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“We’ve Dug Ourselves Into a Really Big Hole”

That’s Legislative Auditor James Nobles’ take on the state’s pension system. How did it happen? And how long a ladder might taxpayers need to provide?

“We’ve Dug Ourselves Into a Really Big Hole”

Minnesota’s projected $5.8 billion budget deficit for the 2011–2012 biennium has been the top issue this political season, and understandably so. But when the three gubernatorial candidates sparred on August 26, the topic debated was a relatively unfamiliar one—the state’s public-employee pension system.

The stock market’s collapse in late 2008 dealt Minnesota’s three principal public-worker plans a stunningly bleak return on their investments in fiscal 2009: down 17.5 percent. At the point that fiscal 2009 ended—June 30 of that year—all Minnesota plans had a shortfall between assets and liabilities estimated to range from $15.4 billion to $24.3 billion, depending on how the assets are measured. Assets comprise contributions, investments, and earnings retained from previous years; liabilities include the money paid to recipients of beneficiaries as well as benefits owed to current government employees as calculated by actuarial formulae.

While the three chief plans have enough retained funds and employer and employee contributions to cover the deficits and pay beneficiaries, prospects for meeting future obligations looked so bleak that the plans’ boards had to craft a “sustainability package.” Approved by the Minnesota Legislature in May, the package will reduce benefits by $2.1 billion and require workers to contribute an additional $313 million over the next five years. The legislation also will add $235 million to the costs facing school districts and state and local governments over this period. A separate part of the package committed state taxpayers to cover millions of dollars in benefits promised earlier to retirees of the Minneapolis Employees Retirement Fund and increased the amounts the St. Paul School District must contribute to its teachers’ pension fund.

The legislative fix and a rebound in stock market returns have eased the situation. But for how long? That’s something of a mystery.

“This is the darkest corner of public finance,” says Mark Haveman, executive director of the Minnesota Taxpayers Association. “It’s such an arcane area that it’s just difficult to engage people to monitor it.”

But flashlights are starting to shine in that corner, as the August give-and-take between Mark Dayton, Tom Emmer, and Tom Horner suggests. Legislative Auditor Nobles, who plans to recommend a fresh examination of the state’s public pension funds early next year, believes that they “can no longer be treated as just the domain of technical experts or special interests.”

That’s especially true if state taxpayers need to shell out more money to keep the funds afloat.

 

The Minneapolis Debacle

In recent years, at least, taxpayers haven’t had to bail out the “big three” statewide pension funds: the Minnesota State Retirement System (MSRS), the Public Employees Retirement Association (PERA), and the Teachers Retirement Association (TRA). Taxpayers do contribute indirectly, of course, since public workers’ employers are schools and state and local governments.

But to get a sense of how ugly things could get, look at Minneapolis.

Problems at the Minneapolis Employees Retirement Fund (MERF) began surfacing in the late 1980s, after speculative investments turned sour. The fund, which struggled for years to dig out, has been propped up by more than $225 million in state contributions. This year’s legislation requires state taxpayers to cough up $22.75 million to MERF starting in 2012 and then $24 million a year beginning in 2015.

The city’s other two plans, the Minneapolis Police Relief Association and the Minneapolis Firefighters Relief Association, also are in trouble. The city won a court decision last year requiring them to collect overpayments to beneficiaries going back to 2000 and to reduce future benefits. The funds are fighting that ruling. Mayor R. T. Rybak says pension obligations will consume 15.7 percent of the city’s general fund by 2015, up from 11.8 percent now. In his 2011 budget message, Rybak said soaring pension obligations, largely to the two relief associations, forced him to propose a 6.5 percent “pension levy” on city taxpayers.

Trying to get a handle on Minnesota’s pension plans can intimidate a brain surgeon. Part of the problem is the sheer number of funds. Despite some mergers in recent years, the state still has roughly 760 funds, most of them run by small volunteer fire departments. Overall, the funds claim 560,000 active workers, pensioners, disabled persons, survivors, and deferred retirees. More than one of every 10 Minnesotans either contributes to or receives money from these funds.

The big bucks—93 percent of the state pension funds’ $41.3 billion in assets—are in the big three’s plans. Roughly 70 percent of the benefits going to their retirees come from returns on investments made for them by the Minnesota State Board of Investment, which hires professional managers to invest the money. The rest comes from contributions by the employees and their employers, with each kicking in 5 percent to 7 percent of workers’ salaries. Currently, upon retirement, a typical beneficiary with 30 years of service and a $60,000 average annual salary for his or her five highest-paid years would receive about $30,600 annually. The three best-paid retirees are getting $179,000 a year, though average payments run roughly a sixth of that amount. Most retirees also receive Social Security.

