State Pension Plans Scramble to Avoid Bankruptcy
A 30-year veteran of organized labor who worked with the American Nurses Association and two federal employee unions before joining AFSCME, Kreisberg develops the union’s policies on pension and health benefits. He believes plans’ financial difficulties are being exaggerated by the media and calls on state sponsors to make greater contributions, especially those that have starved their plans, such as Illinois, New Jersey and Pennsylvania.
“We simply need to put in more money,” he says. “When tax revenues start to recover, states will only have to take a percentage point or less of their budgets to spend on pensions. That doesn’t seem onerous or challenging to the point that it can’t be done.”
DAVID BERGSTROM, executive director of the 87,000-member, $13 billion Minnesota State Retirement System (MSRS), has lived through several pension cycles. Minnesota born and bred, Bergstrom joined the Public Employees Retirement Association of Minnesota, which manages retirement plans for local government and school districts, in 1983 and moved to MSRS in 1992.
Like Colorado, Minnesota has taken the bull by the horns and reduced COLAs for current retirees. In Minnesota funding fell to 65.6 percent at market value of assets for June 2009 from a robust 93 percent in 2006. “Our actuaries told us that we had a significant contribution deficiency, about 6 percent of payroll, and that we would have needed multiple years of 15 percent returns in the investment portfolio to get to full funding,” says Bergstrom.
Plan trustees considered limiting changes to benefits and contributions for new hires, but realized the impact was too small and far-off. Next on the list was raising contribution rates for current employees; the board ruled that out too, because increases from the previous four years were just being phased in. Other, smaller changes in vesting and interest paid on refunds were proposed, but all were entirely prospective and did not take away credits already earned. “We took the COLA reduction and other cuts to our stakeholders — the unions and retirees — and all of them supported the change,” Bergstrom says.
The Minnesota legislature passed the Omnibus Pension Bill by overwhelming margins, and then-governor Tim Pawlenty signed it on May 15, 2010. A new approach shifts some of the funding risk to participants by reducing benefit increases until the plan’s funding, based on market valuation, is restored to 90 percent (compared with 75 percent for the large general employee plan in June 2009). In the general state plan, the COLA has been cut to 2 percent from 2.5 percent. Retired teachers receive no raise this year or next, with 2 percent annual increases to follow until 90 percent funding is attained. The measures reduce the estimated June 2009 underfunding of $3.6 billion by $800 million.
“Our law says that as fiduciaries we have to rely on reason rather than hoping for strong markets,” Bergstrom notes. “We had the opportunity to start saving $52 million a year, so if the market recovery was slow or the market simply did not recover, the delay would have set us back further.”
Complicating the efforts to repair state pension plans are legal challenges brought by pensioners who object to having their cost-of-living increases taken away. There’s real money at stake — in the case of Colorado, the class-action complaint estimates that the cut in the COLA will cost the average retiree more than $165,000 over 20 years.
“The public employees have contracts with the states for benefits, and those contracts should be treated the same as any other, such as the interest states pay to their bondholders,” contends Stephen Pincus, a partner with Stember Feinstein Doyle & Payne, a plaintiffs’ rights law firm in Pittsburgh that is representing pensioners in Colorado, Minnesota and South Dakota.
Pincus asserts that civil-servant retirees are protected by general clauses in the state and federal constitutions about governments breaking contracts, as well as by specific provisions in the three states’ pension laws that prohibit reduction of workers’ benefits once they’re retired. No additional actions are being contemplated against other states, he says, but the 2011 legislative sessions have just begun. Because legal actions are under way, the three states facing class actions can provide little direct comment, but in each case, pension managers forged a consensus with state employees and legislators.
“We assumed from the beginning” that the state would be sued, says Colorado PERA’s Williams. “At the same time we had actuaries crunching numbers, we had lawyers doing legal searches. The board would not have proceeded if it did not feel secure that it was on solid legal ground.”
Bay state picture
THE STATE RETIREMENT system of Massachusetts dates back 100 years. The second generation of its enabling legislation was formulated in the 1940s, when life expectancies were shorter and career tenure was long. For most workers, benefits are modest but come at a high cost: In the general state plan, payments to retirees today average just $25,000, and Massachusetts public workers are not covered by Social Security. Cost-of-living allowances are paid on just the first $12,000 of a retiree’s benefit. Contribution rates on employees hired since 1996 are above 9 percent, among the highest in the U.S.
