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

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

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

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

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

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

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

Makeup of Montana TRS Contributions

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

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

What Drives Montana TRS Pension Debt?

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

Challenge 1: Assumed Rate of Return

Investment Return History, 2001- 2020

Investment Returns Have Underperformed

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

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

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

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

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

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

Expanding Risk in Search for Yield

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

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

TRS Assumptions & Experience

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

Short-Term Market Forecast

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

Long-Term Market Forecast

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

Important Funding Concepts

Employer Contribution Rates

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

All-In Employer Cost

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

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

Baseline Rates

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

Risk Management

Stress Testing TRS Using Crisis Simulations

Stress on the Economy:

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

Methodology:

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

Scenario Comparison of Employer Costs

How a Crisis Increases TRS Cost

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

Unfunded Liabilities Under Crisis Scenarios

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

TRS Solvency Under Crisis Scenarios

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

All Paths to a 7.5% Average Return Are Not Equal

Long-Term Average Returns of 7.5%

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

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

Challenge 2: Deviations and Changes to Actuarial Assumptions and Methods

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

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

Actuarial Assumption and Methods

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

Salary Increase Assumptions

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

Withdrawal Rate, Service Retirement, and Mortality Assumptions

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

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

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

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

Overestimated Payroll Growth

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

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

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

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

Challenge 3: Insufficient Contributions & Debt Management Policies

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

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

Challenge 4: Discount Rate and Undervaluing Debt

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

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

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

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

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

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

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

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

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

Sensitivity Analysis: Pension Debt Comparison Under Alternative Discount Rates

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

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

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

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

Recruiting a 21st Century Workforce:

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

Retaining Employees:

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

A Framework for Policy Reform

Objectives

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

Pension Resiliency Strategies

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

Potential Solutions

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

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

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

Rethink amortization in two steps:

Step 1: Address the Current Unfunded Liability

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

Step 2: Develop a Plan to Tackle Future Debt

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

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

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

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

Improve risk assessment and actuarial assumptions.

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

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

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

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

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

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

Montana Teacher Retirement System (TRS) Pension Solvency Analysis

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

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

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

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

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

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

Challenges Facing ERS

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

Challenge 1: Assumed Rate of Return

Unrealistic Expectations

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

Underpricing Contributions

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

Investment Returns Have Underperformed

ASRS actuaries have historically used an 8% assumed rate of return to calculate benefit cost to members and employers despite significant market changes, only lowering the rate to 7.5% in 2018. • Average long-term portfolio returns have not matched long-term assumptions over different periods of time:

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

New Normal: The Market Has Changed

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

1. Over the past two decades there has been a steady change in the nature of institutional investment returns. 30-year Treasury yields have fallen from around 8% in the 1990s to consistently less than 4% today. New phenomenon: negative interest rates, designates a collapse in global bond yields. The U.S. experiences the longest economic recovery in history, yet average growth rates in GDP and inflation are below expectations.
2. McKinsey & Co. forecast the returns on equities will be 20% to 50% lower over the next two decades compared to the previous three decades. Using their forecasts, the best-case scenario for a 70/30 portfolio of equities and bonds is likely to earn around 5% return.
3. ASRS had yet to recover from the Great Recession, and now it will be dealing with high economic uncertainty and volatility in the wake of COVID-19.

Risk Assessment

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

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

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

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

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

Challenge 2: Amortization Methods

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

What is level percent of payroll amortization?

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

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

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

What does a long amortization period mean?

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

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

Challenge 3: Uncovering Hidden Costs

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

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

New Member Rate Assumptions

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

Withdrawal Rate Assumptions

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

Disability Rate Benefits

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

Active Mortality Rate Benefits

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

Age and Service Retirement

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

Other Missed Assumptions

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

Inactive Mortality Rate Benefits

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

Overestimated Payroll Growth

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

Overestimated Payroll Growth

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

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

Actual Change in Payroll v. Assumption

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

Challenge 4: Discount Rate & Undervaluing Debt

The ASRS discount rate methodology is undervaluing liabilities.

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

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

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

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

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

• Arizona Constitution—Article 29

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

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

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

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

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

A Framework for Policy Reform

Objectives

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

Pension Resiliency Strategies

1. Adopt better funding policy, risk assessment, and actuarial assumptions. Lower the assumed rate of return to align with independent actuarial recommendations. These changes should aim at minimizing risk and contribution rate volatility for employers and employees.
2. Establish a plan to pay off the unfunded liability as quickly as possible. The Society of Actuaries Blue Ribbon Panel recommends amortization schedules be no longer than 15 to 20 years. Reducing the amortization schedule would save the state billions in interest payments.
3. Review current plan options to improve retirement security. Consider offering additional retirement options that create a pathway to lifetime income for employees that do not stay in public service.

