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Pension reforms upheld again by State Supreme Court

Josh Elliott-Traficante

January 16, 2015

Today the New Hampshire Supreme Court issued a ruling in the case of American Federation of Teachers –New Hampshire et al v State of New Hampshire, which upheld pension reforms made in 2007 and 2008.

Background

This suit, brought in 2009 by most of the state’s public sector unions, was against two particular changes made to the system. The first dealt with changing the definition of ‘earnable compensation’, by removing ‘other compensation’. In effect, it meant that special duty pay, for example, could not be used in calculating the pension payout. The second dealt with the method of funding cost of living adjustments (COLAs), specifically the move of $250 million from the Special Account into the rest of the trust fund and the elimination of annual COLAs. Both were efforts to shore up the financial stability of the New Hampshire Retirement System (NHRS).

The Unions’ Arguments

The unions argued that these moves impaired the rights of their members, which they were vested in upon full time employment. Changing the terms of how benefits were accrued and the effective halting of granting COLAs was a breach of contract. Likewise, these moves also constituted illegal taking by the government depriving members of the monetary gain these provisions would grant them.

The State’s Arguments:

The state argued that the statutes changed by the law did not constitute a contract. If they did not constitute a contract, then there could be nothing that could be illegally taken from union members. The employees were only vested in their retirement benefit once they retired. In addition, the plaintiffs did not show either the changes constituted a substantial impairment, or did they prove it was retroactive.  In regards to the COLA question, that by its very nature the COLA was based on a contingency, and not a contract. Even if it was a contract, the changes were reasonable and necessary (established as a key consideration by legal precedent for contract modification ) because without the change, the plan’s tax exempt status was jeopardized.

The Lower Court:

Like in the other pension reform cases, the lower court found that both the state and the unions were wrong in their arguments. Relying on the statutes governing the NHRS the court found that vesting both occurred at 10 years and that created a contract. As such, the changing the definition of earnable compensation did constituted breaking a contract, but only for vested employees. The changes to the COLA, though also breaking a contract, were necessary and reasonable to preserve tax exempt status with the IRS.

The Supreme Court:

When ruling in this case, the Supreme Court relied on the Unmistakability Doctrine’, just as it did in its pension ruling last December. Under the ‘unmistakability doctrine’, the court, in determining if a law constitutes a contract or not, must find evidence that the legislature meant to create a contract. “(A)bsent some clear indication that the legislature intends to bind itself contractually, the presumption is that a law is not intended to create private contractual or vested rights.”

Unlike the ruling on contribution rates, the Court had to deal with the issue of the word ‘vesting’. Rather than using the 10 year mark as the lower courts had done, the Supreme Court on the relied on the precedent set by the First Appellate Court, which had found that “when used in the context of a pension plan, the terms ‘vesting’ and ‘contractual’ are not synonymous and references to ‘vesting’ do not necessarily create a contract.” Looking the language that concerns vesting, the Court found “no unmistakable language that the legislature intended that once a member ‘vests’ that a contractual commitment has been established.” ‘Vesting’ in the sense that it is used by the NHRS does not create a contract.

With the vesting question dispatched, the Court then looked at the statutory language for the definition earnable compensation, and found, again, no unmistakable intent by the legislature to bind itself contractually. In looking at the statues concerning COLAs, the Court came to the same conclusion.

Going Forward:

There is still one pension case left outstanding; it had been stayed pending the outcome of these two cases. With this ruling firmly establishing that the use of the term ‘vesting’ does not in and of itself create a contract, and the application of the ‘unmistakability doctrine’ in both this case and in December’s ruling, all of the recent pension reforms are here to stay.

http://www.courts.state.nh.us/supreme/opinions/2015/2015006americanfederationofteachers.pdf

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A Look at the New Hampshire Supreme Court’s Pension Reform Ruling

Josh Elliott-Traficante

 December 11, 2014

Yesterday the New Hampshire Supreme Court handed down a ruling in the case of Professional Firefighters of New Hampshire, et al v State of New Hampshire; representing the culmination of nearly three and a half years of legal proceedings that sought to answer the question: how far can the state go in reforming pensions? The answer: pretty far. The Supreme Court unanimously ruled that increases can be made in employee contribution rates for all employees, regardless of how long they have been working. The increase in employee contribution rates were a key component of the package of pension reform measures that passed in 2011.

