The Pension Bomb

 

 Just as you probably haven’t socked away enough to retire yet—especially after 2008’s market losses—your state government has fallen behind, too. Way behind. As of the beginning of 2010, Connecticut has put aside only 52 percent of what it will need to pay pension benefits for its 53,000 eligible state employees on the job today and the nearly 40,000 retirees already drawing pensions. That’s about $9 billion short. The big difference beween your retirement and that of state employees is that no one is going to help you make up your retirement shortfall, but you—or your children perhaps—will have to pony up when the state’s pension fund runs dry. This looming deficit is what one economist calls a “sleeper tax” that will awaken sometime in the future. Or you might think of it as a fiscal bomb that is set to explode unless some politically unpopular steps are taken soon.

In addition, there’s a health-benefits bomb to consider. Taxpayers are called upon to pick up the health-care costs of state employees, too—as well as those of their dependents, including Medicare premiums once a retiree becomes eligible. Further, retirees can opt for slightly reduced pension payments to ensure that after they die, their spouses will receive half the pension and health-care coverage until they themselves die.

Most state and municipal governments currently are not required to set aside money for retiree health costs, or even account for them (though the state recently established a retiree health-care fund for new hires and those with fewer than five years of service). Health-care costs for retirees come out of annual operating budgets, lumped together with those still on the payroll. That amount in Connecticut currently comes to about $1.7 billion annually, a figure expected to grow rapidly in the years ahead. Taxpayers are liable for those accumulating costs, too, a long-term liability that the General Assembly’s Office of Fiscal Analysis estimates at $21.7 billion. 

Add it up, and every man, woman and child in the state of Connecticut is on the hook for about $8,700 to cover unfunded state employee pensions and post-employment health care. When you add in similar shortfalls for teachers’ retirement and health-care benefits, and for the thousands of municipal employees toiling for our 169 cities and towns, the per capita amount owed grows to $16,000. And of course, let’s not forget the additional $5,100 we each owe on the state’s $18 billion debt. 

We are not alone. Many government-sponsored pension funds across the country are feeling the pain of tough economic times right now. But we are in worse shape than most. According to a Moody’s Investor Services outlook issued in October that downgraded the state’s credit rating, Connecticut’s pension funding levels were among the lowest in the country in 2008, even before the market turmoil was taken into consideration, while the state’s post-employment benefit liabilities were actually larger than the size of the state’s annual operating budget. The report also noted that if the state were to fully and properly fund its annual required contributions for the health-care liability, it would have to double what it puts aside to nearly $3.5 billion, adding about $1.7 billion to an annual budget that is already seriously bleeding red ink.

The national average funding level for government-sponsored pensions is about 83 percent, even after market losses, compared to Connecticut’s 52 percent for state employees. Most studies suggest that an 80 percent ratio is a sound standard for state and local government pension funds. Anything lower than that is likely to require a combination of further funding through taxes or taking on additional long-term debt, reduced benefits or other spending, or increased employee contributions. Regardless, most solutions require shifting current obligations to future generations of taxpayers.

The silver lining is that the bill for state employee pensions and retiree health care won’t come due all at once. There is money in the fund, about $10 billion, to pay current and future retirees for some years to come. Future investment gains could also help reduce the shortfall. Still, long-term solutions are needed now, and any solution is going to cost money—a lot of money.

 

 

But solutions are not in the offing at present. With a state budget hundreds of millions in arrears and the prospect of the deficit growing into the billions, the focus in Hartford understandably is elsewhere. Unfunded future obligations are not something legislators and union bosses are inclined to worry about just now. As Scarlett O’Hara said, “I can’t think about that right now. If I do, I’ll go crazy. I’ll think about that tomorrow.”

The crux of the matter is that Connecticut taxpayers, already in a deep hole due to consistent neglect and investments turned sour during the stock market collapse, are on the hook for billions of dollars in pension payments. It is a contractual obligation which the state must address and which, unlike private pension funds, cannot be passed off on the federal Pension Benefit Guarantee Corp.