Potential Solutions

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

Risk Assessment and Actuarial Assumptions:

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

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

Current amortization time horizons are too long:

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

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

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

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

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

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

Employees should have a choice to select a retirement plan design that fits their career and lifestyle goals:

• Cash balance plans can be designed to provide a steady accrual rate, offer portability, and ensure a path to retirement security.
• Defined contribution plans can be designed to auto-enroll members into professionally managed accounts with low fees that target specified retirement income and access to annuities

Full Arizona State Retirement System Solvency Analysis  

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

The Florida Retirement System manages retirement benefits for almost 648,000 active members and over 584,000 retirees in the state and is comprised of a traditional pension plan and a defined contribution retirement plan option called the FRS Investment Plan.

Two decades ago the retirement system held a surplus of over $13 billion in assets and stood at 118 percent funded. Today, FRS finds itself $36 billion in debt with only 82 percent of the assets on hand needed to pay out benefits over the long-term, which represents a net change in position of almost $50 billion in just 20 years.

Investment returns falling short of the system’s expectations have been the largest contributor to the Florida Retirement System’s growing debt, adding $16.4 billion in unfunded liabilities since 2008.

The chart below shows the increase in the Florida Retirement System’s debt since the year 2000:

Despite pension reform efforts in 2011 and 2017, structural deficiencies within FRS continue to risk the retirement security of employees and retirees. The 2011 legislative effort reduced retirement benefits for employees and while such a change did lower some costs, it did not fundamentally address why pension debt continues to grow. Similarly, defaulting new FRS members into the Investment Plan in 2018 was a move that better aligned with workforce mobility trends and reduced future financial risks, but it did not address why the system’s pension debt has persisted for a decade.

Furthermore, the FRS Investment Plan is no closer to providing retirement security for Florida’s public retirees than the debt-riddled FRS Pension Plan, as it relies on contribution rates that fall far below industry standards for adequate retirement benefits. Industry experts estimate that 10 to 15 percent of annual income should be required as a contribution to a defined contribution retirement to provide adequate retirement income for public workers. FRS’s aggregate 6.3 percent contribution falls well short of this standard.

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

Current Retirement Option Sets

FRS Pension Plan

• Type: Final Average Salary Defined Benefit Pension Plan
• Final Average Salary: Average of the 8 highest years
• Multiplier: 3%
• Vesting: 8 years
• Normal Retirement Eligibility: Any age @ 33 YOS or vested by age 65
• Regular Member Contribution:
  • 3.09% for Normal Cost
  • 4.30% for Unfunded Liability Payment (beginning FY2019-20)
• Employee Contribution: 3%

FRS Investment Plan

Default option as of January 1, 2018

• Type: Defined Contribution Retirement Plan
• Employee Contribution: 3%
• Employer Contribution:
  • 3.3% to member IP account
  • 3.56% to legacy FRS Pension Plan unfunded liabilities
• Vesting: 1 year
• Investment Options:
  • Investment Funds
  • Target Date Funds
• Default Investment Strategy: Target Date Funds

Reviewing Prior Reforms

Major Reforms to FRS

2000 – House Bill 2393

• Provided a defined, participant-directed contribution (DC) plan option to FRS members.
• One-year vesting for the portability of employer contributions.
• Based retirement benefits on market returns rather than a fixed benefit guarantee.
• Existing members given the option to switch future FRS participation into the DC plan without losing their already earned pension benefits.

2011 – Senate Bill 2100

• Created a new benefit tier for “special-risk” new hires.
• Renamed the FRS defined benefit plan the Florida Retirement System “Pension Plan.”
• Renamed the FRS defined contribution plan from the Public Employee Optional Retirement Program to the Florida Retirement System “Investment Plan.”
• Eliminated post-retirement increases on pension benefits earned after July 2011.
• Decreased both employer and employee contribution rates effective July 2012.
• Led to unfunded accrued liabilities decreasing from $16.7 billion to $15.6 billion.

2017 – Senate Bill 7022

• Defaults new employees hired after January 2018 into the FRS Investment Plan (DC plan) if no election taken after eight months of employment.

