Pensions: We're Not Done Yet

The celebration over this session’s primary political achievement shouldn’t distract from the fact it’s not a solution to our biggest fiscal challenge.

“However, as our panel's final recommendation indicated, more work remains to be done. This year's actions are vital to help stabilize the plan's financial condition, but real and considerable long-term risks remain with respect to younger public employees, future taxpayers, and the delivery of future government services. These include both structural and accounting changes to better support transparent and fiscally responsible pre-funding of our pension promises. We should look at the reform bill passed by the Senate as a vital step in Minnesota's journey for pension reform.”

“Sacrifice together, make good on Minnesota's public pension promises”
Op-ed letter from the members of the Governor’s Blue-Ribbon Pension Commission
Duluth News Tribune, May 6, 2018

In a legislative session marked by acrimony and unproductivity, the unanimous passage and governor’s signature on the omnibus pension bill was an example of textbook lawmaking.  It wasn’t easy.  Three years in the making, the omnibus pension bill featured plenty of its own political drama and frustration.  To help things along, the governor created a blue-ribbon panel on pension reform in 2016 comprised of some of Minnesota’s top finance and legal minds to vet proposals, offer recommendations, and (most importantly) provide needed political cover for some tough decisions.  With its enactment, sorely-needed stabilization measures have now been put in place.

The reaction among stakeholders and political players was one-third parts joy, relief, and hyperbole.  The joy and relief reflected the importance of this issue to public workers and a recognition both of the challenges these plans face and the need to take corrective measures.  The hyperbole centered on just what was actually accomplished.  Public unions cheered the news, telling members the pension bill was “securing public retirements for decades to come.”  Legislators and stakeholders fawned over the “historic” and “unprecedented” accomplishment arguing Minnesota is a model for the rest of the nation.   And at a post-session rally of public sector workers, MMB Commissioner Myron Frans told the audience that when he sells state bonds this summer and rating agencies ask whether the state has solved its unfunded liabilities, “I’m going to say, ‘Yes!”

Some exaggeration can be excused in light of the enthusiasm over something fought for so long and hard.  But that messaging becomes a liability if it detracts from the work that still needs to be done.  That work was captured in the overlooked final recommendation of the blue-ribbon panel (“Support Study of Reform Strategies to Mitigate Pension Risk”) and in the quote above.  “Stabilization” should not be confused with “solution.”

What Was Done…and What Hasn’t Been Done

The pension bill’s substance itself should have been very familiar to anyone who has followed this topic for a while.  It contained the usual “shared sacrifice” elements of employer and employee contribution increases, state aid increases, temporary cost of living cuts, and last, but certainly not least, the critical fresh 30-year reset for paying off unfunded liabilities.  That last change is crucial to be able to bend the PowerPoint presentation graph lines in the right direction and publicly claim the existence of that fiscal unicorn: the “path to full funding.”  (For reference, the Government Finance Officers Association’s Code of Best Practice on pension amortization states that pension plans should “use closed periods (i.e. no resets) that never exceed 25 years, but ideally fall in the 15-20 year range”.1)  One new significant cost saving tweak was added, making a part-public service career more likely to be a losing proposition from a retirement standpoint.  According to the actuaries, the overall result of the bill is a modest 20% bite out of the $16.9 billion unfunded liability reported in the 2017 valuations for these pension plans.

While that assumption change was an important step in the right direction, two problems remain.  First, a 7.5% expected return on investment assets is still considered high.  In a memo to MSRS and PERA officials accompanying their respective valuation reports, the plans’ actuary recommended “an investment return assumption in the range of 6.85% to 7.68%” but also noted, “the selection of an investment return assumption at the upper end of this range results in a higher risk of increased actuarial contributions in the future, as the rate must be reviewed each year for reasonability based on actuarial standards.  A rate near the bottom of the range, such as 7.0%, would be more likely to be sustainable for a longer period.”

