Advancing Pension Reform in Oklahoma

Like many states in the wake of the Great Recession, Oklahoma has faced rising costs and unfunded liabilities associated with unsustainable defined benefit pensions systems promised to public sector workers upon retirement. But unlike many states, Oklahoma policymakers have taken some bold steps in recent years to address these challenges.

A looming pension crisis began to emerge in Oklahoma in the mid-2000s due to a combination of inadequate funding of state pension plans and a ratcheting up of cost of living adjustments to pension benefits. By 2010, the state’s pension systems faced an estimated $16 billion in unfunded liabilities, and the Pew Center on the States ranked Oklahoma in the bottom five of all states in the nation with a 56% funded ratio.

The financial threat posed by the growing liabilities in the state’s main pension fund for general state employees-the Oklahoma Public Employees Retirement System-has prompted the state legislature to enact two waves of pension reform in recent years:

• First, in 2011, the legislature enacted House Bill 2132 to rein in runaway COLAs and benefits by mandating that any future pension benefit enhancements had to be concurrently funded with cash prior to the granting of the benefit. This legislation significantly reduced the system’s unfunded liability, though it still remained high at $10.6 billion, rising again to approximately $11 billion by 2014.
• Second, in May 2014, the Oklahoma legislature took a more ambitious step toward addressing the state’s looming pension challenges by passing House Bill 2630 (“Retirement Freedom Act”), legislation that will phase out the state’s defined benefit pension system for general employees by requiring all new state workers (except hazardous duty employees) to enroll in a 401(k)-style defined contribution retirement plan starting in November 2015. From that point forward, new hires will contribute between three and seven percent of their salaries into the defined contribution system, with an equal employer match from the state. The new law is estimated to produce $3.8 billion in savings over 30 years. However, the law does not affect the benefits received by current employees and pensioners.

As the chair of the House Pension Oversight Committee and author of HB 2132 and HB 2630, Oklahoma State Representative Randy McDaniel has been the primary architect and champion of Oklahoma’s pension reform efforts. Earlier this month, Reason Foundation Director of Government Reform Leonard Gilroy interviewed McDaniel on what prompted him to take on the issue of pension reform in Oklahoma, how he made the case to policymakers and stakeholders, the specifics of the reforms enacted, pension reform challenges and more.

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Leonard Gilroy, Reason Foundation: Can you describe the financial health of the Oklahoma Public Employees Retirement System (OPERS) prior to the two waves of reform in 2011 and 2014, respectively? What prompted the push for reforms?

Randy McDaniel, Oklahoma State Representative: OPERS is the state’s second largest retirement system. In 2010, the system had a $3.3 billion unfunded liability, and we decided to focus on this system for the new plan design for several reasons.

There had been requests from new members indicating the desire for more mobility and freedom. Historically, the system has experienced a higher turnover ratio than other systems, and the funding sources are clearly defined. Moreover, not only is it a large plan, but it also has a solid funding status, which is important in transition costs debates.

Major pension reform in Oklahoma started in 2011. The signature accomplishment that year was the Truth in Funding Act (HB 2132). In the 1970s, Social Security started granting cost of living adjustments (COLAs), and most states followed suit promptly thereafter. Over time, the issue has become the lack of funding for those new enhancements. Most often, there has been no new funding. As a result, COLAs have been a major factor in the growth of unfunded pension liabilities across the country.

My proposal that became law required any future COLAs to be fully funded upfront. In Oklahoma, the cost for a two percent COLA for all state pension systems is approximately $350 million per authorization. The new funding requirement has obviously made it much more difficult to grant a COLA because the funds have to be appropriated within a balanced budget.

The big picture is the state had over $16 billion in total unfunded liabilities. The actuaries had been correctly assuming that we would pass on an unfunded mandate to the pension system. The costs of the new benefit would then be absorbed by the assets of the system and would make the debt larger.

With the new requirement that COLAs had to be fully funded, the actuaries could remove that assumption. The financial condition was improved by $5.5 billion. All of the systems were greatly improved as a result. When looking specifically at OPERS, it went from a $3.3 billion unfunded liability down to a $1.5 billion unfunded liability by 2013.

Gilroy: From your vantage point as chairman of the House Pension Oversight Committee, the looming pension challenges facing the state may have been relatively clear, but that may not have been the case for many of your colleagues in the legislature less versed in such a complex issue. What steps did you take to build the case for reform?

McDaniel: The first step was the acknowledgment of the problem. For many decades, the majority of members took an “out of sight, out of mind” perspective. The costs were growing and the impact on other funding priorities could not be ignored.

Then there’s the realization that teamwork is needed. Leaders had to work together to find real answers. I focused more on the numbers and the facts as opposed to complaining about the abuses that have taken place. We can’t do anything about the past, but we can prepare for the future.