Background:

The pension reforms measures passed in 2011 took a number of steps to shore up what was, and still is, among the worst funded state pension systems in the country. Reforms included changing the way pension payouts were tabulated, such as extending the number of years used to calculate the final average salary from the last three to last five, how much overtime could be counted, and increasing employee contribution rates.

Additional suits had been filed (and are still pending) regarding other facets of reform measures, but this ruling on this case, commonly referred to as ‘Firefighters I’ only dealt with the changes made to the contribution rates for employees. Those changes increased rates for employees and teachers from 5% to 7% of salary, firefighters from 9.3% to 11.55% and police from 9.3% to 11.8%. However, the key point in each of these suits is the determination of when ‘vesting’ occurs. Once a person is vested, it means they have property rights that cannot be violated.

The Unions’ Arguments:

In June 2011, shortly after the increase in contribution rates took effect, a group of unions filed a petition in Merrimack County Court, arguing that these changes were unconstitutional. They argued that ‘members become vested in their NHRS benefits upon commencement of permanent employee status” In short, as soon as an employee makes it through their probationary period, how his or her pension benefits are accrued or contributed to on that day can never be changed.

This claim rested heavily on the precedent set in State Employees’ Association v Belknap County. In that case, a number of county employees were not enrolled in the New Hampshire Retirement system, despite several long standing orders from the State Treasury to do so. In that ruling, the court stated that “(retirement)benefits constitute a substantial part of an employee’s compensation and become vested upon the commencement of permanent employee status.” The use of the word ‘compensation’ was critical to the union’s case, as there is substantial judicial precedent in regarding compensation as contractual. With the Belknap ruling using the word ‘compensation’ in describing retirement benefits, the unions argued that retirement benefits were in fact a contract, and therefore changes made by the legislature were in violation of the Contract Clauses both in the U.S. and New Hampshire Constitutions.

The State’s Arguments:

The state argued that the legislation was not a binding contract, and that the only contract formed is the one once the employee retires and begins collecting his or her pension. If that is the case, then changes could be made to the pension system, such as increasing the amount of money an employee must contribute toward it, right up until the moment an employee retires.

The Lower Court Ruling:

Judge McNamara, of Merrimack Superior Court ruled that vesting occurred at ten years; not as some sort of Solomonic decision, but by looking at the letter of the laws governing the New Hampshire Retirement System itself. The RSA in question, 100-A, states that vesting occurs after 10 years, but crucially does not make mention of retirement benefits being considered as part of compensation.

In his ruling McNamara disagreed with the unions’ arguments on the basis of the Belknap County case. McNamara noted the Belknap decision found that RSA100-A only “(E)ntitles government employees to receive benefits in addition to salary, and that both wages and benefits are a substantial part of the employees’ compensation.” He went on to state that the issue at the heart of the case, the ability of the state to alter those benefits, was not presented in any of the case law cited by the unions.

The Supreme Court Ruling:

Both the State and the Unions appealed the decision to the Supreme Court. Leaving the issue of when vesting occurs aside, the Justices went to the heart of the matter: does language of the law concerning pensions constitute a contract?

Relying on previous case law, the Justices relied on the “Unmistakability Doctrine”, which requires the court to determination whether a challenged law has evidence of “the clear intent of the state to be bound to particular contractual obligations.” After review of the language of the statute that establishes the contribution rates, the court found that “the legislature did not unmistakably intend to establish NHRS contributions rates as a contractual right that cannot be modified.” As such, the Court ruled unanimously in favor of the state. With no contractual rights established in the law, the state can change the contribution rates for all employees.