Most state employees are eligible to draw pensions at age 62 and after as little as five years on the job. About 7,000 employees remain under an older retirement plan that lets them start drawing pensions at 55. Workers are eligible for health-insurance retirement benefits after 10 years on the job. Most employee pensions are calculated as 2 percent of the average of the employee’s salary for the last three years on the job times the number of years in state employ. As workers approach retirement, they can increase their overtime and add accrued unpaid vacation time to increase their earnings up to 130 percent of salary for the purposes of calculating their pension payments.

So a worker who retires after 25 years and who made an average of $66,000 during the last three years on the job would get $33,000 a year in pension benefits. In addition, the state picks up the tab for health insurance for the retiree and his family. As of June 2008, according to the most recent actuarial assessment, the average pension was $27,500, totaling $1.04 billion annually for the state’s 38,100 retirees. The average figures to rise significantly in the future, reflecting steady increases in state-employee salaries. 

A pension fund has three primary funding sources: employee contributions, employer contributions and investment gains. Connecticut at present takes in $330 million annually in employee contributions and is supposed to match that with taxpayer funding amounting to about $335 million in fiscal year 2009 and $340 million in fiscal year 2010. Further, to shore up the unfunded liability, the state, via tax revenue, is supposed to contribute an additional $562 million in 2009 and $603 million in 2010. 

Investment gains, on the other hand, cost taxpayers nothing, but all too often they have been used to cover up deficiencies in contributions. In Connecticut, appreciating assets normally contribute from 60 to 80 percent of what the various pension funds take in each year. State Treasurer Denise Nappier, who has been widely praised for the job she is doing with investing pension monies, admits the last 18 months have been a challenge. “When the market hit its lowest point in the fall of 2008—the crash that was heard around the world—I knew we were in for trouble, she says. “In the fiscal year ending June 30, 2009, we were down 17.3 percent.”

The third quarter 2009 saw a 13 percent increase, “but it’s highly unlikely that the pension funds will generate positive enough returns so that the double-digit gains of this year will mitigate the double-digit losses of last year,” says Nappier. “But as painful as the market environment has been, we do measure our performance over the long haul. We’ve gone through cycles when the market was up and when it was down, but over the long haul we are getting 8.9 percent,” beating the actuarial assumption of 8.5 percent.

Even so, she says, the pension liability is growing faster than assets. With an ever-increasing retiree population, a larger percentage of the funds must be kept liquid to pay current obligations, which leads to smaller returns. “We need a disciplined approach to financing pension-benefit obligations,” she says. “We’ll always have market volatility. The outlook for the current fiscal year and the next five years is quite uncertain, so we need to be aware of what’s going to be a continuing storm.”

But politicians will often look for ways not to pay into the funds. When Gov. M. Jodi Rell and the state employee unions agreed last spring to forgo pay raises for a year in exchange for a promise of no layoffs, a little-noticed provision allowed the state to postpone $100 million of its required annual contribution to the State Employee Retirement Fund if the deficit exceeded $300 million. That provision became a key piece of the deficit-reduction plan House Democrats presented in December to counter Rell’s proposed budget cuts, but, if approved, it just digs the hole a little deeper—with interest. “Most people think that when the state doesn’t contribute fully, that’s it,” Nappier says. “But it’s not a waiver of the contribution, it’s a suspension. And it comes with an 8.5 percent interest charge that’s compounded year after year.”

“We have choices,” says Dan Livingston, a lawyer who represents state employee unions at the bargaining table. “We can increase taxes, we can cut spending, or we can in effect borrow money by slowing down the repayment to the pension fund.

 

 

Of those three choices, the one that does the greatest damage to the economy is cutting public spending. We were willing to agree to some delay in paying into the pension fund because it’s better than budget cuts in this kind of economy. So we have said that, sure, in general slowing down the payment to the pension fund is not a good idea, but compared to the two other choices, borrowing a little money from the pension fund is probably second-worst. The best is to raise taxes on those most able to pay.”

A common analogy equates funding a pension plan to a mortgage. “Having a mortgage in and of itself is not a financial problem for an individual, but if you borrow more than you can afford, then it can become a problem,” says Keith Brainard, research director at the National Association of Retirement Administrators. “If I have a mortgage of $100,000, that sounds like a lot of money, but when you consider it’s something I’m going to pay off over 10 or 15 years, it’s not that big a deal. Similarly, an unfunded pension liability really depends on how big it is and the fiscal condition of the plan’s sponsor.”

