have amounted to $17.1 billion, assuming all plan actuarial and demographic assumptions are met.

SB 72 improved this situation markedly. The total present value of employer cost after SB 72 stands at just $12.2 billion over the same 2020-49 period (See Figures 1 & 2). This is roughly $5 billion, or 28 percent, in long-term savings over the next 30 years.

SB 72 established shared increases in employee and employer contributions over the next four years. This combination of more funding and other benefit changes is expected to help eliminate the plan’s unfunded liability by 2049 versus without the reform (e.g. 100 percent funding under SB 72 vs. 73 percent without the law).

The lower long-term “all-in” employer cost for PERA suggests that accelerating this progression to full funding will save New Mexico employers and taxpayers a significant amount of money in the long run. But that baseline forecast assumes that no market shocks will occur, so it is important to also test how SB 72 affected PERA’s ability to respond to the current and any future recessions.

Figure 1: Pre-SB 72 – Stress-Testing Without Reform.

Source: Pension Integrity Project actuarial forecast of PERA funding. Values are rounded and adjusted for inflation.

The “All-in Cost” includes all employer contributions over the 30-year timeframe, and the ending unfunded liability accrued by the end of the forecast period.

Figure 2: Post SB 72 — Stress-Testing With Reform.

Source: Pension Integrity Project actuarial forecast of PERA funding. Values are rounded and adjusted for inflation.

The “All-in Cost” includes all employer contributions over the 30-year timeframe, and the ending unfunded liability accrued by the end of the forecast period.

Per analysis of PERA’s funding under the first crisis scenario—a 2020 crisis and 6 percent long-term average returns—the combination of more funding and other changes enshrined in SB 72 will save roughly 16 percent in total employer contributions, and reduce ending unfunded liability by around 20 percent (both adjusted for inflation). This yields a net reduction in “all-in” long term costs of $3.3 billion (or 16 percent) by 2049. The additional stress scenarios (see Table 1) show similar new reductions in cost under SB 72 relative to the previous status quo in every case, indicating just how important the reform effort was for reducing long-term employer and taxpayer exposure to financial risk.

Table 1. Pre/Post SB 72 All-In Employer Costs, 2020-49.

Source: Pension Integrity Project actuarial forecast of PERA funding. Values are rounded and adjusted for inflation.

The “All-in Cost” includes all employer contributions over the 30-year timeframe, and the ending unfunded liability accrued by the end of the forecast period.

Conclusion

In short, analysis shows that SB 72 reform made PERA more resilient to single and recurring recessions, long-term investment return shortfalls, insufficient employer contributions, and cash flow strains caused by increasing benefit payouts.

The legislation’s approach of equal contribution rate increases between employees and taxpayers and adopting a benefit adjustment mechanism designed to not pay out automatic, fixed-rate benefit increases represent a smart and collaborative balancing of interests between taxpayers, public employees and current retirees.

Senate Bill 72 created a solid platform to begin the critical work of improving PERA’s long-term solvency. The reform sets PERA up to be much more resilient to the investment and government revenue volatility that New Mexico is already facing in 2020. Other plans should follow New Mexico’s lead and take steps to reduce pension and investment risks and fortify their plans to better withstand future market shocks.

The post Risk Assessment Shows New Mexico Pension Reform Protects Plan Members and Taxpayers appeared first on Reason Foundation.

As the state prepares for budget problems related to the pandemic and recession, PERA administrators and stakeholders are likely to face persistent challenges made more pronounced by ongoing market and revenue volatility.

This solvency analysis, produced by the Pension Integrity Project at Reason Foundation, reviews how recent legislative changes are expected to improve asset levels and shorten PERA’s debt burden, while also providing stress testing and spotlighting opportunities to build in additional risk safeguards to improve long-term financial sustainability.

Prior to the start of the COVID-19 pandemic, PERA had amassed over $6 billion in unfunded liabilities, and the system had, on hand, only 70 cents of every dollar needed to be invested today in order to generate sufficient funds over time to pay out all promised pension benefits.