The Legislative Commission on Pensions and Retirement oversees the plans and recommends changes to the legislature, which almost always heeds the commission’s advice. Ten legislators serve on the commission.

Haveman praises the commission’s staff, but says the pension policy-making process tends to be “data heavy but information light” and replete with jargon that works against transparency. Part of the opacity is inherent in the process, he concedes, since actuaries must navigate through a thicket of assumptions about life expectancy, future wages, inflation, and other factors.

But Haveman argues that some of the fog is self-inflicted. He says he couldn’t get an estimate from the commission or the funds about what would happen if the state reduced its important assumption on future annual investment returns from the current 8.5 percent to 8 percent. The taxpayers association shelled out $1,000 to hire its own actuary, who found that such a move would add $1 billion to PERA’s liabilities. Haveman also says the audiences at the legislative commission’s meetings are typically filled with insiders interested in benefit increases—officials from public employee unions, their attorneys, and retirees.

The solvency of public pension funds has become a national issue. Last February, the Pew Charitable Trusts’ Center on the States described the concerns facing underfunded state retirement systems in a report titled The Trillion Dollar Gap. Pew’s analysis found that states have promised their current workers and retirees $3.35 trillion in retirement benefits—a trillion dollars more than they actually have on hand. Other estimates of the deficit run higher.

Last March, the Chicago-based Heartland Institute, which describes itself as a free-market think tank, ranked Minnesota’s statewide pension plans as the country’s 10th-best system, good enough for a “B” grade. The Pew report was less comforting. Based on data available through mid-2008—a few months before the stock market collapsed—Pew concluded that Minnesota’s system “needed improvement.” The study found Minnesota among “10 lagging states” because its funds received just 74 percent of their required contributions in 2008. Only nine states ranked lower.

 

The 8.5 Percent Assumption

The most commonly cited measure of a pension fund’s condition is its funding ratio—its assets as a portion of its liabilities. Funding ratios at the big three’s general plans have fallen significantly in recent years. By mid-2009, their actuarial funding ratios, calculated by smoothing out market fluctuations over several years, had dropped sharply from their peaks: MSRS to 86 percent from 112 percent in 2001; TRA to 77 percent from 106 percent in 1999; and PERA to 70 percent from 90 percent in 1999.

Larry Martin, executive director of the legislature’s pension commission, prefers another yardstick—the difference between annual funding requirements and contributions. By that measure, each of the three plans had fallen into negative territory by mid-2009.

The funds’ leaders describe the legislative fix as a bold initiative that will close approximately two-thirds of the funding gap. They promise to take tougher measures if needed. “Some critics say we acted too swiftly and we should have given more time for the markets to recover,” says MSRS Executive Director Dave Bergstrom. “Others say we are moving too slowly and should have solved the problem all at once.”

Critics in the latter camp argue that the state investment board has been too optimistic in sticking with its 8.5 percent assumption for returns, a target that’s been enshrined in state law since 1989. The higher the assumption, the lower the need for contributions from the employees and their government employers. Even small shifts in the assumption cause large swings in the amounts that contributors must chip in.

For the fiscal year ended June 30, a rebounding stock market helped the return bounce back to 15.2 percent. And for the 30 years ended June 30, 2010, the returns have averaged 9.7 percent annually. But over the last decade, the state board’s investments had four negative years. After factoring in the 2010 rebound, those returns still have averaged 2.9 percent annually since 2000.

Even before the market cratered in 2008, most public pension funds were assuming returns lower than 8.5 percent. A recent survey published by the National Association of State Retirement Administrators and the National Council on Teacher Retirement found only 17 of 126 state and local public pension plans at 8.5 percent—the highest assumption. Five of those were Minnesota funds, including the big three.

Two actuaries, one for the big three and the other for the legislative pension commission, have recommended lowering the assumption. So have the MSRS and PERA boards. But the commission isn’t rushing to scrutinize the 8.5 percent figure. A lower assumption would toss all three funds into a deeper hole, and put more pressure on governments and workers to contribute more to the plans.

Howard Bicker, the state investment board’s executive director, says the board’s research and long-term investment performance justify a relatively upbeat outlook. So is 8.5 percent still a good assumption? “I hope so,” Bicker told the commission at its July meeting. “I think so.”