Connecticut’s unfunded pension liability is large, but ultimately manageable in normal times. But as Moody’s points out, the state’s fiscal condition is under extreme duress: “Connecticut compares unfavorably with other states on measures such as debt ratios that are among the highest in the nation, pension funding levels that were among the lowest in the country even before the market turmoil is factored, and other post-employment benefit liabilities that are larger than the size of the state’s annual operating budget.” Citing the state’s efforts to solve its budget crisis, Moody’s warns, “These solutions create future structural budget gaps and leave the state with significantly reduced flexibility to address additional fiscal pressures that may arise due to a delayed and/or weaker than expected recovery from the worst economic recession since the Depression.”

Nappier quickly points out the glaring weakness in the mortgage analogy: “Unlike a mortgage, a pension plan is never fully paid for because there will always be new plan participants working toward their retirement.”

How do we get out of this mess? An improved economy with fewer unemployed taxpayers and a bull market would certainly help. So would a group of influential legislators that makes the situation a priority. To get there, however, one has to cross a field planted with political land mines that include some combination of increasing state employee contributions, adjusting cost-of-living increases, tightening practices that inflate salaries used to calculate pensions, raising retirement ages, increasing taxes, or adding even more long-term debt to the state’s books by issuing pension-obligation bonds.

Another widely touted solution is switching from a defined benefit plan that pays a predictable sum on retirement to a defined contribution plan—one familiar to most of us working in the private sector—that requires employees to set aside money each payday and build a less predictable nest egg for withdrawal in the future. As for health care, the state and its public employee unions have taken a small step forward by requiring new hires to contribute to a retiree health-care fund, although the state is in no position to contribute to that fund beyond the $10 million it used to seed the fund.

“To reduce the cost of the pension plan means that you look at a plan design that will lower the costs. And that can be very controversial and sensitive to employees,” Nappier says. “Some plans in other states are redesigning the plan for new hires. It stops the bleeding. The other option is to increase the amount being contributed by all those that contribute, the employee and the employer. Maybe it’s time to rethink that.”

Perhaps, but the unions are unlikely to agree to major adjustments in the plan. “We have a very moderate pension benefit structure in the state and it’s one the state can easily afford,” Livingston says. “It’s not something that we’re unduly concerned about because it’s a moderate benefit structure and there is a system to pay off the unfunded liability over time.”

Issuing bonds in the amount of $9 billion to make up for the unfunded liability in just the state employees’ pension would increase the state’s already massive $18 billion debt burden by 50 percent. In 2007, the state issued $2 billion in bonds to make up for a shortfall in the teachers’ pension fund. “The idea is that you’re going to borrow money at  a rate lower than what you’re going to earn on it and that you’ll come out ahead,” Brainard says. “Evidence that I’ve seen indicates that most pension bonds issued in the last decade are under water.”

Switching new state hires to a defined contribution plan, which works like a 401(k) plan, is probably not a panacea, either. “You’re not relieving yourself of the liabilities that already exist in the plan,” Brainard says. “Simultaneously, you are restricting the payroll base used to pay off those liabilities. Generally, analyses in other states have found that changing new hires to a defined contribution plan takes years, at least a decade, to generate any savings. Then, at that point, the savings are relatively meager.”

Such a changeover also requires labor to go along, which is a doubtful proposition. The state already offers an alternative retirement plan in which workers put in 5 percent of their pay, with the state’s match at 8 percent of salary. But, as Sal Luciano, executive director of Council 4 of the American Federation of State, County and Municipal Employees and a state pension board member, observes, many of the workers who opted for that plan are having serious regrets.

“August ’08 hits and their nest egg is gone,” he says. “You have people who’ve been in there for 25, 30 years and thought they were going to retire. Then they looked at the balance sheet and said, ‘I can’t retire.’”

Ultimately, the executive and legislative branches will have to muster the political will to honestly account for liabilities and address ways to contribute consistently to the fund. “In my view, the way to go about it is to make adjustments to the pension plan,” Brainard says. “You have to embrace and engage the problem. Paying into the pension fund is not sexy. It doesn’t get many votes. But it’s a core responsibility of leaders to pay that.”

The Pension Bomb

Reader Comments

comments powered by Disqus
 
ADVERTISEMENT