crisis in public sector pension plans: blueprint for reform in n j

8/8/2019 Crisis in Public Sector Pension Plans: Blueprint for Reform in N J

1/34

working

paper

The crisis in public secTor pension plans: a blueprinT

for reform in new Jersey

By Eileen Norcross and Andrew Biggs

n. 10-31

J 2010

The ideas presented in this research are the authors and do not represent ofcial positionso the Mercatus Center at George Mason University.


2/34

1

Pensionplansoperatedbystategovernmentsonbehalfoftheiremployeesareunderfundedbyan

estimated$452billionaccordingtoofficialreports,1withtotalliabilitiesof$2.8trillionandtotalassets

of$2.3trillionin2008.However,manyeconomistsarguethateventhesedauntingliabilitiesare

understated.Current

public

sector

accounting

methods

allow

plans

to

assume

they

can

earn

high

investmentreturnswithoutanyrisk.Usingmethodsthatarerequiredforprivatesectorpensions,which

valuepensionliabilitiesaccordingtolikelihoodofpaymentratherthanthereturnexpectedonpension

assets,totalliabilitiesamountto$5.2trillionandtheunfundedliabilityrisesto$3trillion.2Theabilityof

governmentstopayfortheretirementbenefitspromisedtopublicsectorworkersrunsupagainstthe

realityoflimitedresources.

Inthisstudy,weconsiderthecaseofNewJersey,whichoperatesfivedefinedbenefitpensionplansfor

stateemployees.3TheNewJerseySenateunanimouslypassedlegislationinFebruary2010thatwould

putaquestionontheNovemberballottoconstitutionallyrequirethestatetobegintomakeitsfull

annualpaymenttothestatespensionsystem.4Thebillrequiresthestatetocatchuptopayingitsfull

1TheTrillionDollarGap:underfundedstateretirementsystemsandtheroadstoreform,ThePewCenteronthe

States,February2010,23.Wecalculatethesizeoftheunfundedliabilityapplyingadiscountrateof3.5%,the

yieldonTreasurybondswithamaturityof15yearsasofMay27,2010.

2

Novy

Marx,

Robert

and

Joshua

Rauh,

2009.

The

Liabilities

and

Risks

of

State

Sponsored

Pension

Plans,

Journal

ofEconomicsPerspectives23(4),191210,p.42.Thisresultisbasedonthepremise,derivedfromModiglianiandMiller(1958),thatafutureobligationshouldbediscountedattheinterestrateonaportfoliothatmatchesthe

timingandriskofitspayments.Modigliani,FrancoandMertonH.Miller,1958,TheCostofCapital,Corporation

Finance,andtheTheoryofInvestment,AmericanEconomicReview48:261297.3ThesearetheTeachersPensionAnnuityFund(TPAF),thePublicEmployeesRetirementFund(PERS),thePolice

andFiremensRetirementSystem(PFRS),theStatePoliceRetirementSystem(SPRS),andtheJudicialRetirement

System(JRS).Inaddition,thestateoperatestwodefinedcontributedplans,theAlternativeBenefitPlan(ABP),and

theDefinedContributionRetirementPlan(DCRP).Therearetwoexistingdefinedbenefitplansclosedtocurrent

workers,theConsolidatedPoliceandFiremensPensionFund(CPFPF),andthePrisonOfficersPensionFund

(POPF).

See,

the

State

of

New

Jersey,

Department

of

the

Treasury,

Division

of

Pensions

and

Benefits,

http://www.state.nj.us/treasury/pensions/.

4Theproposalrequiresthestatetocontributeatleast1/7

thoftheAnnualRequiredContribution(ARC)in2011and

increasethestatesannualpaymentbyatleast1/7th

foreachofthefollowingsixyearstopermitthestateto

graduallyadjusttoappropriatingthefullamountneededtocontributethetotalARC.FortextofSenate

ConcurrentResolution1,seehttp://www.njleg.state.nj.us/2010/Bills/SCR/1_I1.HTM


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2

obligationbyFY2018.5Fromthatyearforwardthestatewillbeconstitutionallyrequiredtomakethe

fullpaymenttoitspensionsystemseachyearascalculatedbyplanactuaries.Thestatereportsthatits

pensionsystemsareunderfundedby$44.7billion,whenliabilitiesarediscountedatthe8.25percent

annualreturnthatNewJerseypredictsitcanachieveonfundsinvestmentportfolios.

However,whenplanliabilitiesarecalculatedinamannerconsistentwithprivatesectoraccounting

requirements,methodsthateconomistsalmostuniversallyagreearemoreappropriate,6NewJerseys

unfundedbenefitobligationrisesto$173.9billion.7Thisamountisequivalentto44percentofthe

statescurrentGDP8and328percentofitscurrentexplicitgovernmentdebt.Thiscalculationappliesa

discountrateof3.5percent(theyieldonTreasurybondswithamaturityof15years)toreflectthe

nearlyriskfreenatureofaccruedbenefitsforworkers.Itisestimatedifstatepensionassetsaveragea

return

of

8

percent,

New

Jersey

will

run

out

of

funds

to

meet

its

pension

obligations

in

2019.

If

asset

returnsarelowerthan8percent,theywillrunoutoffundssooner.9Stateactuariesestimatethatunder

certainassumptions,NewJerseyspensionplanswillrunoutofassetstomakebenefitpayments

beginningin2013.10

5http://www.newjerseynewsroom.com/state/njpensionreformbillsapprovedbysenatecommittee

6Currentpublicsectorpensionaccountingruleseffectivelyviolatewellacceptedeconomicpreceptssuchasthe

ModiglianiMillerresultsincorporatefinance,theBlackScholesformulaforoptionspricing,andthegenerallaw

ofoneprice.

7Authorscalculations.Waring(2008)findsthatthemidpointofapublicpensionsstreamoffuturebenefit

paymentsisaround15yearsinthefuture.Thus,alumpsumpayment15yearshencecanbetreatedasan

approximationoftheannualbenefitliabilitiesowedbyaplan.FollowingRauhandNovyMarx,wecompoundthe

reportedpresentvalueliabilityforwardfor15yearsattheexpectedrateofreturn,thendiscountbacktothe

presentattheTreasuryinterestrate.Waring,M.Barton,Liabilityrelativeinvesting,JournalofPortfolioManagement30(4).8In2008NewJerseysGrossDomesticProductwas$390.35billionandstatedebtwas$52.785billion.

9JoshuaD.Rauh,AreStatePublicPensionsSustainable?WhytheFederalGovernmentShouldWorryAbout

Pension

Liabilities,

National

Bureau

of

Economic

Research,

May

15,

2010

p.

3.

10AccordingtoNewJerseysactuarialreports,thestatePERSplanwillrunoutofassetstomakeitsbenefit

paymentsin2013.Theplansforteachers(TPAF),judges(JRS),andlocalPERSemployeeswillrunoutofassets

between2014and2015.ThePoliceandFiremensplansandtheStatePolicePlanrunoutoffundsbetween2018

and2019.Thiscalculationisbasedontheassumptionsthattheplansexperiencenogainsfrominvestment

income,nostateandemployeecontributions,andnochangestothesizeofbenefitpayments.


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3

Giventhecostsandrisksinherentinthedefinedbenefitplantotaxpayers,aswellasthepolitical

incentivesforlegislatorstooverpromisebenefitstopublicsectorworkerswhileshirkingonthestates

contributions,thestateshouldclosethecurrentdefinedbenefitplantonewworkersandexpandthe

existingdefinedcontributionplansforallnewstateandlocalworkers.Shiftingemployeestoadefined

contributionplanwouldensurethatNewJerseyspensionsystemforitspublicsectorworkforceis

sustainableinthelongtermandrewardyoungerworkerswithaguaranteedemployercontributionto

theirindividualretirement.

NewJerseycurrentlyoperatestwodefinedcontributionplans.TheAlternativeBenefitPlan(ABP)serves

17,000facultyandadministrativestaffinthestatesuniversitiesandcolleges. Inaddition,in2007the

state

established

the

Defined

Contribution

Retirement

Program

(DCRP)

with

limited

eligibility

for

elected

andappointedofficialsandcurrentparticipantsinthePublicEmployeesRetirementSystem(PERS)and

TeachersPensionAnnuityFund(TPAF).Eithercouldserveasamodelforafuturedefinedcontribution

planforallpublicsectoremployees.

