Policy Brief June 2010

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1 Policy Brief June 2010 Pension Tension: Understanding Arizona s Public Employee Retirement Plans The Arizona Chamber Foundation (501(c)3) is a non-partisan, objective educational and research foundation. The Foundation produces research studies on Arizona public policy issues such as health care, budget, education, regulation, energy, and others in an effort to inform policy makers, business leaders, and the general public. Chancellor Level: Introduction State sponsored pension plans have become a growing concern for states across the country. A February 2010 report from the Pew Center on the States warned of a $1 trillion funding gap for state retirement systems 1. Unfunded pension liabilities are often associated with decision makers who promise future benefits to employees without adequately funding the plan in the present. In many cases, this scenario is true. However, despite Arizona s strong record of making the required contribution every year, the state faces a $10 billion pension deficit. This policy brief identifies liability growth as the driving force behind the deficit. It provides an overview of Arizona s public pension plans and explains the relationship between pension assets, liabilities, and contribution rates. Additionally, the brief highlights the impact of pension liability growth on state and local budgets, acknowledges criticism of accounting methods that may lead to understated liabilities, and presents options for reform. Defined Benefit vs Defined Contribution Employers offer retirement plans that are categorized as either defined benefit or defined contribution. Defined benefit plans are most common in the public sector, while defined contribution plans are most common in the private sector 2. Defined Benefit Employees are guaranteed a set of retirement benefits determined by a formula based on average wage, years of service, and a benefit multiplier. The pension is funded by employee and employer contributions. The size of each contribution is expressed as a percentage of the employee s salary and is determined by the annual valuation. Employers are contractually obligated to deliver the defined pension benefit, so the investment risk is ultimately borne by the employer. Nationally, these plans are most common in the public sector, with 84% of state and local government workers having access to defined benefit plans, compared to 21% of private sector workers. Dean Level: To illustrate how contributions are made and benefits accrue in defined benefit plans, consider a 65 year old employee enrolled in the Arizona State Retirement System (ASRS) who retired in 2009 with 20 years of service. Over the course of the employee s career, both the employer (funded by Arizona taxpayers) and the employee deposited money into the ASRS fund. The size of the deposit depended on the contribution rate (determined by the annual actuarial valuation) and the employee s salary. Based on historical contribution rates and assuming that the employee earned the average wage in the ASRS system each year, the employee contributed a total of $32,717 to the state pension system. That contribution was matched by an equal contribution by the employer, and the funds were invested according to the ASRS investment policy. Table #1 illustrates the schedule of contributions made during the 20 year career.

2 Table #1 solely on the performance of the funds. Employees bear the full investment risk. These plans are most common in the private sector, with 61% of private sector workers having access to defined contribution plans compared to 30% in the public sector. Role of Labor Unions The degree to which employees are unionized directly impacts the availability of defined benefit retirement plans. In the private sector, where only 7.2% of the workforce is unionized, 21% of workers are offered defined benefit retirement plans. In the public sector, where union membership reaches 39%, 84% of employees have access to defined benefit plans. Within the unionized portion of the public sector, 96% of employees have access to defined benefit plans. Arizona Pension Plans While contributions are invested by the fund manager in a wide range of asset classes with varying degrees of risk, the size of the normal benefit does not consider investment performance. Instead, the benefit is determined by the following formula: Years of Credited Service*Benefit Multiplier*Average Salary The average retired ASRS member has 20 years of credited service, so assume that the example employee worked for 20 years, starting in The benefit multiplier depends on years of credited service and ranges from 2.1%-2.3%. For an employee with 20 years of service, the multiplier is 2.15%. Average salary is calculated using the highest 36 consecutive months out of the last 120 months*. Assuming that represent the highest 36 month average in this example, the average salary would be $42,659. Plugging these numbers into the formula yields an annual benefit of $18, years *2.15% * $42,659 = $18,343 Assuming that the retiree will live another 15 years and excluding any permanent benefit increases, the employee will collect $275,145 from the ASRS fund after contributing a total of $32,717 over the course of a 20 year career. Defined Contribution Defined contribution plans do not guarantee any future benefits. Instead, an employer offers employees the opportunity to contribute pre-tax earnings to a retirement fund such as a 401(K). In many cases, the employer will match the employee contribution, and the size of the retirement benefit depends *For members enrolling in ASRS after July 2011, average salary will be calculated using the highest 60 consecutive months out of the last 120. The Arizona State Retirement System (ASRS) is a defined benefit retirement plan that covers the vast majority of state and local government employees, including public school teachers. Active employees totaling 223,323 currently contribute to the program while 103,979 beneficiaries receive retirement payments, health care subsidies, or long term disability benefits. As of June 2009, ASRS s actuarial accrued liability (AAL) of $35.8 billion was 79.3% funded 3. Due to its size relative to the other plans, the majority of this brief will refer to ASRS, but many of the points apply to all of the funds. Other state administered defined benefit pension funds include: Public Safety Personnel Retirement System (PSPRS) 4 $8 billion AAL, 68.2% funded. 19,867 active employees, 8,609 beneficiaries. Correction Officers Retirement Program (CORP) 5 $1.58 billion AAL, 82.6% funded. 14,580 active employees, 2,591 beneficiaries Elected Officials Retirement Program (EORP) 6 $506 million AAL, 71.3% funded. 857 active employees, 905 beneficiaries. For a more extensive profile of each plan s provisions, see Exhibit #1. The funding status of Arizona pensions has deteriorated in recent years. As recently as 2002, ASRS had a $1 billion surplus, but now faces a $7.4 billion deficit. The next section will explain some of the key factors that influence the funding status of pensions and will look at how each of these factors contributed to the growing unfunded liability in Arizona.

