Pension Planning

New Strategies For Public Pension Budgets

Reexamining legacy pension costs with an eye toward greater stability

Excerpts from a new report from the National Institute On Retirement Security (NIRS) look at the challenges of cash-strapped governments, on the heals of COVID-19. Access the full report here.

A new National Institute On Retirement Security (NIRS) report highlights innovative funding solutions for public pensions that have been used in several states across the country. The COVID-19 pandemic has created additional strain on state and local governments to maintain their budgets, and this report outlines how certain funding strategies have been effective.

Strategies such as employer side accounts, pension obligation bonds, and withdrawal liabilities have worked in tandem with measures like paying the annual required contribution (ARC) to ensure that pension plans are adequately funded. This report takes a closer look at several states, including California, Kentucky, Oregon, and Indiana, and examines solutions to both legacy pension costs and to creating stable costs over time.

The recession sparked by the COVID-19 pandemic has threatened many state and local government budgets with a combination of increased costs and decreased revenues. Unlike the 2008-2009 Great Recession, investment markets have been resilient. As such, public pension funds have not experienced major losses in the financial markets and have not taken corresponding decreases in their funded status. However, there are concerns that cash-strapped governments will cut back on funding required contributions to public pension plans.

Funding Strategies

A decrease in funding could be problematic for public pension plans, and particularly concerning for a handful of public pension plans that are not adequately funded due to past funding practices. Against this backdrop, this report examines several innovative and often lesser-known pension funding strategies that have been utilized in the public sector to address legacy pension costs and to create more stable costs over time.

This report also will clearly define what those efforts do and do not accomplish. The collection of funding strategies summarized in this report run the gamut – from implementing a wholesale funding strategy for a large state-wide plan to more targeted reforms that simply give participating employers more control of how costs are paid over time. These innovative strategies extend well beyond the oft-cited paying the Annual Required Contributions (ARC) or Actuarially Determined Employer Contribution (ADEC). Each of these efforts changes the nature of plan funding in different ways, and these case studies can be a useful reference guide for those who are concerned about a well-functioning public finance system and honoring benefits earned by state and local government employees. The case studies discussed in this report are not an exhaustive list. But, the examples illustrate how a wide range of goals can be achieved with various strategies.

Indiana’s Recovery Strategy Following a Late Transition to Prefunding

Public pensions were largely funded on a pay-go basis before the passage of the Employee Retirement Income Security Act (ERISA) in 1974. While ERISA did not require public plans to change this practice, the awareness of the importance and benefits of prefunding became more widely understood by policy makers at the state and local levels following its passage. In response, most public plans began down a path to prefunding in the late 70s and 80s.

The Teachers’ Retirement Fund (TRF) that covered Indiana’s teachers was created in 1921 and was not combined with the Public Employees’ Retirement Fund (PERF)—creating the Indiana Public Retirement System (INPRS)—until 2011. As late as 1995, Indiana schools were still hiring new teachers that were being placed into a pay-go retirement system. So, the state was late to adopt prefunding, at least for the system that covered teachers. Yet, today, the state is rarely mentioned as a serious offender of not adequately funding pension benefits. In fact, Indiana is one of only 13 states that has earned a AAA credit rating from all three major ratings agencies (S&P, Moody’s, and Fitch).

The first example of an innovative funding strategy will be to explain the plan developed by the state legislature, along with INPRS and other in-state parties, to correct course and earn the state credibility with financial markets. First, the plan started by creating a new tier (TRF 96 Fund) for teachers who were hired after June 30, 1995. The new plan utilized the same benefit formula as the old plan for teachers hired into the new TRF 96 Fund. In fact, the new tier was more about creating two separate funding strategies – one for newly hired teachers and one for those who would remain in the pay-go system – than it was for establishing a materially different benefit structure.

Employers Gain Control With Employer Side Accounts

A decrease in funding could be problematic for public pension plans, and particularly concerning for a handful of public pension plans that are not adequately funded due to past funding practices...

One criticism, and often frustration from employers in state-run plans, is that employers do not have control over their retirement systems. Thus, experiences at the local level are driven by funding decisions made at the state level. So, local employers do not have the ability to choose their own funding strategy.

In response, some state-wide retirement systems have implemented various forms of side accounts to give participating employers more options and control. These efforts generally allow employers to pre-pay pension contributions into side accounts to reduce their future costs. Those contributions are then managed for the employer, and various methods are used to determine how future costs will be reduced by these credits. This strategy is reminiscent of a funding practice that has long been available in the private sector: building and utilizing a credit balance. In the private sector, minimum funding is determined by Internal Revenue Service (IRS) regulations. And those minimums can be volatile due to both markets and a funding discount rate that is tied to markets (which itself can be very unstable).

To manage this volatility, employers are allowed to contribute more than the minimum contribution amount into the plan and keep those excess contributions (plus interest) in the plan to use as credits for future years. This means that total contributions will always meet or exceed the accumulated minimum contributions, but the actual contribution for any given year can be less than that year’s required minimum contribution (if employers have made supplemental contributions in the past).

Thus, when executives think about their firm’s financial future, they have the ability to recognize that higher pension contributions might be sensible when they have adequate cash on hand—knowing that such funding strategies can help their firms survive during turbulent times.

Oregon PERS Side Accounts: Early Adoption and Recent Expansion

The Oregon legislature authorized the use of side accounts in 2002 for the Public Employees Retirement System (PERS) system. In this version of side accounts, the excess contributions are typically used to reduce contributions by amortizing those funds over 20 years.

However, legislation passed in 2018 (SB 1566) and 2019 (SB 1049) have added more flexibility, whereby the side account can now be used to reduce minimums for the next six, 10, 16 or 20 years. Of course, if amortization over 20 years is selected, the reduction is less than choosing six years because the total reduction should be actuarially neutral for both the employer and PERS. The side accounts in Oregon PERS are invested along with the system’s other assets. Thus, funds invested from 2007 through 2019 received an average investment return of 7.6 percent during those years.

But returns ranged from -27.8 percent in 2008 to 19.5 percent in 2009. It is noteworthy that 2008 was the only year where a loss of principal has occurred. And, the amount that contributions are reduced can increase or decrease based upon investment experience. The Oregon legislature clearly sees benefits from this program. Not only have lawmakers increased flexibility over time, but they have also added an Employer Incentive Fund (EIF) that “provides a 25 percent match (up to the greater of five percent of an employer’s UAL or $300,000) on qualifying employer lump-sum payments made after June 2, 2018.”

Pension Obligation Bonds

The topic of POBs has been well covered during the past decade. While this may not meet the ‘innovative’ criteria set out as a framework for this paper, POBs are included because they often are discussed in conversations about funding strategies, and also because there are a few observations that may be beneficial for those who are considering this strategy.

In typical conversations about pension bonds, success often is viewed as saving money over the long run. This framing can ignore other benefits, like having increased clarity regarding the timing of costs. But this research accepts the broader framework and focuses on ideas that help increase the odds that pension bonds save money over the repayment period of the bonds.In addition to that primary goal, this research also examines the importance of avoiding a major mistake.

Repayment Terms

First, the term of the pension bond plays a significant role in the likelihood that returns will exceed borrowing costs. When looking at equity returns over different periods of time, longer periods correspond with less volatility. For instance, stock market returns during a five or 10-year period have significant volatility. However, that volatility decreases significantly when looking at 20 or 30-year periods.

Read the complete report here.