TofundthedebtowedtocurrentDBparticipants,thestatemusttakeimmediateaction.Thisincludes

someorallofthefollowing:cappingsalaries,increasingemployeecontributions,reducingtherateof

theaccumulationoffuturebenefits,reducingannualcostoflivingadjustments(COLAs),andincreasing

theretirement

age.

These

measures

will

reduce

the

size

of

the

future

benefits

funding

burden

and

thus

enablethestatetobettermanageitspensionobligationstoemployeesvestedinthesystem.

ThealternativeistocontinuetheDBgamblepromisingbenefitstopublicsectorworkerswhile

concealingthesizeofthatobligationtotaxpayers.ThecurrentlevelofunderfundingindicatesthatNew

Jerseywillhaveadifficulttoimpossibletaskinkeepingitscommitmentstocurrentpublicsector

workers.Tocontinueaddingworkersandliabilitiestothedefinedbenefitplansisnottenableand

representsapromisethatthepubliccannotafford.I. PublicSectorPensions:theDefinedBenefitPlan


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4

Therearetwogeneraltypesofretirementplans:definedbenefitplansanddefinedcontributionplans.

MoststateandlocalgovernmentsintheUnitedStatesofferdefinedbenefitpensionplanstotheir

workers.

Underadefinedbenefit(DB)plan,theemployerpromisesemployeesaregularpensionpayment(i.e.,

anannuity)overtheworkersretirementyears.11Theamountofthebenefitpaymentdependsonthe

workersage,yearsonthejob,andameasureoftheirfinalsalary.12Morespecifically,benefitformulas

generallypayagivenpercentageoftheemployeesfinalsalarymultipliedbythenumberofyearsof

employment.Inadefinedbenefitplan,investmentriskisbornebytheemployersincetheemployers

paymentisindependentoftheinvestmentreturnearnedbythepensionsfund.

In

a

defined

contribution

plan

(DC),

workers

and

employers

make

contributions

to

an

investment

account,suchasa401(k),403(b),orthefederalThriftSavingsPlan.Workersownandgenerallymanage

theseaccountsandbearthetradeoffsbetweenriskandrewardentailedbytheinvestmentsthey

choose.

Becausedefinedbenefitretirementpaymentsareguaranteedbystatelawsorconstitutionsbut

financedwithaportfolioofriskyinvestmentssubjecttomarketrisk,definedbenefitplanspresenta

distinctfiscalrisktotaxpayers.Definedbenefitplansobligatetheemployertopayoutbenefits

regardlessof

the

financial

status

of

the

pension

system

when

the

employee

retires.

Current

actuarial

practiceandaccountingstandardshavecontributedtoasystematicunderestimationofthesizeofthe

obligationowedtopublicsectoremployees,creatingamoralhazardproblem.Legislatorsareableto

overpromisebenefits,oftennegotiatedbypublicsectorunions,whilepassingthecostofthesepromises

ontofuturetaxpayers.Sincemoststateconstitutionstreatpublicsectorpensionsasaformofdebt,itis

11

Edwin

S.

Hustead

and

Olivia

S.

Mitchell,

Public

Sector

Pension

Plans:

Lessons

and

Challenges

for

the

21

st

Century,p.6,inPensionsinthePublicSector,ed.OliviaS.MitchellandEdwinC.Hustead,PensionResearch

CouncilTheWhartonSchooloftheUniversityofPennsylvania,UniversityofPennsylvaniaPress,Philadelphia,

2001.

12OliviaS.Mitchell,DavidMcCarthy,StanleyC.WisniewskiandPaulZorn,p.11DevelopmentsinStateandLocal

PensionPlansinPensionsinthePublicSector,eds.MitchellandHustead,2001.


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5

unlikelythatstatescandefaultonpensionobligationstoemployeeswithoutconstitutional

amendments.13

Thereare222definedbenefitplansoperatedbythestatescovering90percentofpublicsectorworkers

inthestates.Theseplanscover20millionemployeesandsevenmillionretirees.14

Inaddition,thereare

2,434plansoperatedbylocalgovernmentsservingasmallerportionofpublicsectorworkers.15

Afewstateshaveelectedtomovetheiremployeestothedefinedcontributionplan.Michiganclosedits

DBplantonewentrantsin1997.AndAlaskamovedtoaDCplanin2003.Florida,Nebraska,andOhio

offerhybridplans. (SeeAppendix1)

Why

Are

Plans

Underfunded?

Themagnitudeofunderfundingstemsfromhowpensionobligationshavebeenactuariallyvaluedand

howgovernmentshavechosentomanagepensionfundingandbenefitlevels.Thedramaticdownturnin

marketperformanceinthelastfewyears,whileharmful,isnottheprimarycauseofunderfundedpublic

sectorpensionplans.

Pensionplanshavebeensystematicallyweakenedbyinteractionsbetweenactuarialpracticethe

tendencyforgovernmentstomakeunrealisticpromisestoemployees,andthechoiceofgovernments

tocontribute

less

than

what

plan

actuaries

recommended

to

fund

plans

over

aperiod

of

years.

Publicpensionactuarialpracticesassumethatplanassetscanearnhighratesofreturn,leading

actuariestocalculateemployercontributionsatalowerlevelthanneededtofundplanliabilities.In

additiontounderstatingrequiredemployercontributionamounts,becauseGASBfundingrulesfor

13ItisestimatedthatNewJerseysannualpayouttoretireeswillreach$15billion,halfofthestatescurrent

budget,in2017.Inthiscase,thestatemaybeforcedtoreexaminetheconstitutionalprotectionsthatpreventthe

reductioninaccruedbenefitstoretirees.SeeYes,aPublicPensionCanbeForfeited,JohnBury,NJ.com,June28,

2008.(http://blog.nj.com/njv_johnbury/2008/06/yes_public_pension_can_be_forf.html)

14U.S.GovernmentAccountabilityOffice,StateandLocalGovernmentRetireeBenefits:CurrentFundedStatusof

PensionandHealthBenefits,GAO08223,January2008,p.1,http://www.gao.gov/new.items/d08223.pdf.

15GovernmentAccountabilityOffice,StateandLocalRetireeBenefits,GAO071156,p.18,

http://www.gao.gov/new.items/d071156.pdf.


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6

publicpensionsarearecommendationandnotarequirement,manystategovernmentshaveroutinely

putasidelessthanwhatwasrecommendedbyplanactuariestomeetfutureobligations.16Inother

words,pensionaccountinglowersthestandardforplanfunding,andeventhen,manystate

governmentshavefailedtomeetit.

HowDefinedBenefitPublicPensionPlansAreFundedandValued

Publicsectordefinedbenefitplansarefinancedbycurrentemployerandemployeecontributionsand

thereturnsontheinvestmentofthoseassets.17Typically,thesecontributionsareinvestedinamixof

stocks,bonds,andotherfinancialinstruments.Inrecentyears,planshaveincreasinglyturnedtomore

exoticinvestments,includinghedgefundsandprivateequity.18Pensionplaninvestmentsaremanaged

by

financial

managers

selected

by

the

pension

board.

Theamountcontributedbytheemployerandtheemployeetofundthepensionsystemiscalculatedby

actuarieswhodeterminethesizeoftheobligationpromisedtoemployees. Actuariesvalueapension

planbasedondemographicandeconomicassumptions,suchasestimatedageofretirement,mortality

rates,salarygrowth,andinflation,toarriveatanAnnualRequiredContribution(ARC).Iftheactuarial

assumptionsarereasonable,theARCapproximatestheamountthatneedstobecontributedannually

(byemployersandemployees)toensurethepaymentoffutureobligations.

Theseactuarialassumptionsandpracticesplayalargeroleindetermininghowmuchgovernmentsmust

contributetoensureawellfundedplan.Inaccurateassumptionsorunsoundpracticecanresultinan

16AccordingtoThePewCenterontheStatesthecollectiveliabilityforpensionobligationsinthestatesis$2.77

trillion,andstateshavecontributed$2.31trilliontowardsthisobligation,leavinga$452billiongap.However,

whenadjustingthesenumberstoreflecttherisklesscharacteristicsoftheseliabilities,thetotalliabilityrisesto

$5.2trillionandtheunfundedliabilityrisesto$3trillion.SeeTheTrillionDollarGap:UnderfundedState

RetirementSystemsandtheRoadstoReform,ThePewCenterontheStates,February2010,p.15.

17Typicallystateandlocalgovernmentsoperateseparatefundsfordifferentoccupations(e.g.,teachers,public

employees,police,andfiremen).

18AsofApril30,2010,NewJerseyhadinvested$10.6billionof$68.9billioninassetsinalternativeinvestments.

