The Cost of Pension Benefits
Scope of Problem and Suggested Solutions
Joseph Adler
David Boomershine
MAPS Trustee Education Conference
June 9, 2011
1
Private Sector vs. Public Sector
Recent Changes
Issues
Impacts:
Private Sector
Pension
Federal Legislation

Accounting

Asset Losses

Retiree
Medical
Public Sector
Pension

Retiree
Medical


Result: Increased cost and liability volatility for Private Sector Pension Plans
2
Actuarial Cost Viewpoint
Three Phases for Pension and OPEB Plans
 Baseline Actuarial Cost
 Funding Alternatives
 Plan Design Alternatives
Concerns/Interested Parties:




Budgets
Taxpayers
Unions
Bond Rating Agencies
3
Actuarial Funding
 Actuarial Valuation




Demographic data
Assets
Actuarial Method/Assumptions
Plan Design
 Annual Costs/Funding Approach
 Normal Cost
 Amortization of Unfunded Actuarial Liability
4
Demographic Data - Public Sector
 Maturing plan population – shorten amortization period?
 Hiring freezes, reductions – reduces plan costs
 as $ amount, not as % of payroll
 Work furloughs, reduced hours → reduced compensation –
reduces plan costs
 Pay reductions – reduces plan costs
 Reduced employee contributions – net out of cost reductions
 Overall – reduced plan costs
 but not necessarily as a % of payroll
5
Assets
 2008 Asset losses – significant cost increase
 Asset recovery for past few years – helping to
stabilize costs
 Asset smoothing – typically, 5 year smoothing of
investment gains/losses
 Dampens cost fluctuations
 Impact of prior losses continue to phase-in
 Overall – increased plan costs
6
Actuarial Method/Assumptions
 Actuarial Method – Entry Age Normal, Unit Credit
 Demographic:
 Retirement:
 Termination:
 Mortality:
 Disability:
mixed
increase
decrease
increase
 Economic – KEY!
 Interest Rate:
 Salary Increases:
 COLA’s:
decreasing from 8% towards 7.5%
within 3% below Interest Rate
decreasing
7
Funding Relief Alternatives
 Impact Public Sector:
 Pension Plans: due to asset losses
 OPEB Plans: due to new accounting requirement
 Alternatives (check State restrictions)




Amortization basis – Level % of pay
Amortization period – to 30 years
Asset corridor – to 130% of Market Value
Asset smoothing – to 10 years
 Phase-in funding increase: 5 years?
8
Plan Design Changes
Pension Plan Design Changes – significant cost/liability
impact:






Increase employee contribution levels
Retirement eligibility
COLA’s
Revise benefit structure
Final average pay
DROP’s
Other
 Soft Freeze – State Protections?
 DC Plan
 Hybrid Plans


Cash Balance
Basic DB with supplemental DC plan
9
Plan Design Changes - Summary
 Soft Freeze – typical current approach
 Increase employee contributions – typical current
approach
 Other plan provision revisions – for current active
participants – some attempts
 Hybrid Plan – Basic DB plan with supplemental DC
Plan
 Hard Freeze – private sector approach – the Atlanta
challenge
10
Actuarial Funding: Case Study


