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State Pensions: The Unfunded Liability and What it Means

 By Josh Elliott-Traficante

July 2011

The oft cited and growing unfunded liability of the pension portion of the New Hampshire Retirement System (NHRS), pegged at the end of last fiscal year at $3.7 billion, has been the driving force behind pension reform in Concord. This shortfall is not just a result of poor investment returns from the recent recession, rather it is systemic. Every year, for the past ten years, the dollar value of the unfunded liability has increased. Even in years with double digit investment returns, liabilities continued to out pace the growth of assets.

To understand what the unfunded liability is, we need to take a basic look at how the System functions on a financial basis.

According to the 2010 Comprehensive Annual Report (CAFR) of the NHRS, the pension component of the System took in just over $1 billion in contributions and investment income and paid out roughly $530 million in benefits and refunds. If the System operated on a pay as you go basis, it would be in great shape.

However, the NHRS does not function on pay as you go basis; rather it has assets, made up of employee contributions, employer contributions and investment income. Contributions are made to this pool by employees as a percentage of their salary at a rate set in state law. Employers then add a percentage of their employees’ salaries, as determined by the actuaries of the System These funds are then invested, which are now projected by the System to earn 7.75% a year.

Once employees retire, this pool is drawn on to pay their pensions. Money contributed to the pool today does not directly pay for current retirees; rather, the money for current retires was added while they were working. The System functions in this regard as a 401(k) does. Unlike a 401(k) however, the state guarantees retirees a pension amount based on their length of service and their average final compensation, not on the dollar amount of the assets. As of the end of fiscal year 2010 these assets totaled $5.23 billion dollars.

 

All values in millions of dollars[i]

FY 2001

FY 2002

FY 2003

FY 2004

FY 2005
Pension Assets

$3,265

$3,443

$3,500

$3,576

$3,611
Pension Liability

$3,843

$4,196

$4,669

$5,030

$5,991
Unfunded Liability

$578

$753

$1,169

$1,454

$2,011

FY 2006

FY 2007

FY 2008

FY 2009

FY 2010
Pension Assets

$3,928

$4,862

$5,302

$4,937

$5,234
Pension Liability

$6,402

$7,260

$7,821

$8,475

$8,954
Unfunded Liability

$2,049

$2,397

$2,519

$3,538

$3,720

 

Operating on the basis of guaranteeing a payout, the System also carries liabilities in addition to assets. Liabilities for the System are not the same as the commonly held notion of the term. Instead liabilities are the value of assets needed today for with assumptions being made for, among other things, inflation, wage growth, future contributions, the rate of return on investments and the value of future benefits of members in the System.

Today’s Liabilities + Assumptions of Future Revenue and Payouts

= Total Funds Needed to Pay Future Benefits

At the end of fiscal year 2010, the liabilities of the System totaled $8.95 billion dollars. The difference between these two numbers is how the value of the unfunded liability is calculated. Currently the System has $3.7 billion unfunded liability, and with the reduction in the expected rate of return from 8.5% to 7.75%, this number will likely increase.

Even without the recent economic downturn, the increases in the assets of the System have historically been far outweighed by the increases in the liabilities. Over the past 10 years assets have grown by just over 60% while liabilities have increased by 133%. This is not just as a result of the recession. Over the past 20 years assets have increased 288% and liabilities nearly 435%. In fact, every year, for the past 10 years, the unfunded liability has grown.

The Breakout by Group:

The New Hampshire Retirement System sorts employees into four categories: Employees, which includes local, county and state employees, Teachers, Police, which includes local, county, state as well as corrections and Fire. Teachers and Employees operate under one set of Pension guidelines as Group I and Police and Fire operate under another set of guidelines as Group II.

