Post-crisis reforms make pensions sustainable?

Originally posted at www.calpensions.com

A nationwide study, including CalPERS and CalSTRS, projects that huge pension fund losses during the financial crisis will be offset over three decades by a wave of recently enacted cost-cutting reforms — but only if several things happen.

–Pension fund earnings forecasts must hit their target. Critics say the forecasts, 7.5 percent a year for the two California funds, are overly optimistic and conceal massive debt.

–Government employers must make their actuarially required contribution to the pension fund each year. CalPERS has the power to demand full payment. CalSTRS contributions, frozen by legislation, are $4.5 billion a year short of the required amount.

–The cost-cutting reforms must not be rolled back. A state worker pension cut under former Gov. Pete Wilson in 1991 was followed by a major retroactive pension increase under former Gov. Gray Davis, the trendsetting SB 400 in 1999.

The paper issued by the Center for Retirement Research at Boston College, led by Alicia Munnell, is one of the first looks at the long-term impact of the reforms, drawn from a sample of 32 plans in 15 states.

“In short, states have made more changes than commonly thought,” said the paper issued last month. “Whether these changes stick or not is an open question.”

Munnell is not an advocate of the pension status quo. She has said the best retirement plan is a “hybrid” combining a smaller pension with a 401(k)-style investment plan, shifting some of the risk from the employer to the employee.

She has recommended switching the reporting of pension debt to a lower risk-free earnings forecast based on U.S. bonds, rather than a higher but riskier portfolio-based forecast. As Stanford graduate students showed, the change balloons pension debt.

The new study, following an academic format, does not directly engage in the debate about whether public pensions are “sustainable” or will eat up too much of government budgets, shrinking funding for schools, public safety and other programs.

But the findings point to sustainable, if all of the qualifications are met. Under cost-cutting reforms, average pension costs are projected in three decades to take a smaller share of state-local budgets than before the financial crisis in 2008.

The study found that average pension costs before the financial crisis were 4.1 percent of state-local budgets in 2007, jumping afterward to 6.5 percent in 2011. After reforms, pension costs are projected to be 5.3 percent in 2028 and 3.3 percent in 2046.

Before the Boston center sent out a news release about the study last week, Munnell offered a carefully qualified opinion about the findings during a Century Foundation panel discussion on Jan. 31.

“If plans can earn historical returns and if they can stop blowing the tops and if the cuts to benefits that are in place stay in place,” Munnell said, “then I think going forward pensions are not going to be the major culprit in the state-local budget squeeze.”

“But I acknowledge that returns are very uncertain and benefit cuts do not always stay,” she said. “So it’s an area people are going to have to keep monitoring carefully.”

“Blowing the tops” refers to the tendency of pension funds, when flush from a market surge, to cut employer contributions and raise employee pension benefits. (For example, see the Calpensions post on CalSTRS 15 Feb 13)

As in California, the pensions of current workers in the other states studied have legal protection and are difficult to cut. Munnell said she tended to “pooh-pooh” reforms that lowered pensions for new hires because cost savings are delayed for decades.

“But lo and behold, if you think about it, after 35 years everybody’s going to be a new employee,” she said. “So if you look at it over a long time, these changes have a big effect.”

Several of the reforms, including California’s, increased employee pension contributions, regarded by some as a cut in retirement benefits. And some of the reforms cut the cost-of-living adjustments in pensions promised current workers.

“When you get to the area of the COLA,” Munnell said, “a lot of those (cuts) are made for existing retirees, which I found really extraordinary that it happened and that courts have upheld it.”

Munnell said lower compensation can result in attracting lower quality employees, studies show, and cuts should be done carefully. She said pension reform may be needed to address fiscal pressure, imperfect plan design and early retirements.

“The change I would most like to see,” Munnell said, would allow cuts in pension amounts earned by current government workers, giving plan sponsors the flexibility to respond to economic conditions.

She applauded Rhode Island for taking on the issue and triggering a union lawsuit whose outcome will be “very important.” Legislation spearheaded by state controller Gina Raimondo would switch all current employees except police to a “hybrid” plan.

In California, the watchdog Little Hoover Commission urged the Legislature to allow cuts in pension amounts current state and local government employees earn in the future, while protecting pension amounts already earned.

Gov. Brown’s pension reform did not cut pensions for current workers or most COLAs. But AB 340 did reduce pensions for new hires, increase contributions for some current workers, extend retirement ages and cap big pensions.

The new study said the financial crisis will boost the pension share of California state-local budgets from 5.5 percent to 8.2 percent. By 2046 the pension share is projected to drop to 5.7 percent, with the assumed earnings, contributions and reforms.

Because the California Public Employees Retirement System has been receiving its actuarially required contribution, the study said, the financial crisis increased the amount needed to pay the debt or unfunded liability from 5 to 6 percent of pay.

But because the California State Teachers Retirement System, with its frozen rates, has not been receiving its required contribution, the financial crisis more than tripled the amount needed to pay the debt, from 4 to 15 percent of pay.

In a Wall Street Journal article last week, Munnell discussed a new documentary by Canada’s Ontario Teachers Pension Plan about the need for flexible pension systems that can evolve and adjust to changing economic conditions.

A Dutch model that can increase employee contributions and cut retiree pensions is being adopted by a plan in the Canadian province of New Brunswick with the support of some unions.

“In public plans in both the U.S. and Canada, the money is not there to pay the current level of promises in the future,“ Munnell wrote, describing the documentary in which she appears several times. “The message is that we need to recognize and accept this fact and set up a new system with sustainable benefits.

“Sustainability has two dimensions. The benefits must be affordable, in the sense that people cannot receive benefits for longer than they work. And the pension system must have some flexibility so that orderly reductions can be made in bad times and increases provided when times are good.”

Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at http://calpensions.com/ Posted 11 Mar 13

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