Pension Politics in 2017 Just Got a Lot More Interesting

The governor’s somewhat surprising veto of the 2016 omnibus pension bill was disappointing to many pension stakeholders but celebrated by others.  That split reaction alone portends a rather interesting pension policy debate in 2017.  But recent developments and their policy implications guarantee the hearings on the 2017 pension omnibus bill will be memorable.  Here are three reasons.

1. Another year of significantly missed investment return expectations (and likely more of them going forward) will add to the fiscal and political challenge.

The end of the fiscal year marks the date when the snapshot on which pension fund valuation reports are based is taken.  Even though the reports themselves won’t be published until nearly Christmas, the start of the new fiscal year always offers a visit from the “Ghost of Actuarial Future” and “pension things yet to come.”  That’s because the one-year performance of the State Board of Investment’s benchmark indices offers a glimpse into what investment returns we can expect will be reported and in turn, the decision-making context legislators are likely to face in 2017.

Table 1 presents the performance of SBI’s benchmark indices for the recently completed fiscal year.  It’s worth noting these reported returns are not influenced by Brexit-induced fret as the market had essentially recovered the vast majority of its post-Brexit losses by June 30^th.  Actual SBI returns will, of course, vary from what this table reports but don’t be surprised to see the SBI report essentially flat returns later this year.

Table 1: Investment Returns of SBI Benchmark Indices, FY 2016

For the second year in a row, returns will have missed expectations badly, and fund conditions will weaken further.  Because the state directs actuaries to phase in any individual year’s investment gains or losses over a five-year period, the actuarial valuations might preserve superficial appearances as the final realization of gains from the post-Great Recession market boom offset 20% of these unmet expectations.  But on a market value basis, the condition of these pension funds will unquestionably be worse.  Thus, as advocates for the sustainability measures the governor vetoed this spring attempt to resurrect them, the sustainability challenge will have grown.  It would not be surprising to see PERA also seek corrective actions similar to what TRA, MSRS, and St. Paul Teachers have been looking for.

Moreover, if some of the nation’s foremost investment advisors are correct, any hopes of sustained bull markets need to be severely tempered.  As Table 2 indicates, expectations for U.S. equities in the near term range from sluggish to pathetic, especially when evaluated against the return expectations our pension system is based on.  The prognosis for fixed income is not any better as the end of June also ushered in an all-time low in the 30-year Treasury yield while negative bond yields are proliferating in developed economies around the world.  Because the pension system’s fulcrum is set at returns of 8%, a protracted period of underperforming – although positive – returns can be just as or even more damaging as a one-year major market correction.  That’s especially true for underfunded plans needing superior investment returns to both dig out of an existing hole and fund new obligations.

Table 2: Expected Nominal Returns for U.S. Equities from Selected Imvestment Firms

2. Pressure for new direct or indirect state pension aids will increase.

In testimony before the Legislative Commission on Pensions and Retirement this year, school district officials made it abundantly clear they didn’t have the capacity in their budgets to absorb increased pension costs and wanted state aid to pay for it.  Our recent education finance study validates these concerns as we projected that for about 75% of districts, growth in compensation costs through FY 2017 (assuming historical trends remain unchanged) would exceed the 2% per year increase in basic formula aid the state enacted in 2015.  There is no reason to believe the position of school boards and administrators will change in 2017.  As pension plans’ conditions worsen, we can expect the approximate $45 million needed to cover districts’ additional pension costs in 2016 to climb northward in 2017.

Not only would a special appropriation for school pension support be a lightning rod of political controversy, it would open a Pandora’s box of brand new “fairness” concerns among all public plans while establishing an increasingly expensive precedent.  State agency managers would justifiably want to see larger appropriations to offset the impact of their higher cost structures.  Meanwhile, local governments would commit lobbying malpractice if they didn’t argue what’s right for schools is also right for cities and counties.  In fact, the policy position of the influential League of Minnesota Cities already states,

“for the PERA General Plan, any further increases in employer contributions should only be considered by the Legislature after other measures have been considered, including:

a)an increase in employee contributions so that employees and employers truly bear the same responsibility to bring the pension plans to full funding; or

b) the removal of the cap on PERA Pension Aid payments so the state equalizes the contributions of employees and employers.”

The other option will be to advocate for major increases in existing operating aid programs with additional money directed to pension support.  If very visible aid increases specifically dedicated for pensions are too politically uncomfortable, expect big pushes for major increases to the school aid formula, LGA, and County Program Aid instead.  While such pursuits would have their own political obstacles, the primary political advantage is that stakeholders can market the additional money to the public and press as “investment in our communities and schools” instead of as an additional expense for the same pension benefits.

3. Major cracks in the foundation of “shared sacrifice” start to appear

Pension plan boards and public employee unions work very hard to keep all the different sub-interests singing not just from the same hymnbook with respect to pension policy, but also from the same page.  That’s not easy to do.  The interests of younger active employees may conflict with those approaching retirement which in turn may conflict with retiree interests.  As a result, stakeholders and lawmakers are extremely sensitive to the notion of spreading any discomfort corrective actions create around as fairly as possible.  As the governor’s veto demonstrated, policy initiatives can collapse when even the appearance of an imbalance in “shared sacrifice” arises.