I aim to treat everyone with respect. We’re talking about people that are serving the state. It’s not any one group’s fault; it’s a combination of everyone involved, as well as the demographics and investment conditions that we face in the modern world. If you explain all the factors, it becomes self-evident that reforms are necessary.

The final issue is tenacity. Reforms were required if we were going to have a sustainable Oklahoma. We could no longer make excuses and turn our backs on a problem that was impacting all of our other funding priorities. There is no substitute for hard work and dedication to mission accomplishment.

Gilroy: Moving to the 2014 reforms, HB 2360 created a defined contribution system for most new state employees starting next year. Can you explain the rationale behind the legislation?

McDaniel: The key attributes are more freedom for employees and less long-term debt for the state. When we break down some of the related issues, I wanted to have a retirement system that was very attractive, but also sustainable. A comprehensive analysis of not only state retirement plans, but also private sector plans, was conducted. The plan has a matching schedule that is competitive with the biggest and best companies in the country.

Since the costs are certain and affordable, this will allow us to continue funding the current defined benefit plan to ensure its financial viability until its debts are paid off.

Gilroy: How will HB 2630 benefit taxpayers and reduce the state’s financial risk? What were the most effective arguments in favor of reform?

McDaniel: When you have a defined contribution plan, there are no new unfunded liabilities created from that point forward. The argument becomes what happens to the existing plan, and we were able to overcome that concern with data illustrating the financial commitment to the existing defined benefit plan, as well as the new retirement system.

An issue that is overlooked in the mathematical data is the issue of political incentives to harm the system by making unsustainable financial promises. Unfortunately, those incentives are real, and they greatly impact the situation we face today. It’s easy to make promises when someone else is going to have to pay for those promises at some point in the future.

So the two great benefits to the taxpayers are: (1) we know what the costs of the new system are going to be and we can plan for it; and (2) it greatly reduces the political situation that has led to the condition we’re in today.

Gilroy: Across the nation, government employee unions tend to line up in opposition to pension reform as a general rule, but in your state, the Oklahoma Public Employees Association did not actively oppose your efforts to reform pensions through HB 2630. How would you explain their position?

McDaniel: We worked diligently to build support with all the groups involved, including the leadership and members of the Oklahoma Public Employees Association. At one point, they opposed the bill which led to other unions joining together in opposition. But in the end, when it became clear that we were willing to fulfill the agreed-upon pay raises, OPEA agreed to not actively oppose the final passage of the bill. This made all the difference in the world because the other groups decided not to get in the way of their pay raises.

Gilroy: What types of opposition to reform did you run into along the way, and how did you address those challenges?

McDaniel: All of the other special interests involved were following the lead set by OPEA. There was initially some great opposition, and every group was ready to join OPEA. But we had a great relationship with OPEA. We met often and listened to their concerns and viewpoints on what it would take to make this an amenable situation. In the end, because we reached an agreement, the other groups backed off.

Gilroy: Some policymakers resist the idea of shifting from a defined benefit to a defined contribution system over fears of high transition costs involved with the switch. Did you have to confront this concern in Oklahoma, and if so, how did you respond?

McDaniel: If a plan is 100 percent funded, it is difficult to argue there are transition costs. The lower the funded ratio of a plan, the more debatable the issue becomes.

When I first authored legislation to move to a defined contribution plan in 2011, behind the scenes we were presented with an outside analysis stating there would be heavy transition costs. We debated the issue, but at the end of the day, it did stop the momentum. Members wanted to wait and take a further look at the issue.

I was well prepared the second time around and had my arguments ready, with an actuarial study supporting our case. If we continued funding at the existing level, there would actually be savings of $3.8 billion over the actuarial amortization period. No one could make a convincing argument otherwise that any alleged transition costs would be harmful to the long-term strength of the system.

Transition costs can be a debatable issue, but I believe the private sector provides a case in point. Private companies wouldn’t be consistently moving to defined contribution plans, if the transition was harmful or costly to their business. That was my defining argument on the subject. Why would thousands of companies be deliberately switching from a defined benefit pension plan to a defined contribution plan if it was costly to their business, or if it was harmful to their recruitment and retention efforts?

Another powerful argument against the reform was the argument that similar reforms did not work in other states like Alaska, West Virginia and Michigan. The actual financial situation was improved in those states because of a transition to a new retirement plan. Other political and funding decisions are separate issues.

During the final debate, I quoted Reason Foundation’s work to rebut the opposition’s claims. In Alaska, for example, the system would have been worse off if the state had not closed their defined benefit plan to new members. I am greatly appreciative of the analysis done at Reason on this issue. There were a lot of important studies that helped along the way, and this report was one of them.

