Do Public Sector Pensions Teeter on the Edge of Financial Collapse?

What do you know about your pension plan?  Is it defined benefit, defined contribution or some hybrid version?  Does your employer match your contribution?  Is it portable, meaning you take it along when you change jobs?  Who makes the investment choices?  How much do you have in bonds, equities and cash?  What about the municipal bond market downturn; did that cause a volcano inside your pension plan?  Do you even understand how to read the statement?

Most people are not financial wizards but today almost everyone is more personally responsible than earlier generations for knowing something about retirement and pension plans because the good old days of guaranteed lifetime income have come and gone in nearly all professions.

“At the base level, we know there’s fiscal illusion.  That is, people don’t even understand how much they are paying in taxes,” said Georgia State University professor Bart Hildreth.  And when it comes to understanding pension plans, “Most of them could not tell you what they expect to get out of a defined benefit plan.  They know it’s some share of their current salary.”

Georgia State’s Andrew Young School of Policy Studies recently gathered public sector pension and financial analysts for a daylong conference that sought to put some clarity under scary headlines that all pension plans are either insolvent now or they will become insolvent soon.

“There are systems out there; they shouldn’t panic but they should worry,” said Segal Company vice president and actuary Leon Joyner.  “They should worry because they have gotten themselves into a mess.”  Segal has managed private, non-profit and public sector accounts for 70 years.  Joyner said pensions are 4 percent of state spending.  “That’s not exactly bankrupting the budget.”

Mercer University economist Roger Tutterow offered this somewhat different long range view:  “It is probably time in the public sector to have a candid discussion and indicate to employees that the ability to fund the post-retirement contributions, such as health care going forward, we probably will have to talk about how we restructure that.”

How Bad Is the Pension Problem?

“We get lots of quote information on the media outlets,” Leon Joyner said.  “Some of it is true.”

This spring a Pew Center on the States analysis said state pension and health care retirement accounts are at least $1.26 trillion underfunded.  Deeper into the analysis Pew said the real figure might be much larger, perhaps $1.8 to $2.4 trillion if investments do not earn 8% annually.

A Congressional Budget Office report published last month estimated current state employee pension fund and health care liabilities at between $700 billion and $3 trillion.  The reason for the vast range is because actuaries use different methods to predict investment returns.  The CBO said, “By any measure, nearly all state and local pension plans are underfunded.”

That includes Georgia.  The Pew Center ranked Georgia among the 2009 calendar year’s best performers because the state pension system was 87% funded vs. liabilities and the state made its 100% ARC – annual required contribution.  But not so the health care obligation, just 4% funded, and Pew said Georgia made just 30% of the annual required health care contribution.

A Mercatus Center study published last December said “governments have set too little aside to fund future benefits; pension portfolios have shifted toward riskier assets in order to discount their liabilities at higher interest rates; and, basing the discount rate on expected asset returns gives plans the illusory appearance of full funding in years when investment returns are robust.”

Writing in March, the fiscally conservative policy group State Budget Solutions said, “One of the most insidious aspects of pension liability is its stealth nature. Pension obligations don’t appear on state balance sheets.  As such, states with billions in unfunded pension liabilities may technically brag of ‘balanced’ budgets while being swamped by pension debt.”

Colorado faced the possibility of state bankruptcy within 15 years before it enacted reforms last year.  “They changed and lowered the benefit for people who were already drawing a pension,” said Joyner of the Segal Company.  “Is that going to stand in the court system?  It’s my understanding that as soon as the governor signed the papers the lawsuit was filed the next morning and it's now in the courts."

Do public sector employees understand their plans?  “As a general rule, I believe not and I think that’s a fault of our industry,” said Steve Vaughn, who manages 250 public sector plans for the Association County Commissioners of Georgia.  “Once you begin telling them the differences (between plans) and the contribution levels that it’s going to take, it becomes a culture shock.”

Boring Pension Plans Became Real Headline Makers

Not long ago you would be hard-pressed to find traditional news media covered up with pension plan stories.  “Retirement stories” were about fun and travel and the good life.  Today pension stories are major headline makers as public sector employees from Utah to Wisconsin to New Jersey and Georgia engage in often volatile debate about benefits and rights.  Atlanta Mayor Kasim Reed made reform a priority because pension benefits are 20% of the city budget.

The Georgia state government employees plan was reworked three years ago.  New state hires no longer qualify for exclusive defined benefits retirement compensation.  Now they participate in a hybrid model that includes a small defined benefit and a 401(K) option that enables them to decide how much they will save and then manage their own assets.  Georgia actually administers several public sector plans tied to an employee's hiring date.

“What they have done is they have spread the risk of retirement more between employer and employee and less of it being on the employer,” the Segal Company’s Joyner said about the Georgia’s three-year-old state employees plan.  “I would argue they’ve done a pretty good job.”  New state employees still receive a match, but they cannot plan on a defined monthly benefit.