What Does this Mean?

In short, the reforms of the past few years will remain in place. Though the Court only ruled on one narrow piece of the reform package, the impact of the ruling extends to the two other unsettled legal challenges. It its conclusion, the Court found “(T)here is no indication that … the legislature unmistakably intended to bind itself from prospectively changing the rate of NHRS member contributions to the retirement system.” Taking that as a guidepost, a reading of the legal language of the other contested reform measures, turns up nothing that would ‘unmistakably’ establish a contract.

In addition, the bulk of the other reforms made in 2011 were made to those who had not yet hit that critical 10 year mark. Those changes are currently being litigated in the ‘Firefighters II’ lawsuit. Firefighters II is currently stayed, pending the outcome of this weeks ruling and a third suit made against the reforms made to the system in 2008. That third suit, the HB1645 case, which deals with many of the same questions that Firefighters I and II does, was heard before the Supreme Court last month, with no timeline for when a ruling will be handed down.

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IL Bond Rating Downgrade over Pensions should be a Warning to New Hampshire

Josh Elliott-Traficante

With Illinois preparing to go to market with $500 million in general obligation bonds, the big three bond rating agencies, Moody’s, Fitch, and S&P have all issued their ratings of the new debt. Moody’s ranked the bonds as A2, Fitch at A and S&P at A- with all three agencies rating the outlook on the state as negative. This downgrade put Illinois’ bond rating as the lowest in the country. In comparison, the ratings on New Hampshire’s last bond issue were Aa1, AA+ and AA respectively, each 5 notches higher than their Illinois counterpart.

While seemingly archaic financial scores, bond ratings have a large impact on how much the state has to spend in interest payments over the life of the loan. Illinois State Treasurer Dan Rutherford has estimated that Illinois’ poor rating on the latest tranche of bonds will cost the state nearly $95 million.

Much has been made in the past few years over the dysfunction of Illinois’ finances and the legislature’s inability to get the state’s fiscal house in order; however, rating agencies are taking a closer look at another factor that weighs heavily on state finances: pensions.

All three of the rating reports of Illinois latest bond issue underscore the desperate need for pension reform.

From Fitch:

The rating watch negative reflects the ongoing inability of the state to address its large and growing unfunded pension   liability…Fitch believes that the burden of large unfunded pension liabilities and growing annual pension expenses is unsustainable. This large unfunded pension liability is despite the issuance of pension obligation bonds and passage of bipartisan comprehensive pension reform affecting new employees.

Moody’s also highlights the issue in their rating:

Illinois’ rating and negative outlook are consistent with our view that the state’s pension funding pressures are likely to persist and perhaps worsen in the near term. Lawmakers’ repeated inability to reach consensus on retiree benefit measures last year underscored the task’s extreme difficulty…Illinois is heading towards an unsustainable combination of higher pension contribution needs and reduced tax revenues.

S&P pointedly states that:

(t)he downgrade reflects what we view as the state’s weakened pension funded ratios and lack of action on reform measures intended to improve funding levels and diminish cost pressures associated with annual contributions

So while this does not bode well for Illinois, what impact does this have on New Hampshire? No question, Illinois is in much worse financial shape than New Hampshire when it comes to both state finances and pension funding ratio. In New Hampshire’s last bond issue however, while all three agencies affirmed top ratings for the debt, they also highlighted the size of the pension unfunded liability as a concern going forward. (Fitch & Moody’s)

However, state pension systems that have higher funding ratios than New Hampshire, such as Pennsylvania, have seen debt downgraded in part due to pension liabilities. In Pennsylvania’s case, a combination of high debt and modest unfunded pension liabilities contributed to its downgrade. New Hampshire’s relatively light debt load so far has allowed the state to avoid costly downgrades despite a large unfunded pension liability.