SeeNewJerseyDepartmentoftheTreasury,DivisionofInvestment,http://www.state.nj.us/treasury/doinvest/,

andalso,NewJerseyTopsAnotherList,JohnBury,Nj.com,June13,2010.


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7

underfundedplan.Iftheactuarialassumptionscloselyreflectactualoutcomes,thenpayingtheARCin

fullshouldresultinawellfundedpensionsystem.

Todeterminethefundingstatusofpensionplans,actuariesperformannualactuarialvaluations

measuring

the

plans

accrued

liabilities

and

compare

liabilities

to

the

value

of

the

plans

assets.

Comparingplanliabilitiesandassetsallowsactuariestodeterminethedegreetowhichtheplanis

fundedandabletopayoutpromisedbenefits.Actuariescalculatetwobasicmeasuresofpensionplan

performance.Thesearethefundingratiotheplansassetsdividedbytheplansliabilitiesandthe

unfundedliabilitytheplansassetsminustheplansliabilities.Plansthatare100percentfundedand

havenounfundedliabilitiesareconsideredfullyfunded.19

HowReliableIstheARC?TheRoleofActuarialMethods

Accordingto

the

Government

Accounting

Standards

Board

(GASB),

the

ARC

is

to

be

calculated

so

that

it

coversannualbenefitaccrualsandspreadsanyunfundedliabilityovera30yearamortizationperiod.20

Onepracticethathascontributedtothepensionfundinggapistheselectionofanimproperdiscount

ratewhenvaluingpensionplanliabilities.Discountingallowsonetovalueafuturebenefitintodays

dollars.Itasks,Howmuchisneededtoputintothepensionsystemtodayinordertopayouta

promisedbenefitinthefuture?AccordingtotheGovernmentAccountingStandardsBoard(GASB)

ruling25andActuarialStandardsofPractice(ASOP)item27,publicpensionliabilitiesaretobe

discountedbytheexpectedrateofreturnonpensionassets.Typicallypublicpensionfundsassumethey

willearnnominalreturnsofaround8percentannually,usingthisinterestratetodiscountfuturebenefit

liabilitiesbacktothepresent.

However,mosteconomistsbelievethisapproachtobefundamentallyflawed,runningcontrarytoboth

financialtheoryandthepracticeoffinancialmarkets,whichholdthatthemeansbywhichaliabilityis

financedisirrelevanttothevalueofthatliability.Forinstance,DonaldKohn,theViceChairmanofthe

FederalReserveBoard,recentlystatedthat

Whileeconomists

are

famous

for

disagreeing

with

each

other

on

virtually

every

other

conceivableissue,whenitcomestothisonethereisnoprofessionaldisagreement:Theonly

19Ibid,AndrewG.Biggs,TheMarketValueofPublicSectorPensionDeficits,April2010,p.2.

20Amortizationistheprocessofpayingoffaloan,spreadingthecostofpayingtheprincipleandinterestovertime.


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8

appropriatewaytocalculatethepresentvalueofaverylowriskliabilityistouseaverylowrisk

discountrate.21

Discountingpublicsectorpensionliabilitiesattheexpectedrateofreturnonpensionassetsviolatesa

number

of

economic

precepts,

including:

TheModiglianiMillertheorem,whichholdsthatthevalueofaninvestmentprojectisindependentofhowitisfinanced;

TheBlackScholesoptionspricingformula,whichshowsthatguaranteesagainstmarketriskgrowmoreexpensiveoverlongperiodsandwhentheunderlyingassetismorevolatile(public

pensionaccountingholdsthatlongtimehorizonsjustifyignoringmarketriskandthatholding

riskier,higherreturningassetsimprovesapensionsfundinglevel);

TheArrowLindtheorem,whichholdsthatgovernmentscanignoretheriskofinvestmentsonlywhentheinvestmentsaresmallrelativetoanduncorrelatedwiththesizeofthetaxbase;and

Thegenerallawofoneprice,whichholdsthattwoinvestmentsproducingsimilarincomestreamsshouldcarrysimilarprices(publicpensionaccountingimpliesthatgovernmentscan

producethesamelevelofpensionbenefitsatroughlyhalfthecostofaprivatefirm).

Forconsistencywitheconomictheory,thepracticeoffinancialmarkets,andrulesappliedtoprivate

sectorfirms,

liabilities

should

instead

be

valued

according

to

the

risk

inherent

in

those

liabilities.To

do

otherwiseimplieslimitlesspossibilitiesforrisklessarbitrage,producingpotentiallyabsurdresults.22

Fromtheperspectiveofworkers,definedbenefitpensionsinthepublicsectorareriskfree;theyare

guaranteedbenefitsbythestate,whichhasthepowertotax.Thismeans,ofcourse,thatfromthe

perspectiveofthetaxpayer,theliabilityisanearcertainty.Thediscountratechosentovaluefuture

21Kohn,DonaldL.,StatementattheNationalConferenceonPublicEmployeeRetirementSystemsAnnual

Conference.

New

Orleans,

Louisiana,

May

20,

2008,

http://www.federalreserve.gov/newsevents/speech/kohn20080520a.htm

22Forinstance,ifgovernmentscanguaranteehighinvestmentreturnswithoutriskorcostduetotheirlongtime

horizons,therewouldbeenormouswelfaregainsbyhavingallinvestmentsheldandguaranteedbythe

government.Likewise,taxescouldbeeliminatedifthegovernmentborrowedsufficientamountsandinvested

thesesumsinhighreturningassets.


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9

liabilitiesintheplan,therefore,shouldreflectthelowriskcharacterofthebenefitspromisedto

workers.23

Fromthegovernmentsperspective,itisappealingtouseahigherdiscountratetoestimateplan

liabilities

because

it

produces

a

lower

annual

contribution.

By

contrast,

a

low

discount

rate

will

result

in

ahigherannualcontributionrequiredbytheemployer(inthiscase,thegovernment)tofundpension

obligations.

Overthepastdecade,statepensionliabilitieshavebeenvaluedusinganaveragediscountrateof7.97

percent.24Thismayseemreasonable,sincethemedianinvestmentreturnforpensionassetsoverthe

past20yearshasbeenaround8percent.However,returnsonmarketinvestmentsarenotguaranteed,

asthemarketdownturnof20012002andthecrashof2008demonstrate.25Evenifplansaccurately

predicted

average

market

returns

over

a

very

long

period,

the

majority

of

plans

obligations

are

payable

overthenext15years,inwhichaveragemarketreturnswouldbemoreuncertain.Thereisasignificant

possibilityandinsomecases,aprobabilitythatafullyfundedplanwouldbeunabletomeetits

obligationseveniftheplanaccuratelyprojectedaveragemarketreturns.26

23JeffreyR.BrownandDavidW.Wilcox,DiscountingStateandLocalPensionLiabilities,AmericanEconomic

Review:Papers&Proceedings2009,99:2,p.538.

24

See

Novy

Marx

and

Rauh

(2008).

The

median

(and

modal)

discount

rate

for

108

of

the

112

state

pension

plans

withassetsgreaterthan$1billionin2005was8percent.

25AccordingtothePewCenterStudy,theFinancialAccountingStandardsBoard(FASB)whichgovernsrulesfor

pensionsintheprivatesectorrecommendsthatinvestmentreturnsbediscountedmoreconservativelyand

suggestsusingtherateofreturnoncorporatebonds.Asof2008,thetop10privatepensionshadanassumedrate

ofreturnof6.36%.

26Itisunclearwhetherinvestmentreturnsfrompublicplansarepresentedassimpleaverages(thearithmetic

mean)orastheprojectedcompoundreturn(thegeometricmean).Thecompoundreturnislowerthanthesimple

averagereturntothedegreethatannualreturnsvaryfromyeartoyear.Aplanthatwasfullyfundedassuminga

givenprojectedrateofreturnwouldneedtoachieveacompoundreturnatthatleveltobeabletopayitsliabilities

inpractice.Ifaplanprojecteditsfuturereturnasacompoundreturn,thengivenmarketvolatilityonecould

expectafullyfundedplantohavea50percentprobabilityofbeingabletopayitsliabilitiesinpractice.However,if

theplansreturnwasprojectedasasimpleaverageasseemstobethecaseforsomeplansthenonecould

expectabelow50percentprobabilityofafullyfundedplanbeingabletomeetitsobligations.Publicpension

accountingrules,whichconsidertheaveragereturntoplanassetsbutnottheriskofsuchreturns,donotillustrate

therangeofoutcomesthatarepossible.


