When 6.9% Isn't Enough

Some pension systems may be underfunded forever.

Despite earning 6.9% in 2016, the Oregon Public Employees Retirement System (PERS) has announced it faces a projected 20-year actuarial liability of the system close to $22 billion, which is about one-third of the pension fund’s $70 billion in assets.

While the actuarial liability is significant, the fund’s earnings performance during the past two years has fallen well short of its assumed rate of 7.5% set by the PERS board in 2015.

The assumed rate of return was fixed at 8% for more than 30 years, but the board reduced that assumed rate to 7.75% in 2013, and to the current 7.5% in 2015. The board will set a new rate in July for the next two years. A lower rate only increases the system’s liabilities.

In addition to the performance shortfall, the fund is faced with greater longevity among the state’s 130,000 public retirees. When the state legislature attempted to reduce annual cost-of-living increases in 2015, the Oregon Supreme Court barred the retroactive proposed cuts by lawmakers. This helped contribute to the system’s 20-year liability, which has since expanded to almost $22 billion.

To help correct the shortfalls, the PERS board increased pension contribution rates by government employers for the two-year state budget cycle starting July 1, 2017, and additional rate increases will be spread over the next two budget cycles through 2023.

Under the new plan, total contributions will rise from about $2 billion in the current budget cycle to almost $2.9 billion in 2017-2019. This will also comprise a sizable share of the $1.8 billion gap in Oregon’s next state budget.

Milliman, the state fund’s actuarial firm, projected in November 2016 that there is a 50% chance that contributions will reach 30% of public payroll costs in a few years.

How Bad is the State Pension Underfunding Problem?

Oregon’s problems are not unique. Earlier this month, two state pension funds in South Dakota and Michigan announced they were making significant changes to their funds due to reduced expected investment returns and funding concerns.

In an article from the Heritage Foundation, Rachel Greszler, senior policy analyst, entitlement economics, wrote that “state and local pension plans report about $1.4 trillion in unfunded pension liabilities based on their own, unreasonable estimates. Under more appropriate assumptions, similar to those required of private, single-employer pensionplans, state and local pensions’ unfunded liabilities are closer to $5 trillion. A 2016 report from the American Legislative Exchange Council tagged state and local pensions’ unfunded liabilities at $5.6 trillion, or nearly $17,500 for every man, woman, and child in the US. Individual states’ unfunded liabilities per capita ranged from $7,246 in Tennessee to $42,950 in Alaska. Granting states control over a whole new pool of private-sector defined benefit pensions could drive these unfunded liabilities even higher.”

As a result of regular underfunding, many state and local plans have greater obligations than assets. For example: the Public School Teachers’ Pension and Retirement Fund of Chicago has $9 billion in unfunded liabilities. (This plan is only one of Illinois’ 667 public pension plans that total $332 billion in unfunded liabilities); New Jersey is underfunded by $200 billion; and California has the largest unfunded pension liability, $754 billion. These unfunded pensions represent massive taxpayer liabilities, which should cause state and local taxes to increase..

Pension fund experts said a number of factors led to the problem,  such as assuming unrealistic rates of return, being exempt from the formalities of ERISA, failure to enforce contribution requirements from state and local taxing authorities, and politicization of the benefits packages.

As far as choosing rates of return, Olivia S. Mitchell, Executive Director, Pension Research Council at the Wharton School, said “In my view, and in the view of financial economists, public pension plans should be using the rate close to the cost of borrowing public money at 4% to 5%, so they should be using a more realistic discounting rate, rather than coming up with an assumed rate of return.” 

She also said Moody’s, the municipal bond rating company, assumes a 5% a discount rate and this should apply to state funds. The other problem is that taxing authorities often do not make their required contributions annually and this only exacerbates the underfunding over time. This is why states often only have a few choices: cut benefits, raise contributions, or both, she said.

Looking ahead, state plans will face a difficult time when they want to improve their funding status. According to Sona Menon, head of North America Pensions for Cambridge Associates, Boston, a global investment firm that caters to pensions, endowments, foundations and other large investors, state pensions want to maximize their total returns to improve their funded status. But the next five years are not likely to be as easy as the last.

“Over that period, US equities have posted double-digit annualized returns and interest rates have continued to be persistently low. To succeed in what is likely going to be a lower-return environment, plans will have to be careful about portfolio construction, employ more non-traditional asset classes, and seek selective active strategies in which manager skill can help generate the stronger returns that market returns probably won’t produce.”