For over a decade, states* have been enacting laws to address the endemic and growing problem of unfunded pension liabilities. The Pew Center on States estimated in February 2010 that the unfunded liability for pensions and retiree health care costs combined represented a "Trillion Dollar Gap." However, it is generally recognized by financial and actuarial experts that the Pew Center's numbers were actually quite understated due to the use of an 8% discount rate and "smoothing" out investment gains and losses over a number of years. In 2009, for instance, Professors Robert Novy-Marx of Univ. of Chicago and Joshua Rauh of Northwestern University calculated this gap to actually be in the realm of $3.23 trillion.
Governments, and their rating agencies, had recognized for some years that there was a problem but, spurred by these haunting new calculations, there has recently been a huge uptick in the number of states taking action to address their public employee pension systems. In 2010 alone, 20 states enacted legislative changes for this purpose. Since 1997, 38 states have enacted such reform. Measures generally include increasing employees' contribution rates; tightening eligibility requirements; passing "anti-spiking" laws; changing cost of living adjustments (COLAs) to pension benefits; and shifting from defined benefit plans to defined contribution plans or hybrid defined contribution/defined benefit plans. The most popular reforms in 2010 were increasing contributions (11 states), changing eligibility criteria or benefit formulas (13 states), and increasing COLAs (eight states). The reforms in most cases apply only to new employees, but there are some notable exceptions.
"Anti-spiking" laws prevent employees who are near retirement from artificially inflating their compensation--such as by working unnecessary overtime or cashing in vacation and/or sick leave--for the purpose of inflating the final average salary (FAS) used to calculate their retirement benefits. There have been shocking stories of abuse in this regard, prompting the anti-spiking laws. See, generally, While America Aged, by Roger Lowenstein. Despite the public outcries, however, only two states (Iowa and Louisiana) have enacted specific anti-spiking provisions, according to the RBC Report. Nonetheless, quite a number have enacted reforms indirectly having a similar effect, such as limiting salary increases or use of sick leave, or extending the averaging period, for purpose of FAS calculation.
The type of plan determines whether you get a pre-determined amount of retirement compensation from the original contributions ("defined benefit plans"), or whether you put in a pre-determined amount of contribution and then get the contribution and the interest earned upon retirement ("defined contribution plans"). The unfunded liabilities arise in the context of defined benefit plans which have, up to now, been the norm in public sector, as they once were in the private sector.** Specifically, employers are notoriously undisciplined in setting aside adequate money to meet forecasted future obligations under a defined benefit plan. Additionally, all of the existing funds lost a tremendous amount of paper value during the recent recession and stock market volatility. Because of the problems endemic to defined benefit plans, Alaska, Michigan, Minnesota, New Jersey, and West Virginia have shifted to mandatory defined contribution systems for all or certain classes of new employees. A handful of states have begun offering optional defined contribution plans for some or all new employees: Florida, North Dakota, Ohio, Oregon and South Carolina. Several states have also instituted hybrid plans for some or all new employees: Georgia, Michigan, Utah and Washington.
Several states have even changed or are contemplating changes for existing rather than merely incoming employees. In New Mexico, the Education Retirement Board recently proposed comprehensive changes, including increasing contributions and extending age and terms of service requirements. It cause quite a firestorm of opposition from the employees and employee unions, as well as others, and they quickly backpedaled on the harshest proposed recommendations. See Albuquerque Journal, Dec. 18, 2010, James Monteleone. A large part of the more general public outcry concerned the proposed extension of time in service requirement to employees otherwise scheduled to retire as soon as three years. However, in 2009 Rhode Island successfully passed a similar extension of the retirement age that would apply to any employees not eligible for retirement as of September 30, 2009.
Nonetheless, most of the changes made by States since 1997 do apply to new employees only. Much of the difficulty of changing the laws governing existing employees is attributed to statutory and/or constitutional protections granted to the public pension benefits in each state. Of the changes applied to existing employees, increases to the contribution rates and changes in FAS are the most common and, therefore, apparently the least objectionable.
Three COLA cases stand out for a similar issue, e.g., the application of COLA changes to existing retirees. Colorado, Minnesota and South Dakota have lowered COLAs for existing retirees, and they are now under lawsuit alleging violation of contract. These cases will be closely watched by other states, but also--as RBC points out--by rating agencies and other market participants, "for clues as o the future course of state pension fund reform."
As I said, the times they are a-changing.' As the RBC Dec. 2010 Survey reports,"at least eight additional states are expecting to take up pension reform legislation in 2011, with the most notable being New Jersey, where the governor wants to repeal a pension benefit increase granted in 2001." Moreover, as long as an slow, extended economic recovery is forecasted, there is no reason to believe additional reform and relief will not continue to be sought in ensuing years, or will not be pushed as far as legally and politically feasible. Ultimately, the numbers justifying reform are compelling, as "the effectiveness of these strategies is well documented." See RBC. Novy-Marx and Rauh have concluded that "a one percent point decrease in COLAs could potentially reduce pension fun liabilities by (% to 11% and a one year increase in the retirement age could reduce them by 2% to 4%." Id., citing Novy-Marx (2010).
Some financial organizations forecast the public sector will eventually shift completely to defined benefit programs, as the private sector already largely has. 401kplanning.org, for example, concludes the cost is simply not justified in light of the public sector budgetary distress, the decreased lag between public and private sector compensation,and fundamental equity. Id., Reasons Why State & Local Governments Will shift to DC Retirement Plans.
If you are interested in neutral services such as arbitration, mediation or contract ALJ services, in labor/employment or other areas of the law, please contact Pilar Vaile, P.C. at (505) 247-0802, or info@pilarvailepc.com.
NOTES
* Although this blog addresses only state pensions, similar issues exist with at the local government level, which Novy-Marx and Rauh calculate to represent a $574 billion unfunded liability, and where RBC reports are making similar "changes to their pension plans to address funding issues."
** Notably, private sector defined benefit plans are insured by the federal Pension Benefit Guarantee Corporation (PBGC), which is itself near insolvent. Private sector has shifted to defined contribution plans for exactly the reasons discussed here.
Sources
Report, Pew Center on the States (Feb. 2010)
Study, Robert Novy-Marx of Univ. of Chicago and Joshua Rauh of Northwestern University (2009)
Study, Robert Novy-Marx of Univ. of Chicago and Joshua Rauh of Northwestern University (2010)
Research Paper, RBC Capital Markets, LLC, "US Municipal Focus: a Survey of Legislative Changes to State Pension Funds (Dec. 9, 2010)
While America Aged, by Roger Lowenstein (2008)