The other and much more disturbing problem is the continued use of the investment return assumption as the discount rate for determining the present value of future pension cash flows.  Beside violating every precept of financial economics, there is a profound practical implication.  A pension system based on discounting future pension benefit cash flows at a rate of 7.5% functions as a pension system that must make sure adequate revenues are always available to support a 7.5% annual growth rate in liabilities

  • regardless of actual investment performance,
  • regardless of recessions and stressed budgets, and
  • regardless of the fact that in a significantly underfunded situation (as exists today) smaller pools of assets actually have to grow faster than 7.5% just to keep up with the larger pool of liabilities. 

For all the praise showered on it, this pension bill does little, if anything, to stop the ongoing export of billions in current financial obligations onto future taxpayers (who will have their own public sector retirement obligations to pay for).  It does not adequately mitigate the accompanying risks to future taxpayers and public services or the opportunity costs and crowd out effects for future state and local services.  It does ensure government will continue to promise new benefits that won’t be properly funded.  The stabilization plan that was just enacted can best be described as enabling a high wire act of perpetually managed underfunding.  And a concise summary of state pension sustainability strategy is “do ya feel lucky?”

The Prospects for Change

Irrespective of the blue-ribbon panel’s final recommendation, there is likely to be zero interest or appetite for doing anything more on public pensions anytime soon.  Stakeholders view the results of this session as a destination, not a first step as part of a bigger reform journey.  Legislators will not want to dive right back into the political slog of the past three years.  Organizational representatives of cities, county and school district employers – perhaps the closest thing that exists to taxpayer advocates in the world of public pensions – still appear remarkably sanguine and supportive about the state of pension affairs, suggesting their advocacy decisions are more about keeping the peace than tax pressures and budget exposure.  And unless something disastrous happens in the next couple of weeks, FY 18 will prove to be another strong year for investment markets, further mitigating any urgent sense of need to do something more.

If internal pressure for faster change ever materializes it ought to come from the individuals most harmed by the status quo – younger government workers.  That’s a function of the extraordinary cross subsidization of older employees and retirees by younger workers that occurs in defined benefit plans.  Defined benefit plans are intensively backloaded, meaning most of the pension wealth is created in the last few years on the job.  Several studies have examined how long public employees must work until their retirement benefits are worth more than just their own contributions.  The findings are nothing short of stunning.  A study by the Urban Institute2 concluded that Minnesota teachers hired after June 30, 1989 have to work 34 years to break even on their own pension contributions.  Another report3, this time from 2017, concluded Minnesota teachers would never reach a point where their retirement benefits would be worth more than their own contributions – leading the authors to conclude, “It’s not unfair to say current pension systems treat younger employees as sources of revenue for other people’s pensions rather than valued employees in their own right.”

Moreover, every cost saving tweak and adjustment the state has implemented, including this year, to protect retirees and long-term employees exacerbates this problem by imposing large costs on those who may not want to commit to a lifetime of work in the public sector or want to leave “too early.”  The human capital impacts are real, and if younger workers invested in understanding the economics (and future risks) of the state’s defined benefit plan structure as currently designed it would likely transform from an “attraction tool” to a repellant overnight.

For all the congratulatory messages being offered around the state regarding this year’s pension bill, it’s important to keep in mind that the fundamental challenges the design of the pensions themselves posed – as we’ve outlined above – are still in play.  Chronic underfunding, unsuitable measurements of risk and the failure to appreciate how the aging of the system is fundamentally changing the nature of financing these plans are still major problems.  The 2018 legislative session provided a “feel good” moment in traveling down the road toward retirement system health and sustainability.  But this year’s pension bill is a run flat tire – it’ll keep you going for a while but ultimately you will have to make a change.

Footnotes

1 GFOA Best Practice: Core Elements of a Funding Policy.  http://www.gfoa.org/core-elements-funding-policy
2 Negative Returns: How State Pensions Shortchange Teachers, Urban Institute, September 2015
3 (No) Money in the Bank: Which Retirement Systems Penalize New Teachers, Thomas Fordham Institute, September 2017