Previous Reforms Have Not Set the FRS on a Path to Sustainability

• The historic 10-year bull market has not helped FRS recover.
• The 2008 financial crisis weakened FRS’s funded status, but since then markets have recovered while pension funding has not.
• Reducing benefits in 2011 reduced some costs at the expense of inflation protection for retirees, but it did not fundamentally address why pension debt continues to grow.
• Defaulting new FRS members into the Investment Plan in 2018 was better aligned with workforce mobility trends and reduced future financial risk, but it did not address why pension debt has persisted for a decade.
• For three straight years (2016, 2017 & 2018) FRS’s consulting actuary has warned that the assumed rate of return is not reasonable.
• Additional reforms are necessary to ensure long-term solvency.

FRS Remains Unsustainable Despite Recent Reforms

Challenge #1:

FRS Defined Benefit Pension Plan Still Not on a Path to Solvency

• Overly optimistic assumed rate of return creates unnecessary risk.
• Unmet actuarial assumptions and slow-paced changes to those assumptions increases unfunded liabilities over time.
• Insufficient employer contributions inhibits plan assets from compounding growth over decades.
• Discount rate misaligned with risk, underpricing pension cost and undervaluing FRS unfunded liabilities.

Challenge #2:

FRS Defined Contribution Retirement Plan Not Built for Retirement Security.

• An inadequate contribution rate is shortchanging worker retirement security.

Challenge 1: FRS is Still Not on a Path to Long-Term Solvency

Driving Factors Behind FRS Pension Debt

• Changes to Actuarial Methods & Assumptions to better reflect current market and demographic trends have exposed over $16.6 billion in previously unrecognized unfunded liability.
• Deviations from Investment Return Assumptions have been the largest unintended contributor to the unfunded liability, adding $16.4 billion since 2008.
• Insufficient Contributions contributed $1.8 billion to FRS unfunded liability since 2008.
• Undervaluing Debt through discounting methods has led to the tacit undercalculation of required contributions.

Overly Optimistic Assumed Rate of Return

Unrealistic Expectations: Despite the recent change to 7.0%, the Assumed Investment Return for FRS continues to expose taxpayers to significant investment underperformance risk.

Underpricing Contributions: The use of an unrealistic Assumed Return has likely resulted in underpriced Normal Cost and an undercalculated Actuarially Determined Contribution.

FRS Actuaries on Current Return Assumption

• All models developed in 2017 by Milliman and Aon Hewitt had 50th percentile geometric average annual long-term future returns in the 6.6%-6.8% range.
• Models developed in 2018 by Milliman and Aon Hewitt show the average annual long-term future returns in the 6.4-6.7% range, yet FRS Actuarial Assumption Conference adopted a 7.4% return assumption.
• Presenters at the 2020 FRS Actuarial Conference suggested return assumptions within the range of 6.46% (Aon) to 6.56% (Milliman), with a lower inflation assumption of 2.1% to 2.2% relative to the previous conference assumption of 2.6%.
• The 2020 FRS Actuarial Assumption Conference adopted a 7.0% return assumption.

Investment Return History 1996-2020

Investment Returns vs. Assumptions

• FRS historically assumed an investment return rate as high as 8.00% before lowering the assumption to 7.75% in 2004. The plan has adjusted the assumption annually since in 2014, to reach the current 7.0% for 2021.
• FRS expanded investments in high-risk holdings in a search for greater investment returns over the past decade.
• The FRS Pension Plan investment portfolio’s trends have not matched longterm assumptions:

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

FRS Funded Ratio Did Not Recover Despite a Historic Decade for the Stock Market

New Normal: The Market Has Changed

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

1. Over the past two decades there has been a steady change in the nature of institutional investment returns. 30-year Treasury yields have fallen from near 8% in the 1990s to consistently less than 3%. New phenomenon: negative interest rates, designates a collapse in global bond yields. The U.S. just experienced the longest economic recovery in history, yet average growth rates in GDP and inflation are below expectations.
2. McKinsey & Co. forecast the returns on equities will be 20% to 50% lower over the next two decades compared to the previous three decades. Using their forecasts, the best-case scenario for a 70/30 portfolio of equities and bonds is likely to earn around 5% return.
3. The FRS Pension Plan 5-year average return is around 6.48%, well below the assumed 7% return assumption.