3 Net Contribution Net contribution represents the difference between the money deposited into the pension fund by active members and the benefits actually distributed to retirees. The amount of money deposited into the fund depends on the decisions of employers and employees to make the contribution suggested by the actuary. The size of the payments made to retirees depends on the benefit formula and any Permanent Benefit Increases (PBI) or enhanced PBI. Liabilities Retirement benefits are earned by employees in the form of deferred compensation. The liabilities of a pension fund represent the present value of the future retirement benefits that have been earned. The size of pension plan liability is a function of the expected annual benefit payment per employee and the number of payments per employee. Expected Annual Benefit Payment The expected annual benefit payment to an individual employee is based on the benefit formula, which considers average salary, a multiplier set by the legislature, and years of service. Longer spans of employment, higher salaries and increases in the multiplier will increase the annual benefit, which increases the size of the liability. Expected Number of Payments The number of payments that will be made to a given employee in the future is uncertain, because it depends on factors such as retirement age and lifespan. Actuaries make assumptions based on historical data to generate this number. Longer life spans and earlier retirement ages will increase the number of payments, which increases the size of the liability. Number of Employees After determining each employee s liability based on the annual benefit payments and the number of expected payments, the total liability is simply the sum of each employee s individual liability. It is clear that adding employees increases the total liability. Assets The assets of a pension fund are the resources that will be used to meet the retirement obligations represented by the plan s liabilities. The size of the plan s assets at a given moment in time is a function of net contributions and investment income. A PBI is an automatic cost of living adjustment (COLA) paid from the excess investment earnings reserve. The PBI increase is capped at 4% in the ASRS plan. An enhanced PBI is an additional benefit paid to retirees for every five years of retirement if the money is available. Investment Income Pension funds invest in a wide range of asset classes including domestic and international equities, corporate and government bonds and real estate. The performance of these investments directly impacts the total value of the fund. During the last 10 years, ASRS annual investment returns ranged from -18% to 17%. Contribution Rate The contribution rate, which is calculated annually by the actuary and expressed as a percentage of employee salary, is the size of the contribution required to ensure that the assets of the plan can sufficiently cover the future liabilities. The contribution rate consists of two components. Normal Cost The normal cost is the present value of the accrued retirement benefits earned by an employee over the course of the year, and the size depends on the factors that influence the overall plan liability. Increases in salaries, length of employment, the benefit multiplier, or number of employees will increase the normal cost. Investment returns and net contributions have no impact on the size of the normal cost. UAAL amortization payment In a perfect world, contributing the normal cost would sufficiently fund the liability of a pension plan. In reality, negative investment returns, inaccurate actuarial assumptions, and failing to make past contributions generate unfunded actuarial accrued liabilities (UAAL). These unfunded liabilities are paid off over time (30 years for ASRS), by making a UAAL amortization payment as part of the annual contribution. Ultimately, the annual contribution is equal to the sum of the normal cost and the amortization payment. For the ASRS,