The plan was a pay-as-you-go arrangement until the late 1980s and had an unfunded liability of $23.8 billion at market value as of January 2010, mostly attributable to the 70 years that the state wasn’t funding it. The antique design, covering more than 100 state and local employers and 510,000 workers and retirees, places a great burden on the plan today: Only a quarter of the state’s contributions — projected at $1.4 billion for 2011 — are allocated to paying benefits, while the remainder goes to reduce the unfunded liability.
In 2009, after embarrassing media coverage, the legislature closed several egregious loopholes in benefit policies, such as one that granted an additional year’s benefits for one additional day of service. Next, Governor Deval Patrick appointed a 17-member commission for a second phase of pension reform, made up of legislators, pension executives and, as co-chairmen, two prominent academics: Alicia Munnell, director of the Center for Retirement Research at Boston College, and Nobel Prize–winning economist Peter Diamond of the Massachusetts Institute of Technology. The commission met nine times between March and September 2009, when it offered 32 recommendations covering benefit design, retirement security and plan funding.
“There were two lights — the co-chairs,” recalls Michael Widmer, president of the 80-year-old Massachusetts Taxpayers Foundation, who attended two of the sessions. “But the meetings were in another universe. The debate was supposed to be over reducing the underfunding for the pension plan, but some of the conversation was over how we would expand benefits. In theory, they would spearhead phase-two reform, but because there were so many advocates for pension recipients on the committee, its promise was ended the day it was appointed.” No real progress was made during the 2010 election year, he adds.
But Patrick won reelection, and Widmer has proposed more-aggressive measures with the 2012 budget, including extending the amortization period through 2040. “These proposals kick the can down the road by extending amortization of the unfunded liability to 2040, but they’re the minimum of what’s necessary,” Widmer says.
Savings from the governor’s early-2011 proposals are estimated at $5 billion over 30 years. If the amount seems small in comparison to the $20 billion-plus underfunding, it is, but the state is facing a deficit for 2011 estimated by the Massachusetts Taxpayers Foundation at $2 billion, so near-term resources are scarce. Moreover, Patrick’s proposals cite the need to honor contracts with employees and retirees and specifically rule out the tough measures of cutting existing benefits. “The outside world may see a liberal patina on Massachusetts, but we have a very entrenched political culture here and tend to be slow on reforms like this,” observes Widmer. “We’ll see how much the legislature can handle.”
Another state that is slowly working to right its public pensions is Pennsylvania, where the general and teachers’ plans claim combined membership of 670,000 and assets of $67 billion. After investment windfalls pushed funding rates over 100 percent in the late 1990s, legislators increased benefits and granted employers several years of contribution holidays. The free spending eroded funding ratios nearly every year of the past decade, even before the financial crisis — to 69 percent for the general plan and 56 percent for the teachers’ plan (both at market value of assets as of December 2009 and June 2010, respectively).
State senator Glen Grell, a Republican who has represented the 87th district in south-central Pennsylvania since 2004 and who served in the administration of former governor Tom Ridge from 1995 to 2000, proposed in 2010 that the state’s general and teachers’ schemes be reorganized into arrangements that combined elements of defined benefit and defined contribution plans — guaranteeing small lifetime benefits to be supplemented by personal accounts funded 3 percent by contributions from employees and 2 percent from the state. “I was out talking about the proposals for six months, and while the teachers’ union never warmed to them, there were individual teachers and school boards that appreciated we were proposing a middle-of-the-road change compared to our prior plan,” Grell says.
In a lame-duck legislative session, Grell’s hybrid idea was ruled out, but nine significant reforms were made to the defined benefit plans, including benefit reductions for new employees and higher retirement ages and employer contributions. The bill also prohibited Pennsylvania from issuing bonds to fund its liabilities. It passed the Pennsylvania house in November by a vote of 165 to 31.
The benefits of current retirees were left untouched because, as Grell notes, “no one wanted to put together a plan that would immediately wind up in court.” As with other plans that have affected only future benefits, the net present value of savings is small and achieved only in the long run: a reduction in benefits of $24.7 billion over the next 30 years, offset by $23.3 billion
of actuarial and funding changes to amortize the unfunded liability, for a net savings of $1.4 billion.
“Of course there are some that don’t think we went far enough, who would like to see us close out the plan and start all new employees under a DC plan,” says Grell. “And there may be an effort in that direction, depending on how aggressive the new governor [Tom Corbett, a Republican] wants to be.”