Expanding Risk in Search for Yield

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

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

FRS Assumptions & Experience

• A probability analysis of FRS historical returns over the past 20 years (2000-2020) indicates only a modest chance (28%) of hitting the plan’s 7.0% assumed return.
• FRS’s own investment return assumptions imply a 43% chance of achieving their investment return target over the next 20 years.

Short-Term Market Forecast

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

Long-Term Market Forecast

• Longer-term projections typically assume FRS investment returns will revert back to historical averages.
  • The “reversion to mean” assumption should be viewed with caution given historical changes in interest rates and a variety of other market conditions that increase uncertainty over longer projection periods, relative to shorter ones.
• Forecasts showing long-term returns near 7.0% likely also show a significant chance that the actual long-term average return will fall far shorter than expected.
  • For example, according to the BlackRock’s 20-year forecast, while the probability of achieving an average return of 7.0% or higher is about 56%, the probability of earning a rate of return below 5.5% is about 26%.

Risk Assessment

How resilient is FRS to volatile market factors?

Important Funding Concepts

Statutory rates are more susceptible to the political risk inherent to the legislative process and often result in systemic underfunding, especially when legislatively established rates fall short of what plan actuaries calculate as necessary to ensure funding progress.

Employer Contribution Rates

• Statutory Contributions: Annual payments usually based on rates set in state statute, meaning contributions remain static until changed by legislation.
• Actuarially Determined Employer Contribution (ADEC): Unlike statutory contributions, ADEC is the annual required amount FRS’s consulting actuary has determined is needed to be contributed each year to avoid growth in pension debt and keep ERS solvent.

All-in Employer Cost

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

Baseline Rates

• The baseline describes FRS current assumptions using the plan’s existing contribution and funding policy and shows the status quo before the 2020 market shock.

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

Stress Testing FRS Using Crisis Simulations

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

If you assume FRS will achieve an average six percent rate of investment return over the next 30 years plus experience one financial crisis in this time, analysis shows that the pension plans unfunded liability would spike to $80 billion before the year 2050.

This likely economic scenario would cost the state almost $120 billion more in pension contributions than what they currently plan to spend on the plan.

Seeing as FRS only averaged a 5.62 percent market valued investment return rate between 2000 – 2019, and that we have seen two major economic crisis in the last 20 years, it is reasonable to assume the next 30 years will look somewhat similar.

An additional $120 billion in pension costs would put significant strain on the state budget.

Stress on the Economy:

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

Methodology:

• Adapting the Dodd-Frank stress testing methodology for banks and Moody’s Investors Service recession preparedness analysis, the following scenarios assume one year of -24.6% returns in 2020, followed by three years of 11% average returns.
• Recognizing expert consensus regarding a diminishing capital market outlook, the scenarios assume a long-term investment return of 6% once markets rebound.
• Given the increased exposure to volatile global markets and rising frequency of Black Swan economic events, we include a scenario incorporating a second Black Swan crisis event in 2035.

Outdated and Aggressive Actuarial Assumptions and Methods

• Deviations between actuarial experience and assumptions, and delays updating those assumptions, has led to an underestimation of the total FRS Pension Plan liability.
• Adjusting actuarial assumptions to reflect the changing demographics and new normal in investment markets exposes hidden pension cost by uncovering existing but unreported unfunded liabilities.
• If aggressive assumptions continue to misprice pension benefits, FRS experience will continue to deviate from the plan’s expectations and allow for the continued growth of unfunded liabilities.
• Generally, each assumption used by plan actuaries to calculate the cost of benefits over time come with the inherent risk of being wrong any given year resulting in unfunded liabilities.
• When an assumption is off, and assets actuaries were expecting from a given source are not contributed to make up the difference, the plan passively accrues unfunded.
• When an assumption is deliberately adjusted in a way that increases the probability of the expected outcome, cost hidden in the assumption are exposed, resulting in unfunded liabilities increasing in exchange for a more stable assumption and contribution rate.

Insufficient Contributions

Imprudent Funding Policy is Creating Structural Underfunding for FRS

1. From 2011-2013, FRS employer contributions failed to meet the actuarially determined contribution (ADC), increasing the Unfunded Actuarial Liability by $2.45 billion.
2. In 7 of the past 17 years, employer contributions have been less than the interest accrued on the pension debt (e.g., negative amortization), which allowed for the unfunded liability to grow in absolute terms.
3. The 30-year period FRS uses to pay off unfunded liabilities is greater than the Society of Actuaries’ recommended funding period of 15 to 20 years, resulting in higher overall costs for the plan. Due to the long 30-year closed amortization schedule used to pay off the annual unfunded liability employer pension contributions have not always kept up with the interest accrued on the pension debt.