The NHRS also breaks out the unfunded liability by into the constituent categories of the System:

Employees (Group I)

Teachers (Group I)

Police (Group II)

Fire (Group II)

Group I Average

Group II Average
Percentage of the UL Responsibility by Category 33.88% 40.41% 17.15% 8.55% 74.29% 25.70%
Membership of the NHRS by Category 50.91% 36.35% 8.99% 3.74% 87.27% 12.73%
Unfunded Liability Portion per Member $31,813 $53,143 $91,150 $109,220 $40,698 $96,462

 

As shown in the chart above, there is not a correlation between the percentage of the unfunded liability by group and weighted membership for some of the categories. If the unfunded liability were equitably distributed among the groups, the “Membership of the NHRS by Category” field should be the same as the “Unfunded Liability by Category” field. They do not match however, with exception of Teachers, which is only four percentage points off. Group I Employees as a category account for 33.88% of the unfunded liability, yet in terms of their total membership in the System, they make up roughly half of those in the retirement system. Group II Fire on the other hand is responsible for 8.55% of the unfunded liability, yet in terms of their numbers in the System; they only make up 3.74%.

Thus, Group II Police and Fire account for a disproportionate share of the unfunded liability relative to their membership numbers in the System. Group II members are weighing more heavily on the System by a factor of well over 2 to 1 over their Group I counterparts. Going a step further, one Fire Fighter in the System has the same financial impact on the System of three Employees. This is not to say that Group II members alone are causing the issues facing the NHRS, but the data shows that they have a deeper financial impact on the System than Group I members.

Changes to the System: Rate of Return and Legislative Reforms:[iii]

When the retirement system changed their assumption on the rate of return on investments from 8.5% to 7.75% and the rate of wage growth from 4.5% to 3.75% in May, the liabilities will grow with the next valuation of the System. Part of that expected future revenue (investment income) is can no longer be counted on, so the needed present day value of the assets needs to be higher in order to payout the future benefits. Therefore, in order to keep the equation on page two of this paper balanced, the shortfall in future anticipated investment revenue must be offset by a corresponding increase in the liabilities. The unfunded liability will likely grow with the change; however this is highly dependent on the returns of the System over the past fiscal year and the extent of the normal increase in liabilities. Even though assumptions made by the System such as future pension amounts, contributions and total cost change slightly under the pension reforms, they are dwarfed by the financial impact of changing the rate of return.

Among other changes made by the legislature to the System this past session, Group I employees (Employees and Teachers) will now contribute 7% of their salary up from 5% and retire at 65 rather than 60. For Police members contributions rates go up to 11.55% of their salary and Fire 11.80%, up from 9.3% for both and retire at 50 rather than 45.

Contribution rates will take effect as of July 1, 2011 and the retirement ages will be phased in for Group II and for new hires of Group I only.

Group II has higher contribution rates because of their younger retirement age, shorter service and the fact that they don’t pay into, nor receive Social Security benefits.

While it will take some time to see these reforms take effect, it is a step in the right direction. With the changes in contribution rates taking effect next month, the funding of the System should improve, but the extent of which it is working will not be known for sure until the release of the CAFR for Fiscal 2012.

[i] NHRS Comprehensive Annual Reports, 2001-2010

[iii] SB3, the original pension reform bill was vetoed by Gov. Lynch on June 15th. In response, the House rolled the language of SB3 into HB2, the budget companion bill that contains enabling legislation.

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Defined Contribution Models in Other States

By Josh Elliott-Traficante

October 2011

With mounting unfunded liabilities in their pension systems, made worse by the recent economic turmoil, many states have begun looking at other retirement benefit options. In recent years, policy makers in a number of states have turned away from the pure pension model, instead opting for plans that are not only fair to the employees but also free the taxpayers from being left with the bill for huge deficits. Given the scale of the pension funding crisis, several reform minded states have instituted a variety of systems to replace their pension systems, which are outlined in the following paper.

Defined contribution systems however, come in a number of varieties and the basics of plans currently used by other states are laid out below:

Pure Defined Contribution System:

A pure defined contribution system functions in the same way as a private sector 401(k) functions. Money is contributed by the employee and generally matched by the employer, up to a certain percentage of the employee’s salary. Under this setup, as the employee gets closer to and passes the age of retirement, the ratio between stocks and bonds in the portfolio declines, reducing risk in exchange for greater stability. Under this set up, all of the risks and rewards of the fund is placed on the employee. There is no governmental liability once the contributions have been added.

