Coates & Crow: The Art of the Possible... Not Really

Recently the Pension Benefits, Design, and Funding Task Force (Task Force) released their final report, which included recommendations to fix the retirement systems for state workers and teachers (Retirement Systems). Given the stakeholders involved and the desire to have majority approval, the report’s recommendations were seen as the best that could be done for now. A good start considering the circumstances, but they do not include the systemic solutions needed to make the Systems sustainable.

WHAT IS THE DEAL?

Without getting too far into the weeds, the state would add $200 million of one-time funding to the pensions within the Retirement Systems and $67 million to prefund the retiree healthcare benefits under the Retirement Systems (otherwise known as OPEB). The state would also put in $30 million from FY 2024 through FY 2026 and then contribute $30 million annually after that. The recommendations also include increasing that state workers’ and teachers’ contributions to the pensions under Retirement System and placing some limitations upon annual cost-of-living increases.

 

WHAT IS THE IMPACT?

All these changes are good. The recommendations are projected to reduce the Retirement Systems’ unfunded liabilities by $2.0 billion. These recommendations also will commence the amortization of the OPEB liabilities, something our state treasurer, Beth Pearce, has been encouraging for several years.

 

A CLOSER LOOK.

We have read and heard certain legislators and union leaders indicating the problem is now solved. We wish that were true but after carefully analyzing the impact of the recommendations over time, we believe these recommendations come up short – likely far short. None of the recommendations include the structural changes needed to make the Retirement Systems sustainable. Instead, the changes are incremental and only offer temporary relief, meaning we all will be dealing with this problem again in the not-too-distant future.

When you dissect this $2.0 billion reduction in unfunded liabilities, only $300 million of that amount would reduce the pension liability, which is just 10% of the current $3 billion liability (as of 6/30/21) - certainly not very much in the overall scheme of things.

The other $1.7 billion, although substantial, is an accounting change. By prefunding the OPEB benefits, governmental accounting rules allow the actuary to use a higher discount rate that serves to reduce the present value of the obligation to the participants. In this instance, this means that the $2.9 billion (as of 6/30/21) unfunded liability for OPEB benefits would be reduced to $1.2 billion. This is a good thing, especially since it will bring the state’s net worth from a $300 million deficit to a positive balance. But bear in mind, no recommendations were made to alter OPEB benefits, including what the participants pay for them (currently approximately 20% of the cost). These extraordinary benefits, not generally found in the private sector, remain unchanged.

And where is most of the new, ongoing funding coming from? Mostly from the state. Taking FY 2026 as an example (since this funding would be phased in over time), the state would add, in addition to the Actuarially Defined Employer Contributions (ADEC) $53 million of new funding. This new state funding, when added to the then existing ADEC, would come out to be $94 million. The additional amounts the state workers and teachers will pay into the system
through additional contributions and adjustments to cost-of-living increases would be $36 million. Thus, the state is contributing over two and half times more than the state workers and teachers in these recommendations. All of this while teachers and state workers remain in the top 25% of average pay for all Vermonters, and that’s not including benefit packages.

Looking ahead, it won’t be long before we’re in the same or worse predicament. Based on the Governors FY 2023 budget for the Retirement Systems, the projected costs will increase each year and by FY 2026 they will be 20% higher (from $394 million to $473 million). Yet, state revenues are projected to increase by only 1% to 3% over the next several years. While the costs are increasing at a slower rate due to these proposals, they continue to significantly outpace projected revenues. Clearly, the math doesn’t work.

 

WHAT STILL NEEDS TO BE DONE.

Enacting the Task Force’s recommendations will be a great first step to addressing our (taxpayers) unfunded liabilities to the Retirement Systems. But we must go further if we really want to implement solutions that will result in sustainable Retirement Systems. While there are other steps that can be taken, such as eliminating OPEB benefits for spouses or capping how much the state will spend on early retirement OPEB benefits (until age 65), to reach a meaningful, long-term solution, the following should be part of the plan.

 

1. More frequent review and adjustment of assumptions. The actuarial assumptions must be reviewed more frequently. The current version of the bill incorporating the Task Force’s recommendations extends the existing assumptions, established in 2019, to 2023. In our opinion, actuarial assumptions should be reviewed at least every three years if not sooner, especially when adverse economic conditions occur. Already, the assumptions used to calculate the savings from the Task Force’s recommendations may be out of date, as assumptions for cost-of-living adjustments and wage increases appear to be based on pre-inflation numbers. We must keep a closer watch on these assumptions to avoid or at least better manage surprises down the road.

Also, the actuarial assumptions include using a 7% rate of return and discount rate through 2038. By comparison, the California Retirement System (CALPERS), the largest retirement system in the country, recently projected a 6.2% rate of return over the next ten years. It’s just not realistic that we will attain a 7% rate of return over that time period, especially since the rate of return determines the discount rate applied to the unfunded liabilities (the last time we reduced the rate of return/discount rate from 7.5% to 7%, we saw a 600 million increase in unfunded liabilities). That means the amount the state is paying into the Retirement Systems, now and with the Task Force’s recommendations, is likely too low.

By way of example, if the rate of return and discount rate were 1% less, or 6%, that would result in a nearly $900 million increase in the unfunded pension liability and would require much higher ADEC payments by the state/taxpayers (possibly over $100 million). We should be realistic about what the actual liabilities are and will be so that we better understand the magnitude of the problem and how critical it is that we address it now in a more sustainable fashion.

2. Alternative plans for new hires. We must create different plan structures for newly hired state employees and teachers. This step alone is critical to reaching a sustainable solution. Otherwise, the unfunded liabilities will just keep growing. This should entail implementing some form of defined contribution plans, whether they be the sole plans available to new hires or a component of defined contribution/defined benefit hybrid plans. At a minimum, defined benefit plans for new hires should be restructured to reduce costs while still remaining competitive. (e.g., provide for higher contribution rates for pensions, limit or do not offer spousal coverage, do not cover early retirement for OPEB, eliminate OPEB (something most other workers don’t even have), or at least have new hires pay more for this generous benefit, etc.).

3. Risk-sharing policy. There is no provision in the Task Force’s recommendations to address unanticipated, significant downturns in the economy. Yet, unfortunately, these things happen. Think short- or long-term deviations from plan assumptions, such as our current rapid inflation rate, the 2007 Great Recession or in response to poor investment returns or unrealistic plan/funding ratios. The impact of these things occurring should not fall entirely on the state (taxpayers), as it currently does. There are no guarantees in this world and unexpected cost increases between the state and the Retirement Systems should be equitably shared. It’s only fair and the right thing to do for all Vermonters.

 

FINAL THOUGHTS

We are grateful for the Task Force’s efforts so far, but more must be done. The goal is to make the Retirement Systems sustainable. That’s exactly what Treasurer Pearce’s 2021 recommendations for changing the Retirement Systems were trying to achieve. One-time money and small plan changes is not going to create the necessary systemic change to shift the cost curve. Given the scale of the challenge, providing benefits structured more in line with other Vermonters does not seem unreasonable, nor does asking the state workers’ and teachers’ unions to share a more equitable portion of the burden in solving this critical issue that continues to threaten the financial wellbeing of our state.


David Coates
KPMG (Ret.)

Mark Crow
Tenth Crow Creative, Inc.

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  • David Coates
    published this page in Blog 2022-03-31 08:40:27 -0400

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