Actual v. Required Contributions

Negative Amortization: Understanding the Current Funding Policy

• From 2011-2013, FRS employer contributions failed to meet the actuarially determined contribution (ADC), increasing the Unfunded Actuarial Liability by $2.45 billion.
• Starting in the 1998 actuarial valuation, the Legislature required all UAL bases in existence to be considered fully amortized, since the plan was in a surplus position.
• As part of the funding policy selected by the Florida Legislature, the actuarially calculated contribution rate is based on a “layered” approach that includes closed 30-year charge and credit bases for the amortization of any accrued UAL.
• The Unfunded Actuarial Liability (UAL) is amortized as a level percentage of projected payroll on which UAL rates are charged in an effort to maintain level contribution rates as a percentage of payroll during the specified amortization period if future experience follows assumptions.

Negative Amortization Growth (2009-2020)

Discount Rate & Undervaluing Debt

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

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

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

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

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

• State law requires protection of pension benefit payouts. Florida State Statutes § 121.011- 121.40; 121.4501-121.5912 & Florida Administrative Code 60S-4

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

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

Sensitivity Analysis: Pension Debt Comparison Under Alternative Discount Rates

Change in the Risk-Free Rate Compared to FRS Discount Rate (2001-2020)

Challenge 2: FRS Defined Contribution Plan is Not Built for Security

FRS Defined Contribution Plan Overview

The FRS defined contribution retirement plan—the FRS Investment Plan—is the state’s current default (as of 2018).

• Members are vested after one year of service in the FRS Investment Plan.

Employees may choose to receive their account balance at the end of employment as a lump sum or take periodic withdrawals either on-demand or by a pre-determined payout schedule.

The FRS Investment Plan has shown consistent growth since its introduction in 2002.

•  FRS Defined Contribution Plan members currently account for nearly 23% of total FRS membership and 26% of total FRS payroll.

The Legislature can increase or decrease the amount employers and employees contribute to plan members’ accounts.

FRS Investment Plan Funding

Current FRS Investment Plan contribution breakdown:

Best practice says employers should continue making payments towards their legacy pension debt as if all new hires were still entering the Pension Plan.

Inadequate Contribution Rates are Jeopardizing Retirement Security

• The aggregate 6.3% FRS Investment Plan contribution rate falls far below industry standards for retirement benefit adequacy.
• Industry leaders, retirement experts and independent studies consistently estimate 10% to 15% of annual income to be required to provide adequate retirement income.
• For regular plan members alone contribution rates need to rise at least 400 basis points to provide retirement security.
• Higher contribution rates may be required for older workers to achieve adequate savings for retirement due to chronic underfunding.

FRS Investment Plan – Gold Standard Score

A Framework for Policy Reform

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

Defined Contribution Reform Best Practices

1. Adopt Better Risk Assessment and Actuarial Assumptions

• Lower the assumed rate of return to align with independent actuarial recommendations.
• These changes should aim at minimizing risk and contribution rate volatility for employers and employees.

2. Establish A Plan To Pay Off The Unfunded Liability As Quickly As Possible

• The Society of Actuaries Blue Ribbon Panel recommends amortization schedules be no longer than 15 to 20 years.
• Reducing the amortization schedule would save the state billions in interest payments.

3. Review Current Plan Options To Improve Retirement Security

• Consider offering additional retirement options that create a pathway to lifetime income for employees that do not stay in public service.

4. Adopt Better Funding Policy

• Financial experts strongly recommend contributions 10 to 15 percent of pre-tax earnings into a retirement account.
• Older workers with a closer retirement horizon and inadequate savings may need to contribute even more.

5. Encourage Use of Target Date Funds

• Well-designed DC plans should also offer the correct age-appropriate investment mix. This is generally accomplished by using target date funds that adjust investment risk to the employee’s retirement horizon to protect the value of the account from market fluctuations as the worker nears retirement.

6. Encourage Use of Annuities for Improved Retirement Security

• The mix of proprietary investment funds and reasonably priced target-date funds give participants adequate “one-choice” options. However, without guaranteed investments included in the target-date portfolio constructions and deferred annuities the FRS Investment Plan will continue to limit a members’ financial flexibility.
• Despite a lifetime annuity option being available to members, generally the distribution choices offered by the FRS Investment Plan limit its attractiveness as a true, core retirement option.