States with mandatory defined contribution systems:

Alaska, The District of Columbia, Michigan (state employees), Utah (must choose between defined contribution plan or Hybrid plan)

States with open optional defined contribution systems:

Florida, Montana, Colorado, Ohio (all but Police &Fire), South Carolina (all but Police &Fire), North Dakota (non-classified employees)

Benefits:

–          Potential for employees to realize greater returns

–          No liabilities for the taxpayers

–          Greater portability

Disadvantages:

–          All of the investment risk falls on employees

Member Direction:

In all of the states offering defined contribution plans, the employees have a say in the investment direction. While employees do not get to pick what particular stocks or bonds to buy as they would with a brokerage account, they do pick the fund. Alaska, for example, offers a selection of funds for their employees to choose from ranging from Target Date Funds to Treasury Bond funds and everything in between.[i] Among states that offer DC plans, this is a standard practice.

Variations: In House vs. Contracted Out

When discussing the possible implementation of a defined contribution system the question arises of whether to manage the assets of these plans in house, or let an investment company such as Charles Schwab or ING manage the funds. Both options are currently being exercised in other states. In Alaska’s plan for example, assets are managed by number of firms including Black Rock and T. Rowe Price, while in Utah the assets are managed in house.

Implementations and Important Considerations:

No two states are exactly alike, so what simply taking what one state has done and doing it here in New Hampshire without modification would be unwise. For New Hampshire to switch over to a defined contribution system, changes would be need to be made to Group II (Police and Fire) to ensure equity between the two groups. Currently Group I employees pay into Social Security while working and receive benefits when they retire. It functions similarly to a pension plan in that it provides a regular and guaranteed payment. Group II however, neither pays into, nor receives Social Security (in part this is why they pay higher contribution rates currently.) In order to give Group II retirees the same assurances their Group I counter parts have, there are two potential options, either require Group II members to enroll in Social Security or create a version of a Hybrid Plan, which combines a pension and a 401k scheme that is only open to Group II.

The Hybrid System:

Hybrid System, combines a reduced pension and with a supplemental 401(k) for retirement benefits. The idea, similar to that of social security, is to give retired state employees some sense of stability in their retirement income, while not also burdening the tax payers with large pension liabilities. In the example of a hypothetical Hybrid System, the employee’s and employer’s contribution total 10% of the salary of the employee. This 10% contribution is then divided between a pension fund and a 401(k) fund. Each year the contribution rate for the pension portion is assessed, so as an example for Utah the 2011-2012 year the rate was calculated by actuaries to be 7.59%. The remaining 2.41% was contributed to the 401(k) portion.[ii]

The above model is only one way for a hybrid model to function. For example, under Georgia’s plan, the employee pays 1.25% towards the pension portion and the state contributes a portion set by actuaries (7.42% for 2011-2012 year). The employee contributes mandatory 1% to the 401(k) plan, with the state matching 100% for the first 1% and 50% for the next 4%. In simpler terms, the state’s maximum contribution to the 401(k) portion is 3%[iii]

States with mandatory Hybrid systems: Washington State (Teachers), Georgia

States with open optional Hybrid systems: Ohio, Oregon, Indiana, Washington State (All but Teachers), Michigan (Teachers), Utah (must choose between defined contribution plan or Hybrid plan

Benefits:

–          Investment risk spread between tax payers and employees

–          Combination of potential greater return and stability

–          Portability of 401(k) portion

Disadvantages:

–          Taxpayers still liable for short falls, albeit smaller than normal pension plan

Variations: COLAs

It is important to note that the contribution rates for Utah take into account cost of living increases (COLA) to the pension portions that are based on the Consumer Price Index. COLAs are capped at 2.5% per year. COLAs in the Georgia plan are at the discretion of the retirement board but not specifically built into the plan.