CLOSING PENSION PLANS TO new state employees is a drastic step. Before 2010 only two states had done it, shunting new hires to defined contribution plans: Alaska in 2006, and Michigan in 1997 (for general state employees). West Virginia ended its defined benefit plan in 1991 in favor of a defined contribution arrangement but returned to a pension plan in 2008.
It’s true that, at a glance, defined contribution plans appear much less expensive to employers than defined benefit plans. States don’t have to kick in much more than the current year’s contributions, and the risks of generating investment returns and providing lifetime incomes, and the liabilities that come with them, are handed over to the employee. But a sponsor does not simply walk away from a defined benefit plan.
The defined benefit/defined contribution decision goes far beyond the cost of the retirement benefit — it can change the very nature of employment in the public sector. The prospect of a pension is an important factor in people’s decisions to take what are often lower salaries in the public sector.The long-term result for those states that end their public employee pensions could be a workforce that demands higher pay and won’t have an incentive to stay in jobs as long.
The idea of preserving the obligation to pay lifetime benefits may not resonate with taxpayers in times of fiscal austerity, but as a retirement vehicle, the defined contribution plan simply is inferior, says pension scholar Waring. “The most stingy defined benefit plan gives a better benefit than the most generous defined contribution plan,” he explains. “A benefit set at just 1 percent of final salary per year of service gives you a real retirement payment, whereas the median balance in defined contribution plans for people retiring now is under $100,000, because people don’t save enough. It’s not that in principle a DC plan couldn’t be as generous, but in practice they’re just not.”
Paternalism aside, the costs of an underfunded defined benefit plan don’t stop when it’s closed to new employees. “The biggest issue is that closing your DB plan does not eliminate the liabilities — you will be working down those obligations for 40 more years,” observes David Stella, secretary of the Wisconsin Department of Employee Trust Funds. Younger employees, an important source of defined benefit contributions, are no longer in the plan, but benefits still have to be paid to retirees, and the obligations to current employees keep growing. “Where does the difference come from?” Stella asks. “You have to increase the contributions from the people still in the plan or from employers, or both, or you have to earn greater investment returns.”
Alaska’s case illustrates his point. The defined benefit plan’s funded ratio, measured at market value of assets, dropped to 52.4 percent for fiscal 2009 from 81.1 percent in June 2006, just before the plan was closed. The markets were a factor, of course: Assets dropped to $5.1 billion from $6.6 billion. But despite Alaska’s closing the plan to new entrants, liabilities rose by about 20 percent over the four years, to $9.7 billion from $8.1 billion.
Republicans’ good fortune in the recent elections, combined with the current fervor over budget-cutting, is pushing a number of states to consider shutting plan doors. In addition to Corbett in Pennsylvania, the new GOP governors of Alabama, Nevada, Tennessee and Wisconsin all back defined contribution plans for new hires, and Republican lawmakers in Oklahoma are making similar noises.
Alaska’s experience is too brief to allow conclusions to be drawn about the adequacy of benefits or cost differentials, but Michigan, which closed its defined benefit plan for general state employees in 1997, offers a benchmark. “When we made the change, the predictability of cost was important from the employer standpoint,” explains Phillip Stoddard, director of Michigan’s Office of Retirement Services since 2004 and a 23-year veteran of the Michigan retirement system. “For the employees, there was a lot of talk about portability, and the investments were doing so well. It was innovative on the part of our executives at the time, who had been looking at private enterprise moving to DC plans.”
Thirteen years on, 29,000 active participants, or more than half of the system’s employees, are in the defined contribution plan. The average balance is about $50,000, but for employees close to retirement — age 60 or higher — the average account is about $123,000. Michigan’s actuaries reckon that a defined contribution balance that size can provide retirement income of about $9,000 per year. Meanwhile, in the defined benefit program, the average benefit for people currently retiring is closer to $30,000 annually. The defined contribution plan saves the state about $25 million a year over the defined benefit plan, on a total cost of $429 million in fiscal 2009.
Stoddard concedes that the defined benefit plan is providing a more robust benefit: “I’m pleased that our plan is in the mainstream in that it includes an employer contribution and employer match” — 4 percent and 3 percent, respectively, the latter contingent on the employee contributing at least 3 percent. “But,” he adds, “the $50,000 and the $123,000 average balances — those clearly need to grow.”