Reviewing South Carolina’s New Funding Policy

South Carolina has taken a step towards solving its pension-funding crisis, but a few more strides are necessary to ensure the state is on a path to solvency. Fortunately, pension reform work isn’t done in the Palmetto State.

Last month the South Carolina legislature passed a bill that will increase employer contributions into the South Carolina Retirement System (SCRS) and Police Officers Retirement System (PORS), the two largest public pension plans in the state. The additional contributions come primarily as the result of a slight reduction in the plans’ assumed rate of return (7.5% down to 7.25%) and taking the current 30-year open amortization schedule down to 20 years over the next decade.

All totaled, the employer share of contributions to SCRS will increase from 11.56% this past year to 13.56% starting July 1, 2017. The employer contribution rate will then increase by five 100 basis point steps up to 18.56% starting July 1, 2022. PORS will see a similar graded increase maxing out at 21.24% by July 1, 2022. All totaled, these changes will increase contributions from the state and municipal employers by roughly $800 million over the next six years.

Phasing In Contribution Increases

In some ways this statutory increase in employer contributions is a good example of how to phase in contribution rate changes triggered by adopting more responsible funding policy.

For more than a decade, SCRS has been using a 30-year, open amortization schedule — an actuarial practice that resulted in artificially depressed contribution rates. Worse, those actuarially reduced contribution rates meant SCRS wound up in perpetual negative amortization, with payments towards its pension debt being less than annual interest accruing on those unfunded liabilities. We reported on this trend last year in analysis presented to a joint legislative committee in South Carolina set up to review the state’s pension problems, and at the same time highlighted that while SCRS has been assuming a 7.5% return on assets when its actual returns have averaged just 5% over the past fifteen years.

These kind of problems necessitate making big changes to funding policy — or, in other words, these problems are only solved by getting more money into the pension fund.

Adopting a responsible set of funding policies all at once can be a shock to state and local budgets. That is why a progressive phase-in of necessary contribution rate increases can help a legislature embrace sound management of a pension system without crowding out all other budgetary expenditures.

However, in other ways the funding policy legislation falls short. Phasing in the costs of adopting better funding policy makes sense. But once the target rate is achieved (in 2022-23) SCRS and PORS should shift to using the actuarially determined contribution rate for more accurate year-to-year estimates. As it stands, the pension reform adopted by South Carolina has a statutory employer contribution rates detailed only through 2027, including the same rate every year from fiscal year ending 2023 to 2027.

Fortunately, South Carolina has about five years to amend this practice. The legislature can wait a few years to see how the statutory rates are working out and then look to either increase those rates come 2022 or vote to just pay the actuarially determined contribution rate — which would be the best practice.

Changing Actuarial Assumptions

Another component of the funding policy reform was to reverse the decision-making structure for the assumed rate of return. Beginning in 2021, the board overseeing SCRS and PORS will recommend an assumed rate of return to the legislature. That rate will become effective unless the legislature acts to reject the proposal. And this process will repeat every four years.

Setting the default option to accepting the proposed rate will likely minimize the political influence on the assumed rate of return. The legislature would have to have a wide ranging, compelling reason to stop an assumed rate from being reduced.

At the same time, because the state is using statutorily—not actuarially—determined contribution rates, a change to the assumed rate of return would not automatically increase the employer contribution rate. In fact, the SCRS board would not be able to change the rate relative to a reduced assumed return until after 2027 without legislative approval. This limits the ability to incorporate necessary contribution rate changes from one year to the next.

Employee Contributions

Meanwhile, the funding policy change also decouples the employee contribution rate from the employer rate. The employee contribution was scheduled to increase from 8.66% to 9.16%, following a statute that required the employee rate be within at least 2.9 percentage points of the employer contribution rate. Instead, the new law locks in the employee rate at 9% permanently moving forward. The primary intention of the legislature in making this change was to avoid an increase in the employee contribution rate that could create a recruiting or retention problem with public sector employees.

While this change may or may not help to avoid a brain drain, it certainly eliminated one of the best funding policy features of SCRS and PORS without replacing it with a comparable change — namely, the fixed differential cost-sharing mechanism.

The maximum differential between employees and employers created a political incentive to adopt responsible funding policy and fully fund the plan to protect employee benefits and contribution rates. In some ways, this hadn’t been working because bad funding policy was in place the past few years. In other ways, it was one of several catalysts for the legislature being forced to deal with SCRS and PORS insolvency now.

The current recognition of the need to improve funding policy to avoid spikes in employee contributions rates is the kind of political incentive that the cost-sharing mechanism was designed to create.

The overall pension reform effort would have been improved by replacing the cost-sharing mechanism with some other constraint on liability growth. However, the chosen approach of South Carolina’s joint committee for pension reform was to take up this particular issue in context of designing a new retirement system for future hires — and this effort is scheduled to continue starting next Fall.

Overall Assessment

On the whole, our analysis indicates that relative to the status quo SCRS and PORS will be better off with the funding policy changes adopted by the legislature and signed into law by the governor.

However, if all that is accomplished in the near-term is what has been adopted this year, then South Carolina will have come short of the goal of achieving comprehensive pension reform for SCRS and PORS. And the members of the General Assembly will likely find themselves returning to confront the same challenges a few years down the road.

Specifically, our independent modeling of SCRS suggests that even with the adopted changes unfunded liabilities will continue to grow for the next decade and be larger than $30 billion by the 2030s. This is primary because the assumed rate of return was only dropped to 7.25% — and we think it needs to be significantly lower in order to avoid continued underperformance of the assets. However, without the additional employer contributions granted by the reform the growth in pension debt would have been even faster.

Fortunately, the General Assembly recognizes that more work needs to be done so that South Carolina has a true path for sustainability and solvency. The governor when signing the bill indicated that this would not be the last word on changes to help SCRS and PORS. And members of the legislature’s joint pension reform committee have all said as much during the past session and have created a schedule for continuing work on pension reform throughout the remainder of 2017.

The next steps for South Carolina pension reform should be:

1. Create a new retirement system for future SCRS and PORS hires that has predictable costs, competitive benefits, responsible funding policy, minimized taxpayer risk, and allows the state to keep 100% of its promises to public sector workers;
2. Further lower its assumed rate of return on assets (and discount rate) towards something closer to 6% in order to reduce the risk of investment underperformance and more accurately report the value of existing pension liabilities;
3. Monitor the existing statutory rates and look for the opportunity to adopt a closed 20-year amortization schedule with actuarially determined employer contribution rates instead of the existing 10-year count down to a 20-year open amortization schedule with statutory rates.

For more Pension Integrity Project coverage of pension reform in South Carolina, see reason.org/SCRS