Variations: Institutional vs. Member Direction:

For the 401(k) portion of the hybrid plans, there is states have taken different routes in terms of who dictates the direction of the investments. In states such as Utah, Oregon and Georgia, for example, all of the investment direction is done in house by the respective retirement systems. In contrast, Ohio’s system allows for employees to choose between different in house managed funds.[iv]

Variations: Parallel Hybrid vs. Stacked Hybrid[v]

Parallel Hybrid:

This is the type of hybrid plan now in effect for the all of the states mentioned above. The employee receives a split DC/DB plan at all income levels. Though pensions would be smaller in comparison to a pure defined benefit plan, there is no cap.

Stacked Hybrid:[vi]

This type of plan, proposed by the Center for Retirement Research at Boston College, flips the parallel hybrid plan on its side. Rather than a split plan at all income levels, an employee is given a pension, based on a capped salary, for the sake of argument, $45,000. For those who make less than this amount, they and the employer only make contributions for a pension. For those who make more, say $60,000, the employees and employers would make contributions to the pension portion on the first $45,000, while any contributions made on salary over that amount would be placed into a 401(k).

Implementations and Important Considerations:

In the case of the stacked hybrid plan, suggested as an alternative to the parallel plan, what the cap is on the pension can vary. The proponents of the plan at the Center for Retirement Studies at Boston College proposed having the cap set at the average salary for the resident of the state, which is then indexed to inflation going forward.[vii] This cap could be set at any level, average state salary, median state salary, or just a round number, like 45,000, which is then indexed in some way to the growth of inflation so as to retain its intended value.

The contribution rates and ratios between the 401(k) and pension portion of the hybrid plans expounded on in this paper should not be taken as specific policy suggestions; they have been merely used to illustrate how other states administer similar systems. I am not, nor do I purport myself to be an actuary so I do not know, nor would I venture a guess as to what contribution rates would work for New Hampshire for the system to remain solvent.

Ohio Option:

Offering the greatest variety of choices to their public employees is Ohio. Under the Ohio Public Employee Retirement System (OPERS) employees are given the option of joining a traditional defined benefit plan, a hybrid plan, or a defined contribution plan.

Plan details:

Pension

Multiplier: 2.2% x Final Three Years Average Salary x Years of Service

If the years of service is 30 or over, the multiplier is 2.5%

Employee Rate: 10-11.1%

Hybrid

Multiplier: 1.1% x Final Three Years Average Salary x Years of Service

If the years of service is 30 or over, the multiplier is 1.25%

Employee Rate: 10-11.1%

Member Directed

Rates: Employee 10%, Employer 14%: Normal Cost 8.73%, Health 4.5%, Mitigation, .77%

Note: Plan stipulates that if Pension System needs financial shoring up, employer assessments on Member Directed Plan employees may be required. This mitigation rate is set at .77%

Conclusion:

There has been a slow, but gradual shift in the past twenty years to move state retirement benefits plans from pensions to 401(k)s or hybrid plans in an effort to either eliminate the future liabilities of the state or to at least share the financial risk between the state and the employees.

While there will be no silver bullet to fix the current short falls of the system, establishing a plan that does not leave the taxpayers on the hook will ensure the future fiscal health of the state.

[i] http://doa.alaska.gov/drb/dcrp/financial/dcrp-investment-options.html

[ii] https://www.urs.org/pdf/AnnualReport/2010/annualReport.pdf

[iii] http://www.ers.ga.gov/plans/ers/formspubs/GA%20ERS%206-30-2009%20Valuation%20Report%20Final.pdf

[iv] https://www.opers.org/members/combined/index.shtml

[v] Image taken from “A Role for Defined Contribution Plans in the Public Sector” released by the Center for Retirement Research at Boston College.

[vi] http://crr.bc.edu/briefs/a_role_for_defined_contribution_plans_in_the_public_sector.html

[vii] http://crr.bc.edu/briefs/a_role_for_defined_contribution_plans_in_the_public_sector.html

 

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