1

The Cost of Pension Benefits

Scope of Problem and Suggested Solutions

Joseph AdlerDavid BoomershineMAPS Trustee Education ConferenceJune 9, 2011

2

Private Sector vs. Public Sector

Issues Impacts:

Private Sector Public Sector

PensionRetiree Medical Pension

Retiree Medical

Federal Legislation

Accounting

Asset Losses

Result: Increased cost and liability volatility for Private Sector Pension Plans

Recent Changes

3

Actuarial Cost Viewpoint

Three Phases for Pension and OPEB Plans

Baseline Actuarial Cost Funding Alternatives Plan Design Alternatives

Concerns/Interested Parties:

Budgets Taxpayers Unions Bond Rating Agencies

4

Actuarial Funding

Actuarial Valuation Demographic data Assets Actuarial Method/Assumptions Plan Design

Annual Costs/Funding Approach Normal Cost Amortization of Unfunded Actuarial Liability

5

Demographic Data - Public Sector

Maturing plan population – shorten amortization period? Hiring freezes, reductions – reduces plan costs

as $ amount, not as % of payroll

Work furloughs, reduced hours → reduced compensation – reduces plan costs

Pay reductions – reduces plan costs Reduced employee contributions – net out of cost reductions Overall – reduced plan costs

but not necessarily as a % of payroll

6

Assets

2008 Asset losses – significant cost increase Asset recovery for past few years – helping to

stabilize costs Asset smoothing – typically, 5 year smoothing of

investment gains/losses Dampens cost fluctuations Impact of prior losses continue to phase-in

Overall – increased plan costs

7

Actuarial Method/Assumptions

Actuarial Method – Entry Age Normal, Unit CreditDemographic:

Retirement: mixed Termination: increase Mortality: decrease Disability: increase

Economic – KEY! Interest Rate: decreasing from 8% towards

7.5% Salary Increases: within 3% below Interest Rate COLA’s: decreasing

8

Impact Public Sector: Pension Plans: due to asset losses OPEB Plans: due to new accounting requirement

Alternatives (check State restrictions) Amortization basis – Level % of pay Amortization period – to 30 years Asset corridor – to 130% of Market Value Asset smoothing – to 10 years

Phase-in funding increase: 5 years?

Funding Relief Alternatives

9

Plan Design Changes

Increase employee contribution levels Retirement eligibility COLA’s Revise benefit structure Final average pay DROP’s

Other Soft Freeze – State Protections? DC Plan Hybrid Plans

Cash Balance Basic DB with supplemental DC plan

Pension Plan Design Changes – significant cost/liabilityimpact:

10

Plan Design Changes - Summary

Soft Freeze – typical current approach

Increase employee contributions – typical current approach

Other plan provision revisions – for current active participants – some attempts

Hybrid Plan – Basic DB plan with supplemental DC Plan

Hard Freeze – private sector approach – the Atlanta challenge

11

Actuarial Funding: Case Study

Funding Approach: Normal Cost (NC) + mixed 15/30 year Amortization of UAL

Actuarial Valuation Baseline Results ($ in thousands):

2011

Actuarial Liability (AL) $800,000

Plan Asset Value* 680,000

UAL 120,000

Total NC

- Employee Contributions

- Net NC

15,000

5,000

10,000

Amortization of UAL** 12,000

Total 22,000

- % of payroll 17%* Includes 5 Year Smoothing/+ 20% corridor** Uses Level $ Amortization

12

Funding Approaches: Case Study

Comparative Results:

Annual Cost as % of Payroll

• Current Valuation 17%

• Level % of Pay Amortization 14%• 30 Year Amortization Period 15%• 130% Asset Corridor 15%• 10 Year Asset Smoothing 15%• 5 Year Phase-in* 13%

*Note: expected increases for 5 years

13

Plan Design Changes – Case Study

Selected Alternatives:

A: Soft Freeze with revised DB plan for new employees including: NRA, Final Average Pay, Benefit %, COLA and employee contribution revised provisions

B: Maintain DB plan, increase employees contribution rate by 2%

C: Revise current DB plan for current employees, including: NRA, Final Average Pay, Benefit %, COLA and employee contribution revised provisions

D: Hybrid Plan: Basic (reduced) DB plan with supplemental DC plan (3% employer contribution)

E: Hard Freeze, with a replacement DC plan (6% employer contribution)

14

Plan Design Changes – Case StudyProjected Comparative Plan Costs – as a % of payroll

Year CurrentPlan

Alternatives

A B C D E

2011 17% 17% 15% 10% 10% 8%

2012 18% 18% 16% 11% 11% 9%

2013 17% 17% 15% 11% 10% 8%

2014 17% 17% 15% 10% 10% 8%

2015 16% 16% 14% 10% 10% 8%

2016 16% 15% 14% 9% 10% 8%

2017 16% 15% 14% 9% 10% 8%

2018 16% 15% 14% 9% 10% 8%

2019 16% 15% 14% 9% 10% 8%

2020 16% 15% 14% 9% 10% 8%

15

Plan Design Changes – Case Study

Projected Comparative Cost Savings vs. Current Plan ($ in millions)

PeriodAlternatives

A B C D E

5 Years $.6 $14 $49 $50 $64

10 Years $4 $32 $112 $105 $137

Notes: Sample Plan:• 3,700 participants• 2011 payroll $127,000,000

16

Why is this an issue?

Subprime mortgage debacle and near collapse of financial system causing a contraction of U.S. economy

Steep decreases in tax revenue for most state and local governments

Poor investment choices, underfunding or non-funding of pension obligations

17

Magnitude of Problem Pew Research

Center estimated that the gap between assets and future legal liabilities for US state plans is at least 1.26 trillion dollars

18

Other grim statistics Pension funding shortfalls accounted for $660

billion of the $1.26 trillion gap, and unfunded retiree health care costs accounted for the remaining $607 billion.

States had only about $31 billion, or 5 percent, saved toward their obligations for retiree health care benefits.

State pension plans were 78 percent funded, declining from 84 percent in 2008

19

Comparison of some Mid Atlantic States Funding Levels New York 101% Pennsylvania 81% New Jersey 66% Delaware 94% Maryland 65% W.Virginia 56% Virginia 80%

20

Reasons for underfunding

Power of public unions Profligate politicians Lack of managerial influence in financial

area High debt ratios Lack of professional support for

legislature Public employee density—positive

correlation

21

Focus on Maryland 350,000 current and

future retirees Steep losses in 2008

and 2009 saw the funded ratio drop from 78% to 65% (actuarial)

In real market terms the funded ratio fell to 54%

22

Focus on Maryland—decisions Quality Teacher

Incentive Act-1999 pumped $14 million toward local schools—portion was used for salary enhancements

Governor’s Teacher Salary Enhancement Grant—2000, made upwards of $55 million available for instructional

staff salary increases.

23

Focus on Maryland-decisions, continued Bridge to Excellence Act

(Thornton Act) 2002. committed $1.3 billion in new state aid towards local school systems

The Act also mandated that the state pick up the cost of pensions for teachers paid by certain grants—previously paid by local governments

24

Focus on Maryland—decisions, continued State Employees’ and

Teachers’ Retirement Benefit Act of 2006

Increased multiplier from 1.4 to 1.8% retroactive to 1989

Member contributions increased from 2% to 5% phased in over three years

25

Avoid dark corridors

In 2002 the state abandoned the traditional technique of funding and adopt the “corridor method”.

Instead of making an annual payment based on its payroll number which is then multiplied by the actuarial certified contribution rate, the legislature replaced it with a system which froze the contribution rate at the FY 2002 rate as long as the funding ratio remained in a “corridor” between 90 and 110 percent.