This systematic underfunding is largely the result of missed investment and other assumptions, insufficient contributions fixed into state law, and negative amortization. Only some of these challenges were addressed in the 2020 legislative session, leaving additional opportunities for policymakers and PERA trustees to shore up the plan further in 2021 and beyond.

Highlighted in the report are the technical aspects of the various issues identified as contributors to the growing debt reported by PERA. The problem of investment returns averaging below the long-term assumed rate of return has added $2.93 billion in unfunded liabilities to PERA’s balance sheet since 2010. Investment expectations contribute to this problem, and despite the recent lowering of the investment return assumption to 7.25 percent, PERA remains exposed to significant investment underperformance risk.

Stress testing designed to highlight potentially latent financial risks and exposure to market volatility is also provided to stakeholders to help contextualize this risk under volatile market conditions. Reason’s solvency analysis also explores other existing structural challenges within PERA before providing a framework around which stakeholders can work together to ensure current funding, risk and actuarial policies best support the pension system’s long-term sustainability.

To further protect taxpayers, employees and retirees, legislators and stakeholders should continue to find bipartisan solutions to the funding issues at hand. With independent third-party actuarial analysis and expert technical assistance, our organization stands ready to continue assisting New Mexico policymakers and stakeholders address the shifting fiscal landscape.

New Mexico Public Employees Retirement Association (PERA) Solvency Analysis

The post New Mexico Public Employees Retirement Association Solvency Analysis appeared first on Reason Foundation.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Five Guiding Principles of Pension Resiliency

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Conclusion

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

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

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

The post Seeking Pension Resiliency appeared first on Reason Foundation.

In This Issue:

• Articles, Research & Spotlights 
  • New Mexico Enacts Bipartisan Pension Reform
  • Pension Fund Challenges with Alternative Investments
  • Arizona Municipal Pension Debt Driving Rising Costs
  • Coronavirus Compounds California’s Local Debt Issues
  • Kansas at Risk of Avoiding Payments and Growing Debt Levels
  • Massachusetts Considers Move to Bolster Pension Funding
• News in Brief
• Quotable Quotes on Pension Reform
• Featured Graph
• Contact the Pension Reform Help Desk

Articles, Research & Spotlights

New Mexico Enacts Bipartisan Pension Reform to Improve PERA Solvency

Earlier this month New Mexico Gov. Michelle Lujan Grisham signed into law Senate Bill 72, bipartisan legislation designed to begin tackling the Public Employees Retirement Association’s (PERA’s) solvency challenges through benefit design changes and increased annual contributions. Facing over $6.7 billion in pension debt, state lawmakers found a way to build a bipartisan consensus between labor associations, PERA’s governing board, local governments, and other stakeholders. In this analysis, members of the Pension Integrity Project evaluate the changes and use actuarial modeling to forecast the long-term results of the reform. The analysis suggests that SB 72 represents a giant leap forward in reducing the risk of rising costs in the future, but additional work remains to get the pension plan fully on track to meet what appears to be a darkening market forecast. Additionally, Reason Foundation’s Anil Niraula examines why Moody’s recently found New Mexico’s pension reform bill “will reduce state and participating local governments’ unfunded pension liabilities and susceptibility to investment return volatility.”

Opaque Alternative Investments Add Uncertainty to Public Pension Fund Reporting

As they’ve chased increasingly unrealistic assumed rates of return, many public pension funds have transitioned their investment strategy over the past decade, swapping relatively stable and transparent public equity and fixed income investments for less transparent and more volatile so-called “alternative” assets in search of higher yields. This trend is most apparent in the increased allocation in alternative investments, such as private equity. In this commentary, Reason’s Marc Joffe warns that some “private equity fund managers exaggerate the reported net asset value of their funds” and that crises like the coronavirus pandemic could cause additional instability for public pension funds that are too reliant on private equity.

