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Pension Problems: Breaking down state pension liabilities

(Journal graphic by Journal Graphic Designer Selena Hautamaki)

The first in a six-part series on the state of pensions in Michigan

– At just 61.6 percent funded, Michigan ranks 39th nationally for the health of its public pension system, according to a report by the Wall Street Journal

MARQUETTE — A perfect storm has converged around public pension plans, putting municipalities, schools, administrators and legislators in a bind over how to rebuild and fund benefits sustainably into the future.

With costs rising to meet the growing liability, public entities are facing difficult decisions.

“You start playing this game of, well, what’s more important — should we pave this road or pay this extra retirement contribution?” said Marquette City CFO Gary Simpson.

Unfunded accrued pension liability is the difference between the total amount due to both retirees and current employees upon retirement, and the actual amount of money the system has on hand to make those payments.

Negaunee City Manager Jeff Thornton said the impact of unfunded pension liability is being felt in cities across the state. For instance, downstate Port Huron led a conference call on unfunded liability with the Michigan Municipal League a couple months ago, he said.

“They actually said on the phone call that if something doesn’t change, they will be bankrupt in three years,” Thornton said.

Concerns about growing liability are reaching a fever pitch because of a complex web of pressures on the system, which this series will seek to untangle while shedding light on local challenges and efforts to pay down the looming burden.

By state

At just 61.6 percent funded, Michigan ranks 39th nationally for the health of its public pension system, according to a report by the Wall Street Journal that looked at 2013-14 data from the Bureau of Economic Analysis and the National Association of State Retirement Administrators.

NASRA has said a minimum funding target for states should be at least 80 percent, but 100 percent is the goal.

Two states, Wisconsin and South Dakota, are 100 percent funded, while Washington, North Carolina and Oregon are more than 95 percent funded.

Connecticut on the other hand — one of the wealthiest states in the country with an average income of nearly $65,000 — ranks 48th in the WSJ study at just 52 percent funded. Other states at the bottom are Kansas, Alaska, Kentucky and Illinois.

So why are some fully funded and others 50 percent in the hole?

The answer gets complicated fast, and wide disparities among state systems make accurate comparisons difficult.

The basics

A large percentage of all public pension assets in Michigan are administered by the Michigan Office of Retirement Services via four systems, one each for state employees, public school employees, judges and state police. ORS also serves Army National Guard retirees, for a grand total of about 250,000 active and 265,000 retired members — impacting one out of every nine Michigan households, according to ORS.

The Municipal Employees’ Retirement System, on the other hand, is administered separately as a statutory public corporation, operating on a not-for-profit basis and governed by an elected board. MERS serves public employees in 841 municipalities, each municipality with a separate trust within the pool.

Traditionally, the basic concept behind pensions has been that employers and employees paid incrementally into a statewide pool, which was then invested and grown over time and used to support retirees.

Public pensions in Michigan are legally required to be pre-funded, though calculating future needs to keep them that way isn’t an exact science. The system collects payments based on complex algorithms that include uncertain assumptions like projected interest rates and life expectancy that don’t always come true.

As liability has grown in recent decades, there has been a call to close public pension systems altogether and a move to individual plans — an idea that has people divided.

The Mackinac Center for Public Policy warns of “fiscal calamity” if public pension pools aren’t closed.

“If legislators want to do something that will benefit millions of Michiganders for decades to come, one goal stands above all: Put a cap on massive legacy costs of public pension systems,” writes Executive Vice President Michael Reitz.

However, the National Institute on Retirement Security has released studies showing that pooled pension systems can offer the same benefits as individual plans at nearly half the cost, due to longevity risk pooling, a more balanced investment portfolio, lower fees and higher returns.

But let’s back up.

Plans

Pooled pension systems once guaranteed “Defined Benefit” plans for its retirees wherein they were promised a defined amount based on their salary and length of service. But increasingly that has been replaced by the individualized “Defined Contribution” plan, where you get exactly what you and your employer put in, plus or minus market performance.

School employees, state police and some other public employees in Michigan are offered a third option of a hybrid of these two, typically called a Pension Plus plan.

Non-unionized workers were moved to the individual plans earlier, for instance judges and some managerial MERS members as early as 1997, while teachers, police and some other municipal employees have been given the option of the hybrid or DC plans more recently, since about 2010.

Some reasons for the shift toward individualized plans are they’re more portable, so it’s easier to change jobs; more personalized and flexible, because you manage your own investments; and for the employer, more sustainable long-term because it is the contribution instead of the benefit that has been contractually defined.

But others argue it’s less secure for the employee; less efficient due to higher administrative costs and lower overall returns; and it drastically changes the way the system was funding itself, increasing liability in the short-term. This is because when the employer closes the DB pool, new employees are not paying into it. They’re paying into their own individual fund instead, while employers do double duty, paying on that closed pool, while also contributing to their current employees’ individual plans.