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10

Inadditiontounderstatingfundingrequirements,usingahighdiscountratetovaluepublicpension

liabilitiesencouragesplanmanagerstoinvestinhigherriskportfoliosinordertotargettheexpected

rateofreturn,producingbadincentivesinthemanagementofpensionassets.27 Instead,financial

theorysuggestspensionsshouldbediscountedaccordingtothelowerrisk(andlowerreturn)Treasury

bondratingof3.5%.28

Whenapplyingamuchlowerdiscountrate,basedonthereturnonTreasurybonds,thesizeofpension

obligationsisfarlargerthanstateestimates,29risingfrom$2.8trillionnationwideto$5.2trillion.30In

otherwords,thesizeoftheobligationowedtopublicsectorworkerswillrequireafarlarger

contributionthancurrentactuarialreportswouldsuggest.

Boom

and

Bust:

Pension

Asset

Investments

Byassumingahigherrateofreturnonpensionassetsinvestments,statespursuedinvestmentstrategies

thatfavoredhigherrisk,highervolatilityinvestments.31Beforethe1980smostsystemsheldtheirassets

mainlyinfixedincomesecurities.Investmentchoiceswererestrictedbylegallists.Inthe1980slegal

listswerereplacedwiththeprudentpersonrule.32Movingtothisstandardallowedpensionsystems,

27Wilcoxnotesthatthelinkbetweendiscountratesandinvestmentreturnsisremarkablebecauseitsuggests

thatplansponsorscanreducetheirfundingobligationsbyinvestinginriskiersecurities,whereasconventional

financetheorywouldsuggestthatagivenlevelofbenefitsecuritycanbemaintaineddespiteashifttoriskier

investmentportfolio

by

increasing,

rather

than

reducing,

contributions

to

the

plan.

See,

Brown

and

Wilcox,

DiscountingStateandLocalPensionLiabilities,2009,p.538.

28AccordingtoBrownandWilcox,Theidealsetofdiscountrateswouldbederivedfromsecuritiesthatdeliver

fullytaxablecashflows;thatdeliverthosecashflowswithahighdegreeofassurance;thattradeinmarkets

withoutextraordinaryliquiditycharacteristics;andthatarefreeofflighttoqualityeffects.p.541.

29Ibid.NovyMarxandRauh,PublicPensionPromises,2010,p.2.

30Ibid.NovyMarxandRauh,PublicPensionPromises,2010,p.42.Wearriveatatotalliabilityof$5.2trillion,by

discountingthetotalliabilityforstatepensionssystemsof$2.8trillionin2008reportedbythePewCenterusing

the3.5%yieldon15yearTreasurybondsasofMay27,2010.Thisissubtractedfromthetotalreportedassetsin

2008of

$2.31

trillion

to

arrive

at

atotal

unfunded

obligation

of

$3

trillion.

31J.FredGiertz,TheImpactofPensionFundingonStateGovernmentFunds,StateTaxNotes,August18,2003,p.

511.

32TheprudentpersonrulewascodifiedwiththeEmploymentRetirementIncomeSecurityActof1974(ERISA),

whichestablishedstandardsforprivatesectorpensions.


12/34

11

aslongasstandardsofdiversificationandprudenceweremet,toholdlargerpercentagesofequities

andcapturethehigherreturnsbeinggeneratedinaboomingmarket.33

Duringboomyearstheeffectofhighreturnsonpensionassetsmayhaveinducedotherbehavioral

changesinthemanagementofpensionassetsandencouragedmorerisktakingwithpensionassets.

BecausetheI.R.S.codestatesthatnopartofplanassetsmaybeusedforpurposesotherthanthe

exclusivebenefitofemployeesandbeneficiariestheguaranteedbenefitcoupledwiththeworkers

claimonsurplusescompoundthemoralhazardprobleminthemanagementofpublicpensions.Where

accountingmethodsbasepensionassetvaluationsonahighriskexpectedrateofreturn,political

pressuremayresultinexcesssurplusesofpensionassetsbeingdistributedtopublicemployeesas

enhancedbenefits.Thismagnifiestheincentivetotakerisksinpensionassetinvestmentsinorderto

apply

surpluses

as

expanded

benefits,

particularly

in

plans

that

have

heavy

employee

representation.

34

Thisisborneoutinthechangingmakeupofpublicpensionassetsinvestments. Followingtheadventof

theprudentpersonrule,theseinvestmentshaveincreasinglybeeninvestedinhigherreturnand

higherriskvehicles.

In1990,40percentofpublicsectorpensionassetswereheldinequities,risingto70percentin2006,

roughly10percenthigherthantheallocationofpensionassetstoequitiesinprivatepensionsystems.35

33OliviaS.Mitchell,DavidMcCarthy,StanleyC.Wisniewksi,andPaulZorn,DevelopmentsinStateandLocal

PensionPlans,Chapter2inPensionsinthePublicSector,eds.OliviaS.MitchellandEdwinC.Hustead,UniversityofPennsylvaniaPress,Philadelphia2001,p.14.

34J.RichardAronson,JamesA.DeardenandVicentC.Munley,PublicEmployeeDefinedBenefitPensionSystems:

theImpactofExplicitSurplusSharingContractsandStakeholderInfluenceonInvestmentStrategies,February

2007(LehighUniversity)p.3.

35AndrewG.Biggs,TheMarketValueofPublicSectorPensionDeficits,RetirementPolicyOutlookNo.1,

AmericanEnterpriseInstituteforPublicPolicyResearch,April2010,p.2.


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12

TheEmployer:HowPublicPensionPlansareOverpromisedandUnderdelivered

Inthecaseofmanystatepensionplans,governmentsmaychoosetopaylessormorethantheARC.36

TheARCisarecommendation,notarequirement.Asweoutlinedabove,ARCscalculatedundercurrent

pensionaccountingrulesareinadequatetoguaranteethatplanscanmeettheirobligations.Andmany

stategovernmentsfailtopayeventheARCsthatarecalculated,leavingplanfundingwellshortofwhat

istrulyneeded.Theresultisgreatercostsandgreaterriskshiftedontofuturetaxpayers.

Theamountcontributedtothepensionsystembythegovernmentistheemployercontribution,

sometimesreferredtoasthestatutorycontribution.Inmanystates,theannualcontributionmadeto

pensionsystemshasbeenbelowtheARC.Thesechoicesmadebymanystategovernmentsinclude

puttingoffpaymentsintothepensionsystempensiondeferralsorpensionholidayscontributing

lessthantheARCinordertoexpandspendinginotherareasortoavoidtaxincreases,andawarding

increases

in

retirement

benefits

for

public

sector

employees

in

lieu

of

salary

increases.

All

of

these

result

fromtheincentivesfacingtheemployerthestateaspensionplansteward.

Intheprivatesectortheemployermayalsopassontheriskofanunderfundedpensionplan.Private

sectorpensionsareguaranteedbythePensionBenefitGuarantyCorporation(PBGC).Thisguarantee

createsthepotentialformoralhazardinhowprivatesectorpensionsareinvested.Sincebenefitsare

partiallyguaranteed,privatesectorpensionmanagersfortroubledfirmsmaybeincentivizedto

embraceahigherriskinvestmentstrategy.37Fromthepointofviewoftheworkercoveredundera

privatesector

DB

plan,

ahigh

risk

investment

strategy

may

not

be

as

appealing.

If

aprivate

employer

defaultsontheirpensionobligationtoemployees,theamountpaidoutbythePBGBmaybelessthan

theamounttheemployerpromised.38

36GovernmentAccountabilityOffice,StateandLocalRetireeBenefits,GAO08223,p.9.

37SeeJeffreyR.Brown,GuaranteedTrouble:TheEconomicEffectsofthePensionBenefitGuarantyCorporation,

JournalofEconomicPerspectives,Volume22,No.1,Winter2008,pp.177198.Brownfindsthefinancial

deteriorationofthePBGCtoagovernmentorganizationwithadeficitin2006of$18.9billionisduetodesignflaws

leading

the

PBGC

to

a)

fail

to

properly

price

insurance

and

thus

encourage

excessive

risk

taking

by

plan

sponsors,

b)

failtopromoteadequatefundingofpensionobligations,andc)failtopromotesufficientinformationdisclosureto

marketparticipants.

38JeffreyBrown,GuaranteedTrouble,Winter2008andalso,AndrewBiggsandJeffreyBrown,Reformingthe

PensionBenefitGuarantyCorporation,forthcomingchapterinPublicInsuranceandPrivateMarkets,JeffreyR.Brown,ed.,AEIPress,2010.


