A Critique of the State Retirement Plan Design Summary

“If you can’t change something, study it” may be an unsatisfying policy response, but occasionally it’s a good idea. In 2010, after a last minute attempt to transition Minnesota public retirement programs from a defined benefit (DB) system into a defined contribution (DC) system failed, the Legislature mandated a study of existing and alternative retirement plans for public employees by the three statewide public retirement systems (MSRS, PERA, and TRA). Given the number of complicated issues surrounding any potential conversion from DB to DC, a study of retirement plan design options, costs, and potential transition issues would seem necessary before embarking on potential reform.

The 114 page report “Retirement Plan Design Study” (available at the websites of all three retirement associations) has now been released and will undoubtedly be the primary resource for any public pension reform debates for the forseeable future. It contains important background information on retirement income planning and the state retirement systems, presents the pros and cons of different retirement plan designs, and provides an analysis of transition costs.

However, several critical issues central to the legislative intent of the study were either excluded or treated incompletely. Looking forward, our primary concern is that the study will have the unfortunate consequence of stifling quality deliberation rather than supporting it by pacifying elected officials, soothing opinion makers, and recreating the taxpayer complacency which has surrounded this issue for so long.

“Stop or I’ll Shoot”

The legislation ¹ required an “analysis of the feasibility, sustainability, financial impacts, and other design considerations” of various retirement plans. By far the most significant contribution of this study is new information on the cost of transitioning state retirement plans from a defined benefit system to a defined contribution system.

Courts across the nation have consistently ruled that defined benefit pensions for public employees for past years of service must be paid and cannot be reduced. Thus closing DB plans to new employees does not remove the obligation to pay for existing benefit promises. Instead, costs increase over the near term because any unfunded liabilities in the existing DB plan must be paid off over a shorter timeframe while cash flow from contributions entering the system steadily declines. The larger the unfunded liabilities, the bigger the near term costs. The “closed fund“ problem is always raised as the primary economic argument against change. It is a real and powerful gun held to the head of any pension reform effort.

$15.6 billion of unfunded liabilities ² within the three major state retirement plans means the gun is fully cocked and loaded in Minnesota. According to the actuarial analysis included in the study (Table 1), closing the existing defined benefit plans and transitioning new hires to a defined contribution plan would cost taxpayers $1.5 billion over the next five years and $2.8 billion over the next decade for all three retirement systems. Such findings are consistent with similar investigations undertaken in other states and suggest the need to approach the issue of reform very carefully.

	Years	PERA	TRA	MSRS	Total
	1-5	$573	$653	$276	$1,502
	6-10	$529	$433	$298	$1,260
	11-15	$302	()$57)	$238	$483
	16-20	$58	($610)	$161	(#391)

The (Un)Sustainability of the Status Quo

However, any investigation of “sustainability and financial impacts” of retirement plan options should also include information on the long term cost issues and cost exposure created by the status quo. A chief concern about the current system’s sustainability is whether the assumed 8.5% average annual rate of investment return can be realized in perpetuity. Returns averaging only 7.0%, for example, over a long period of time would have a profound impact on the financial health of the various retirement systems and begs some fundamental questions, including:

• What would the growth in unfunded liabilities look like?
• How much in additional contributions would the retirement systems need over time to make up for this investment return shortfall?
• What is the potential magnitude of taxpayer dollars diverted away from actual public service delivery to pay for these obligations under different “underperformance” scenarios?

The report contains no quantitative information on the potential costs taxpayers face or the risks to public service delivery should markets fail to cooperate as expected.

Moreover, even if an 8.5% average investment return would be realized over the next 30 years, the financial sustainability of these funds still remains in serious question. According to the report, the State Board of investment realized average annual returns of 9.7% over the past 30 years. Yet we are still in a $15 billion hole.

