Selected SLC Research
Presentation | March 26, 2009
State Retirement Systems: Recent Trends
Joint Hearing of the Pennsylvania House State Government Committee and the House Education Committee, Pennsylvania State House, Harrisburg, Pennsylvania, March 2009
It is a great honor to be here this morning and I thank Representative Josephs and Representative Roebuck for extending this invitation to me and to The Council of State Governments (CSG). While I work for CSG's Southern Region, the Southern Legislative Conference in Atlanta, Pennsylvania is served by CSG's Eastern Region, the Eastern Regional Conference, located in New York City. I bring greetings from Wendell Hannaford, the ERC Director and I know a number of Pennsylvania legislators are active with the Eastern Regional Conference and we do appreciate their support and involvement.
My presentation deals with a topic that has enormous implications for state finances: public pensions. This is a topic that I have been exploring for some years now and I continue to study and highlight this critical issue in presentations and publications before legislative and other audiences. It is important to note that there are two issues here: one, the enormous investment losses public pension plans have experienced in the last six months, and two, the fact that even before these losses, an increasing number of public pension plans faced significant funding challenges.
Broadly, my presentation comprises five interconnected parts. Part I explores the impact of recent market losses on state retirement systems. Part II reviews why it is important for policymakers to focus on the financial position of state retirement systems. Part III looks at where we stand in terms of state pensions and Part IV provides a snapshot of several key developments related to these plans. Finally, Part V describes the various strategies deployed in states across the country to bolster their pension systems.
State pension funds, like almost every other investment category, have taken a severe beating in the last six months or so. In fact, between October 2007 (the market peak) and early March 2009, stocks lost $11 trillion in market value, based on the Dow Jones Wilshire 5000 index, which includes nearly every U.S.-listed stock. Losses between the beginning of 2009 and the first week of March total $2.6 trillion with nearly half of all stocks in the Wilshire 5000 trading at less than $5, and 37 percent under $3.
In such a Bear market, state pension funds have also been battered. According to the Center for Retirement Research at Boston College, state governments ran up pension fund losses totaling $865 billion when assets for 109 pension funds dropped 37 percent in the 14-month period ending December 16, 2008. For individual state plans, the losses remain staggering: CalPERS, the California state employee retirement plan, the largest in the U.S. and the fourth largest in the world dropped from $260 billion in October 2007 to $186 billion at the end of 2008, one of the plan's worst annual declines since its inception in 1932.
In the light of such overwhelming losses, what is the prognosis for public pension plans? The important point here is that public pension investments are geared toward the long term which allows these plans to phase in investment gains and losses, a strategy that softens the negative blows of short term market volatility. These "smoothing" strategies, based on actuarial tools, facilitate gradual changes to public pension funding levels and required contributions, spreading adjustments over several years. As a result of "smoothing", not only will the investment losses be phased in – most often over five years – investment gains from previous years will be incorporated, tempering the losses experienced recently. In sum, the volatility of assets in public pension plans do not immediately equate to volatility in the state's annual budget.
Experts also note that public pensions have recovered to emerge with strong investment returns after periods of extreme turbulence. For instance, median public pension fund investment returns remained positive in 22 of the 25 years between 1982 and 2007, a period that included the 1987 market crash, the 1991 and 2001 recessions, the bursting of the dot com bubble, 9/11 and assorted corporate scandals. Nevertheless, despite the protection of asset "smoothing" techniques, public pension plans are not completely immune from financial turmoil, even in the long term. Consequently, higher contribution rates and benefit cutbacks might be necessary in the future.
Before the extreme financial turbulence of fall 2008 and the ongoing recession, there was growing consensus across the country that more attention needed to be directed toward retirement planning and developing a retirement infrastructure with the capacity to absorb the needs of all Americans. Reforming public pensions was an important element of these discussions and many states had or were in the process of initiating remedial measures. This included setting aside funds to pay for "other post-employee retirement benefits," OPEB, comprising mostly retiree healthcare. Even though these remedial efforts have been displaced by the severity of the ongoing recession and the need to come up with solutions to bridge significant budget shortfalls, it is a certainty that once state finances stabilize and the current recession ends, policymakers will have to pay attention to public pensions.