4 Table #2 (Millions $) *Surplus/Deficit numbers are at June 30, 2000 and June 30, The FY 2002 rate is based on the status of the fund at June 30, FY 2011 rate is based on status of the fund at June 20, a 12.98% normal cost combined with a 6.22% amortization payment yields a contribution requirement of 19.2%, which is split equally between employers and employees. This means that the UAAL causes the annual contribution to be 48% higher than it would be otherwise. Table #2 highlights change in UAAL and employer contribution rates over the past decade for the four major Arizona pension plans. It is important to note that the employee contribution for the non-asrs plans are set in statute, so any increase in required contribution is funded solely by the employer. Recent Trends The financial position of ASRS has weakened significantly over the past decade. The plan currently has a $7.4 billion UAAL just ten years removed from a $3.6 billion surplus. As a result, the employer contribution rate (the taxpayer contribution to the public pension plan) has risen to 9.6%. Table #3 highlights some of the factors that contributed to development of the ASRS UAAL since Table #3 Trends, As table #3 indicates, plan liabilities more than doubled due to a growing public employee workforce, rising salaries, and legislative action. To put the employment and wage increases in context, total Arizona employment grew by 8% over the same time period, and average Arizona wages increased by 29% 7. In addition to increasing the benefit multiplier, the legislature also: Increased the health insurance medical benefit. Increased the maximum COLA from 3% to 4%, Removed parameters that limited COLA increases to increases in the consumer price index (CPI) Removed minimum age restriction for COLA eligibility Decreased the threshold for determining excess earnings Removed a cap on the maximum benefit size as a percentage of salary that had been set at 80%. AVA vs Fair Market Value Before discussing the assets, it is important to understand that pensions do not report the fair market value of assets. Instead, they report the actuarial value of assets (AVA), which makes adjustments to the fair market value of the plan by smoothing investment returns over multiple years. For example, in FY 2009, the market value of ASRS assets declined by $6.6 billion. However, only 10% of this loss was immediately recognized, while the remaining 90% will be recognized in future valuations. Due to the recognition of deferred investment gains from , ASRS actually experienced a $480 million increase in actuarial assets during 2009, despite a $6.6 billion fall in market value. The use of AVA rather than fair market value prevents large fluctuations in contribution rates from year to year. While this may be helpful for budgeting purposes, it does not accurately reflect the funding level of the plan. With $28 billion of actuarial assets, ASRS reported a funding level of 79% on June 30, This number fails to account for significant recent investment losses that will be recognized over the next ten years. By comparison, the market value of assets at the same date was $20 billion, which translates to a 57% funding level. Implication of UAAL A UAAL becomes a significant burden on both public employees and taxpayers. Current employees end up contributing to their own retirement (normal cost) and subsidizing the retirement of current retirees (amortization payment). State and local governments end up dedicating more scarce resources to pension obligations, which inevitably leads to either tax increases or reductions in funding for other government functions.

5 discount rate should be based on the risk free U.S. Treasury yield curve. Using the yield curve and assuming a typical pension duration of roughly 15 years, the discount rate should be closer to 4% ASRS Valuation Since the contribution rate paid by each ASRS employee and employer bottomed out at 2% of salary in 2002, it has climbed to 9.6% for FY 2010 and is conservatively forecasted to continue rising beyond 11% through at least FY During FY 2009, the 9% rate translated to an $891 million contribution to ASRS by state and local governments. Contributions to the public safety, corrections, and elected officials plans totaled $328 million, $56 million, and $11.3 million respectively, for a total pension contribution of $1.3 billion. It is important for state leaders and the public to recognize the impact of these rising pension costs. Unlike many city budgets, there is no specific line item in the state budget that explicitly identifies pension costs. Instead, the costs are reflected in the employee related expenditures of each agency, which includes all employee benefits. Increases in the contribution rate places upward pressure on each agency budget. Why these costs may be understated At face value, the growth of Arizona s unfunded liability should be a serious concern for policy makers. An even greater concern may be the shortfall that official numbers fail to reflect. Pension funding levels reflect the ratio of the actuarial value of assets to the actuarial accrued liabilities. The actuarial value of liabilities represents the present value of future retirement benefit payments. A central component of any present value calculation is the choice of discount rate. A higher discount rate results in a smaller present value while a lower discount rate results in a higher present value. Some argue that the 8% discount rate that is typical of public sector pension plans is too high, and therefore the stated liabilities are too low 8. Financial liabilities should be discounted at a rate that reflects the risk of default. The risk associated with a pension liability is the probability that the future retirement benefit will not be paid. Due to the constitutional protections that guarantee the payment of public retirement benefits, the probability of pension default is very low, if not zero 9. As a result, the choice of As anticipated, the size of the liability increases when a risk free discount rate is used. An analysis performed by researchers at the National Bureau of Economic Research suggests that the cumulative size of unfunded state pension liabilities calculated using U.S. Treasury yields is more than three times larger than the $1 trillion reported by the states. The Goldwater Institute calculates that the $10 billion shortfall reported by Arizona pension plans is actually more than $50 billion when using Treasury yields. Options for reform In order for Arizona to rein in pension costs, the state needs to acknowledge the full size of its current obligations and make meaningful reforms that curb the growth of future liabilities. Due to the Constitutional protections afforded to previously earned pension benefits, these efforts must focus on future enrollees. During the most recent session, the Arizona legislature passed and the Governor signed HB 2389, which made three main changes to ASRS that will apply to those enrolling after July 1, Raised the normal retirement threshold from 80 to 85 points (age + years of service). Increased the number of months used to calculate average compensation from 36 consecutive to 60 consecutive. Eliminated employer contribution refunds. Currently, terminated employees are partially vested in the employer contribution after five years, and fully vested after 10 years. HB 2389 eliminates the refund of employer contributions at any point, unless the employee is terminated due to an Employer Reduction in Force or position elimination. As a result of these three plan changes, the actuary estimates a present value savings of $953 million. While these significant reforms address some of the factors contributing to growing liabilities, they do not fundamentally change the state s defined benefit approach to retirement. A number of states have shifted to alternative plans, including defined contribution and hybrid plans. Defined Contribution Plans Two states, Michigan and Alaska, have addressed their own pension problems by enrolling new employees in defined contribution plans. Alaska closed enrollment in the old defined benefit plan for state workers and teachers in Since then, all new employees have enrolled in a defined contribution plan. Employees contribute 8% of salary, and employers