Moving to the corridor scheme allowed the state to legally underfund its payment as long as the investment returns were robust, and the five year smoothing method disguised the true funding ratio of the pension system.

26

Reaction by Trustees of the Plan The Board of Trustees of

the State Retirement and Pension System began to sound the alarm in 2005, a year when the returns were in the double digits, and has repeatedly called for the abandonment of this

funding method.

27

Policy Options

Option one: Shift the cost to local governments.—have counties and Baltimore pick up some or all of the cost of teachers’ pensions.-$850 million shift

Option two: Eliminate or reduce defined benefit pension plans for current employees.

28

Options, continued

Option 3: Reduce future liabilities by increasing participant contribution rates and introducing a two tiered system Existing employees and teachers would be allowed to

remain in the defined benefit plan, albeit with a higher contribution rate, and new employees hired after July 1, 2011 would be in a modified defined contribution plan. In 2010 nine states increased participant contribution rates as one step in reigning

in their future funding obligations.

29

Options, continued

Montgomery County’s Retirement Savings Plan (RSP) and Guaranteed Retirement Income Plan (GRIP)

In 1994, Montgomery County required all new nonpublic safety employees to enroll in the RSP, a defined contribution plan, whereby the employee contributes a percentage of their salary, which is matched by the county and invested in an instrument selected by the employee. The investment choices are selected and monitored by an official fiduciary, the Board of Investment Trustees, made up of representatives of employee unions, county officials, and

members of the public.

30

GRIP In 2008, the County

introduced the cash balance concept. Members in the RSP and newly hired employees can select an option, (GRIP) whereby they relinquish making the investment choices to the BIT for a guaranteed 7.25 percent rate of return

31

DB Plans-Can They Survive? Long term trends transforming the national economy

and reorienting the social contract between employers and employees point away from traditional pension plans. In the private sector, for example, the number of traditional defined benefit plans have declined greatly. In 2007 only 32 percent of households had an employer provided defined benefit pension plan. From 1990 to 2007, the number of active participants in such private sector plans fell by 26 percent, even as the workforce increased by 22 percent.

Source, United States Government Accountability Office, letter to Senator Herb Kohl, April 28, 2010, p.6 . Accessed through http://www.gao.gov/new.items/d10632r.pdf. December

4, 2010

32

Changes to Maryland’s Pension Plans Enacted by 2011 General Assembly

Cost-of-living Adjustments For service credit earned after June 30, 2011, the COLA will be linked to the performance of the SRPS investment portfolio. If the portfolio earns its actuarial target rate (7.75% for fiscal 2011), the COLA is subject to a 2.5% cap. If the portfolio does not earn the target rate, the COLA is subject to a 1% cap.

33

Changes, Continued

Member Contributions: Beginning July 1, 2011, member contributions for current active members of EPS and TPS increase from 5% of earnable compensation to 7% of earnable compensation. Member contributions for current active members of LEOPS increase by 4% to 6% in fiscal 2012 and from 6% to 7% beginning in fiscal 2013.

34

Changes, continued

Future SRPS Members Vesting Increases from5 to 10 years Average 5 highest years- up from 3 Multiplier decreased to 1.5% from

current 1.8% Normal service retirement will be 65

years old and at least 10 years of service-compared to 62 and 5

Early retirement—62 and 15 instead of 55

35

Policy Changes—narrowing the corridor The pension reform provisions of the BRFA of 2011

establish a goal of reaching 80% actuarial funding within 10 years by reinvesting a portion of the savings generated by the benefit restructuring into the pension system in the form of increased State contributions above the contribution required by statute. In fiscal 2012 and 2013, all but $120 million of the savings generated by the benefit restructuring are reinvested, with the $120 million dedicated to budget relief each year.

Beginning in fiscal 2014, the amount reinvested in the pension fund is subject to a $300 million cap, with any savings over that amount dedicated to budget relief.

36

Light at the end of the tunnel?

37

Questions???