Gilroy: You mentioned having actuarial studies supporting your case for pension reform. Can you describe the role they played?

McDaniel: Our state’s independent actuary has decades of experience with the plans, which leads to credibility since he wasn’t hired by the new majority party. At the end of the day, his office was not prepared to have a full-blown actuarial analysis of the bill, but his decision on whether our legislation was either fiscal or non-fiscal is the legal and binding opinion. Let me explain.

The legislature’s independent actuary makes the official determination of whether legislation affecting the state pension system is fiscal or non-fiscal. With HB 2630, our actuary delivered us a bullet point saying that our legislation would not have a fiscal impact. Still, to win the debate, you need more than a bullet point stating a proposal is non-fiscal. We still needed to convince members to vote for it and to counteract what the opposition was saying.

I’m very thankful that the Oklahoma Council on Public Affairs (OCPA) provided a key document-a full-blown actuarial report that members could review that outlined the findings of their independent actuary. Consequently, it allowed us to counteract what those opposing the bill had produced. The local leader for Americans for Prosperity was prepared to produce another independent actuarial report, if needed.

It was useful to be able to counteract the opposition claims and come back with an independent analysis showing that there would indeed be savings-approximately $3.8 billion over a 30-year period, according to the report requested by OCPA.

Gilroy: From a human resources standpoint, how do you think HB 2630 will affect the state’s ability to attract and retain future workers?

McDaniel: Young workers are most interested in pay. That drives their decisions, even more so than in the past. As we look at an increasingly mobile society, people want to have their retirement plans move with them throughout their careers. Overall, I think it will be helpful if we can reduce pension costs and make them sustainable, thereby allowing pay to become more competitive with the private sector. I call it the “prosperity gap” in my new book. I contend that the very reason we have stagnant pay in the public sector is because of social insurance programs that are absorbing a growing share of the resources available.

Gilroy: What’s next in terms of pension reform in Oklahoma? Are additional steps needed to reduce unfunded liabilities in the legacy pension system and reduce risk for taxpayers? And what about the teachers’ pension system, which has the largest unfunded liability of Oklahoma’s state systems and was not affected by HB 2630?

McDaniel: I will continue looking for solutions to improve the financial security of the system. There are a couple of issues involved in what we do moving forward. One issue is the new Government Accounting Standards Board rules and what impact they’ll have on the system. That’s relevant because those in opposition to reforms look for reasons to say that the reforms already enacted aren’t working. So we have to be mindful that as new accounting rules are implemented, that could create the appearance of a worse financial condition, which presents a potential timing issue for future reforms.

In the case of Oklahoma, the teachers’ retirement system is our largest pension plan and it is more underfunded than most of our other plans. There are issues to consider, such as debatable transition costs as well as the diverse funding mechanisms that have been implemented to shore up that system.

Overall, my goal is to make all of our pension systems sustainable. We’re going to look at each situation separately and evaluate the numbers and needs. We have been very diligent over the last four years and have made great strides, with each step building on the last. I will continue in that manner, trying to find fair solutions to one of the state’s greatest financial challenges.

Gilroy: What are some of the lessons learned from Oklahoma’s pension reform efforts that you would offer to peers in other states who may be contemplating similar moves?

McDaniel: I’m very thankful for the relationships I have with my colleagues in the House and Senate, and the leadership from the governor and other top officials. Major reforms do not happen without key leaders making the issue a top priority. In Oklahoma, it took a teamwork approach to get things done.

Also, there is no substitute for hard work. Hard work includes not only a willingness to boldly advance reform ideas, but also a tireless commitment to bring people to the table to hear all sides of the issue. I’ve learned over the years that sometimes you can find support in very unlikely places. Plus, there may just be one small flaw in a proposal that can be the game changer, making the difference between success and failure.

The most important lesson I’ve learned is to never give up. The issue is too important to the future financial health of the state.

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Oklahoma State Representative Randy McDaniel received a bachelor’s degree in Economics from the University of Oklahoma where he was selected as the Outstanding Senior Man. He graduated from the Institute on Business and Government Affairs at Georgetown University prior to earning a master’s degree from Cambridge University in England.

McDaniel served in the military before being elected to the Oklahoma House of Representatives in 2006. In the House, he has served as the Chairman of the Economic Development & Financial Services Committee and also as the Chairman of the Pension Oversight Committee. As a successful financial advisor, he has worked for more than 20 years in the financial services industry.

McDaniel has served in leadership roles with the Southern Legislative Conference and national legislative organizations regarding state pension systems. In 2014, he authored the book Pensions and Prosperity, which details the history of pensions and solutions for reform. He and his wife Julie have two wonderful children: Grace and John. They attend Crossings Community Church in Oklahoma City.

Other articles in Reason Foundation’s Innovators in Action 2014 series are available online here.