What's the Latest in Pension Reform?

We examine proposals still brewing in legislatures, how already-enacted reforms are playing out, and the model based on one of the world's strongest pension systems that a Canadian province is using to keep costs under control.
by | August 14, 2013
Illinois Gov. Pat Quinn holding the bill that suspended legislators' pay as of Aug. 1.
Illinois Gov. Pat Quinn holding the bill that suspended legislators' pay as of Aug. 1. AP/M. Spencer Green

The nation’s pension crisis remained front and center in recent months as new reports emerged about states’ liability imbalances and Detroit’s public employees were forced to place their retirement fate in the hands of a bankruptcy court judge. Some of the hardest-hit pension funds are in states that bore the brunt of the recession (like Michigan) and those (like Illinois) that have a decades-long burden as a result of mismanagement, borrowing and shaky investments.

In June, Moody’s released a report using fiscal year 2011 pension information to compare what states owe to what states have. Illinois topped the list with a liability-to-revenue ratio of 241 percent. For every dollar Illinois needs to save to erase its shortfall, it has set aside only 43 cents. The top of the liability list continues with Connecticut (189.7 percent), Kentucky (140.9 percent), New Jersey (137.2 percent) and Hawaii (132.5 percent).

On the other end of the spectrum, the states most prepared to pay their pension obligations were Nebraska with the lowest ratio of 6.8 percent, followed by Wisconsin (14.4 percent), Idaho (14.8 percent), Iowa (16.1 percent) and New York (16.6 percent).

Overall, the median liability-to-resource ratio in FY 2011 was 45 percent; and according to CNBC, only 17 states have financially sound plans funded at more than 80 percent of their projected liability.

There’s a wide range of reasons why states’ ratios (ranging from 6.8 percent to 241 percent) are so varied. Historic and current management, funding efforts and the size of benefits and the payee pool -- whether the state fund has responsibility for teachers or local government employees, for example -- all play into the numbers. Regardless of the reason, though, if U.S. Sen. Orrin Hatch of Utah gets his way, states may soon be forced to address their collective $1 trillion pension liability shortfall by reducing their employee benefits or transitioning to a 401(k)-style plan.

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Some localities have already done the latter for incoming employees; however, there’s no lack of effort at the state level to fix the pension problem. This year alone, more than 1,200 pension-related bills have been introduced proposing a variety of reforms that range from increasing employee contributions to adding defined-contribution plans and ending cost-of-living adjustments for retirees.

Although it’s hard to compare pension reform from state to state given the intricacies of each system, we examined proposals still brewing in state legislatures, how already-enacted reforms are playing out, and the model that one Canadian province is using to keep costs under control based on one of the world's strongest pension systems.

Illinois

Illinois’ pension woes date back decades and amount to somewhere in the range of $90 billion to $100 billion. When the legislature adjourned in May without taking any action to stop the bleeding, Moody’s and Fitch Ratings downgraded the state’s credit rating to the lowest level in the state’s history -- and the lowest nationwide.

After legislators failed to take any action in a special session, Gov. Pat Quinn used a budget line-item veto to withhold their pay beginning Aug. 1. The legislature’s bipartisan pension committee stated that it’s working on a reform proposal developed by the University of Illinois’ Institute for Government and Public Affairs. But the proposal hasn’t been released; and until it is, lawmakers won’t see any checks unless their lawsuit against Quinn to have their pay reinstated is successful.

Rhode Island

Back in 2012, Chicago Mayor Rahm Emanuel suggested that Illinois look to Rhode Island as a source of inspiration for pension reform. But what’s being done there has proved to be a major point of contention.

In 2011, the legislature approved a pension reform package driven by a required taxpayer-funded contribution to the pension fund that would double between 2010 and 2013 and leave little for additional investments in other areas like education. The reforms focused on shared risk for the employer and employee by ending the traditional defined-benefit (DB) plan in favor of a hybrid plan with a less generous DB plan and a supplemental defined-contribution plan, ending cost-of-living adjustments until the plan is funded to at least 80 percent, and raising the retirement age.