To prevent New Hampshire from going down the path of Illinois or Pennsylvania, the state policy makers must keep bonding in check and not only hold the line on past pension reforms, but reform the system further by taking steps to spread the risk more equitably between the public employees and the taxpayers of the state.

[UPDATE: Illinois has postponed the bond issue mentioned below, citing “unfavorable market conditions”]

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Pension Reform Study Commission Falls in Committee of Conference

A study commission that would have looked at instituting a defined contribution retirement plan (ie a 401(k) style plan) for state employees failed to make it pass a committee of conference.

Both the Senate and the House, while agreeing in principle to study the idea of implementing a defined contribution plan, had passed differing versions of a study commission, with the House passing a more aggressive timeline for reporting as well as a provision that would have enacted a DC plan should the legislature had failed to act on the commission report.

Though most of the disagreements were worked out over the course of three meetings, including the controversial “Sword of Damocles” provision. The major sticking point revolved around the Request for Proposals process. The House position was that the commission needed to be able to issue RFPs themselves rather than through DAS (Department of Administrative Services) to get concrete details about what a plan would look like while the Senate, uneasy with the unprecedented nature of giving a commission such authority, wanted DAS or the Retirement System to issue them and provide technical assistance which was complicated in of itself due to the nature of the NHRS as well as existing priorities of DAS.

The Senate and House could not agree on this point and in the words of Rep. Ken Hawkins had to “agree to disagree.”

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NHRS System Returns Show Strong 3rd Quarter, Still Behind for the Year

The recently released investment return figures from the third quarter show that while the New Hampshire Retirement System investment fund saw a 8.4% return in the corpus’s investments, beating the benchmark, the fund has only seen returns of just under 3% so far for the year, falling short of the 7.75% assumed rate of return.

The domestic equity portfolio, saw a 12.2% return, though falling short of the benchmark of 12.9%. Non-US equity saw 13.2%, which beat its benchmark by 2 points. Fixed income assets also did well, seeing a 2.5% return versus a .9% benchmark.

Due to the complex nature of the valuation of assets of Alternatives and Real Estate, the figures and benchmarks a lagged by one quarter, but the data is still valid. Real Estate saw 1.3% return, though the benchmark was 3.1%.

Lagging behind all other investment vehicles was Alternatives. Alternatives are private equities, essentially stakes in a company that does not have shares that are publicly traded. For example, Burger King and Toys R Us, fall into this category. Bain Capital, which was in the news as of late, as well as Berkshire Hathaway are both involved in these financial sector.

Alternatives saw a -.2% loss for the quarter, while the benchmark was 9.2%. So far this fiscal year and year to date, the NHRS has lost money on these investments. Annualized returns have also the System lagging far behind. Granted, the system had left the Alternatives portfolio go dormant, (i.e. new investments were not made, but money was not pulled either) until its revival in fiscal year 2011. For FY11, Alternatives saw a 13.9% return.

All that being said, it is hard to gauge the success or shortcomings of an investment class over the time frame of less than two years and even more so for just a single quarter that this investment snapshot looked at.

In the world of pension funds, Alternatives are a mixed bag. Some systems embrace them, seeing them as a way to close unfunded liabilities without resorting to pension reform. Others shun them, viewing them as far too risky an investment. While the gains could be substantial, so could the losses they reason.

The New Hampshire Retirement System currently allocates roughly 2.1% of the fund for these kinds of investments, roughly $132 million. Their new target 10%, all things being equal would mean an investment of more than $650 million. While that in of itself is not a bad thing, investments in this area must be carefully placed and closely monitored. Big risks can mean big rewards, but we shouldn’t forget it can mean big losses as well.

Though the fund is currently falling short of the 7.75% goal, the books do not close until June 30th, so there is time to make up the difference. Only time will tell if we hit or miss the mark this year.