Fiscal Implications of Rising Pension Debt for Arizona’s Local Governments

While some of Arizona municipalities are having difficulties budgeting for public services and others are seeking ways to pay down pension debt faster, a common theme uniting them all is the dramatic increase in pension costs over the past two decades. In a series of briefs, Reason’s Zachary Christensen examines the primary drivers behind rising pension costs and the fiscal impacts of pension plan underperformance for a subset of Arizona’s cities and counties, including Maricopa County, Scottsdale, Tempe, Mesa, and more.

COVID-19 and the Economic Impacts on California’s Pension Systems and School Districts

Market volatility associated with COVID-19 developments is likely to put even more budget pressures on school districts, many of which are already facing significant increases in pension costs. A recent report from California’s Legislative Analyst’s Office, as summarized by Reason’s Alix Ollivier, suggests that the state should dedicate some of its budget surplus to alleviate CalSTRS unfunded liabilities to help reduce costs imposed on school districts. The report also proposes a restructuring of health benefits to slow the growth of pension debt.

Kansas Shouldn’t Push Pension Debt into Future So It Can Spend More Today

The Kansas Public Employee’s Retirement System (KPERS) has only 64 cents saved for every dollar needed to pay for retirement benefit promises. This relatively low funded ratio makes Gov. Laura Kelly’s recent proposal to reduce state contributions to KPERS problematic. In order to fund the budget, Gov. Kelly would like to refinance the pension plan’s debt and allow the state to extend payments out further into the future in exchange for smaller pension contributions in the short run. Reason’s Ryan Frost and Michael Austin from the Kansas Policy Institute examine the potential downsides of pension debt re-amortization, warning the legislature to cautiously approach this element of the budget proposal.

Massachusetts’ Legislature Should Help Gov. Baker Make Good on Pension Promises

In response to growing concerns associated with long-term pension security, Massachusetts Gov. Charlie Baker has proposed a prudent increase in annual employer contributions into the state’s Public Employee Retirement Administration Commission (PERAC). As Reason’s Raheem Williams explains, the proposed payment increases are much needed to help the severely underfunded pension plan, but reforms would need to reach beyond contributions to fully pull PERAC out of its current funding challenges.

News in Brief

Pension Integrity Project Seeking Quantitative Analyst

The quantitative analyst will work with the Pension Integrity Project team to develop actuarially-driven analysis of public sector pension plans. For more details on the position, please see the job posting here.

Variance in Private Equity Fees Across Public Pension Plans:

While the primary focus of pension funds usually gravitates around maintaining adequate funding levels and ensuring responsible investments, one often overlooked, yet important, element of pension management are the fees applied to private equity investments. These fees can vary greatly and make a significant difference in overall costs for a fund. In a new paper, Juliane Begenau of Stanford’s Graduate School of Business and Emil Siriwardane of Harvard Business School examine fees paid by pension investors into various private equity funds. They find that fees are at most modestly affected by systemic factors such as pension total liabilities or governance structure. The authors conclude that the differences between the fees paid by pension plans could vary by up to 15 percent, even among similar plans investing in the same private equity funds.

Evaluating the Retirement Benefits of New York City Teachers:

Several pension reform efforts in New York have generally preserved the benefits of existing teachers while adjusting the benefits of new workers. This has resulted in multiple tiers of workers, all with varying levels of retirement benefits. In this new report, TeacherPensions.org uses benefit modeling to examine the adequacy of New York’s various pension tiers. They find that some tiers are falling short in providing adequate retirement benefits and that this shortcoming can be mitigated with increased contributions to the tax-deferred annuity program.

Quotable Quotes on Pension Reform

“By paying out more than it was taking in, PERA was on a path to eventual bankruptcy. Now we’ve reversed course, and I’m confident New Mexico can keep its promises to current and future retirees. […] Legislators from both parties recognized the dire need for this reform, and I thank them for their leadership.”
—Michelle Lujan Grisham, governor of New Mexico, quoted in “Gov. Lujan Grisham signs retirement security measure into law”, March 2, 2020.