A fundamental and unrecognized issue critical to planned sustainability is that both the timing of all cash flows in and out of a fund and “how” the average investment return actually materializes over time substantially influence a retirement plan’s future funding costs. As a very simple illustration of this issue, consider the underfunded Teachers Retirement Association plan and the market plunge in 2008 which sent the Dow spiraling to the 6600 level. Had the full contribution increase of 4% of payroll enacted in 2009 instead been in effect when the market bottomed out, additional resources would have been available to take full advantage of the market rebound, lowering future funding costs since the retirement plans would have “bought low.” Instead, the phased-in 4% contribution increase schedule was delayed until this year – after the market nearly doubled – likely increasing long term funding costs. Instead of amortizing investment losses as soon as possible through additional required contributions, accounting rules allow public pension plans to take their time to close their funding gaps – up to 30 years. All the while, when markets perform well, the pension fund is missing assets on which those market returns could potentially be earned.

Investment returns are only earned on assets that actually exist, so any cash flow out is also a drag on investment return. Because benefit payouts (cash flow out) are still required even when a plan is underfunded, defined benefit pension plans are highly susceptible to “reverse dollar cost averaging.” Simply translated: underfunded plans need more than their assumed rate of return just to maintain their existing underfunded status. It also means the longer it takes to get a plan to full funding status, the more expensive the plan will become in the long run.

This is why benchmarking of investment performance against assumed investment returns as reported by the State Auditor, State Board of Investment, and state pension plans is a very poor and very misleading proxy for evaluating the past success and the financial sustainability of defined benefit plans. It is also why many pension experts (and the MTA, and Governor Dayton when serving as State Auditor) have long argued for adopting dollar weighted return reporting which links cash flows with periodic investment returns and provides a truer sense of fund condition and funding costs.

Disappointingly, the report is completely silent on these important issues. It provides no sense of the extent of any existing reverse dollar cost averaging problem or potential problem that may emerge in the coming years as retirements increase. Given that the Government Accounting Standards Board is considering modifications to pension accounting which could significantly increase reported unfunded liabilities and trigger higher reported contribution deficiencies, the lack of information and perspective becomes even more troubling.

What is “Adequate”?

It’s been said there is no such thing as an unaffordable defined benefit pension plan; there are only unaffordable promises. Any review of the sustainability and impacts of a DB system should include an examination of the level of benefits it provides. It’s important for all stakeholders to get a better perspective of how generous these plans are both in absolute terms and relative to what a secure retirement entails.

The study provides the “average retirement benefit” for benefit recipients in 2010 which ranges from $13,236 for PERA to $26,141 for TRA. However, this average benefit includes large numbers of employees who willingly chose to enter and leave public service at various stages of their professional careers. These individuals earn a much lower public pension benefit than do career public servants, but would fully be expected to have access to private-sector retirement plans to complement their public pension benefit. In the vast majority of cases, individuals make these employment changes willingly based on their own economic self-interest. The state should not determine benefit adequacy policy based on individuals who make government employment only a part of their career path.

A better basis for evaluating pension benefit adequacy is the career government employee who is fully dependent on his or her government employment for retirement income. In 2010, newly retired career employees had an average initial pension benefit 64% - 120% higher than the reported average plan benefit (Table 2).

		"Average Benefit" in 2010 as reported in Retirement Study	Average Initial Benefit in 2010 for Career Employees*
	TRA	$26,141	$42,968
	PERA - General	$13,236	$29,184
	MSRS - General	$16,650	$28,992

It is also important to note that including long-time retirees with lower initial base benefits does not distort the comparison. Even though initial base benefits for career employees were undoubtedly lower in previous years, state pension policy has increased these benefits and has kept most segments of the retiree population more than whole with respect to inflation (Table 3).