6 contribute an additional 5%-7% of salary. Michigan began enrolling new state employees in a defined contribution plan in 1997, which today enrolls around half of the state workforce. Public school teachers and police are still offered separate defined benefit plans. The state contributes between 4% and 7% of salary depending on the employee contribution level, which can range from 0% to 12% of salary. Hybrid Plans Hybrid plans blend elements of defined benefit and defined contribution plans. These plans generally offer employees an employer funded defined benefit plan that offers lower benefit levels than typical public pensions. Employees then have the opportunity to contribute additional money to a 401 (K) style defined contribution program. Variations of this approach have become mandatory in Georgia, Indiana and Oregon, while Ohio and Washington offer hybrids plans as an alternative for new hires and non-vested workers 11. The hybrid approach has also been adopted by some firms in the private sector. For example, in a cash balance plan, the firm sets up a retirement account for each employee. The account is funded by employer contributions that are set as a percentage of salary. The employer then guarantees a rate of return based on a metric such as U.S. Treasury yields. Employees can then elect to enroll in a supplemental 401 (k) type program if they are looking for a higher return. However, they bear the risk associated with that higher return. Conclusion Arizona s current $10 billion unfunded pension liability should be considered a best case scenario. As noted above, current asset levels are overstated compared to market fair market value. In addition, the liabilities are likely understated due to discounting that does not accurately reflect risk. Meanwhile, employees continue to accrue constitutionally protected benefits that increase the overall liability of Arizona taxpayers. In the absence of meaningful reform, unchecked liability growth will force the state to allocate more resources to pension funding, leaving fewer resources for core governmental functions. Notes 1 Pew Center on the States The Trillion Dollar Gap. 2 National retirement benefit statistics derived from U.S. Bureau of Labor Statistics. March, National Compensation Survey: Employee Benefits in the United States 3 ASRS financial and enrollment data derived from the 2009 Comprehensive Annual Financial Report and 2009 Actuarial Report on the Valuation of the Plan. 4 PSPRS financial and enrollment data derived from the 41st Comprehensive Annual Financial Report and 2009 Annual Actuarial Valuation. 5 CORP financial and enrollment data derived from the 23rd Comprehensive Annual Financial Report and 2009 Annual Actuarial Valuation. 6 EORP financial and enrollment data derived from the 28th Comprehensive Annual Financial Report and 2009 Annual Actuarial Valuation. 7 Arizona Department of Commerce. Arizona Workforce Informer. 8 Recent publications include: Novy-Marx, Robert, and Rauh, Joshua. December, Public Pension Promises: How Big Are They and What Are They Worth? Goldwater Institute. March, $50 Billion Tidal Wave: How Unfunded Pensions Could Overwhelm Arizona Taxpayers. Stanford Institute for Economic Policy Research. April, Going For Broke: Reforming California s Public Employee Pension Systems. Manhattan Institute for Policy Research. April Underfunded Teacher Pension Plans: It s Worse Than You Think. 9 Arizona State Constitution. Article 29. Section U.S. Treasury Department. Daily Treasury Yield Curve Rates. May National Association of State Retirement Administrators. February Comparison of selected features of statewide hybrid retirement plans.

7 Exhibit #1

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