State Pension Plans Scramble to Avoid Bankruptcy
In September 2009, one year after the failure of Lehman Brothers Holdings, Meredith Williams left his office in Denver to travel around Colorado with the board of trustees of the state’s Public Employees’ Retirement Association, stopping in eight cities to meet with active and retired members. The pension plan had suffered monumental investment losses during the financial crisis — $11 billion, or 26 percent of its portfolio — and its funding ratio (based on the market value of assets) had tumbled to 52.7 percent. The pension had been fully funded at the start of the decade, prompting legislators to grant generous benefit increases and reduce contributions, but with the severe drop in asset values, “suddenly the plan was not sustainable for the long term,” says Williams, executive director of Colorado PERA.
He figured the eight-city “listening tour,” reaching out to the membership of 440,000, could start building the consensus essential to righting the plan. However, his most potent proposal — reducing the annual 3.5 percent cost-of-living allowance (COLA) for retirees — met with a lot of push-back.
“The loudest voices were from those in retirement, or about to be,” Williams recalls. “They said, ‘I’ve done my time and everything I was asked. Make the cuts to someone who is still working or to the new people.’”
Suggestions and objections in hand, Williams and the trustees returned to Denver and crafted proposals to present to the Colorado legislature. “We were fortunate to have the backing of the senate president, and he was joined by the minority leader, a Republican, so we had a lot of support right out of the gate,” Williams says. With the help of software from the plan’s actuarial consultant, legislators could input their own solutions and see firsthand the challenges of reshaping the plan. They quickly realized that without significantly reducing the COLA, the state would run out of money before any longer-term changes, such as granting new hires lower benefits, could make an impact. A nagging concern, however, was the likely legal challenge to rolling back benefits already promised, a move contrary to contracts clauses in both federal and state constitutions.
After the board’s legislative recommendations took shape, the Colorado PERA team made another trip around the state — 13 meetings in October and November 2009 — to a more receptive membership: 84 percent of attendees gave their support. “This time the reaction we heard was, ‘Now I understand why these steps are necessary. But what if a lawsuit prevails and you can’t reduce the COLA? What is your plan B?’” Williams remembers. “Our answer was, ‘There is no plan B. If the courts don’t allow our plan, you’re not going to like what will follow.’”
Then–Colorado governor Bill Ritter Jr., a Democrat, signed the bill into law on February 23, 2010. Less than three days later, retirees filed a class-action lawsuit contesting it.
Colorado PERA is not alone. State pension funds, facing a potential multitrillion-dollar shortfall, find themselves in the center of a four-way battle: Employees and retirees expect to be paid their promised benefits; the pension systems have clear obligations but may not have the resources to pay them; politicians are looking for ways to resolve the underfunding and balance the burden among retirees and workers; and state taxpayers, challenged to provide for their own retirements, resent the additional tax load.
Accordingly, over the past three years, most states have taken measures to shore up their defined benefit pension plans. A few, such as Colorado, Minnesota and South Dakota, have made the difficult choice of cutting benefits to current retirees, and all three are facing legal action on the grounds that they are not honoring their contracts. Other states are trimming their plans around the edges, adjusting benefits and contributions for the next generation but resolving to reach full funding over several decades. And following the current popularity of tea parties, smaller government and budget-cutting, a handful of states are even making noises about closing their traditional defined benefit plans and letting new employees fend for themselves with defined contribution plans. There’s even been talk in Washington about trying to pass legislation that would allow states to do the previously unthinkable — petition for bankruptcy — to get out from under their debt burdens. But while calls for state bankruptcies might play well with the Republican faithful, most observers doubt such a solution will ever become a reality. Instead, the real dramas are already playing out at the state level as officials and lawmakers desperately seek solutions to their pension crises.
The shortfall between state pension liabilities and the assets plans have gathered and invested to pay for them has been variously estimated at anywhere from $500 billion to $3 trillion. The figure at the lower end is an aggregation of fiscal year 2008 funded status taken from the states’ own reports by the Pew Center on the States and published in Pew’s comprehensive white paper on state pension and health care plans, “The Trillion Dollar Gap.” The larger figure, by professors Joshua Rauh of Northwestern University and Robert Novy-Marx of the University of Rochester, is an estimate of underfunding as of June 2009, following the peak of the financial crisis; though pension funds’ assets were smaller at that time, the professors’ estimate sets much higher values on liabilities, borrowing methods from financial economics that differ from governmental accounting principles (see “Colored by Numbers,” below). Rauh and Novy-Marx grimly conclude that as of June 2009, state plans in the aggregate were funded at 41 to 56 percent, based on assets at market value and liabilities estimated using market discount rates.
The governmental pension community prefers the less-dire Pew report, naturally. The National Association of State Retirement Administrators, a research and lobbying group for state plan managers, quotes Pew’s study on its web site: “In aggregate, states’ systems were 84 percent funded — a relatively positive outcome, because most experts advise at least an 80 percent funding.” Pew has not updated its 2008 take on funding for the effects on portfolios of the financial crisis or the subsequent recovery.
A more timely assessment of state fund health by consulting firm Wilshire Associates, also based on states’ own financial reports, estimates that after hitting 95 percent in 2007, then staggering to 79 percent in 2008, funding of states’ pension obligations had fallen to 59 percent by June 2009. Wilshire calculates funding levels using market values of assets rather than smoothed actuarial values.
(In this article we report asset values and funding rates at market wherever possible, as of the latest available reporting dates.)
