Most sponsors of public sector defined benefit pension
plans have struggled to meet budgets and maintain a healthy funded status for
their plans in recent years. One difficulty is that pension contribution
requirements increase in ways that cannot be predicted in advance due to market
downturns, just as revenues available to fund these contributions decline.
Meanwhile, most systems automatically decrease contribution rates when the
market begins to recover and this can cause increased strain on budgets later.
Is there another way for a pension plan to meet its funding needs?
The following is a case study for a large municipal
defined benefit retirement system (the System) with a “fixed” funding
contribution rate. Most defined benefit pension plans have variable contribution
rates that change on a regular basis as a product of an annual actuarial
valuation. The System takes a different approach, and when done properly, the
System’s approach can provide added stability in the contribution rates, assist
with budgeting, and result in a better funded status than typically seen for
public sector plans.
The funded ratio is a measure of a plan’s funded status
and is equal to the ratio of dedicated assets to the measured liabilities.1 It
is an important metric used by the System. The latest report from the Center
for Retirement Research (CRR) at Boston College estimates that the funded ratio
of public pension plans rose from 72% in 2013 to 74% in 2014.2 By contrast, the
System had a funded ratio over 95% using smoothed assets and 101% using market
assets as of the most recent actuarial valuation.
Most defined benefit systems have variable contribution
rates that automatically decrease (increase) after favorable (unfavorable)
experience regardless of the municipality’s budget situation or the long-range
outlook of the retirement system. Some fixed-rate plans have had difficulty
maintaining contribution rates at the levels required to adequately secure the
payment of future benefits. This particular System has used its “funding and benefits
policy” as well as an emphasis on discipline, prudence, shared responsibility,
and a long-range perspective to make the difficult choices required to put
itself in a sound actuarial position.
A misnomer
A necessary ingredient for proper management of a
fixed-rate plan is to acknowledge that the “fixed” rate is not truly fixed.
Adjustments must be made periodically. A better name would be a “sticky” rate
plan in that the rate does not automatically change every year, but rather
remains stable until circumstances warrant a change. When the environment does
change, this System’s actions in 2008 demonstrate that a fixed rate plan can
react swiftly if well managed.
One fundamental equation applies for any retirement
system, no matter if it is maintained by an employer, an individual, or a
government for all its citizens. It applies to defined contribution plans,
defined benefit plans, and hybrids. The contributions (C) combined with
investment income (I) into the System must equal the benefit payments (B) and
expenses (E) paid out of the System. This results in the equation of C + I = B
+ E.
In a defined benefit program, “B” is typically defined.3
A retirement system should be designed to meet the obligations of the benefits
that have been promised to employees. For large public defined benefit systems,
the “E” portion of the equation is typically very small relative to benefits
and cannot be easily altered in a meaningful way. The “I” for investment income
is variable and unknown in advance, so with B and E difficult to change, the C
portion of the equation, contributions, must be adjusted in order for the
equation to balance when investment income fluctuates. For this reason, the
plan’s contribution rate must not be truly fixed. The contribution rate must be
able to adjust if the plan’s funding becomes inadequate.
Response to the
2008 global financial crisis
When the investment markets crashed in 2008, the System’s
funded status plummeted as happened with nearly all pension plans. Most public
sector defined benefit plans waited until after the next actuarial valuation in
2009 to make adjustments to contribution rates. There is often a lag of 12 to
24 months between the valuation date and the date when contribution rates
change, meaning that the contribution rates did not adjust to reflect the
market crash until 2010 or 2011.
By contrast, the System responded much more swiftly.
Meetings were held in November and December 2008 to discuss various options,
months before the stock market indices hit bottom in March 2009. In those
meetings, policymakers made a quick but measured response to increase the rates
gradually, starting in February 2009. At that time, the combined contribution
rates for the employer and employees increased from 14% to 16% of payroll.
Eventually, the total contribution rate increased to 20%
of payroll in January 2012 and has remained at that level since that time. The
contributions are the shared responsibility of the employer and employees, with
the employer paying just over half of the total. This shared responsibility
means that both employees and the employer are aware that a fixed contribution
rate can change.
Funding and
benefits policy
As with most public sector defined benefit systems, the
funded ratio for the System is measured on an annual basis. As seen in the 2008
example, assets are monitored more frequently and adjustments can be made when
necessary. While the promised benefits are studied and analyzed every year, the
contribution rate does not always change.
While policymakers have the discretion to recommend a
change to contribution levels when deemed necessary, the funding and benefits
policy has guidelines and metrics to assist those policymakers with the
difficult decisions required. The policy has a relatively wide (but not too
wide) zone for maintaining the status quo. When the funded ratio is between 95%
and 120% and certain other parameters are met, the policy advises that no
action should be taken.