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13

Inthecaseofpublicsectorplans,thestatespassonthecostassociatedwiththeguaranteeoffull

benefitstothetaxpayer.Sincethestatehasthepowertotax,fromtheworkersperspectivethisisthe

equivalentofa100percentguaranteedbenefit,regardlessofthefinancialconditionofthepensionplan

whentheyretire.Taxpayersareresponsibleforpensiondeficits,butworkersoftenhaveaclaimon

pensionsurpluses.Howplansurplusesaretreatedmayinfluenceinvestmentandfundingchoicesof

governments.Forexample,plansurplusesmaybesharedbetweentaxpayers(intheformofareduced

statecontribution)andemployees(asenhancedbenefits).39Duringabullmarket,pensionsmay

experiencesurplusesevenwhencontributionsarezero,creatinganincentiveforpublicsector

employeestofavorheavierinvestmentofpensionassetsinhighriskassets.40

The

magnitude

of

the

pension

crisis

in

the

states

points

to

the

inadequacy,

and

fiscal

dangers,

of

offering

definedbenefitplanstopublicsectorworkers.ActuarialmethodsinformedbytheGovernment

AccountingStandardsBoardareflawedandreflectinadequateunderstandingofthepropertreatment

ofpensionliabilities.Governmentsasemployersandpensionstewardsfaceverydifferentincentives

thanemployersintheprivatesector,sinceliabilitiesareguaranteedbytaxpayersat100percentoftheir

value.Stateshaveeffectivelymisusedpensionfundsunderfundingobligationstobalancebudgetsor

expandspendingwhileoverpromisingbenefitstoworkers.

TheAlternative:

The

Defined

Contribution

Plan

Inadefinedcontributionplantheemployerandemployeegenerallyeachcontributeacertain

percentageoftheemployeespaytoanindividualpensionaccount.Thesecontributionsareinvestedin

acombinationofstocks,bonds,andotherinstruments,andgrowovertime.Thekeydifferencebetween

theDCplanandtheDBplanistheassignmentofrisk.InaDCplan,theriskorrewardofvarying

investmentperformanceisbornebytheemployee,whoreceivesahigherorlowerpensionbasedupon

thereturnsgeneratedbyinvestmentsheldinhisaccount.Theemployersobligationsaretomanagethe

planandtomakeannualcontributionsaspromised;theemployerbearsnocontingentliabilityregarding

39Ibid,J.RichardAronson,JamesA.Dearden,andVincentG.Munley,PublicEmployeeDefinedBenefitPension

Systems,p.4.

40 Ibid,J.RichardAronson,JamesA.Dearden,andVincentG.Munley,PublicEmployeesDefinedBenefitPension

Systems,pp.78.


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14

theperformanceofplanassets.Theriskistransferredfromtheemployer(orinthecaseofthepublic

sector,thetaxpayer)totheemployee.InaDCplan,theemployersfinancialobligationceaseswhenthe

requiredcontributionismadetotheindividualemployeesretirementplan.

Therisksbornebytheemployerinadefinedbenefitpensionareonereasonwhy,beginninginthe

1970s,theprivatesectorbegantoswitchtoofferingitsemployeesdefinedcontributionplans.Between

1979and1998,theshareofemployeescoveredbyDBplansfellby17percentandtheshareofthose

coveredbyDCplansroseby12percent.41

AsecondreasonthattheprivatesectorswitchedtotheDCsystemisthatitoffersemployeesgreater

mobility.BenefitsarelessportableinaDBsystem.InmostDBsystems,anemployeesaccrued

benefits

depend

on

their

final

salary

at

the

time

they

terminate

employment.

If

an

employee

moves

jobs

multipletimestodifferentpensionsystemsandhasmultipleDBaccruedbenefits,thetotalofallvested

benefitsislessthanwhatthebenefitswouldbeiftheemployeestayedinonesystem.42Oncevestedin

aparticulardefinedbenefitpensionplan,theemployeeriskslosingasignificantamountofbenefit

incomebyterminatingtooearlyormovingaroundtoooften.43ThismakesDBpensionslessattractiveto

younger,moremobileworkersthatemployersmightwishtoattract.

41StephanieAaronsonandJuliaCoronado,AreFirmsorWorkersBehindtheShiftAwayfromDBPensionPlans?,

FinanceandEconomicsDiscussionSeries,DivisionsofResearch&StatisticsandMonetaryAffairs,FederalReserve

Board,Washington,D.C.,February2005,p.1.

42KarenSteffen,StateEmployeePensionPlans,inPensionsinthePublicSector,eds.OliviaS.MitchellandEdwin

C.Hustead,PennsylvaniaUniversityPress,Philadelphia2002,p.52.

43FirmpreferencesandtheenactmentofERISA(TheEmployeeRetirementIncomeSecurityAct)in1974areoften

citedasreasonsforthegrowingshiftawayfromDBplansandtowardsDCplansintheprivatesector.Another

factorisincreasedworkerdemandforDCplans.AaronsonandCoronadofindthatchangingworkforce

characteristicsincludingtheinfluxofwomenintheworkforceandconcomitantincreaseindualincomeearner

householdsmayhaveincreasedthedemandforflexibilitybyworkers.Womenascaregiversmayhaveless

attachmenttospecificemployersandthelabormarket.Dualincomehouseholdsmustengageinjointdecision

makingadjustingtheiremploymentinresponsetoachangeinemploymentofaspouse.See,Aaronsonand

Coronado,AreFirmsorWorkersBehindtheShiftAwayfromDBPensionPlans?,FederalReserveBoard,February2005,pp67.


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15

CanaStateCatchUp?

Ifstatepensionplanswerefrozentodaywithnonewemployeeseligibleforbenefits,wouldstatesbe

abletocatchuptotheirobligationstocurrentbeneficiaries?Withlowerassetvaluesthaninprioryears

andrisingnumbersofretirees,statesnowfacedifficultpolicyoptionsastheyattempttocatchupon

pensionfundingcontributionsduringaperiodofprolongeddecreasesinrevenues,evenasemployees

continuetoaccruerightstofuturebenefits.Sincestatesareeitherconstitutionallyorstatutorily

obligatedtopayoutbenefits,thesizeofthatunderfundingmeansthateitherbenefitamountsand

salariesmustbereduced,taxationmustbesignificantlyincreased,orstatesmaybefacedwithadefault

scenario.

II. CaseStudyNewJerseyTheStateofNewJerseyoperatesfivedefinedbenefitpensionplans.44TheseincludetheTeachers

PensionAnnuityFund(TPAF),thePoliceandFiremenRetirementSystem(PFRS),PublicEmployees

RetirementSystem(PERS),StatePoliceRetirementSystem(SPRS),andtheJudicialRetirementSystem

(JRS).45

Intotal,NewJerseysfiveactivedefinedbenefitplanscover770,869workers.InFY2010theplanspaid

out$5.85billionto265,296retireesandbeneficiaries.

Theactuarial

assumptions

used

to

value

New

Jerseys

pensions

include

an

assumed

rate

of

return

on

pensionassetsof8.25%.TheassumedrateofreturnisestablishedbytheStateTreasurer,notbyplan

44Inaddition,thestateoperatestwoplansthatareclosedtonewmembers.ThesearetheConsolidatedPoliceand

FiremensPensionFund(CPFPF):L.1952,c.266andPrisonOfficersPensionFund(POPF):L.1941,c.220.

45NewJerseysstatepensionsystemsdatetothecreationoftheTeachersRetirementFundin1896,astatewide

contributoryannuityplan.Theplanmadenoprovisionsforthefundingofpensionliabilities,leadingtoitsnear

collapse.In1919theNewJerseylegislatureinstitutedtheTeachersPensionandAnnuityFund(TPAF)toensure

thatthesystembeestablishedonascientific(actuarial)basis.Between1941and1973,theremainingsix

retirementsystemswereestablished.ThePERS,PFRSandCPFPFplans,allowedlocalgovernmentstomovefrom

theirunfundedpensionstoStateadministeredplansthatallowedcentralizedadministrationofthesebenefitsand

fundingonanactuarialreservebasis.TodaytheprocessofconsolidatingpublicretirementbenefitsinaState

administeredplanisnearlycompleted.Afewlocallyadministeredsystemsremain,includingtheEmployees

RetirementSystemofNewJerseyandasmallnumberofspecialfundsforlifeguardsinafewbeachfrontcities.