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Pension Reform Resources

With growing funding shortfalls, exacerbated by the recent economic turmoil, many states are taking a hard look at reforming their state pension systems. We here at the Josiah Bartlett Center have been following this trend here in New Hampshire as well as in other states across the country. Below is some of our work done on pensions so far as well other informational resources.

New Hampshire Specific:

A JBC study that explains what an Unfunded Liability is and why it is important

Another JBC report on the current state of the New Hampshire Retirement System and why reform is desperately needed

The current legislation in the New Hampshire Senate, SB229, which would create a defined contribution plan for state employees

The most recent analysis of SB229 done by the NHRS actuary

 

National:

A JBC study on defined contribution (401(k)) models that other states currently have in place

Research done by NCSL on the types of retirement systems used by various states across the US

Further research on the growing problem with unfunded liabilities in state pension systems

A recent US Senate report on the current pension funding crisis as well as a piece from Real Clear Markets on the issue

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An Updated Look at the New Hampshire Retirement System, the Unfunded Liability and Troubling Trends

Joshua Elliott-Traficante

February 2012

 

Earlier this month, the New Hampshire Retirement System (NHRS or ‘the System’) released its Comprehensive Annual Financial Report (CAFR) revealing the current state of the System at the close of the last fiscal year. Fiscal Year 2011 saw assets grow by nearly $1 Billion, however the funding ratio dropped more than a percentage point to an unhealthy 57.4%. Though this seems counter intuitive, this shows the folly of judging the financial soundness of the System by looking at a single data point. Instead the following paper seeks to take apart the complex CAFR and explain the financial status of the pension portion of the System in layman’s terms, as well as look at the troubling historical trends.

 

Asset Growth

 

It is critical for any retirement system is to see solid returns on investments, and 2011 was certainly a stellar year for the NHRS. The System saw a 23% return on its investments; over $1 Billion, which added nearly $993 million in assets to the system. Under 5 year smoothing, the first 8.5% is recognized immediately, with all growth over that amount phased in over the following five years. However, it is important to recognize that for all the gains made in the past year, the system is still absorbing the losses of 2008 and 2009.

 

An Apples to Apple Comparison: Liabilities, Reforms and the Rate of Return:

 

While undoubtedly an investment return of nearly $1 Billion is excellent news for the financial health of the NHRS, it only tells half of the story. It is the liabilities that tell the crucial other half of the story. Put simply, the liabilities of any pension system is the sum of money needed today, given certain assumptions about payroll growth, the rate of return on investment and retirement age, among a litany of other metrics, to pay for future retirement benefits.

 

As is the nature of actuarial assumptions, these are regularly tweaked to fit a changing workforce as the need arises. For the most part, apart from a major unforeseen demographic change in the state, they are usually small adjustments. However, when it comes to the assumptions regarding the assumed rate of return on investments and how benefits are calculated, this can cause major changes in the value of the liabilities for the System.

 

The revision of the anticipated rate of return from 8.5% to 7.75%, on the advice of the Gabriel, Roeder and Smith (GRS) and approved by the Board of Trustees, increased the liabilities of the system by roughly $757 million. With the reforms in the calculations of benefits, which passed last year, decreased the unfunded liability by roughly $430 million for a net result of a $327 million increase in the unfunded liability due to these reforms.

 

In order to do an apples to apples comparison of the growth of liabilities over past years, these reforms must be taken into account. Doing so, by backing out these two changes, the liabilities of the System increased $717.3 million.

 

Net investment income, allowing for 5-year smoothing, was $993 million, leaving in a theoretical net gain $275.7 million under this scenario.

 

Current Liabilities

 $9,998,251

Revision of rate of return

–

 $757,000

Revision of payout calculations

+

 $430,000

Adjusted Liabilities

=

 $9,671,251

 

Even taking into account this reforms, liabilities still grew by 8.19%. This is where, in part, the problem lies with the pension system: the growth of liabilities.

