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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

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]

 

 

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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