“The solutions in this bill will go far to get our retirement system back on track while protecting our most vulnerable retirees from any hardship. […] It’s never easy making changes. A downturn is inevitable and we’ve taken the right steps to guard against it. We’re watching after everyone’s future and safeguarding the state’s bond rating.”
—George Muñoz, New Mexico state senator, quoted in “Gov. Lujan Grisham signs retirement security measure into law”, March 2, 2020.

“The Office of Retirement Services’ failure to follow state law would have resulted in chronic underfunding of the retirement system. Failing to address a broken pension system is no different than robbing the next generation of its wealth and spending it today. This is both unsustainable and unfair to our kids who will eventually foot the bill.”
—Thomas Albert, Michigan state representative, quoted in “State representative spars with Whitmer administration over school pension assumptions”, The Center Square, Feb. 25, 2020.

Featured Graph

Each month, we feature a pension-related chart or infographic of interest curated by one of our Pension Integrity Project analysts. This month, Reason’s Truong Bui displays assumed rates of return for state pension plans over time. The full chart, featuring all 50 states, is here.

Contact the Pension Reform Help Desk

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

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

The post Pension Reform Newsletter: New Mexico Enacts Pension Reform, Coronavirus Compounds Pension Debt, and More 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.

Per Moody’s, the recent reforms to PERA “will reduce state and participating local governments’ unfunded pension liabilities and susceptibility to investment return volatility.”

Indeed, per the Pension Integrity Project’s actuarial projections of SB 72, the legislation will significantly reduce—or even eliminate—PERA’s unfunded status over the next 30 years. This will certainly alleviate stress on New Mexico’s future public budgeting priorities, state taxpayers, and PERA cash flows.

Credit ratings, such as those provided by agencies like Moody’s, are important because they typically influence costs borne by the government, and ultimately taxpayers. When credit ratings improve, states and their taxpayers typically pay lower interest rates on the funds borrowed from bond buyers to finance various public priorities, like road construction and other public infrastructure projects.

As noted in Moody’s commentary, the legislation will also improve PERA cash flows by increasing employer and employee contributions, making cash flows less sensitive to capital market risks, and PERA, which primarily serves New Mexico’s state, municipal, county and public safety workers, less dependent on investment returns in general.

Moody’s stamp of approval is more evidence that Senate Bill 72 was a meaningful first step toward improving the financial health of both PERA and the state of New Mexico. With the recent development of the COVID-19 pandemic and a significant nosedive in financial markets, the people of New Mexico should appreciate the fact that state policymakers effectively improved the state’s pension fund, making it more resilient to capital market volatility and fiscal pressures.

More work needs to be done to match the scale of the current financial challenges pension funds face. And the Pension Integrity Project will continue to engage state leaders and pension stakeholders in New Mexico to find opportunities to further strengthen the state’s retirement systems in the years to come.

The post Moody’s Considers New Mexico Pension Reform Credit Positive appeared first on Reason Foundation.

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

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

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

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

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

The Problem

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

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

Figure 1. PERA Historical Solvency, 1990-2019

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Figure 5. PERA Employer Statutory Contribution Projections

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

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

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

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

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

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

Modernized COLA Designed to Protect Retirees From the Threat of Inflation

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

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

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

Table 1. Average COLA & Inflation Projections

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

Conclusion

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

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

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

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

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

The post New Mexico Enacts Bipartisan Pension Reform to Improve PERA Solvency appeared first on Reason Foundation.

In This Issue:

Articles, Research & Spotlights 

• North Carolina’s Pension System Is Strong, But Risks Loom
• Analyzing Proposed Changes to Georgia’s Teacher Retirement System
• Changes to Improve New Mexico’s Pension Board 
• Ohio Considers a Freeze on Cost-of-Living Adjustments
• When Governments Go Under, Who’s Responsible for Pension Debts?

