By Charlie Arlinghaus

March 2, 2011

As originally published in the New Hampshire Union Leader

Pension and retirement obligations are the biggest long term problem facing the state. New Hampshire’s four long-term pension and retiree health benefit obligations have current unfunded liabilities of more than $7 billion. Changing the state’s pension and health obligations is no longer optional.

Through the Retirement System, the state administers a pension plan for state and local employees and a retirement health benefit. Those two components have unfunded liabilities of $4.7 billion. In addition, outside of the system there is a much larger health benefit with an unfunded liability of $2.4 billion and a much smaller judicial retirement plan with rapidly eroding funding — $15 million in the hole after just five years.

Reform efforts right now are focused on the largest component, the pension plan of the Retirement System. For state and local employees, employees contribute a percentage of their income and the taxpayers contribute a percentage. Theoretically, the contributions plus the investment income earned on those contributions pay for the cost of an employee’s retirement benefit earned according a formula based on years of service and three highest years of salary.

The problem is theory hasn’t worked in practice. When the system began in 1967, it was expected that an employee would receive benefits for about ten years. The current life expectancy of a 65 year old is 20 years and most employees retire well before 65. For police and fire retirees who can retire as early as 45, they can earn benefits for twice that long.

Over the last 25 years, employees and employers (taxpayers) have each contributed about $2.1 billion into the system. Those contributions have earned a total of just over $5 billion. Despite that, the system is short $3.7 billion in the pension benefit alone.

Most of the theories behind the shortfall are wrong. Switching from one valuations schematic to another made a small difference but the two (open group aggregate and entry age normal) were relatively close to each other in the seven years before we switched from one to another.

Taxpayer contributions did not match employee contributions for many of the last 25 years but they have exceeded them in recent years and the aggregate contributions are roughly equal.

The problem with the system is that it assumes a very static employment history when almost no one’s is static. If an employee stays in the same job at the same level with no promotions other than cost of living adjustments, the system works for most state employees.

But if your salary increases more than 2.5% in a year because of step increases or perhaps getting a better job, the system doesn’t keep up. Your benefit will be based on your highest salaries not your average salaries. But your contributions were based on a much lower number.

In a world where almost no one can be expected to stay in the exact same job with no promotion and no increased responsibility for 20 or 30 years, our retirement system works only if they do. That means that for the vast majority of employees contributions and investment income don’t cover their costs and the system will get worse and worse.

In fact the history of the system bears this out. While the unfunded liability has been increasing every year, we took steps a few years ago to supposedly fix the system. The greater portion of the taxpayer contributions to the system are to pay off the accumulated liability. If the fix is working our accumulated liability will slowly decrease over 26 years to zero.

Yet last year, when the system had a significantly better than average investment return and taxpayers supposedly paid a large installment on the unfunded liability, liabilities still increased by more than a billion dollars

To make matters worse, this picture is probably overly optimistic. Our estimate of the unfunded liability is based on a number of assumptions. One of them is that the system’s return on investments is going to be 8.5% per year. This assumed rate of return is significantly higher than the historical experience of the pension fund. Assuming a higher rate of return makes the problem look better than it really is.

The pension system is broken and tinkering on the edges won’t fix it.

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