Note that the “no action” zone is not symmetric around
100%. This is by design, which is due to the belief that actions required to
increase the funded ratio when it dips below 100% are more urgent than taking
actions that could decrease the funded ratio as it exceeds 100%. Reserves over
100% may be needed for future rate stabilization. The funded ratio is a useful
measure, but it is based on the assumption that best estimates are met. A
cushion above 100% is welcomed when assumptions are not met.
Often in the public sector, there are significant
governance issues once there is a “surplus” as measured by a funded ratio above
100%. Permanent benefit improvements can be made based on temporary highs in
asset values.
To illustrate just how common benefit improvements can
be, consider the findings of a survey conducted by the Wisconsin Legislative
Council.4 The report compared significant features of major state and local
public employee retirement systems in the United States. According to the
survey, 30 of the 85 plans increased their formula multipliers between 2000 and
2002. In addition, 32 of the 85 plans studied increased their formula
multipliers between 1996 and 2000.
While the booming equities markets of the late 1990s made
these benefit improvements look affordable when they were granted, the markets
this century have not kept pace with actuarial assumptions and many funds are
seriously depleted as a result. For plans that did not enhance benefits in
those years, the plans that varied the contribution rates on an annual basis
automatically reduced the contribution rates when asset values increased,
typically without providing a cushion for future experience lagging
expectations.
Note that in the System’s policy, the term “funding
reserve” is used instead of surplus when the funded ratio is above 100%. While
this is only terminology and does not directly influence anything, it reflects
a mindset that having a funded ratio above 100% does not mean that you have
extra money that must be spent; instead there is a reserve for rate
stabilization.
Funded ratios
above the no action zone
When the funded ratio is above 120%, the policy states
that de-risking will be considered followed by consideration of contribution
reductions and/or benefit improvements, provided that the system’s funding
status is expected to remain stable after the changes. The funding policy is
integrated with considerations for benefit levels and investments. Rather than
taking the approach that the benefit levels should be maximized based on what
the latest measurements and current market expectations imply are affordable,
consideration is given to investment risk and the long-term stability of the
system.
De-risking could include the purchase of annuities for
part of the future benefit payments or simply increasing the allocation to
fixed income in the investment policy, away from more volatile categories such
as public and private equities or real estate. De-risking would not mean
offering lump sum buyouts. For private sector defined benefit plans,
“de-risking” often does mean offering lump sum buyouts, where the investment
and longevity risk are pushed from the retirement system to retirees. The
longevity risk should be easier for the system to shoulder than it would be for
each individual participant, who typically cannot predict the end of life,
while a mortality table can help a system predict the mortality of a large
group.
Note that decreasing the risk taken by the plan would
decrease the measured funded ratio. This is because the liabilities are
measured based on discounting future benefit payments at the expected rate of
return. A less risky portfolio will typically have a lower expected rate of
return as the investor is no longer being compensated for the risk taken. The
lower expectation will mean a lower discount rate, which will mean higher
measured liabilities and a lower funded ratio. While the funded ratio is lower,
the actual expected benefit payments do not change and those payments should be
more secure with a more conservative asset allocation. The de-risking could
push the funded ratio back into the no action zone.
Funded ratios
below the no action zone
When the funded ratio falls below 95%, increases to the
contribution rates are considered. There are additional guidelines to assist
with setting a schedule for increased contributions. Those guidelines include
considerations of long-term funding projections and consideration of both
actuarial and market value funded ratios. There is a goal to have a
contribution rate sufficient to return to a 100% funded status in less than 30
years if all assumptions are met. Practical considerations, such as making
incremental changes and providing lead time so that both employers and
employees can adjust budgets, are also part of the guidelines.
Conclusion
The comparative success of the System was not attained easily
and certainly there will continue to be challenges. Adverse experience,
particularly regarding investment performance, can significantly weaken funded
status. While the current funded ratio does signify better funding than most
systems, continued diligence will be required for future success. The funding
and benefits policy has served this system well and appears to give it the
right foundation to assist with future challenges.
1Here the measured liabilities are known as the actuarial
accrued liability (AAL). The AAL is essentially a funding target based on the
discounted value of projected benefit payments. The AAL is the portion of that
value allocated to service prior to the valuation date.
2Alicia H. Munnell and Jean-Pierre Aubry in “The Funding
of State and Local Pensions: 2014 – 2018”, June 2015, p. 2 from the Center for
Retirement Research at Boston College.
3While the strength of the laws protecting benefits
varies by state and the laws are being challenged in the courts in some
locations, it is usually difficult to alter benefits that have been accrued,
and, in many cases, it is even difficult to change the benefit formula for
future service once a public employee has been hired. This is commonly referred
to as “vested rights.”
42002 Comparative Study of Major Public Employee
Retirement Systems, dated December 2003, page 25
Source: Milliman
US
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