See,TheNewJerseyPensionSystem,TomBryan,inPensionsinthePublicSector,eds.OliviaS.MitchellandEdwinHustead,UniversityofPennsylvaniaPress,2001.


17/34

16

managersoractuaries.Applyingthisrateofreturn,NewJerseypensionsfaceanunfundedliabilityof

$45.8billionasofJune30,2009.Whenapplyingtherateofreturnoninvestmentsthatreflectstherisk

freecharacterofpensionobligations,suchasthecurrentTreasurybondrateof3.5%,theunfunded

liabilityinNewJerseysstatepensionsincreasesto$173billion.46

Giventhecurrentmarketvalueofassetsandthepreviousyearsbenefitpayments,stateactuaries

calculatethatNewJerseyspensionplanswillstarttorunoutofmoneyin2013.47Thisprojectionis

basedonaspecificscenario,onethatexcludesgainsfrominvestmentincome,stateandemployee

contributions,andchangestothesizeofbenefitpayments.(SeeAppendix2fortheunfundedliability

andyearsuntilbenefitsareexhaustedineachplan.)

HowPensionsHaveBeenManagedandPromisedinNJ

The

implicit

debt

facing

New

Jersey

in

its

underfunded

pension

plans,

as

with

most

states,

was

encouragedbytheactuarialmethodsusedtovaluetheplansandthechoicesoflegislatorsoveraperiod

ofyearstoextendgenerousbenefitswhiledeferringpaymentstothepensionfunds.Morestringent

accountingruleswouldhaveencouragedgreaterfundingandmorerestrainedbenefitgrowthovertime.

Severalchangesundertakeninthe1990schangedhowtheNewJerseypensionsystemwasvalued,

allowingthestatetoloweritsannualcontribution.In1992underGovernorJimFlorio,thePension

RevaluationAct(PRA),(L.1992,C.41)changedtheinterestrateassumptionusedtocalculateplan

liabilities,replacingthebookvalueinterestrateassumptionof7percentwiththemarketvalueinterest

rateassumptionof8.75percent.48Ahigherassumedrateofreturnonfundsallowedlocalitiestoreduce

46 Authorscalculations.

47PublicEmployeesRetirementSystemofNewJersey,55

thAnnualReportoftheActuary,July1,2009,p.21,

http://www.state.nj.us/treasury/pensions/pdf/financial/2009

actuary

report

pers.pdf.

See

also,

Actuaries

Going

Ballistic,JohnBury,nj.com,February28,2010.

48See,TheHallInstituteofPublicPolicy,HistoryandFutureofNewJerseyPensions,p.3.Additionalactuarial

assumptionswerechanged.Theaveragesalaryincreaseassumptionwentupfrom4.75percentand5percentto

6.25percent.TheCOLAinflationassumptionincreasedfrom2.25percentand2.5percentto3percent.SeeTom

Bryan,TheNewJerseyPensionSystem,inMitchellandHustead,pp.337338.


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17

theirpensioncontributionsinFY1992andFY1993by$1.5billion.Thelegislationwasintendedtohelp

balancetheFY1993budgetandpayforunfundedcostoflivingadjustmentsadoptedinthe1970s.49

In1994,thePensionReformAct(L.1994,C.62)requiredthestatetoswitchthemethoditusedtovalue

the

fund

from

the

Entry

Age

Normal

method

(EAN)

to

the

less

demanding

Projected

Unit

Credit

Method

(PUC)andresettheamortizationperiodfortheunfundedaccruedliabilityfrom30to40years.

Additionalchanges,includingadownwardrevisionintheCOLAassumptionandareductioninthe

averagesalaryscale,ledthestatetoreducestateandlocalemployercontributionstothepensionplans

by$547.4millioninFY1994,andby$946.8millioninFY1995,allowingGovernorChristieWhitmanto

reducetaxesandpresentabalancedbudget.50

Thesegainsweretemporary,theresultsofassumptionchangesratherthanreality.Theswitchin

methodology

and

changed

assumptions

led

to

an

underestimation

of

contribution

amounts,

producing

a

fundinggap.Toclosethegap,in1997ThePensionSecurityPlanpermittedthestatetoissue$2.8billion

inpensionobligationbondswhichwereusedtopartiallyeliminatea$4.25billionunfundedliabilitythat

hadsurfaced.51Theproceedsofthebondsaleweredepositedintothepensionsystem.

FullannualcontributionsweremadetoNewJerseyspensionsuntil1997,butstatesmaydefer

paymentstopensionsystemswhentheycontainexcessassets.Duringthisperiodthepensionsystem

investedheavilyintechnologystocks.52In2000,technologystockscomprised32percentofthepension

49TheHallInstituteofPublicPolicy,HistoryandFutureofNewJerseyPensions,p.3andTomBryan,TheNew

JerseyPensionSystem,p.337.AnnualCOLAbenefitshadbeenprovidedtoretireesandbeneficiariesbeginningin

1969onapayasyougobasis.ThestatehadbeenpayingthefullcostofhealthbenefitscoverageandPartB

Medicarepremiumsforitsqualifiedretireesandtheireligibledependentssince1972.In1987,theNJEA

successfullylobbiedforlegislationrequiringthestatetopayforteacherhealthbenefits.

50SeeTomBryan,TheNewJerseyPensionSystem,inHusteadandMitchell,p.343foradetaileddescriptionof

theeffectsofeachalterationtothepensionsystemandtocontributionsfortheperiodbetweenFY1994andFY

1998.

51EileenNorcrossandFredericSautet,InstitutionsMatter:CanNewJerseyReverseCourse?MercatusCenter

WorkingPaperNo.0930,July2009,p.22.

52In2000NewJerseysfivelargestinternationalcommonstockinvestmentswereconcentratedininformation

technology:Nokia(AB)Oy,Ericsson(LM)Tel.,Alcatel,VodafoneGroup,NortelNetworksCorp.SeeHistoryand

FutureofNewJerseyPensions,TheHallInstituteofPublicPolicy,p.5.


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18

planscommonstockallocations.53Theboominhightechstocksduringthelate1990scoupledwiththe

pensionbondgavethetemporaryappearanceofafullyfundedplan.

Onceexcessassetswereexhausted,thepensionquicklyreturnedtoitsunderfundedstatus.Pension

deferrals

also

weakened

the

system.

While

deferring

payments

provides

short

term

budgetary

relief

to

stateandlocalgovernments,italsocreatesafiscalillusion.Intheshortterm,governmentsadjusttheir

behavior,dedicatingrevenuesmeantforthepensionsystemtootherareas.Whenscheduled

contributionsresume,governmentsfindtheyareunabletopaythefullamountbecausetheyhave

adjustedtheirspendingbehaviorbytreatingtemporarypaymentreductionsaspermanent.This

necessitatesagradualphaseinoffullcontributions.

In2003,localgovernmentsgraduallybegantoincreasetheircontributionsatincrementsof20percenta

year

until

they

reached

100

percent

of

the

calculated

local

contribution

for

the

ARC

in

2008.

Phase

ins,

bycontinuingtodelayfullcontributionstothesystem,increasetheamountneededtofullyfundthe

pensionsystem.

Inadditiontodeferringtheemployerspayment,thestatereducedtheamountrequiredforemployees

tocontributetotheirretirement.InJanuary1998,theStateTreasurerreducedtheemployee

contributionrateintheTPAFplanfrom5%to4.5%through2001.Theratewasfurtherreducedto3%

untilDecember31,2003.InJanuary2004,theTPAFemployeecontributionratereturnedto5%.

53TheHallInstituteofPublicPolicy,HistoryandFutureofNewJerseyPensions,September2009,5,

http://www.hallnj.org/index.php/component/content/article/90publicpension/421pressreleasestructurla

changesinnjpensioninvestmentsystem?directory=216.


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19

InthePERSplantheemployeecontributionratewasreducedto3%fromJanuary1,2000throughJune

30,2004,atwhichtimeitrevertedbacktothe5%contributionforstatePERSemployees.The3%

employee

contribution

rate

remained

in

effect

for

local

PERS

employees

until

January

2005.

Deferredcontributionsandaccountingchangeswerecoupledwithaseriesofpensionenhancements.In

1999benefitswereextendedtosurvivingspouses,increasingliabilitiesby$500million.In2001several

billswerepassedthatincreasedbenefitsforcurrentandretiredemployeesby9.12percentbychanging

thepercentageusedtocalculatebenefits,effectivelyraisingthepercentageofaveragesalarybeing

replacedintheannualbenefit.54Thisactcoincidedwiththebustofthedotcombubbleleadingtoa

significantincreaseinthesizeoftheplansunfundedliabilities.