Corporate and public sector defined benefit plans were built on the premise there would always be money coming into the system to satisfy the obligations.  That worked well in private industry when there were few retirees, lots of growth and profit and strong investment returns which all were true over the past 100 years while America was unchallenged as the world’s best economy.

Public sector plans were financially strong because economic expansion fueled rapid increases in government revenue.  Americans bought lots of things including houses; they paid lots of sales, income and property taxes and U.S. stock markets clicked along at an 8.8% annual gain, allowing for booms and downturns.  Local and state governments satisfied enormous appetites to spend more money by selling bonds, incurring debt to be paid off in later years.

It looked for all the world like the perfect scheme (like Social Security).  The contraction of the U.S. economy ten years ago was a warning light for the worst recession since the Great Depression.  The 2008 downward spiral caused radical declines to government revenues, including in Georgia.

States like Georgia that must balance budgets created “balance” with federal stimulus dollars – more than $3 billion in Georgia since fiscal 2009 — and by draining their savings.  Georgia’s $1.7 billion shortfall reserve in fiscal 2007 dipped below $200 million in fiscal 2010.  The state is under significant pressure to rebuild the shortfall reserve fund or see its AAA bond ratings downgraded.

“We have been through downturns before and governments have weathered them pretty well,” said Tutterow, the Mercer University economist who served on last year’s Georgia tax reform special council.  “But we have not been through one in which the job loss and the implications for sales tax collections were as pronounced as they were in this recession.”

The Role of Investment Return Predictions

Pension plan fiscal health is very tied to the financial markets.  There’s no getting around that.

Three months ago the U.S. Census Bureau published data that tracked securities and all other financial instruments held by large public retirement systems during six years ending in 2010.   The systems owned $2.92 trillion in assets in December 2007.  Fifteen months later assets were $2.1 trillion, down almost one-third.  They recovered to $2.63 trillion at the end of last year.

Last month the Center for Retirement Research at Boston College reported that state and local government pension plans were just 77% fully funded when 2010 ended, down from 103% funded in the year 2000.  Reduced investment earnings, increased long-term obligations and the inability of some states to fully fund required annual contributions were among the factors.

The Segal Company’s Joyner told the Andrew Young Policy School conference that pension funds have returned 8.8% annually for 25 years.  “We can ask the question, because of 2008, have the dynamics changed?  Is there something we should look at?  The answer is yes, we should always be looking… but to say 8.8% is unrealistic… is a little fanciful,” Joyner said.

Degas Wright respectfully disagrees:  “The key question is should we be using that historical picture going forward and I would say, probably not.”  Wright is a U.S. Military Academy trained mathematician, also owner and chief executive officer of Decatur Capital Management. 

Wright’s illustration: A pension plan that holds a 60/40 equities/bonds split would need to earn 11 percent annually in equities to post an 8 percent overall gain if the bonds earned 4 percent.  He thinks that equity earnings percentage cannot be sustained.  The Mercatus Center would appear to agree with Wright; Mercatus says pension plan earnings estimates should be tied to U.S. Treasury bond returns, which currently earn 4 percent.  Georgia estimates 7.5 percent annual investment returns.

Wright also noted that pension plans were heavy on bonds several decades ago but now they are primarily heavy on equities.  The Standard and Poor’s 500 Index that tracks 75% of all U.S. equities returned 3.32 percent during the five-year period that ended May 31.  The 10-year tracking return is even lower at 1.99 percent through Friday June 10, according to Morningstar.

Pension Reforms Will Play Out Over Decades

In April the National Conference of State Legislatures said 21 states enacted pension plan reforms last year.  Most states adjusted existing defined benefit plans.  Utah became the first state to adopt a full defined contribution plan for public sector employees since Alaska in 2005.  Michigan created a hybrid with elements of defined benefit and contribution plans.

States will continue to owe defined pension benefits for several decades.  Defined benefits are received by millions of retirees now, and millions more will receive them later.  New public sector employees in defined contribution or hybrid plans will not retire for decades.  That is why states and local governments must remain pro-active with their benefit plans.

“You’ve got to ask some basic questions about what you are trying to accomplish,” said Steve Vaughn of the Association County Commissioners of Georgia.  “What do you think is the right blend of cost-sharing?  What do you think is the right blend of risk sharing?  Most of the time, I find policy makers haven’t thought about those issues.”

For the final word we return to Leon Joyner of the Segal Company:  “As a society we are going through a fairly significant change to our mindset.  This includes how long we work, how long we live, how much longer we should work because we live longer, how much any pension plan should replace.  The big issue is not financing these programs.  It is financing the whole entity government.”

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