	Years	Benefit Increase Since Retirement			Inflation (CPI)
		MSRS	PERA	TRA
	1980 Retirement	426.9%	421.8%	416.6%	194.7%
	1985 Retirement	287.0%	283.2%	279.4%	108.5%
	1990 Retirement	171.8%	169.1%	166.5%	75.7%
	1995 Retirement	115.1%	113.0%	110.9%	48.0%
	2000 Retirement	39.3%	37.9%	36.5%	32.0%
	2005 Retirement	15.4%	14.3%	13.1%	16.8%

Ideally, a complete perspective on benefit levels would also provide information on what active employees in each retirement system could expect to receive as an initial base benefit after a career in public service. The report could easily have presented an “average projected initial benefit” for career employees based on the average plan salaries and the appropriate actuarial assumptions, but such information was not included.

Combined with Social Security (and with no other retirement savings), Minnesota public DB plans achieve income replacement rates of 85-90% of pre-retirement income for “career” employees ³ . The retirement study notes that 85% of pre-retirement income is also the generally accepted standard for retirement adequacy as recommended by retirement and financial planning experts. However, the concern in retirement plan design is not whether income replacement standards are too high or low – an 85% replacement ratio is a perfectly fine target. The relevant issue is to how much income replacement should be guaranteed by taxpayers via a defined benefit.

Under the current system, Minnesota’s public DB plans essentially guarantee retirement income at levels that provide seniors with the lifestyle they experienced during the highest-earning period of their working careers. Affordability issues aside, there are important questions of principle that need to be asked. If a guaranteed benefit is to be provided at all, should it be designed to fully support pre-retirement lifestyles? Or should it be designed to augment Social Security to eliminate longevity risk while providing additional income security for life essentials and necessities? Should retirees themselves bear any responsibility to make the transition to retirement living as seamless and “opportunity filled” as they wish?

The above issue takes on even greater relevance when recognizing that many household spending obligations decline substantially in retirement; especially those related to pension and Social Security contributions, housing, and transportation. According to the BLS Consumer Expenditure Survey average annual expenditures for seniors 65 years and older average 28% less than expenditures for those aged 55-64 and 36% less than those for the 45-54 age cohort. An 85% -90% replacement income ratio may often result in higher disposable income levels than existed during peak earning years.

It is also worth noting that in a state that values equity, a defined benefit system that equates adequacy with the preservation of a pre-retirement lifestyle turns this concept on its head. According to a consulting study cited in the report, an “adequate” retirement income for a person making $20,000 pre retirement is $22,600 per year while an “adequate” retirement income for someone making $90,000 pre retirement is $73,800. Why should the price of retiring with dignity and security be 227% more for a manager than a cashier? Why are their needs that much more expensive?

Where does the discussion go from here?

"While we retirement fund directors made every effort to keep our biases out of the report, there is no hiding the fact we still believe our current defined benefit plans offer the best solution for reasonable benefits and security at an affordable cost, and that they best meet the needs of our members and employers."

— Mary Most Vanek
Executive Director, PERA

Since we began our work on pension issues, MTA has developed considerable respect for the executive directors of the retirement systems issuing this report. They are charged with some of the most challenging tasks in government considering the immense political pressure placed on them, the strong competing interests within the populations they serve, and the fact that elected officials ultimately control so much of their fate. Although it may have seemed like a band-aid to outsiders, the changes the retirement funds successfully shepherded through the legislature last year were not an inconsequential fix either substantively or politically. And we have always appreciated their honesty, as illustrated by the quote above.

But the Retirement Study does exhibit the strong perspective bias suggested in the quote by discussing the topic primarily through the narrow lens of retirement issues and interests rather than broader taxpayer interests. We need full disclosure of the potential costs and implications of the status quo in a world that may not live up to actuarial expectations — absent all the distorting baggage of time weighted rates of return and ever-extending amortization periods. We need information to guide debates about what retiring with dignity and financial security actually means and how much of that security taxpayers should be expected to guarantee. And we need information on how this highly back-ended form of compensation contributes to or distracts from the imperative of greater efficiency, performance, and cost effectiveness in government service delivery.

It’s essential that public retirement systems reduce taxpayer risk and avoid substantive, harmful, and lasting impact to governments’ operating budgets and their delivery of public services. These considerations are no less a legitimate and essential part of any effort to design a retirement system that works for everyone.