Full Florida Retirement System Pension Solvency Analysis 

The post Florida Retirement System (FRS) Solvency Analysis appeared first on Reason Foundation.

With $14.7 billion in unfunded liabilities, the retirement security of state employees and retirees may be in jeopardy. Even the system’s own actuaries have warned that “there is a strong possibility that Texas ERS will become insolvent in a 30 to 40 year timeframe which is within the current generation of members.” This very real threat is the result of two decades of underperforming investments, insufficient contributions, and undervalued pension promises. The shocking growth of the Employees Retirement System’s debt can be seen below.

The $14.7 billion in unfunded benefits earned and owed to ERS members and retirees have driven up pension costs, which are ultimately borne by taxpayers and members alike. Furthermore, underperforming investments and growing liabilities have led to Texas reaching its constitutionally set cap on annual contributions. The cap on state contributions does not stop members from accruing benefits, however.

Challenges Facing ERS

• Deviations from Investment Return Assumptions have been the largest contributor to the ERS unfunded liability, adding $8.43 billion since 2001.
• Extended Amortization Timetables and Statutory Contribution Limits have resulted in interest on ERS debt exceeding the actual debt payments (negative amortization) since 2001 and a net $4.46 billion increase in the unfunded liability.
• Deviations from Demographic Assumptions including deviations from withdrawal, retirement, disability, and mortality assumptions — added over $1.5 billion to the unfunded liability since 2001.
• Changes in Actuarial Methods & Assumptions have exposed over $2 million in previously unrecognized unfunded liabilities over the last decade.
• Undervaluing Debt through discounting methods has led to the tacit undercalculation of required contributions on the part of the state.

Assumed Rate of Investment Return

Unrealistic Expectations

Despite recently lowering the investment return assumption to 7.0 percent, Texas ERS remains exposed to significant investment underperformance risk.

Underpricing Contributions

The current investment return assumption leads to underpricing benefits and an under-calculated actuarially determined contribution rate.

Investment Returns Have Underperformed for Years

• ERS Texas actuaries have historically used an 8 percent assumed rate of return to calculate member and employer contributions, slowly lowering the rate to 7 percent over the past two decades in response to significant market changes.
• Average long-term portfolio returns have not matched long-term assumptions over different periods of time: Note: Past performance is not the best measure of future performance, but it does help provide some context to the challenge created by having an excessively high assumed rate of return.

New Normal: The Market Has Changed

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

• Over the past two decades, there has been a steady change in the nature of institutional investment returns. 30-year Treasury yields have fallen from near 8 percent in the 1990s to consistently less than 3 percent. Read more: Why Low-Interest Rates Are Bad for Public Pension Plans. The U.S. just experienced the longest economic recovery in history, yet average growth rates in GDP and inflation are below expectations.
• McKinsey & Co. forecast the returns on equities will be 20 percent to 50 percent lower over the next two decades compared to the previous three decades. Using their forecasts, the best-case scenario for a 70/30 portfolio of equities and bonds is likely to earn around 5% return.
• ERS consulting actuary comments:
  “[…] if the investment experience had met the current assumptions over the last 20 years, ERS would effectively be fully funded […]”
  “[…] actual returns have not been available in the market to meet the assumption.”Source: Texas ERS CAFRs and *2019 valuation report, page 8.

Risk Assessment & State Budget

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

If you assume the current economy does not fully recover until 2023, and also predict an additional downturn sometime between 2035 and 2038, as well as a 6 percent rate of investment return over the next 30 years, analysis shows that Texas ERS’s unfunded liability would equal $64 billion in the year 2050. Currently, the state assumes that the plan’s unfunded liabilities will increase to only $26.8 billion by 2050.

Seeing as ERS Texas only averaged a 5.83 percent investment return rate between 2000  and 2019 and that we have seen two major economic crises in the last 20 years, it is reasonable to assume the next 30 years will look somewhat similar.

If this is the case, our projections show that the cost of the pension plan would increase to nearly 25 percent of employer payroll, putting significant strain on the state budget.

Texas State Constitution Limits Contributions

Texas Constitution Article 16, Section 67(b)(3) caps state contributions to Texas ERS at 10 percent of payroll, which can only be exceeded under an emergency declaration and requires that benefits should be financed in a way that is consistent with best practices.