Funding Approach: Normal Cost (NC)
+ mixed 15/30 year Amortization of UAL
Actuarial Valuation Baseline Results ($ in thousands):
2011
Actuarial Liability (AL)
$800,000
Plan Asset Value*
680,000
UAL
120,000
Total NC
- Employee Contributions
- Net NC
15,000
5,000
10,000
Amortization of UAL**
12,000
Total
22,000
- % of payroll
17%
*
Includes 5 Year Smoothing/+ 20% corridor
** Uses Level $ Amortization
11
Funding Approaches: Case Study
Comparative Results:
Annual Cost as % of Payroll
• Current Valuation
17%
•
•
•
•
•
14%
15%
15%
15%
13%
Level % of Pay Amortization
30 Year Amortization Period
130% Asset Corridor
10 Year Asset Smoothing
5 Year Phase-in*
*Note: expected increases for 5 years
12
Plan Design Changes – Case Study
Selected Alternatives:
 A:
Soft Freeze with revised DB plan for new employees including:
NRA, Final Average Pay, Benefit %, COLA and employee
contribution revised provisions
 B:
Maintain DB plan, increase employees contribution rate by 2%
 C:
Revise current DB plan for current employees, including: NRA,
Final Average Pay, Benefit %, COLA and employee contribution
revised provisions
 D:
Hybrid Plan: Basic (reduced) DB plan with supplemental DC
plan (3% employer contribution)
 E:
Hard Freeze, with a replacement DC plan (6% employer
contribution)
13
Plan Design Changes – Case Study
Projected Comparative Plan Costs – as a % of payroll
Alternatives
Year
Current
Plan
A
B
C
D
E
2011
17%
17%
15%
10%
10%
8%
2012
18%
18%
16%
11%
11%
9%
2013
17%
17%
15%
11%
10%
8%
2014
17%
17%
15%
10%
10%
8%
2015
16%
16%
14%
10%
10%
8%
2016
16%
15%
14%
9%
10%
8%
2017
16%
15%
14%
9%
10%
8%
2018
16%
15%
14%
9%
10%
8%
2019
16%
15%
14%
9%
10%
8%
2020
16%
15%
14%
9%
10%
8%
14
Plan Design Changes – Case Study
Projected Comparative Cost Savings vs. Current Plan
($ in millions)
Period
Alternatives
A
B
C
D
E
5 Years
$.6
$14
$49
$50
$64
10 Years
$4
$32
$112
$105
$137
Notes: Sample Plan:
• 3,700 participants
• 2011 payroll $127,000,000
15
Why is this an issue?
 Subprime mortgage debacle and near
collapse of financial system causing a
contraction of U.S. economy
 Steep decreases in tax revenue for
most state and local governments
 Poor investment choices,
underfunding or non-funding of
pension obligations
16
Magnitude of Problem
 Pew Research
Center estimated
that the gap
between assets
and future legal
liabilities for US
state plans is at
least 1.26 trillion
dollars
17
Other grim statistics
 Pension funding shortfalls accounted for $660
billion of the $1.26 trillion gap, and unfunded
retiree health care costs accounted for the
remaining $607 billion.
 States had only about $31 billion, or 5 percent,
saved toward their obligations for retiree
health care benefits.
 State pension plans were 78 percent funded,
declining from 84 percent in 2008
18
Comparison of some Mid
Atlantic States Funding Levels