In2007,GovernorJonCorzinepromisedseriousrestructuringofthepensionsystem.Afewminor

changesweremade.ThePublicEmployeePensionandBenefitsReformActof2008increasedthe

54Chapter133,P.L.2001,S2450,http://www.state.nj.us/treasury/pensions/pdf/laws/c133pl01.pdf.


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20

retirementagefrom60to62,55andincomeeligibilityrequirementsforateacherspensionwere

increasedto$7,500.InMarch2009,thelegislatureapprovedthegovernorsproposaltoallow

municipalitiestodefer,forthenextyear,halfoftheirpaymentsintothepensionsystemtopreventan

increaseinpropertytaxes.

GovernorChrisChristiesignedlegislationonMarch22,2010toreducethesizeoftheunfundedliability.

Thesemeasuresincludecappingpaymentsforunusedsickdays,banningparttimeworkersfrom

receivingpensions,andrequiringgovernmentworkerstocontribute1.5percentoftheirsalariestoward

healthcare.Legislationalsoadjustedtheformulausedtocalculatebenefits,returningtothepre2001

formulawherebenefitsequalled1.7percentoffinalsalarytimesnumberofyearsofservice,versus1.8

percentoffinalsalaryintheTPAFandPERSplans.Also,membersoftheseplanswouldhavetheir

retirement

allowance

calculated

based

on

the

final

five

years

of

service,

instead

of

the

final

three.

However,thesechangestobenefitswouldapplyonlytonewlyhiredpublicemployees.Currentworkers,

eventhosewhorecentlyenteredthejobrolls,wouldbeabletocontinueunderthecurrentbenefit

formulafortherestoftheircareers.56

Thesemeasureswillhelpatthemarginsbutdolittleornothingtoaddressthesizeoftheliabilitythat

hasalreadybeenaccrued.Therateofaccrualofbenefitswillhavetobereducedfurther,andemployees

willhavetocontributemoretotheirplans.Thestatemustrecognizethataddingmoreworkerstoa

systemthat

is

underfunded

by

$173

billion

by

market

standards,

representing

over

40

percent

of

New

JerseysGDP,isnotatenableoption.

Recommendations

55Chapters92and103,P.L.2007andChapter89,P.L.2008changedtheenrollmentandretirementcriteriafor

PERSmembersenrolledatcertaindates,creatingmembershiptiers.Tier1members,thoseenrolledpriortoJuly1,

2007,andTier2members,thoseeligibletoenrollbetweenJuly1,2007andNovember1,2008,areeligiblefor

retirementat

age

60.

Tier

3members,

those

eligible

to

enroll

after

November

2,

2008

are

eligible

for

retirement

at

age62.

56Chapter1,P.L.2010,http://www.state.nj.us/treasury/pensions/newlaw10.shtml#chap1,also,

http://www.state.nj.us/treasury/pensions/epbam/exhibits/pdf/coltr0410chapter1perstpaf.pdf.


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21

1)ExtendtheDefinedContributionPlan.TheStateofNewJerseymadeadecisiontoofferaDCoption

tostateemployeesin1965whenitcreatedtheAlternativeBenefitPlan(ABP)foruniversityfacultyand

administrativestaff.TheABPisataxdeferred,definedcontributionsysteminwhichuniversity

employeescontribute5%oftheirbasesalarytoataxdeferredinvestmentaccount.Thisismatchedby

an8%employercontribution.57

Inthisplan,participantsarevestedafteroneyearofparticipationinthe

system.Asadefinedcontributionplan,itoffersworkforcemobilitytoemployeessinceretirementfunds

canbecarriedtoafutureemployerorrolledintoanIRA.

Thestatemovedfurthertowardthismodelin2007whenitcreatedtheDefinedContribution

RetirementProgram(DCRP).58TheDCRPprovidesmemberswithasupplementalretirementtothe

existingDBplans.TheDCRPisataxsheltereddefinedcontributionretirementbenefit.Eligibilitywasat

firstrestrictedtostateandlocalofficialsandemployeesofthePERSorTPAFsystemswhoearninexcess

ofthe

established

maximum

contribution

limits.

In

FY

2009/2010

this

maximum

wage

was

established

at

$106,800.Employeesearningabovethemaximumareautomaticallyenrolled(unlesstheywaive

participation.) In2008,eligibilitywasexpandedtothoseTPAFandPERSemployeeshiredafter

November2,2008whodonotearntheminimumannualsalaryof$7,700.59

Employeescontribute5.5%oftheirsalaryandthestatecontributes3%.Thefundsareinvestedinan

accountestablishedwithPrudentialFinancial,whichadministerstheDCRP.

2)Reducetheliability.Thestateshouldmovetoreducetherateofaccumulationofbenefitsfor

workersgoingforward.Thisincludesadjustingthesalaryreplacementfactorsusedtocalculatethefinal

benefit.Chapter1,P.L.2010changedtheformulatocalculatebenefitsintwoimportantways.First,

pensionbenefitsarenowequalto1/60thoffinalsalaryforeachyearofemployment(fromapriorvalue

of1/55th);second,finalsalarywasincreasedfromthehighestthreetothehighestfiveyearsofservices,

fornewhires.TheStateshouldconsidergoingfurtherthanthis;thesestandardsshouldbeappliedto

currentparticipants,andnotsimplyappliedtonewhires.

57TheemployeemayhavesomeoptioninchoosingamongauthorizedcarriersincludingAIGVALIC,AXAFinancial

(Equitable),TheHartford,INGLifeInsuranceandAnnuityCo,MetLifeandTIAACREF.

58Chapter92,P.L.2007andChapter103,P.L.2007,expandedinChapter89,P.L.2008.

59Seehttp://www.state.nj.us/treasury/pensions/epbam/exhibits/factsheets/fact82.pdf.


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22

Toreducethesizeoftheunfundedliability,thestateshouldconsiderreducingorfreezingcostofliving

adjustments(COLAs).Forinstance,a1percentagepointreductioninannualCOLAswouldreducethe

plansaccruedliabilitybyapproximately10percent.60

Alternately,

COLA

payments

could

be

limited

to

the

currently

projected

rate

of

1.8

percent

per

year,

basedontheformulawhereCOLAsareequalto60percentofthechangeintheConsumerPriceIndex.

Thiswouldlimitplanpayoutsinthecaseinflationweretoexceedprojectedrates.

3)TransitionnonvestedworkerstotheDCplan.Currently,thereare274,380workerswhoarenotyet

vestedintheirbenefits.Theseworkersshouldbeshiftedtothedefinedcontributionplan.Theswitch

willaccomplishtwoobjectives.Itwillguaranteenewworkerswithacurrentcontributiontotheir

retirement.Andinthelongrun,itwillreplacetheDBsystemwithonethatissustainablewhileshifting

risk

away

from

the

taxpayer

and

removing

the

moral

hazard

associated

with

the

states

management

andstewardshipofpublicworkerinvestments.Accordingtostateactuarialreports,between5and18percentofaccruedbenefitsarenotyetvested.61

ShiftingnonvestedemployeestoaDCplancouldreducetheseliabilities,evenifemployee

contributionstotheDBplanwerepartiallyorfullyrefunded.YoungeremployeesoftenpreferDCplans

overDBpensionsforreasonsofportability,soitmaybepossibletocometoanagreementwithcurrent

nonvestedemployees.Suchachangecouldsignificantlyreduceplanliabilitieswhilemorequickly

movingtoasustainablepensionfinancingmodel.

Thesestepswouldnotsignificantlyreducecurrentpensionliabilities.Accruedpensionbenefits,bethey

intheprivatesectororthepublicsector,arerarelyreducedtoanysignificantextent.However,shifting

employeestoadefinedcontributionsystemand/orreducingbenefitaccrualratesforemployeeswho

remaininthedefinedbenefitprogramswouldbetterinsurethatunfundedliabilitiesdonotcontinueto

growovertime.Whentheprogramsunfundedliabilitiesarecapped,thestatecanbetterplanhowto

60ThiscalculationisbasedonamodeloftheSocialSecuritypopulationandsocoulddiffersomewhatbasedonthe

characteristicsofpublicsectoremployeesandretirees.Thereductioninplanliabilitiesisroughlylinearandso

couldbescaledupordown.

61Thepercentagesare4.6percentforPERS,5.5percentforSPRS,12.5percentforJRS,and18percentforPERS.

NovalueisreportedforTPAF,thoughwecaninferthatitlieswithinthatrange.