There are four major reasons why the financial future of state retirement systems requires the undivided attention of policymakers, particularly once state economies recover.
One, while our economy remains ensnared in a recession, one that is already longer than all the recessions since the Great Depression, public pensions are only one in a list of expenditure categories that policymakers will have to contend with in the post-recessionary period. In fact, the huge revenue shortfalls and yawning budget gaps practically every state currently faces masks a number of enormous fiscal challenges states will have to grapple with in such areas as healthcare, education, emergency management, corrections, infrastructure, unemployment insurance, transportation and of course, public pensions.
Two, a close review of national financial and demographic trends reveals that every element of our nation's retirement architecture faces serious challenges, a development that threatens to jeopardize the retirement plans of a majority of Americans. Alongside the weaknesses in public retirement systems, the other strands in our retirement architecture – the looming shortfalls expected in Social Security and Medicare in coming decades; the precarious financial position of corporate pension plans and the federal Pension Benefit Guaranty Corporation (PBGC); and, the low personal savings rates of most Americans (notwithstanding the improvement in this category recently), coupled with high rates of consumer and household debt – remain very troubling.
Three, our society is an aging one and Census Bureau figures indicate that in 2030, when all of the baby boomers will be 65 or older, nearly one in five U.S. residents will be at least 65. The 65 and over age group is projected to increase to 88.5 million in 2050, more than doubling the number in 2008 (38.7 million) and increasing from 13 percent of total population in 2008 to 20 percent in 2050. In contrast, in 1935, this age cohort amounted to 6 percent of total population.
Four, along with the wave of baby boomers that were eligible to retire in 2008, experts point to the fact that people are living longer. According to June 2008 federal statistics, life expectancy at birth in the U.S. hit a new record high of 78.1 years, a 0.3 year increase from the previous period. This trend has led to a steadily declining worker-to-beneficiary ratio in terms of workers paying into Social Security: from 16.5-to-1 in 1950, to 3.3-to-1 in 2007, to 2-to-1 in 2032. In fact, the 18-64 age cohort – the peak working cohort – will decline from 63 percent of the population in 2010 to 57 percent in 2030, further demonstrating the shrinking workforce.
These four reasons cumulatively amount to a fiscal tsunami looming ahead on our nation's financial horizon that requires the urgent attention of policymakers at all levels of government.
Before the onset of the current recession, a number of research studies had indicated that a majority of public pension plans were under-funded or unfunded to varying degrees, i.e., assets were less than their accrued liability. Many experts consider a funded ratio (actuarial value of assets divided by actuarial accrued liabilities) of about 80 percent or better to be an adequate level for government pensions. The farther a plan's funding level is below this optimal amount, the greater the contributions the government will eventually be required to make to finance its unfunded liability.
It should be noted here that issues related to the release of timely and uniform pension data make reaching conclusions a challenge. Nevertheless, several national studies highlight some of the financial difficulties confronting public pension plans. For instance, a very comprehensive Pew Center on the States report released in December 2007 indicated that while states had socked away enough to cover about 85 percent of their pension costs at the end of fiscal year 2006, they had put aside very little for non-pension benefits (such as retiree healthcare). This report noted that states faced about $731 billion in unfunded bills coming due. A July 2008 U.S. Government Accountability Office report noted that 58 percent of the 65 large pension plans reviewed reached the 80 percent threshold in 2006, a decrease compared to 2000 when about 90 percent of the plans were so funded. More recently, in February 2009, a Standard and Poor's report noted that for 2007, the mean funded ratio for state pension plans was 83 percent, the number recorded in the early 1990s. Similarly, the March 2009 Wilshire report noted that the funding ratio for all 125 state pension plans reviewed in 2008 declined to 84 percent, down sharply from 96 percent in 2007. In line with the timeliness issue mentioned earlier, it is certain that when the market losses of the last six months are factored in, public pension plan performances will be negative.