An actuarial valuation report provided to the state in June 2011 found an immediate reduction in the state’s unfunded liability by $2.7 billion, but also predicted that contributions funded by taxpayers would increase. (Note: Taxpayer-funded contributions actually decreased from 2012 to 2013 but are expected to rise in 2014.)

According to Fitch Ratings, the Rhode Island Retirement Security Act of 2011 is the most comprehensive pension reform package implemented by any state to date. The reforms are projected to save $4 billion in taxpayer dollars over two decades. But since its inception, the law has been plagued by lawsuits and speculation about how the reforms are actually being implemented and what impact they’ll have on employees and the state.

A study by the liberal-leaning Economic Policy Institute found the hybrid plan to be less cost effective than initially indicated and also believes the plan will significantly reduce retirement benefits for employees. Forbes contributor Ted Siedle says that changes made to the plan’s investment portfolio increase risk and fees, which will eventually put both taxpayers and retirees at risk. You can read more of Siedle’s opinions, which the Rhode Island Treasurer’s Office has strongly criticized, here and here. The state’s union leadership is also unsurprisingly critical of increasing pension costs. Philip Keefe, the president of SEIU Local 580, alleges that the increases are caused by high payments being made to investment managers. But former State Treasurer Frank Caprio contends that the increase could be due to the wave of baby boomer retirements finally hitting government and people living longer.

Massachusetts and Connecticut

Rhode Island’s neighbors have been facing uphill pension reform battles of their own.

Massachusetts started the new fiscal year on a high note with a 12.7 percent investment gain for its pension fund. This record gain comes amid promises from the state treasurer and pension fund executive director that innovative reforms are coming in the next year. Goals for reform include saving $100 million in annual fees and expenses on investments, reducing investment management fees and finding alternative investment options.

A Boston-based think tank, the Pioneer Institute, estimates that the state could close its pension gap by combining its 105 separately managed pension plans into a centralized program and saving $25 million a year in “overstaffing” employment costs. In addition to the savings, they expect the plan would be better managed and more transparent.

South of the Bay State, Connecticut Gov. Dannel Malloy set about reversing decades of underfunding in FY 2012. The key tenet of his plan involved the state paying an extra $3 billion toward pensions until 2023, after which the contributions would decrease annually. The governor claimed his plan would put Connecticut’s pension fund $5.8 billion ahead by 2031. In FY 2013, the first year of implementation of the reform plan, state payments to the fund rose $87 million and were expected to reach $1.1 billion in FY 2014. The implementation came a year after the state reached agreements with its public employee unions that included an increase in retirement age, modified cost-of-living adjustments, increased penalties for early retirement and a new hybrid pension plan.

Although Connecticut remains the second worst funded pension in the nation, the reforms seem to be paying off so far. Thanks to strong equity gains, the plan grew during FY 2013, even after taking into account the payments made to retirees. The preliminary investment return, net of expenses, for the Connecticut Plans and Trust Funds was 11.49 percent.

New Brunswick, Canada

The Canadian province recently decided to try a new pension reform approach based on the reality that it had fewer people in its workforce and retirees who are living longer -- and it did so with the support of its labor unions.

Rather than guaranteeing retirees one set benefit, retirement payouts are now divided into two categories: base and ancillary. The base benefits are guaranteed to retirees while the ancillary benefits are paid out depending on the health of the fund. If the fund has a bad year, retirees get smaller ancillary benefits and the government infuses more money into the plan. If the opposite is true, retirees get bigger monthly checks and employers are able to recoup some of their contributions from the down years.

A similar “shared risk” model was pioneered by the Dutch, who are considered to have one of the strongest pension systems in the world. It involves a less volatile investment mix to absorb market fluctuations as well as a marginal increase in contributions.

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