US public sector pension funds will have to take a radical private-enterprise approach to reforming employee benefits and revising investment expectations if funds are to fulfil their obligations to existing and new employees.
The Pew Center’s report in February on underfunded state retirement systems has revealed a horrendous chasm – $1 trillion – between reserves of $2.35 trillion and the liabilities of $3.35 trillion for pensions and health benefits for public sector employees.
Pension funds must start five fundamental reforms immediately if they are to deliver on the pension plans, health care and other benefits promised to public servants. These reforms include: maintaining funding needs; cutting benefits and/or lifting retirement ages; sharing the risk with employees; increasing employees’ contributions; and slashing investment returns’ assumptions from 8 per cent to 6.36 per cent.
First, in keeping up with funding needs, states will have to not only meet actuarial targets but also ensure that the calculations’ assumptions are correct. Both Utah and Pennsylvania have cut their investment assumptions [from 8 per cent to 7.75, and from 8.5 per cent to 8, respectively]. Indeed the report cites Warren Buffett who has said these levels are too generous, and the Financial Accounting Standards Board is touting the private sector’s assumed return of 6.36 per cent as more realistic.
Second, funds will have to cut benefits for new employees by changing the funds’ formulas and/or lifting retirement ages. In Nevada, employees hired after January 1 this year will have years of service multiplied by a lower 2.5 per cent [2.67 per cent previously] to derive the salary percentage to be replaced by pension benefits. As well, these new sign-ons will have to work until they are 62 [60 previously] to retire with 10 years of service.
Third, sharing the risk with employees will have to become more common as the public sector hybridises defined benefit and defined contribution plans [these will be similar to the private sector’s 401(k) DC plans]. Nebraska’s cash-balance plan is one such hybrid, with the guarantee to employees of an annual investment return of 5 per cent.
Fourth, employees will have to contribute more than the existing 40 per cent of non-investment contributions. This will have the benefit of fostering employee buy-in: employees pay more attention to their fund, and also pressure pension officials to keep the plan well-funded. In Arizona, general [non-public safety] employees and employers each pay equal shares of the annual contribution, and if the employer contribution rises, so does the employee’s.
In tandem with this fourth reform, health care benefits will need revisiting. Kentucky, New Hampshire and Connecticut are leading this charge on this front. Kentucky now requires new employees to pay 1 per cent to fund post-retirement health care and other non-pension benefits. Connecticut has been even tougher: new employees, and current employees with fewer than five years’ service, will have to contribute 3 per cent of their salaries.
Fifth, the bar will have to be raised for governance and investment oversight. With Warren Buffett calling for substantial cuts to investment return assumptions, pension plan officials would do well to consider the Financial Accounting Standards Board’s recommendation that the rate on corporate bonds be the norm. In December 2008, the top 100 private pensions had an average assumed return of 6.36 per cent. Simultaneously, underfunded plans will have to professionalise the complexity of pension investments away from trustee boards to investment experts. In Vermont, investment decisions for the state’s three retirement systems are now made by the Vermont Pension Investment Committee which can also move more quickly on asset allocations than in the past. Simultaneously, the combining of administration of the state’s three retirement systems has saved money.