Notwithstanding these challenges and the fact that the extreme market losses of the last six months are not factored in, several plans did secure an actuarial funded ratio greater than 100 percent. According to the February 2009 Standard & Poor's report, seven states – Delaware, Florida, Idaho, New York, North Carolina, Oregon and Utah – all secured funded ratios greater than 100 percent. Pennsylvania stood at 89.5 percent. At the other end of the spectrum, Connecticut, Illinois, Indiana, Louisiana, New Hampshire, Oklahoma, Rhode Island, South Carolina and West Virginia – were the states with funded ratios lower than 70 percent.
My ongoing review of public retirement plans reveals several trends. First, the increasing move by state plans to invest in non-governmental securities (such as corporate bonds, stocks, foreign investments, hedge funds and real estate) away from government securities (such as U.S. Treasury bills). For instance, in 1993, state and local government retirement plan investments in non-governmental securities amounted to 62 percent as a percent of total cash and investment holdings; by 2007, this percentage had escalated to 78 percent. As expected, while pension plans enjoyed above-average investment returns when the equity markets soared, they experienced steep declines when they disintegrated.
Second, given a spate of accounting and corporate scandals and the significant losses experienced by public pension plans, there is a great deal more activism on the part of the boards overseeing these plans and state lawmakers to monitor their performance and management more closely. A number of state pension plans (Maryland, Iowa and North Dakota) were plagued by financial scandals leading to lawmakers in those states initiating reviews and reforms.
Third, the impact of a Governmental Accounting Standards Board (GASB) ruling on teetering public pension plans. (GASB is the independent standard-setter for 84,000 state and local government entities.) According to this ruling, state and local governments have to place a value on "other post-employee retirement benefits" – consisting mostly of health care – they promise to employees. They have to record as an expense the amount – the annual required contribution – they would need to stash away to fully fund this long-term liability over 30 years. This is because nearly all governments pay for health benefits for their retired employees on a pay-as-you-go basis each year and generally, do not set aside funds to address future benefit obligations. Given that healthcare costs in the United States are rising so rapidly, this GASB ruling is designed to provide a complete and reliable reporting on the costs of future financial obligations such as retiree healthcare.
In responding to the growing crisis associated with their pension liabilities, lawmakers around the country have either proposed or adopted a number of strategies to buttress the finances of these systems.
- Pension Obligation Bonds:
Given their increasing fiscal problems, states and localities opted to issue debt to raise money to plough into their pension systems and pay off, in a lump sum in today's dollars, their unfunded liabilities. Since interest rates have been at historically low levels for some years now and the fact that raising taxes continues to be politically radioactive, the opportunity to raise funds via enhanced borrowing quickly loomed as an attractive strategy.
Some of the states that pursued the pension obligation bond strategy earlier on this decade to replenish their pension plans include California ($2 billion), Illinois ($10 billion), Kansas ($500 million), Oregon ($2 billion) and Wisconsin ($1.8 billion). In May 2008, Alaska authorized the sale of up to $5 billion in pension obligation bonds to offset state and local government unfunded retirement liabilities while Wisconsin, also in 2008, authorized Milwaukee County to do so.
In selling these bonds, states are counting on the interest payable on the bonds being lower than their pension investment earnings. If a state pension plan can earn 8 percent by investing money the state borrowed at 6 percent, the state is ahead of the game. Another advantage is that states experience immediate budget relief because their current year contributions to a pension plan can be secured from the proceeds of the bond issue.
On the flip side, there is always the possibility that the market may not generate the returns to cover the interest rate. Furthermore, once a state issues a bond, it is locked into paying the debt whereas the state has much more flexibility in deciding on future pension contributions, including size, rate and regularity.