News in Brief

Quotable Quotes on Pension Reform

Featured Graph

Contact the Pension Reform Help Desk

Articles, Research & Spotlights 

North Carolina Teachers’ and State Employees’ Retirement System: A Pension Solvency Analysis

North Carolina’s largest pension plan, the Teachers’ and State Employees’ Retirement System (TSERS), is one of the best-funded plans in the country boasting a nearly 90 percent funded ratio, but even some of the better-funded pension systems are showing signs of trouble. While TSERS enjoys funding above the national average, the system’s unfunded liabilities have grown significantly over the past two decades. This policy study, by the Pension Integrity Project at Reason Foundation and the John Locke Foundation, takes an in-depth look into North Carolina’s pension system, identifying the primary causes of the current $9.6 billion in unfunded liabilities, risks facing the system and potential solutions to ensure the long-term retirement security of their members.

» FULL ARTICLE

The Impacts of Proposed Changes to Georgia’s Teacher Retirement System

This legislative session the Georgia legislature has been evaluating two major reforms proposed for the state’s underfunded Teachers Retirement System (TRS). The first, House Bill 662, would lower the retirement system’s assumed rate of return, while the second, House Bill 667, would accelerate the state’s payment of TRS pension debt by scheduling all additional unfunded liabilities to be paid within 15 years instead of the current 30-year plan. In this analysis, Reason’s Jen Sidorova and Leonard Gilroy use actuarial forecasts to evaluate the fiscal impact of these proposed changes. They find that both reforms would result in a more stable future for TRS, with more predictable contributions and a higher chance of reaching full funding. However, absent additional reforms that are designed to improve solvency, the proposed reforms will likely be diminished by the continued accumulation of unfunded—but earned and legally protected—benefits. 

» FULL ARTICLE

Restructuring New Mexico’s PERA Board Would Improve Expertise, Balance Representation Long-Term

In addition to the major contribution rate changes recently enacted in Senate Bill 72, New Mexico legislators considered, but did not enact, legislation that would have restructured the state’s Public Employees Retirement Association (PERA) pension governing board via Senate Bill 201. The reform would have reduced the overall size of the board and improved the representational balance between the pension system’s various stakeholders. In this commentary, Reason’s Anil Niraula, Steven Gassenberger and Leonard Gilroy evaluate the proposal and explain why a new board structure could improve the overall financial expertise and stakeholder representation of the governing body.

» FULL ARTICLE

How Ohio’s Proposed Cost-of-Living Adjustments Would Impact OPERS’ Unfunded Liabilities

Managers of the Ohio Public Employees Retirement System (OPERS) are considering a temporary freeze on cost-of-living adjustments as a way to reduce costs and slow the growth of the $24.4 billion shortfall in funding needed to pay for promised pension benefits. OPERS has yet to release a report on the fiscal impact of such a freeze, but the savings are not expected to be a complete fix to the state’s underfunding struggles. In this commentary, Reason’s Marc Joffe and Anil Niraula detail the likely fiscal impacts of the proposed change and examine why OPERS’ shortfalls, as given in official reports, are likely understated due to overly optimistic investment return assumptions. As a result, the state likely needs much more comprehensive reforms if it wants to resolve its growing pension-related challenges. 

» FULL ARTICLE

When Governments Go Insolvent, Should Others Absorb Their Retirement Plans’ Costs and Risks?

A San Francisco ballot measure, on the city’s March 3 ballot, asks voters if the city can absorb the retirement plans and promises of an insolvent housing authority. If passed, the city would take on the responsibility of funding retirement promises that were made and guaranteed by the now-nonexistent government authority. Reason’s Marc Joffe notes that while the actual impact of this decision is likely relatively minor due to the small number of pension accounts being transferred, the issue does raise important questions about the fairness of larger government —and taxpayers— taking on the pension obligations of struggling smaller government entities.

»FULL ARTICLE

News in Brief

Calm Amid the Chaos: Wisconsin’s Pension System and the 2008 Financial Crisis: 
The 2008 financial crisis had a detrimental effect on the funded levels of many state and local pension plans. Many public pension plans were forced to initiate reforms in order to recover from the impact of the financial crisis and recession. Anthony Randazzo and Scott Alexander of the Equable Institute have written a paper examining the steps Wisconsin took in order to reach full funding. They detail how Wisconsin implemented a number of important reforms, such as mandatory funding, to fully meet actuarial standards, as well as structuring the board in ways that help insulate it from politics. The paper can be found here. 