The definition of actuarially sound principles is not expressly defined in the Texas Constitution, however, The Society of Actuaries Blue Ribbon Panel has outlined pension best practices, such as ensuring the amortization schedule is less than 30-years and paid off over a fixed period.

The need for higher contributions is likely to be on-going for at least the next 20 to 30 years. Thus, the use of an emergency clause would likely not be a viable solution should the legislature desire to contribute above the 10 percent of payroll cap on contributions.

Insufficient Contributions & Pension Debt Management

State Statutes Have Created a Structural Underfunding Challenge for Texas ERS:

• Over the past 18 years, statutory employer contributions have routinely fallen below actuarially determined contribution (ADC) rates.
• Employer contribution rates determined by legislative statute are not enough to keep up with the actual amount necessary to amortize the debt.
• 2019: Employer ADEC v. Statute
  • Statutory Employer Contribution: 10 percent of payroll
  • Actuarially Determined Employer Contribution: 15.98 percent of payroll

With the employer contribution rate fixed in statute and a 31-year, open amortization policy, Texas ERS now faces an infinite amortization period, meaning it is not projected to ever pay off its unfunded liabilities.

Actuarial Assumptions & Methods

Flawed Contribution and Debt Management Policies

Setting contribution rates in the statute that are below ADEC and using optimistic return assumption resulted in interest on ERS Texas debt exceeding the actual debt payments (aka negative amortization) and have added a net $4.46 billion increase in the unfunded liability since 2001.

Changes in Actuarial Assumptions and Methods

ERS Texas made alterations to its actuarial assumptions (e.g. changes in the assumed rate of return in 2017) that have collectively unveiled $2 billion of hidden unfunded liabilities from 2001-2020.

Deviations from Service Retirement and Other Demographic Assumptions

ERS’s unfunded liability has increased by $1.45 billion between 2001-2020 due to misaligned demographic assumptions, which include deviations from the plan’s withdrawal, retirement, disability, and mortality assumptions.

Overestimated Payroll Growth

ERS employers have not raised salaries as fast as expected, resulting in lower payrolls and thus lower earned pension benefits. This has meant a reduction in unfunded liabilities of $1.1 billion from 2001 to 2019.

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

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

Discount Rate & Undervaluing Debt

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

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

Setting a discount rate too high leads to undervaluing the amount of accrued pension benefits:

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

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

Article 16, § 66(d) of the Texas Constitution protects against impairment or reduction of accrued pension benefits “[A] change in service or disability retirement benefits or death benefits of a retirement system may not reduce or otherwise impair benefits accrued by a person…”

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

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

The Existing Benefit Design Does Not Work for Everyone

The turnover rate for members of ERS suggests that the current retirement benefit design is not supporting goals for retention.

64 Percent of new ERS Texas members hired at age 25 leave before 5 years

• Regular State employees must work 5 years before their benefits become vested.
• Members who leave the plan before then must forfeit contributions their employer made on their behalf.
• Another 19 percent of new members still working after 5 years will leave before 15 years of service.

Recruiting a 21st Century Workforce

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

Retaining Employees

• If worker retention is a goal of the ERS Texas system, it is clearly not working, as nearly 65% of employees leave within 5 years.
• After 20 to 30 years of service, there is some retention effect, but the same incentives serve to push out workers in a sharp drop off after 30 years of service or reaching the “Rule of 80” threshold.

Framework & Solutions for Reform

Pension Integrity Project Policy Objectives

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

Practical Policy Framework

1. Adopt better funding policy, risk assessment, and actuarial assumptions. Lower the assumed rate of return to align with independent actuarial recommendations. These changes should aim at minimizing risk and contribution rate volatility for employers and employees.
2. Establish a plan to pay off the unfunded liability as quickly as possible. The Society of Actuaries Blue Ribbon Panel recommends amortization schedules be no longer than 15 to 20 years. Reducing the amortization schedule would save the state billions in interest payments.
3. Review current plan options to improve retirement security. Consider offering additional retirement options that create a pathway to lifetime income for employees that do not stay in public service.

Full Employee Retirement System of Texas (ERS) Pension Solvency Analysis (March 2021) 

Update 5/19/2021: This post previously stated that 66 percent of new ERS members leave before five years of service. Corrections to our employee attrition calculations now show that 64 percent of new ERS members will leave employment before five years of service.

The post Texas Employee Retirement System (Texas ERS) Pension Analysis appeared first on Reason Foundation.