 

Fiscal Year

Liability Increase

2011 (Adjusted)

8.19%

 

Though this increase is below the old rate of return of assumed rate of return of 8.5%, it is now above the new rate of return of 7.75%. Taking a longer view of the system, we see this troubling trend more clearly:

 

 

 

Over the past 22 fiscal years, the compounded annual growth rate in the liabilities of the system was 8.93%, outstripping most of the projected rates of return for that time frame, as well as the 7.19% compounded growth rate in assets, leading to the growing unfunded liability.

Compounded Annual Growth Rate

Assets

7.19%

Liabilities

8.93%

 

Granted, this time frame covers two revisions in the rate of return (1992 from 9.5% to 9% and in 2005 from 9% to 8.5%. Figures for 2011 have adjusted to account for the recent change) as well as two changes in accounting methods in 1992 and 2007. While the CAFRs from the respective years do not detail the extent to which the changes affected the growth or decline in liabilities, below details the average yearly growth in liabilities for all of the 22 years analyzed as well as a the average yearly growth with the atypical years removed. The results are essentially the same.

 

Average Yearly Growth Rate of the Liabilities

All 22 Years

9.51%

Atypical Years Removed

9.54%

 

As mentioned in earlier works, one cannot judge the soundness of a financial institution by looking at one side of the ledger sheet. Below is the same liabilities data alongside the actuarial value of assets.

 

 

 

It should be stressed that the asset figures are not investment rate of return figures, rather they are the actuarial value of assets figures, which are used in calculating the unfunded liability of the system. Again however, we see the same trends: the rate of increase in the liabilities is outstripping the rate of growth of assets. As always there are years which are anomalous, in the case of assets, 2007, where due to legislative reforms, previously siphoned off funds were returned to the pension Trust Fund.

 

Average Yearly Growth Rate

Liabilities

9.51%

Assets

7.88%

 

So what does this all mean? Simply put, the retirement system is on less than stable long term financial footing. This is not to say that the system is going to collapse, but the trends over the past 22 years are not good ones and point to issues greater than just short term market cycles.

 

These trends stand for themselves. Years of record investment returns of the 1990s, which averaged nearly 14.5% a year from 1990 to 2000, played a role in masking the problem with the growth in liabilities. In those years the growth in liabilities were overshadowed by the investment returns, so there was no problem; as long as the investment returns were consistently in the double digits, year over year.

 

But this highlights the issues facing the current system, which without consistent double digit investment returns, it cannot keep up with the growth in liabilities. Again, this is not a problem with investment returns; this is a liability growth issue.

 

While the current amortization schedule will fix this problem over a 30 year period, we cannot keep in place a system that only works well for everyone when it realizes double digit return on investments.

 

Looking Towards the Future: A Defined Contribution Plan

 

One policy decision that could be made to prevent this from happening again is to switch all new employees to a defined contribution plan. Currently under consideration is SB229, which proposes to do just that.

 

Under such a plan, the state’s liabilities end once the employer contributions are deposited into the employee’s accounts. Thus, there can be no unfunded liability to the system. This gives the state, counties, cities and towns budget certainty because there is a set amount that goes into the employee’s accounts and that figure does not change based on what happens in the market. Such certainty is critical for local and state government to be able to hire more teachers, police officers and firefighters.

 

Such a system also protects the employees. Once those funds are deposited into their accounts, that money is theirs and only theirs, no legislative actions can change that.

 

An added benefit of a defined contribution system is that since the employees own the accounts, it travels with them when they change jobs. We live in an era where people typically do not work in the same industry for 30 years and a pension model does not fit the needs of these people as well as a defined contribution plan would.

 

Defined contribution plans have been adopted in several other states across the country, Michigan has had one in place since 1996. What this shows is that not only is it possible to create and implement a defined contribution plan for government employees, but that it works, and it can be done well.

 

Joshua Elliott-Traficante is a Policy Analyst at the Josiah Bartlett Center for Public Policy, a free-market think tank based in Concord, NH. He can be reached at [email protected]

 

 

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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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