New York
101%
Pennsylvania 81%
New Jersey
66%
Delaware
94%
Maryland
65%
W.Virginia
56%
Virginia
80%
19
Reasons for underfunding
 Power of public unions
 Profligate politicians
 Lack of managerial influence in
financial area
 High debt ratios
 Lack of professional support for
legislature
 Public employee density—positive
correlation
20
Focus on Maryland
 350,000 current and
future retirees
 Steep losses in 2008
and 2009 saw the
funded ratio drop
from 78% to 65%
(actuarial)
 In real market terms
the funded ratio fell
to 54%
21
Focus on Maryland—decisions
 Quality Teacher
Incentive Act-1999
pumped $14 million
toward local schools—
portion was used for
salary enhancements
 Governor’s Teacher
Salary Enhancement
Grant—2000, made
upwards of $55 million
available for instructional
staff salary increases.
22
Focus on Maryland-decisions,
continued
 Bridge to Excellence Act
(Thornton Act) 2002.
committed $1.3 billion in
new state aid towards
local school systems
 The Act also mandated
that the state pick up the
cost of pensions for
teachers paid by certain
grants—previously paid
by local governments
23
Focus on Maryland—decisions,
continued
 State Employees’ and
Teachers’ Retirement
Benefit Act of 2006
 Increased multiplier from
1.4 to 1.8% retroactive
to 1989
 Member contributions
increased from 2% to
5% phased in over three
years
24
Moving to the corridor scheme allowed the state to legally underfund its payment as long as the investment returns were robust, and the
Avoid dark corridors
 In 2002 the state abandoned the
traditional technique of funding and
adopt the “corridor method”.
 Instead of making an annual payment based
on its payroll number which is then multiplied
by the actuarial certified contribution rate, the
legislature replaced it with a system which
froze the contribution rate at the FY 2002 rate
as long as the funding ratio remained in a
“corridor” between 90 and 110 percent.
25
Reaction by Trustees of the
Plan
 The Board of Trustees of
the State Retirement and
Pension System began to
sound the alarm in 2005,
a year when the returns
were in the double digits,
and has repeatedly called
for the abandonment of
this funding method.
26
Policy Options
 Option one: Shift the cost to local
governments.—have counties and
Baltimore pick up some or all of the
cost of teachers’ pensions.-$850
million shift
 Option two: Eliminate or reduce
defined benefit pension plans for
current employees.
27
Options, continued
 Option 3: Reduce future liabilities
by increasing participant
contribution rates and
introducing a two tiered system
 Existing employees and teachers would be allowed to
remain in the defined benefit plan, albeit with a
higher contribution rate, and new employees hired
after July 1, 2011 would be in a modified defined
contribution plan. In 2010 nine states increased
participant contribution rates as one step in reigning
in their future funding obligations.
28
Options, continued
 Montgomery County’s Retirement
Savings Plan (RSP) and Guaranteed
Retirement Income Plan (GRIP)
In 1994, Montgomery County required all new nonpublic
safety employees to enroll in the RSP, a defined contribution
plan, whereby the employee contributes a percentage of
their salary, which is matched by the county and invested in
an instrument selected by the employee. The investment
choices are selected and monitored by an official fiduciary,
the Board of Investment Trustees, made up of
representatives of employee unions, county officials, and
members of the public.
29
GRIP
 In 2008, the County
introduced the cash
balance concept.
Members in the RSP and
newly hired employees
can select an option,
(GRIP) whereby they
relinquish making the
investment choices to
the BIT for a guaranteed
7.25 percent rate of
return
30
DB Plans-Can They Survive?
 Long term trends transforming the national economy and
reorienting the social contract between employers and
employees point away from traditional pension plans. In
the private sector, for example, the number of traditional
defined benefit plans have declined greatly. In 2007 only
32 percent of households had an employer provided
defined benefit pension plan. From 1990 to 2007, the
number of active participants in such private sector plans
fell by 26 percent, even as the workforce increased by
22 percent.


Source, United States Government Accountability Office, letter to Senator Herb Kohl,
April 28, 2010, p.6 . Accessed through http://www.gao.gov/new.items/d10632r.pdf.
December 4, 2010
31
Changes to Maryland’s Pension Plans
Enacted by 2011 General Assembly
 Cost-of-living Adjustments For
service credit earned after June 30, 2011, the
COLA will be linked to the performance of the
SRPS investment portfolio. If the portfolio
earns its actuarial target rate (7.75% for fiscal
2011), the COLA is subject to a 2.5% cap. If
the portfolio does not earn the target rate, the
COLA is subject to a 1% cap.
32
Changes, Continued
 Member Contributions: Beginning
July 1, 2011, member contributions for
current active members of EPS and TPS
increase from 5% of earnable
compensation to 7% of earnable
compensation. Member contributions for
current active members of LEOPS
increase by 4% to 6% in fiscal 2012 and
from 6% to 7% beginning in fiscal 2013.
33
Changes, continued
 Future SRPS Members
 Vesting Increases from5 to 10 years
 Average 5 highest years- up from 3
 Multiplier decreased to 1.5% from
current 1.8%
 Normal service retirement will be 65
years old and at least 10 years of
service-compared to 62 and 5
 Early retirement—62 and 15 instead
of 55
34
Policy Changes—narrowing the
corridor
 The pension reform provisions of the BRFA of 2011
establish a goal of reaching 80% actuarial funding within
10 years by reinvesting a portion of the savings
generated by the benefit restructuring into the pension
system in the form of increased State contributions
above the contribution required by statute. In fiscal 2012
and 2013, all but $120 million of the savings generated
by the benefit restructuring are reinvested, with the
$120 million dedicated to budget relief each year.
 Beginning in fiscal 2014, the amount reinvested in the
pension fund is subject to a $300 million cap, with any
savings over that amount dedicated to budget relief.
35
Light at the end of the tunnel?
36
Questions???
37