That is one form of pressure on the system, but there are many others factors at play — from market performance, to the size of benefits, to what proved to be unrealistic assumptions.

Assumptions and the market

The switch to individualized plans is one of many reforms triggered in part by the Great Recession.

The global stock market crash reduced state and local pension fund assets from $3.2 trillion at the end of 2007 to $2.1 trillion in March 2009, according to NASRA. This caused pension costs to rise, which hit state and local governments right as the economic recession began to shrink their revenues.

To stop the bleeding, reforms aimed to increase employee contributions, lower benefits and move toward individualized plans to shore up future security.

To make matters worse, actuaries tasked with calculating annual pension contributions had been assuming some things that turned out to be financially optimistic.

For instance, MERS figured on an 8 percent return on investment, which has been the average long-term return over the last 25 years. But since the recession, which saw a return rate of negative 25 percent, MERS’ returns have been volatile, from 17 percent in 2009 to negative .85 percent in 2015, according to MERS’ 2016 financial report.

In response, MERS has lowered that assumption a quarter percentage point to 7.75 percent.

“See, these systems project that they’re (going to) make 7-8 percent annual returns to fund these things, and for like 9-10 years, that didn’t happen. We’re just now back up to 2008 levels,” Simpson said. “And it’s like that seldom happened but people weren’t really caring. But when all of this went down, all these systems started taking a look at — well maybe we need to revise that. MERS is only 7.75 percent, which is probably still unrealistic. So any time it’s less than 7.75 percent, that has to be made up in future years’ contributions.”

One reason the system hasn’t abruptly changed their assumptions is due to the shock it would cause small governments that are already struggling with revenue losses. Lowering the presumed return rate increases municipal monthly contributions significantly.

The even bigger assumption actuaries got wrong wasn’t so optimistic: They assumed people would die sooner. The good news is people are living longer, but living is expensive.

Another added pressure on the system is the fact that public entities have been cutting back their workforce, creating an imbalance among the number of retirees versus active employees. This trend requires working employees to increase their contributions even more to support retirees.

Reporting changes

Yet another pressure has to do with how municipalities report their liability. Changes in reporting requirements introduced in 2012 by the Governmental Accounting Standards Board are intended to increase governmental transparency and accountability, according to GASB.

But those changes have also thrown a wrench in local budgets, officials say.

Since 2014, GASB requires municipalities, schools and all public entities to report their unfunded liability in the line items of their budgets, instead of as a footnote at the end of their financial reports. This way, liability is listed as a present cost along with salaries, infrastructure and all other expenses.

Simpson said it’s been a big change.

“In a lot of ways it’s like you’re playing a football game, then halfway through the third quarter, you’re told you’re playing a basketball game. So it’s a whole new game that we’re playing and we just had no time to adjust to it basically,” Simpson said.

Even more dire, reporting requirements for healthcare liabilities and all other retirement benefits are due to hit the books in 2018, and those systems have lower funding ratios by far, according to their annual financial reports. The lower funding level is because Other Post-Employment Benefits have always operated on a pay-as-you-go basis, rather than being pre-funded.

For instance, MPSERS, the school retirement fund, is about 60 percent funded for its pensions, but its OPEB fund is just 21 percent funded. State employees’ pension system is 62 percent funded, but its OPEB is 12 percent funded. And the state police pension fund is 63 percent funded, while its OPEB is 12 percent funded, according to financial reports.

By contrast, the system for judges, which closed its pension pool in 1997, is more than 90 percent funded for both pension and OPEB. Rather than receive OPEB, retired judges enroll in the state health plan – which is deducted from their monthly pension check – until age 65, when Medicare becomes their primary health insurance, according to annual financial statements.

Solutions

MERS offers recommendations for municipalities to deal with ballooning liability payments, according to Jennifer Mausolf, marketing and product development director at MERS.

Mausolf said over the last five years, 73 percent of MERS customers have taken additional steps to reduce liabilities.

“There are several ways a municipality can close its unfunded liability gap,” she said.

Options include increasing assets by either borrowing to fund the gap — for example, through bonding, which requires that the DB plan be closed — or paying more than the required minimum contributions. In 2016 alone, 117 municipalities have chosen to contribute more, she said.

The other recommendation is to reduce or eliminate liability moving forward.

“Reduce the liability for new hires by offering a lower tier of benefits to new hires. Reduce the liability for new hires and existing employees by ‘bridging’ their benefit multiplier to a lower one and freezing final average compensation. Eliminate the liability for new hires by closing the Defined Benefit Plan and offering a Defined Contribution Plan to new hires,” Mausolf said.

But, she warned, closing the pension plan to new hires won’t eliminate the funding gap.

“The only way to eliminate an unfunded liability is to pay it off. This is because, whether a pension plan is open or closed, the obligation to pay for benefits earned in the past will remain,” Mausolf said.

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