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payoffthesedebtsovertime.Withoutreforms,though,itislikelythatunfundedpensionobligations

willcontinuetogrow,eventuallytoanunsustainablelevel.

Conclusion

Publicsector

pension

plans

around

the

country

face

significant

funding

shortfalls,

facilitated

by

accountingpracticesthatunderstatetrueliabilitiesandstateandlocalgovernmentsthatoftenfailedto

meettheirfinancialobligationsevenunderthesemorepermissiveaccountingstandards.When

measuredonamarketvaluationbasis,whichisrequiredofprivatesectorplansandwhicheconomists

universallybelievetobetheappropriatestandard,publicsectorpensionsnationwideareunderfunded

bymorethan$3trillion.Stateandlocalgovernmentsaroundthecountryfacemassivefiscal

consolidationsasthesebillscomedue.

NewJerseys

public

pensions

are

emblematic

of

pension

funding

problems

across

the

country.

Over

the

pasttwodecades,NewJerseysplansloosenedaccountingstandardsandincreasedinvestmentrisk

whilethegovernmentoftenfailedtomeetitsrequiredcontributions.Asaresult,NewJerseyplansare

underfundedbymorethan$100billiononamarketvaluationbasis.NewJerseyhasrecentlypassed

reformsthatwouldincreasefundingandreducebenefitsfornewlyhiredpublicemployees.Thesesteps

areusefulbutmustgomuchfurtherifapotentialfiscalcrisisistobeaverted.

WeoutlineseveralstepsNewJerseypolicymakersmayconsider.First,allnewlyhiredemployeesshould

beshifted

to

adefined

contribution

pension

model

based

upon

the

plan

already

offered

to

New

Jerseys

universityemployees.Adefinedcontributionmodelismoreattractivetotheyoung,mobileemployees

stategovernmentsseektoattractandprovidesaclearmeasureofthestatesfundingobligations.

Second,currentreformsloweringpensionreplacementratesshouldbecontinuedand,ifpossible,

extendedtocurrentemployees.Allvestedbenefitsshouldbehonored,buttherateatwhichfuture

benefitsareearnedshouldbereduced.Suchachangeiscommonplaceintheprivatesectorandthereis

noreasonpublicemployeesshouldbeexemptedfromsuchchanges.

Third,NewJerseypensionsshouldconsiderreductionsorfreezesinCOLApayments,whichcouldreduce

futurebenefitliabilitiesandspreadtheburdensofreformmoreevenlybetweentaxpayers,newlyhired

employeesandcurrentemployees,andretirees.


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Finally,currentemployeeswhoarenotyetvestedintheirbenefitsmightbeshiftedalongwithnewly

hiredemployeestoadefinedcontributionplan.ThisstepcouldproducesavingstoexistingDBplans

whilemovingmorequicklytoasustainablepensionmodelforpublicemployees.

Additionally,

New

Jersey's

pension

reports

contain

useful

and

detailed

information

on

plan

liabilities

and

thedistributionofbenefitsbyage,experience,andearnings.However,thesereportscanbeimproved,

inparticularbymakingpubliclyavailableamoredetailedanalysisoftheassumptionsinvolvedin

projectinginvestmentreturnsinthepensionassetsportfolio.Mostpublicpensionfinancialandactuarial

reportsmakeonlyacursoryefforttojustifytheirinvestmentreturnassumptions.Thisisparticularly

importantgiventhecrucialrolethediscountrateplaysinpublicpensionaccounting.


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Appendix1:PensionPlansintheStates


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Appendix2:CurrentFundingLevelsandContributionamountsinNewJerseysPensionPlans

TeachersPensionAnnuityFund(TPAF)

CurrentEmployees Participants TotalPayroll

ActiveMembers 157,109 $10,353,262,361TotalPensions

Annuitants 78,782 $2,849,806,472

ActuarialValue

ofAssets

(a)

ActuarialValue

ofLiabilities

(b)

MarketValueof

Liabilities(3.5%

discountrate)

(c)

ActuarialValueof

UnfundedLiability

(ab)

MarketValueof

UnfundedLiability

(ac)

Actuarial

Funded

Ratio

(a/b)

Market

Value

Funded

Ratio

(a/c)

$34,708,001,341 $53,418,328,576 $104,713,728,495 ($18,710,327,235) ($70,005,727,154) 65% 33%

MarketValueof

Assets

Accumulated

Contributions

NetAssets AnnualPayouts YearsLeftfor

assetstocover

benefits

payments

$24,973,886,910 ($8,516,171,922) $16,457,714,988 $2,842,667,672 5.8


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N.J.PoliceandFiremensRetirementSystem(PFRS)

CurrentEmployees

Participants

Total

Payroll

TotalActiveMembers 45,150 $3,747,580,414

TotalPensions

Annuitants 34,364 $1,482,924,846

ActuarialValue

ofAssets

(a)

ActuarialValue

ofLiabilities

(b)

MarketValueof

Liabilities(3.5%

discountrate)

(c)

ActuarialValue

ofUnfunded

Liability

(ab)

MarketValueof

Unfunded

Liability

(ac)

Actuarial

Funded

Ratio

(a/b)

Market

Value

Funded

Ratio

(a/c)

$22,937,837,757 $32,442,101,245 $63,555,697,190 (9,484,263,568) (40,617,859,433) 71% 36%

MarketValueof

Assets

Accumulated

Contributions


assetstocover

benefit

payments

PFRS

State

$1,742,699,083 ($365,634,110) $1,377,064,973 $159,495,927 8.6

PFRS

Local

$16,283,683,457 ($2,609,938,624) $13,673,744,833 $133,573,198 10.3


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29

N.J.PublicEmployeesRetirementSystem(PERS)


ActiveMembers

316,849

$12,945,484,573

TotalPensions

Annuitants 150,523 $2,289,727,172

ActuarialValue

ofAssets

(a)

ActuarialValue

ofLiabilities

(b)

MarketValueof

Liabilities(3.5%

discountrate)

(c)

ActuarialValueof

UnfundedLiability

(ab)

MarketValueof

UnfundedLiability

(ac)

Actuarial

Funded

Ratio

(a/b)

Market

Value

Funded

Ratio

(a/c)

$28,879,176,416 $44,470,403,155 $87,173,482,327 ($15,591,226,739) ($58,294,305,911) 65% 33%

MarketValue

of

AssetsAccumulated

ContributionsNet

Assets

Annual

Payouts

Years

Left

for

assetstocover

benefitpayments

PERS

State$7,973,790,423 ($3,926,154,800) $4,047,635,623 $965,453,712 4.2

PERS

Local$13,395,099,723 ($5,869,939,115) $7,525,160,608 $1,308,332,821 5.75


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N.J.StatePoliceRetirementSystem(SPRS)


TotalActiveMembers 3,016 $287,267,502

TotalPensions

Annuitants 2,585 $1,333,573,198

ActuarialValue

ofAssets

(a)

ActuarialValue

ofLiabilities

(b)

MarketValueof

Liabilities(3.5%

discountrate)

(c)

ActuarialValueof

UnfundedLiability

(ab)

MarketValueof

UnfundedLiability

(ac)

Actuarial

Funded

Ratio

(a/b)

Market

Value

Funded

Ratio

(a/c)

$2,067,242,877 $2,825,455,368 $5,538,623,073 ($758,212,691) ($3,471,380,196) 73% 37%

MarketValueof

Assets

Accumulated

Contributions


assetstocover

benefits

$1,564,180,409 ($178,485,658) $1,385,694,751 $133,573,198 10.3


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N.J.JudiciaryRetirementSystem(JRS)


TotalActiveMembers 422 $70,133,372

TotalPensions

Annuitants 485 $38,566,144

ActuarialValue

ofAssets

(a)

ActuarialValue

ofLiabilities

(b)

MarketValueof

Liabilities(3.5%

discountrate)

(c)

ActuarialValueof

UnfundedLiability

(ab)

MarketValueof

UnfundedLiability

(ac)

Actuarial

Funded

Ratio

(a/b)

Market

Value

Funded

Ratio

(a/c)

$2,067,242,877 $2,825,455,368 $5,538,623,073 ($758,212,691) ($3,471,380,196) 73% 37%

MarketValueof

Assets

Accumulated

Benefits

NetAssets AnnualPayouts Yearsleftfor

assetstocover

benefits

$261,751,336 ($38,208,152) $223,543,184 $38,472,184, 5.8

crisis in public sector pension plans: blueprint for reform in n j

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