Bicker cites the board’s 30-year investment return of 9.7 percent. But stocks, which account for three-fifths of the funds’ assets, have often fared poorly over long stretches in the past—1964 to 1982, for instance.

Another reason why the funds are running short: From 1995 to 1999, the investment board’s annual returns averaged a frothy 17.3 percent. The returns in excess of 8.5 percent flowed to retirees rather than being retained by the funds. Beneficiaries enjoyed pension increases averaging 9.7 percent a year from fiscal 1997 to 2000. In 2008, legislators limited annual increases to 2.5 percent.

This year’s legislative action was designed to get the plans back on the road to financial health. But that journey could be littered with obstacles.

 

Possible Solutions

For one thing, the ink was barely dry on the legislation when a Pittsburgh law firm filed suit in Ramsey County District Court. The suit alleges that the state and the funds violated the Minnesota Constitution by slicing retirees’ guaranteed annual increases of 2.5 percent to between 1 percent and 2 percent. The state is seeking to dismiss the suit; a ruling on the state’s motion isn’t expected until next year.

Many private sector workers complain that Minnesota’s public employees enjoy the kind of defined benefit plans that many businesses have moved away from. Some have shifted to defined contribution plans such as 401(k)s; others offer no retirement plans at all. It would only be fair, private sector employees say, to bring public sector benefits down to comparable levels. Public fund managers reply that this would create a downward pressure on benefits for all employees, public and private.

Haveman argues that the existing plans that guarantee defined benefits should be replaced with a hybrid system. Under that proposal, employees would build up retirement savings in 401(k) funds; the state investment board would continue to manage their money.

This year’s legislation also requires the big three to come up with possible alternatives to the current system by next June. But the funds’ executive directors warn that closing their defined benefit plans to new members would raise costs by depriving them of contributions still needed to pay beneficiaries.

Another solution, which public pension plans in Minnesota are moving toward: Transferring costs to younger workers by guaranteeing fewer benefits to new hires than retirees are getting now or that older employees have been promised.

Then there’s that matter of too many funds. Consolidation into the three large plans could bring stronger management to now-freestanding funds. Some consolidation has occurred: For instance, 44 local police and paid-firefighter relief associations were merged into PERA from 1987 to 1998, and the troubled Minneapolis teachers fund was merged into TRA in 2006. But consolidations typically require massive efforts: Members at the independent plans often view merger proposals as power grabs by bureaucrats in St. Paul.

 

Watchdogs Barking

The big three’s directors say this year’s legislation represents shared sacrifice by workers and beneficiaries.

“I think we’ve done a hell of a job,” the MSRS’s Bergstrom says. “The primary focus of the bill is to lower liabilities, which saves taxpayer money.” Referring to Wall Street’s role in triggering the financial meltdown that led to the plunging investment returns, he adds that “the greed of private industry got us into this mess, and we’re the ones getting attacked.” Haveman counters that under the legislation, the plans will still fall short of full funding.

In any case, the increasing scrutiny being directed at the state pension funds offers some measure of satisfaction for Don Moe, a St. Paul legislator for 20 years. Moe was a feisty watchdog who often barked at the funds’ policies and practices. He lost his state senate seat in 1990 after public unions mounted an aggressive, well-funded campaign to oust him. Now retired, Moe hasn’t changed his take on the issue: “There’s a huge network designed to promote the employees’ interests. The state lacks the ability to resist their demands.”

Legislative Auditor Nobles sees Moe as something of a Cassandra. “On a lot of these issues,” he says, “Don has proven to be correct.”
 

The Big 3

Fund Full name Who the fund primarily covers Total membership*
MSRS Minnesota State Retirement System State employees 98,454
PERF Public Employees Retirement Association City and county workers 374,235
TRA Teachers Retirement Association Teachers not covered by other funds 163,557
*This number includes retirees, current contributors, survivors, former employees with disabilities, and those who’ve deferred their retirement. (As of 2009.)

 

Key Source of Pension Tension

The health of Minnesota’s public pension funds depends largely on the returns generated by the billions of dollars in fund assets invested by the Minnesota State Board of Investment. In the last 30 years, the returns have fallen into negative territory only five years. But four of those five have come since 2001. That includes a crushing 17.5 percent loss in fiscal 2009, when the financial meltdown slammed the returns. (Results are for fiscal years ending June 30.)


 

More retirees—and fewer contributors

Years Contributors Beneficiaries Deficiency
2007 146,226 61,436 $52 M
2008 145,238 63,880 $78.6 M
2009 142,097 66,089 $136.7 M
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