An Introduction to Police and Fire Pensions:
Local governments are generally held responsible for providing police and fire-fighting services. However, the fiscal stress of hiring personnel has risen due to the growing price of providing public retirement plans. Jean-Pierre Aubrey and Kevin Wandrei of the Center for Retirement Research at Boston College have released their latest brief on providing for retirements for these workers. They find that while public safety retirement plans are more costly than other workers due to early retirements, the plans are generally significantly smaller than general employee plans and do not make up a majority of local government spending. The brief can be found here. 

The Pension Debt Levels of Illinois’ State and Local Governments:
The Illinois state government, and local governments across the state, are not contributing enough to their pension plans, according to a white paper by the Institute for Illinois Public Finance. The author, Kenneth Kriz, director of the institute, concludes “current contributions are insufficient to pay off their unfunded liability debt in the timeframe that Illinois law requires.” He also argues that the assumptions built into the actuarial analyses are overly optimistic. The white paper can be found here. 

Quotable Quotes

 “A stable and solvent PERA matters to all New Mexico taxpayers. We must make changes now – the alternative is to saddle New Mexicans with unacceptable risk. I want to thank senators of both parties for recognizing the essential nature of this reform and the shared sacrifice required to ensure New Mexico’s pension plan remains the finest in the country.”

—New Mexico Gov. Michelle Lujan-Grisham, quoted in a press release, Feb. 12, 2020.

“It’s a great year and it helps absolutely, but it doesn’t solve the problem.  Market returns alone aren’t going to improve pension funding significantly.”

—Karen Carraher, executive director of Ohio Public Employees Retirement System (OPERS), commenting on the system’s 2019 returns in “Your OPERS benefit cuts questions answered,” The Columbus Dispatch, Jan. 16, 2020.

“People are living longer and working longer and the minimum retirement age was set decades ago. The biggest recruiting issue for state employees I hear is pay, not benefits. Lowering the cost of the pension system will lower contribution rates for both taxpayers and employees, raising take-home pay.”

—Duey Stroebel, Wisconsin state senator, quoted in “Proposed bill would raise the retirement age for teachers, public workers,” WIProud, Jan. 31, 2020.

“A deputy with a $40,000 salary is an $80,000 employee… For a small county like us, it’s a huge deal. If you look at the primary property tax – we bring in about $2.8 million. A third of that’s going to just the excess state retirement payments.”

—Apache County Manager Ryan N. Patterson discussing the high cost of pension payments in “Pension woes haunt county, town budgets,” White Mountain Independent, Feb. 11, 2020.

Featured Chart

Each month we feature a pension-related chart or infographic of interest. This week we looked at the aggregate funded ratio and employer contribution for teacher pension plans across the country. 

Contact the Pension Reform Help Desk

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

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Current PERA COLA Policy Is Flawed

• A cost-of-living-adjustment (COLA) is meant to protect the purchasing power of retirees’ pension, but PERA’s current fixed 2 percent compounded policy is flawed.
• Being locked to a fixed rate instead of floating with inflation, PERA’s current policy effectively acts as an automatic benefit increase untethered to any actual change in consumer prices throughout the economy.
• The proposed profit-sharing COLA structure, along with other COLA changes, offers PERA a more sustainable approach and helps increase the likelihood of achieving full funding by 2043 according to the Governor’s Solvency Task Force.

A Pragmatic COLA Solution

• Transitioning to a COLA based on the performance and health of the fund as included in Senate Bill 72 is the same approach used in other pension plans able to maintain full funding despite economic volatility.
• Actuarial modeling by the Pension Integrity Project at Reason Foundation finds that:
  • The reformed COLA is likely to produce annual benefit increases in the 1.2 percent – 2.4 percent range over the 2023-49 period.
  • 50 percent — Probability the proposed COLA would average at least 1.7 percent annually through 2049, consistent with the PERA actuary’s 1.64 percent COLA projections.
  • 37 percent — Probability that the proposed COLA would average out to 2.0 percent or above over the 2023-2049 period.