After the market shock of 2008, the heads of pension systems saw that their plans were in a bind that was not likely to be relieved by a few good years in the markets. One pension expert believes that without significant changes to benefits and contribution policies at many public funds, they could be out of money to pay benefits in as few as ten years.
At Colorado PERA, where funding fell to 52 percent in December 2008 and recovered to 58 percent a year later, Williams came to the same realization. “If you drop below 40 percent funding, No. 1, you have no ability to survive another market event like 2008,” he says. “Second, liquidity becomes a major concern. Your asset allocation has to become more conservative, and earning less on the portfolio just speeds up the process of hitting bottom.” Therein lies the motivation for Colorado’s drastic steps. In 2009, Williams persuaded the legislature to roll back the annual COLA to 2 percent. Other changes included small increases to contributions for both employers and employees, and a requirement that most members work longer before they retire. “What struck us was that reducing the cost of the plan through changes to new hires takes decades to have an impact on the funding status,” Williams adds. “We didn’t feel that we had decades.”
Most state legislatures, however, so far have taken less painful measures than Colorado has, such as pushing through contribution increases amounting to 1 or 2 percent of compensation, lengthening the time frame for calculating final average salary (to reduce the number on which retirement income benefits are based), and limiting changes to new employees.
Other states have been more determined to try to fix the problem. In California many employees will see the normal retirement age rise to 60 from 55 and will contribute 3 percent more of their pay starting this year, while the state’s contribution will rise to $3.9 billion from $3.3 billion. Missouri has bumped up its normal retirement age to 67, the highest in the nation, and new hires in 2011 and beyond will contribute 4 percent of pay to the plan, up from zero percent for current employees. Illinois, where funding in the State Employees’ Retirement System stood at 57.3 percent at market value in June 2009, has cut its COLA and raised its normal retirement age to 67. In Virginia new hires will contribute 5 percent of pay, versus none for past cohorts, and the state has deferred its contributions until 2013 as a budget-balancing measure.
The glacier analogy
During the first ten months of 2010, 18 states took action to reduce their pension liabilities, either through trimming benefits or increasing employee contributions, according to the Pew Center. In 2009, 11 states made similar changes, and eight did so in 2008 (some states made multiple changes). Over the three-year span, however, 20 states enacted no legislation. Of that group, a handful of states, such as Delaware, Florida, Idaho, North Carolina, Washington and Wisconsin, have been able to report high funding all through the crisis. The reason for their success is not complicated, but is very difficult to carry out year after year: They’ve all made contributions adequate to support the benefits they’ve promised.
One observer, a municipal bond investor who incorporates the health of pension funding into his analyses of states’ creditworthiness, believes many states are taking the easy measures first, such as cutting benefits for new hires or curbing “spiking,” the abusive practice of inflating an employee’s last few years’ pay and thus the basis for benefit calculations. The investor says, “The political process will not go after the biggest bang first — cutting the benefits to retirees — because there is always the possibility that the stock market comes back and the problem starts to go away.”
A pension plan’s benefit obligations are something like a glacier. They start as a bare mountainside, but a little snow accumulates and freezes, then more ice builds up over many years in small layers. In the same way, each employee accrues a little more retirement benefit each year. There are two ways to make the glacier smaller. One is to reduce or stop the addition of new layers — in the case of a pension plan, perhaps reducing the benefits for new employees. But that tactic can only alter the glacier a little bit at a time. The second way, which can reduce the glacier rapidly, is to address the many accumulated layers frozen in the middle — the existing benefit obligations for today’s retirees and employees.
Last year professors Rauh and Novy-Marx authored a paper, “The Intergenerational Transfer of Public Pension Promises,” that compared the effectiveness of policy options available to state pension funds. The solution, they concluded, is confronting the obligations to the current base. A 1-percentage-point reduction in COLAs for retirees would reduce total liabilities by 9 to 11 percent; because many state plans provide for COLAs of 3 percent, cost-of-living increases make up about one third of their benefit obligations.
Reductions to COLAs work so well because they restrict the increases in benefits for everyone in the plan, whether retired or still working. That breadth also means that legislators wind up taking retirement income away from neighbors, family members and other constituents. “The measures that would actually have a substantial impact on unfunded liabilities are too strong to be politically acceptable,” says Rauh. “Unfortunately, attempts to reduce unfunded liabilities through the kinds of cuts legislators can pass easily are likely to fall short of what’s necessary to avert a crisis.” Therefore, lawmakers often resort to cutting benefits for people yet to be hired.
“The COLA is probably the most expensive feature, and plans that are legally and politically able to are considering getting rid of it,” says M. Barton Waring, who retired as global chief investment officer for investment policy and strategy at Barclays Global Investors and is an active pension scholar whose articles have appeared in many financial journals. “A lot of times they’ve been written into the plan in a hard way, and once they are granted it’s difficult to take them away. Protection of the COLAs is what ought to be unconstitutional.”
The other major lever at hand, increasing contributions, doesn’t reduce a plan’s liabilities but does improve funding. But it can also violate the existing social contract: Younger workers wind up subsidizing older ones who have made lower contributions all along. As a bargaining tactic, it presents a potential conflict of interest for labor unions, because they are supposed to represent all their members evenly, note Rauh and Novy-Marx.
Public employee unions are resisting reductions in benefits. Members of the American Federation of State, County and Municipal Employees, 1.6 million strong, earn just $45,000, on average, while working and retire with benefits of $19,000 or $20,000, says collective bargaining director Steven Kreisberg: “Should that be a problem in America — allowing public employees to retire with dignity?” He points out that most state employees make large contributions to their own defined benefit retirement and that about one quarter of state workers are outside the Social Security system.