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Slow Progress on Public Pension Reform

 The economy is on a tear, with the national growth rate high and unemployment low. Eighty percent of U.S. companies have reported earnings that exceed Wall Street forecasts. City and state revenues are surging, as the Great Recession fades in the rear view mirror.

 

But many of the pension funds that finance retirements for state and local employees as well as teachers remain on shaky ground. The 100 largest public employee pension systems earned just $14.3 billion on investments in the first quarter, their worst performance since September 2015, according to Census Bureau data.

 

Susan Banta, director of research reform for the Pew Charitable Trusts, warns of obstacles ahead.

 

“Pension systems are vulnerable to the next recession,” she said at a recent National Conference of State Legislators (NCSL) meeting in Los Angeles.

 

The NCSL panel explored efforts by policymakers to strengthen state retirement systems, especially through stress testing. There’s growing momentum for such “nonpartisan, evidence-based financial stress testing” according to a Pew paper by Greg Mennis and Stephen Fehr.

 

Seven states – California, Colorado, Connecticut, Hawaii, New Jersey, Virginia and Washington – now engage in stress testing. Todd Tauzer, director of S&P Global Ratings, said such tests enable states to evaluate the ability of their plans to withstand future risks, such as an economic downturn.

 

Pension fund managers are struggling even during a robust economy for several reasons. For starters, the proportion of active workers to retired workers is steadily declining while life spans are increasing. Many retirees live longer than originally estimated, a happy fact for them but a problem for the solvency of pension systems.

 

Increasing liabilities encourage pension fund managers to make risky investments. Sixty-eight percent of pension funds in 2015 were in high-risk equities or alternative investments, an 8 percent increase in five years, according to an S&P Global report

 

Tauzer favors a conservative approach. “States that consistently fund full required contributions on an actuarial basis and use conservative assumptions and methods are more likely to effectively manage their pension liabilities and the associated long-term budgetary costs than states that do not,” he told the NCSL panel.

 

There has been progress in this direction in several states, most notably New York, North Carolina, South Dakota, Tennessee and Wisconsin. These states have joined Indiana, Utah and West Virginia in making significant progress in funding their pension systems.

 

At the other end of the spectrum are the usual suspects: New Jersey and Illinois. Partisanship and public employee unions have consistently frustrated attempts at pension reform in both states.

 

Other states that lag in funding their pension systems include Alaska, Colorado, Hawaii, Kentucky, Massachusetts, Minnesota, Oregon and Pennsylvania.

Not all of these states are standing still, however.  Late last year in a significant show of bipartisanship, Republican state lawmakers and a Democratic governor in Pennsylvania approved a pension reform bill moving most future public employees into a 401(k)-style retirement plan. This helped staunch a $70 billion unfunded liability.

Gov. Tom Wolf (D) said in signing the bill that it was fair to workers and “a win for Pennsylvania taxpayers.”

Across the county, California’s two giant public pension systems have reported earnings above their assumed rate for the second consecutive year.

 

The California Public Retirement System (CalPERS) said its investment portfolio earned 8.6 percent during the fiscal year that ended June 30. The California State Teachers Retirement System (CalSTRS) did even better with an 8.96 percent gain. This beat projections of 7 to 7.5 percent.

But fund managers aren’t crowing over these strong performances.

 

“We need to repeat that performance year in and year out, on average, over the next 30 years,” said Christopher Ailman, chief investment officer for CalSTRS.

 

Considering the inevitability of recessions and periodic market slumps, that’s a challenging – but not impossible – goal. In its analysis of public pensions the Pew Charitable Trusts assumes only a 6.5 rate of return on investments. Since 1965, however, the S&P 500 index of major stocks has produced annualized returns of 9.7 percent.

 

Like several other systems, CalPERS has attempted to reduce pension liabilities by requiring higher contributions from employees.

 

The situation is more complicated for CalSTRS. The California Legislature approved and Gov. Jerry Brown (D) signed a plan that slightly increased contributions from employees and the state while more than doubling the payments for school districts. This solution has kept CalSTRS solvent while creating a budget crisis for a number of school districts.

 

Michael Fine, CEO of the Fiscal Crisis and Management Team, the California agency that deals with schools with financial problems, says the pension-fixing remedy adopted by the state had turned school district budgets “upside down.” He said building maintenance, grounds care, class size, athletic and other programs could suffer.

 

(An in-depth examination of the impact of pension reforms on California school districts, written by Jessica Calefati, can be found on the CALmatters website.)

 

One of the perennial obstacles to pension reform is the legal status of pensions, which in many states are a vested right. States usually have more leeway with new hires.

 

A Pew study found that retirement plans in almost a third of the states share unexpected costs with new employees. For example, the contribution rate for recently hired employees in Pennsylvania’s State Employees and Public School Employees retirement system can be raised by a half-percentage point every three years if investment assumptions are not met.

 

Cost-sharing can both increase and decrease retirement benefits. For members of the Minnesota General Employees Retirement Plan, the annual cost-of-living increase for retirees switches from 2.5 percent to 1 percent and back, depending on the plan’s funding level.

 

It’s worth noting that such cost-sharing plans are the products of agreements between the employer and the union or other group representing employees.

 

The California Supreme Court this month unanimously overturned a voter-approved retirement plan in San Diego because the mayor had declined to negotiate its contents with the employees union as required by state law.

 

On balance, recent good news on public pension reform outweighs the bad. But reforms come at a time when many states are trying to climb out of a hole they have mostly dug for themselves.

 

The annual report of the Pew Charitable Trusts found that public pension funds owed retirees and current workers $4 trillion as of 2016. They had $2.6 trillion in assets, creating a gap of about one-third, or a record $1.4 trillion.

 

The first step in getting out of a deep hole is to stop digging, as many states have done. Over time, reforms like the one in Pennsylvania, where retirees have a 401k plan instead of a defined benefit, could make pension funds solvent.

 

But this solvency, if it comes, is 20 years or more down the road. In the interim, pension beneficiaries and states must hope for continuation of the economic recovery, now chugging ahead in its tenth year.

 

For as Susan Banta observed, most public pension plans are highly vulnerable to the next recession.