Planning for pension payoffs

Local governments are facing complex challenges in managing the retirement plans of their employees. Several factors have converged to create the fiscal crisis enveloping local government pension plans, including the currently collapsing stock market. Compounding the problem are the municipalities that have been forced to cut back on services because of declining revenues while increasing their contributions to employee retirement plans that relied too heavily on stock market profits.

The dimensions of the problem can be seen at both the state and local levels, and from coast to coast. According to a recent report from Los Angeles, Calif.-based Wilshire Associates, 51 percent of all state retirement systems were underfunded in 2001, compared to only 31 percent in 2000. Orange, Calif., for example, will see a 384 percent jump in pension payments for police and fire personnel in the next fiscal year. Cities and counties in New York are facing 7 percent increases in property taxes in 2004 just to cover skyrocketing pension costs.

How it happened

In the 1970s, the average municipal defined benefit (DB) pension plan was a mess. Rampant inflation in salaries — which drive costs in pension plans — had increased the liabilities of those programs, and the asset portfolios suffered as both stocks and bonds languished. Inflation brought high interest rates, and bond prices declined. Escalating operating costs affected the profitability of businesses, which decreased the value of their stock. Price-to-earnings ratios also had to increase to match higher bond yields, so the prices of most stocks declined. Thus, the ratio of pension assets to their liabilities sank, and many of the plans eventually became underfunded, sometimes catastrophically.

The problem is different now, but it has familiar tones. The root of today’s problem began in the 1990s as public pension plan portfolios grew at double-digit rates. With their coffers overflowing, the trustees of some plans often were persuaded by employee groups to enrich their benefits formulas. As a result, the percentage of final salaries that now are paid out as pension was raised by 20 percent to 40 percent in many of those plans.

The trustees also told their plan sponsors that they could cut their contributions. In some cases, there were “funding holidays” for cities and counties whose plans were “fully funded.”

In essence, those plans were acting as if the good times would never end. It was assumed that markets would continue producing double-digit returns perpetually, without a correction. As everyone knows all too painfully, after a third year of declining stock markets, the unprecedented returns were too good to be true.

Many public pension plans cannot pay for promised benefits without increasing the employer contributions. This comes at a time when most state governments have exhausted their rainy-day funds and have started to put the squeeze on local governments’ shares of state collected revenues.

It also is likely that most city and county pension funds, and the state pension plans to which many local governments contribute, will be forced to make lower actuarial assumptions about future earnings rates. With U.S. Treasury bonds now yielding only 4 percent to 5 percent, and stock market returns expected by some to be in the high single digits for several years, it is difficult to justify the 8 percent and higher portfolio-return assumptions used by many pension plans.

Defined contribution plans losing steam

By the late 1990s, several state governments and dozens of local governments were changing their retirement plan structures to allow employees to take money out of their pension plans and invest it in defined contribution plans (often called DC plans or 401 plans).

Other public plans adopted features of DC plans within their traditional pension plans, according to the Washington, D.C.-based National Conference on Public Employee Retirement Systems. “Public sector retirement plans have begun to explore modifications to traditional DB plans, responding to increased worker mobility, nontraditional career paths and the demand for total compensation packages,” the organization stated in its publication, “The Evolution of Public Sector Retirement Plans.”

Employers who adopted those plans were able to avoid the constant pressure from their employee groups to keep raising benefit levels. Because the assets are “portable” and can be transferred from one employer to the next, or rolled into an IRA, those plans are popular with many employees. Other employees, however, who joined in the movement to DC plans were more interested in becoming rich from escalating stock market returns.

The stock market decline also has reduced the value of most public employees’ supplemental savings in their 457 deferred compensation plans. Less than half of all city and county workers have opened such accounts, but they are an important source of retirement income.

Now that the stock market’s nosedive has reduced the value of the 401 and 457 plan accounts, some public employees have been forced to postpone retirement, which has a direct impact on local government budgets. For example, employers will not be able to replace retired older workers with younger employees at lower salaries or reduce headcount by leaving the positions unfilled. However, keeping experienced workers can be beneficial if their value to the organization is difficult to replace.

The main differences between DB and DC plans are twofold. First, in contrast to DB plans, DC plans do not force taxpayers to make up the stock market’s losses. The marginal cost of paying older employees to work for a few extra years to make up for losses in their DC plans is less than paying for decades of pension benefits to workers with DB plans. The employers of workers with DC plans will continue to pay the same percentage of salary into their 401 plans, but not more.

Second, now that the stock market has declined, many employees would be better off to join a 401 plan, and move their money from the pension fund even at reduced levels under revised actuarial assumptions. Thus, employers who adopted hybrid DB-DC plans and gave employees the option to transfer into a DC plan should consider re-opening them to existing employees. In the long run, that could reduce the employer plan contribution costs and give employees the opportunity to “buy low.”