The standard recipe for shared sacrifice has always been equal parts employer and employee rate increases plus a dash of lowered cost of living adjustments for retirees.  But even these carefully measured ingredients don’t guarantee fairness will be baked into state pension policy.  For example, with respect to a permanently lowered cost of living adjustment, the accompanying table illustrates why recent retirees might ask just why they are being treated in the same way as longer-term retirees – many of whom have already benefitted from an increase in their base pension benefit since their retirement that is well over two times the rate of consumer inflation.

Table 3: Comparison of Retiree Benefit Increases to Inflation, Selected Pension Plans

On the contribution side, pressure is building to deviate from historical policy which has more or less required employees and employers to fund the system equally.  With more and more dollars being directed to take care of existing unfunded liabilities, there is increasing reticence to saddle current government employees with the pension costs of their predecessors.  The vetoed 2016 omnibus bill would have set the employer contribution rates for the general MSRS plan and TRA one percentage point higher than the employee rates, on the grounds that current employees should not be penalized because retirees are living longer than expected.

The problem, of course, is that from a practical perspective, the differentiation between an employee and employer contribution is not that clear cut.  Local governments and state agencies may remit pension contributions to the SBI, but similarly to business taxes a lot of incidence of those contributions will ultimately fall on government employees.  Based on plan valuation reports we estimate that by the end of FY 2015, increased contribution rates for Minnesota’s major public pension plans above their FY 2009 levels directed an additional $1.4 billion in resources to pension support.  Or to put it another way, that’s over $500 million  in redirected takehome pay and another  $900 million of potential salary growth that never materialized.  The prospects of government employers having to commit larger and larger shares of potential compensation dollars to pensions is likely to hang like a dark cloud over wage negotiations in union contracts for the foreseeable future.

As a result, bigger grumblings from within over the fairness of “shared sacrifice” proposals in 2017 seem very likely to emerge.  A temporary 1% reduction in the cost of living increase on a retiree’s benefit (which in conjunction with Social Security already is designed to replace over 90% of the income from one’s peak earning years¹) will likely be on the table again next year.  Meanwhile, school districts and teachers are already collectively directing 15% of payroll to pay for pension support.  Will going up to 16% or more of wage compensation seem like equivalent sacrifice to a college loan-stuffed young teacher, especially when the benefit will not be realized for 30 to 40 years?

Our Margin for Error is Vanishing

In large part, the 2017 pension bill will be about making the money pension funds need available to them as soon as possible.  That objective already faces some self-imposed policy obstacles which facilitate chronic underfunding, like elevated return expectations, extended amortization periods, and protracted contribution phase-in periods.  Even though some of these practices drive the actuarial required contributions (ARC) for the pension plans down, collectively the state’s major public pension plans have still not made the required ARC for 12 years in a row.  That’s not an accident.

Those policies could be fixed (at considerable political risk and government expense), but there’s a bigger issue that cannot.  Thirty years ago, Minnesota’s pension plans brought in more from contributions than they paid out in benefits, allowing for the excess to be invested to meet future retirement commitments.  Thanks to changing demographics, that is no longer the case.  Figure 1 graphs the 30-year history of the net cash flows for Minnesota’s major public pension plans, after taking out investment returns.  Last year alone, these pension plans paid over $2 billion more in benefits than they received in contributions from all sources.  It puts the $85 million “fix” from the increase in employer contributions proposed this year in some perspective.

Why does this matter?  As this trend continues, and less capital is retained to invest, it will become more and more difficult to rely on investment performance alone to solve these pensions’ financial problems.  In the process the primary advantage of even having defined benefit pensions plans – risk mitigation – is being undermined.

From a retirement interest perspective, the strongest argument in favor of preserving defined benefit pension plans is that they eliminate “sequence risk”.  Numerous studies have demonstrated how two people in defined contribution plans with identical salaries and salary growth, identical career lengths, identical investments, and even identical average annual returns can have differentials in wealth at retirement in the hundreds of thousands of dollars due only to “when” they started investing.  Sequence risk results from getting the “right” returns in the “wrong” order – like having the bad years closer to retirement when more wealth is exposed.  In theory, defined benefit plans eliminate this risk because stable pools of cash flows going in and out relative to the size of the asset base makes “how” investment returns materialize irrelevant.  But if defined benefit plans experience big cash flows in either direction, sequence risk is back on the table.

As Figure 1 shows, once upon a time sequence risk was a non issue for state defined benefit plans.  Growing contributions from an increasing public sector workforce and positive worker to retiree ratios kept net cash flows in good shape helping to insulate plans from bad market years.  Today the demographics have flipped and billions more go out than come in – even with our recent history of employee and employer contribution increases.  Nor have past contributions increases put a dent in net cash flows relative to the asset base – in this regard, the sustainability repairs of recent years are better described as “treading water.”

Figure 1: Net Cash Flows and Nets Cash Flows Relative to Asset Base for Major Minnesota Public Pension Plans (less investment returns), 1985-2015

As a result our margin for error in occasionally “missing” investment return expectations is vanishing.  The impact of any bad year or string of poor years is aggravated by gradually declining net cash flows within pension funds.  And with these negative cash flows the biggest disadvantage of defined contribution retirement plans – sequence risk – is infecting state defined benefit plans.

All this together points to a “new normal” of increasing contribution pressures.  Whether legislators will come to grips with this or simply continue to apply the same band aids of “shared sacrifice” remain to be seen.