Takeaway: Senate Bill 72 aligns PERA benefit adjustments with other fully-funded state pension plans and provides robust protections for retirees against inflation.

PERA’s Redesigned COLA Provides Retirees Inflation Protection and Improved Sustainability

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This column was co-written by Paul Gessing, president of New Mexico’s Rio Grande Foundation.

In the weeks leading up to the 2020 legislative session, an all too rare alignment has occurred in New Mexico — the governor, legislators from both parties, labor and taxpayer representatives, plan managers and other stakeholders in Santa Fe all agreed that it is time to reform the state’s largest public pension system.

The post Key Stakeholders Agree It’s Time to Reform the New Mexico’s Largest Public Pension System appeared first on Reason Foundation.

PERA is currently governed by a 12-member Board of Trustees. Ten members are either active or retired state or local employees and almost all are elected by PERA members. New Mexico’s secretary of state and state treasurer also serve as ex officio members but participate little in the daily management of the PERA system.

The proposed bill would reduce the number of trustees from 12 to nine, while also reducing the share of trustees elected by plan participants—and would require reconstituting the board with new appointees upon passage.

While the current composition ensures that active employee and retiree interests are well represented on the board, the current governing structure may not provide the overall stakeholder balance nor the financial and technical skills generally expected of fiduciaries managing over $15 billion in assets and a $6 billion debt owed to public employees.

In fact, according to the Hoover Institution, having a large number of member-elected trustees on the pension board is proven to have a strong negative correlation to a plan’s investment performance. The report finds:

Funds whose boards have high fractions of members who either sit on the board by virtue of their position in state government (ex officio) or were appointed by a state official underperform the most, followed by funds whose boards have a high fraction of members elected by participants.

Similarly, the Center for Retirement Research at Boston College found a positive relationship between the best board composition practices (e.g., having a single fiduciary board, no more than 70 percent active and retired members, at least two members with actuarial or financial expertise, and more) and plans’ 10-year investment returns.

A 2017 study by three prominent academics found that alternative investments (e.g., private equity, hedge funds, real estate, etc.) by public pension plans tend to consistently underperform if their boards of trustees are dominated either by state officials or by trustees elected by plan participants.

As such, the characteristics of pension boards—meaning their structure, composition, experience, size, and tenure—matter. Having financial expertise balanced with broad stakeholder/retiree representation involved in the decision-making process contributes to better board performance, at least in the crucial metric of investment returns.

Importantly, the New Mexico proposal enlists more trustees with skills in retirement investments or retirement plan management and creates the conditions for more balanced stakeholder representation.

If passed, the PERA board would be reconstituted with new members, and all newly appointed board trustees would be required to “have skill, knowledge, and experience in financial matters.”

The reconstituted PERA Board of Trustees would consist of:·

• Four active employee members participating in the state general and municipal general plans,
• Two retired PERA members,
• New Mexico’s secretary of finance and administration (replacing the secretary of state and state treasurer), and
• Two new non-PERA members that have “skill, knowledge, and experience in retirement investment products or retirement plan designs.”

By increasing the financial expertise on PERA’s governing board and expanding the non-member share of board representation, the proposed legislation offers the promise of improving the experience and oversight capabilities of PERA’s governing board, which in turn is likely to result in improved plan solvency over time.

There would likely be an infusion of fresh perspectives on the board to inform many of the financially pressing topics that will inevitably come before them. And the boost in financial and investment acumen among trustees is expected to improve their ability to navigate complex pension funding challenges, thereby helping keep PERA on course to full funding.

Below we present a breakdown of how well the proposed PERA reform meets the Pension Integrity Project’s reform objectives:

Does the Proposed New Mexico PERA Pension Board Legislation Meet the Objectives for Good Pension Reform?

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