Governmental entities also should consider a conversion from DB to lower-cost DC plans. Even though the DC plans are not as popular with current employees because of their stock market losses, DC plans may be more beneficial for public employers in the long term. Both new and existing employees who convert balances would be buying into the market at a relatively lower price level. Recent changes in federal legislation to permit portability from public sector 401(a) and 457 plans to private sector 401(k) plans and non-profit 403(b) plans should make those arrangements more attractive.

Retirement healthcare funding crisis looming

Except for a small number of finance officers, most city and county officials are unaware of the extent of their next financial crisis, which will revolve around changing the way local governments pay for post-retirement medical benefits. The Norwalk, Conn.-based Government Accounting Standards Board (GASB) — an organization that sets accounting rules for the public sector — has proposed a procedure like the one the private sector uses to account for its retirement medical benefits and similar expenses.

It is expected that after public review, GASB will adopt the private sector model that has led to many large employers decreasing retiree healthcare benefits. Implementation of the new rule would occur in mid-decade.

As retiree health care program costs continue to soar, the expected change in accounting rules would require those cities and counties that now pay all or part of their retirees’ medical insurance or related benefits to record the actuarial value of those benefits, as they do with pension benefits. Likewise, there must be liabilities shown in the financial statements that are not just the annual benefit costs, but also the accruing costs of fully funding those future benefits.

The current practice of pay-as-you-go funding will show rapidly increasing liabilities in financial statements. That could completely wipe out some municipalities’ fund balances and actually put them into both an operating deficit and a balance sheet deficit. In addition, bond ratings could be at risk in some cases. (For additional information about the Other Post Employment Benefit issue, visit http://www.gasb.org.)

Retirement medical insurance costs are one of the most important barriers to retirement for employees. Generally, healthcare costs are increasing two and three times greater than the inflation rate. Moreover, the percentage of gross domestic product (GDP) allocated to healthcare costs has increased from around 12 percent at the beginning of the 1990s to approximately 15 percent today. Some estimate that healthcare costs will reach as high as 20 percent of GDP over the coming decades.

Medicare, the source of basic medical care for many retirees, does not cover the costs of prescription drugs and long-term care — two areas growing at rapidly escalating rates, especially for the elderly. The estimated cost of providing Medicare Part B and Medigap coverage for a person living 15 years beginning at age 65 is $82,000. The inability to pay those types of medical costs keeps many city and state workers on the payroll.

A new retirement program — a DC retiree health savings plan — allows the public agency and the employee to set money aside, including unused sick leave, to fund a personal account that can be used in retirement. The health savings account is similar to an annual (Section 125) flexible spending account, but it does not wipe out the money that has not been spent at the end of the year and remains available for medical costs in retirement on a pre-tax basis. Thus, the dollars are not taxed at the time of the investment and are not taxed when spent if used for qualified retirement medical expenses.

Another variation of a retirement plan that may become popular will require taxpayers to cover some long-term employees’ retirement medical costs. In that type of plan, the employees would make additional mandatory contributions to an account that they can spend if they leave city or county employment.

As Baby Boomers begin to retire, America’s cities and counties must face the looming financial crisis in retirement plan finance. Municipalities are discovering that medical and retirement-related costs are their most rapidly growing expenses.

Finding creative solutions to the escalating needs of retiring employees will be difficult for many city and county managers. Their choices are clear, however. Doing nothing will result in spiraling costs and eventually will become evident to taxpayers, elected officials and public employees. Sound planning, on the other hand, will produce significant long-term community benefits.

Girard Miller is CEO of the Washington, D.C.-based ICMA Retirement Corp., a not-for-profit plan administrator serving cities and counties.

GLOSSARY

Defined benefit pension plan — A traditional plan that promises employees a specific monthly benefit at retirement. The amount of the benefit is known in advance and is usually based on factors such as age, earnings and years of service. The plan may state the promised benefit as:

• a percentage of salary and years of service with the employer (for example, 1 percent of final pay times years of service);

• a specific dollar amount and years of service (for example, $30 per month at retirement for every year of service with the employer); or

• an exact dollar amount (for example, $100 per month at retirement).

• 457 plan — A plan that deducts a specified amount from employees’ compensation on a pre-tax basis each payroll period. The federal and, in most cases, state income taxes on the compensation that is deducted are deferred until the assets are withdrawn.

  401 plan — A qualified defined contribution retirement plan in which employees’ eventual retirement benefits are based on the contributions made by employees and the employer, plus the investment earnings on those contributions.

  Portability — With the most recent changes in tax laws, the assets in public sector 401(a) and 457 plans can be transferred upon leaving service to private sector 401(k) plans or non-profit 403(b) plans.

  Government Accounting Standards Board (GASB) — The board that sets accounting rules for the public sector. A proposed rule from GASB would change how states and local governments budget for their retiree health plans.