New Jersey's experience in the 1990s offers a cautionary tale for states mulling this option. Then-Governor Christine Todd Whitman led an effort that resulted in the state issuing $2.8 billion in bonds that promised to pay off its unfunded pension liability, solve all of its pension problems for the next 36 years, make the state's contributions to the plan for that year and free up $623 million for tax cuts. The state banked on getting returns exceeding 7.6 percent, the interest it was paying on the bonds. For the first few years, while the economy surged ahead and the stock market roared, the gamble appeared to have paid rich dividends. Then, the economy slumped and the stock market collapsed, resulting in a severe drop in investment earnings. By mid-2003, even after the stock market had recovered, the state only saw returns of 5.5 percent, significantly lower than the required 7.6 percent. New Jersey's pension system was in deep trouble.
The anemic earnings were only compounded by several Governors' balancing budgets by skipping pension contributions and granting "pension holidays." In fact, Governor Corzine recently indicated that in his first three years in office, the state had allocated more money into the pension system than governors had done in the previous 15 years, though the state is still short of what is actuarially needed to fully fund benefits. As of June 2007, the state pension fund had an unfunded liability of $28 billion, an amount that is indisputably higher now given recent market losses.
Of course, given the credit freeze that swept across the economy starting in October 2008, state and local governments have found it increasingly difficult to secure funds from the bond markets. Even though the situation has improved marginally in recent months, the pension bond option might not be as straightforward as it was before the fall 2008 credit crisis.
- Trimming Benefits
Several strategies crop up under this category.
- Moving workers hired in the future to 401(k)-style investment accounts away from the current format of a guaranteed pension based on years of service and highest salary. Alaska became the first state in the country to switch all state workers hired after July 2006 to 401(k)-type accounts. Governor Schwarzenegger in California , Governor Sanford in South Carolina, Governor Corzine in New Jersey have advocated this approach and so have lawmakers in Michigan, Illinois, Kentucky, Oregon and Virginia. More recently, in Rhode Island, a House panel recommended that state employees hired after July 1, 2009 be placed in a 401(k)-style plan.
- Reviewing and reducing the annual cost-of-living adjustment (or COLA) increases for retiree pensions. Rhode Island has proposed paying an annual COLA tied to the yearly cost-of-living index as opposed to an automatic percentage increase. Kentucky reduced the COLA in the state's legislative plan while Vermont replaced its existing-law COLA with a smaller increase.
- Adjusting the age at which employees are paid full benefits. In New Jersey, there is a proposal to raises the retirement age for public employees and teachers from 60 to 62; Rhode Island has proposed a minimum retirement age of 65 for state employees and teachers; Kentucky has set eligibility for retirement medical benefits at a minimum age of 60 with 15 years of service; Governor Patterson and Mayor Bloomberg in New York have called for a minimum retirement age of 50 in NYC, where no minimum age exists.
- Creating different benefit tiers for current and future employees. Governors Patterson in New York and Quinn in Illinois have proposed a new, less-generous retirement tier for future employees while Governor Gibbons in Nevada called for trimming retiree benefits across the board.
- Capping annual retirement benefits. New Hampshire, in 2008, set a limit of $120,000 as an annual retirement benefit.
- Reducing retiree pay with Rhode Island proposing that an employee's pension be based on a five-year salary average instead of the current three-year. Wisconsin has an unusual policy of adjusting the amount of benefits paid based on its pension fund's performance. Now, for the first time in 25 years, a majority of retirees will see a benefit reduction.
- Eliminating programs like the Deferred Retirement Option Plan, or DROP, which allowed state workers with 30 years on the job to retire and continue working up to three years, while escrowing their retirement benefits at a guaranteed rate of return. Florida is also cracking down on "double" dipping, a system that allows officials to "retire" by taking 30 days off and returning to work in their old jobs with a salary and a pension. New Mexico also placed salary caps on state and local government retirees who return to work in government jobs.
- Ending lucrative retirement plans where certain state employees serve a brief period in a position to secure a significant boost in pension income. Missouri eliminated its administrative law judge retirement system which allowed this practice.
- Debating and enacting restrictions on the ability of public sector systems to continue offering lucrative retiree healthcare. In North Carolina and Michigan, until a few years ago, any state employee with five years of service was eligible to receive free retiree health insurance for life. Indiana ended lifetime health insurance for lawmakers subsidized by taxpayer dollars. Kentucky increased the vesting requirement for retiree medical benefits from 10 to 15 years.
A number of states have increased the cost for employees to participate in their pension systems. For instance, Kentucky increased employee contributions for legislators and judges joining the system after September 2008 and instituted a new, 1 percent employee contribution for public workers hired after September 2008 to fund medical benefits. New Jersey increased membership eligibility in the state retirement plan for teachers and public employees. Also, in 2008, Iowa enacted numerous changes to its state retirement plans, including increased contribution rates. Wyoming hiked its required employer contribution for judges and in Vermont, members' contribution rates increased from 3.25 percent to 5 percent until July 1, 2019.
- Consolidating Boards
West Virginia teachers merged their two retirement systems to create greater efficiencies while Minnesota merged the troubled Minneapolis teachers' pension fund with the larger, statewide fund. In Vermont, the governor and lawmakers agreed to combine the funds of its three state retirement systems for investment purposes. Indiana lawmakers weighed a proposal to merge the state's employee and teacher pension plans.
- Guaranteed Returns
In a contrarian approach that hailed it as the first pension fund in the United States to do so, Maine adopted a strategy known as matching, i.e., deliberately aiming for low, but guaranteed, investment income to pay for retirement benefits. In 2003, Maine put a third of its assets into very conservative bonds. The bonds pay a low interest rate, but their values will rise or fall in conjunction with the value of the pensions the state must pay its retirees, regardless of the trajectory of the markets. A review of how Maine fared in the downturn reveals that between January 1 and October 30, 2008, while U.S. stocks were down 34 percent, Maine's investments were down between 24 and 28 percent.
- Deferring Contributions
Governor Corzine in New Jersey proposed and both houses of the Legislature recently approved that counties, municipalities and school districts temporarily defer 50 percent of their retirement payments into the public employee pension system for a year. Kentucky is considering cutting the amount of funds that state and local governments contribute to their public pension plans and also proposed spreading out payments that cities and counties are supposed to make into the state's retirement system from five to 10 years.
- "Unorthodox Investments"
The Retirement System of Alabama embarked on a series of unorthodox investments that enabled the fund to progress from $500 million in assets in 1973 to $35 billion by 2007. Some of these acquisitions include New York City real estate, media outlets (television, newspapers), hotels, a cruise ship terminal, golf courses and becoming the largest stake holder of US Airways. Massachusetts considered a proposal to allow all state residents to invest in the state's public employee pension fund.
In conclusion, when states emerge from the current recession with their balance sheets in better shape, unfortunately, they will be pummeled by several expenditure categories, including unfunded and under-funded pension liabilities. Even before the current recession, public pensions faced challenges that have now heightened given the collapse of the equity markets in the last six months. While in certain instances, this weakened pension outlook was the result of states skipping their required contributions, the severity of the recent fiscal downturn, demographic changes and the steep rise in healthcare costs will pose additional challenges. Then, the implementation of the GASB ruling could propel unfunded pension liability levels to new heights, a trend that could damage state bond ratings. Yet, the "graying" of America, the fact that states will have more retirees living longer in the coming years and the ability of the public sector to attract quality employees in an era of dwindling retirement benefits, requires innovative solutions. Further complicating the public pension outlook is the fact that the financial viability of every other element of our retirement infrastructure remains shaky. Ensuring both the short-term and long-term financial viability of the different elements in America's retirement systems, both private and public, remains of paramount importance. In fact, first resuscitating and then sustaining the financial health of our different retirement income flows provides the foundation of the United States as an economic, political and military powerhouse in the global context.