For the Public Benefit

The issues facing public-sector pension programs mirror those of private industry, with some predicting a funding crisis on the horizon.

Friday, June 2, 2006
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They patrol the streets, teach in public schools and administer the functions of local government. They work for less than colleagues in the private sector. They expect a secure retirement.

State and local government employees are critical providers of public service, and their retirement plans are the cornerstone of public human resource management relationships, says Gary Findlay, executive director of the Missouri State Employee Retirement System, which provides a defined-benefit pension, life insurance and long-term disability benefits to more than 100,000 Missouri state employees.

Recently named "Savviest Public Plan of the Year" by Money Management Letter, a publication of Institutional Investor Inc., the public plan has more than $7 billion in assets and has earned 11.3 percent return on its investments, far better than the industry median of 7.1 percent. Though MOSERS has built a national reputation as an investment powerhouse, Findlay says its mission isn't just to churn investments, but to support a sensible public employee human resource strategy.

The system's mission, he says, is to facilitate the recruitment of employees who will provide high-quality services to state residents, but also to facilitate orderly departure from the workforce with financial security at retirement.

"Public employers have somewhat different human resource goals than private-sector employers," he says. "[Public-sector workers] are often paid less than similar employees in the private sector but expect a richer level of benefits."

That expectation, he says, fits the public recruitment-and-retention strategy.

"Generally, our goal is to attract and keep employees for their most productive 30 years. Our ideal scenario is to hire well-prepared employees in their early 20s and have them with us until their early 50s."

MOSERS is just one of hundreds of state and local employee programs providing millions of government workers and retirees with pensions and post-retirement benefits that often include retiree medical insurance.

According to the Public Fund Survey (, a database of public plans that voluntarily contribute financial reports, 103 of the largest state and local funds manage a combined market value of $2.24 trillion and pay benefits to more than 18 million workers and retirees. (The database is maintained by the National Association of State Retirement Administrators, a nonprofit organization that represents both public fund administrators and their advisors.)

However, not all of the public retirement systems are as secure as MOSERS and many face both financial and political challenges that could lead to a government human resource crisis.

Political Challenges

In February, Chicago Federal Reserve Bank President Michael H. Moskow hosted a State and Local Government Pension Forum for pension experts who specialize in the public sector, and pointed to an evolving funding crisis.

"Public pension obligations are growing rapidly and beginning to reduce the ability of governments at all levels to fund other public programs," he says, pointing to a combined public retirement funding gap estimated to range from $278 billion to nearly $700 billion.

Moskow says that like private pension funds, public funds are affected by both investment returns and changing demographics, and will likely have to be modified for both funding and human resource strategic reasons.

"It is likely that pension funds will need to be structurally changed, which includes identifying new funding sources and restructuring pension payouts," he says.

But, "pensions must be recognized as part of any employee's total compensation program. The human resource management dimension is important to consider when redesigning pension programs to be actuarially sound and meet the needs of today's employees," he says. "Pension programs need to reflect the needs of organizations in meeting their human capital requirements. No one-size-fits-all plan will be appropriate."

Unlike single-employer and multi-employer private retirement plans, public retirement systems are not established under the Employee Retirement Income Security Act, or protected by the Pension Benefit Guaranty Corp., the federal agency that insures private pension plans. Instead, they are usually chartered under state laws that can mandate various fiduciary and investment guidelines and plan designs.

Nancy Williams, a principal at Ennis Knupp & Associates in Chicago, an investment advisory firm that specializes in public plans, says most public funds contend with a more diverse set of administrative and actuarial problems than is sometimes encountered in the private sector.

Most public plans cover employee groups that are homogenous only by geography, covering public safety employees who work in high-risk jobs, office bureaucrats and laborers -- all with similar benefits and actuarial projections. And public retirement-system coverage can also range from large statewide-employee groups such as teachers and state civil servants, with thousands of plan participants, to tiny municipal groups with fewer than 10 employees.

Depending on the size of the constituencies, public plans also conduct a more diverse set of administrative activities than their private-sector counterparts, ranging from investing funds and writing checks to hands-on employee-benefit communication and retirement counseling, tasks usually given to human resource departments or consultants in the private sector.

State and local government plans are also not subject to the same level of funding scrutiny as private plans. While public plans track their liabilities according to the Government Accounting Standards Board, and invest to meet actuarial targets to fund those liabilities, many of the state laws do not require full or near-full funding, and trustees do not incur federal fiduciary liability under ERISA.

Keith Brainard, Austin, Tex.-based research director of NASRA, says the financial strength of public funds has generally tracked that of private defined-benefit pension plans. Flush with cash during the booming equity markets of the 1990s, the funds increased their benefits and reduced cash contributions.

Funding Levels Plummet

In the market downturn that began in 2001, some public funds stepped up their contributions to cover losses, while others languished, letting their actuarial funding levels plummet to levels that would have triggered plan freezes or terminations in the private sector.

"Public retirement plans are generally in pretty good shape. But like the private sector pension plans, some public funds are doing very well, some not so well and some very poorly," Brainard says.

According to the Public Fund Survey, actuarial funding levels among the participating funds vary from more than 100 percent to as low as 25 percent. Systems such as MOSERS, funded at more than 80 percent of their actuarial targets, are considered healthy.

Some of the more poorly funded plans, however, have generated national attention. In the past five years, several large public-retirement funds and the public-retirement system in general has come under the scrutiny of both state lawmakers and public policymakers.

According to Richard H. Mattoon, senior economist and economic advisor at the Chicago Federal Reserve Bank, "It's not everywhere, but there are specific plans in some jurisdictions that have developed a pattern of underfunding that may be reaching a crisis in proportion."

Some of the underfunding is a direct result of poor investment returns, similar to the private sector, he says. But weak investment results are sometimes compounded by political considerations -- administrations that choose to underfund in order to pay for more politically popular social programs.

For example, in Illinois, one of the problem states identified by Moskow and Mattoon, the State Employee Retirement System is funded at only 55 percent of its actuarial target, and the State Teachers Retirement System is at about 60 percent of its target.

This year, Illinois Gov. Rod Blagojevich withheld full pension contributions to the state's largest retirement fund, which already faces a $39 billion shortfall. The decision resulted in a negative opinion by Fitch Ratings, a leading Wall Street bond rating company, and a threat by Fitch to lower the state's AA bond rating if the pension liabilities are not corrected in the next year or two.

Mattoon says funding problems are compounded by other post-employment benefits provided by public retirement systems, notably retiree medical insurance.

"There is still an expectation among public employees that their retirement systems should provide these benefits. In a large part, the recent New York transit strike was about retiree medical benefits," he says.

Under Attack

Even some well-funded state plans have come under attack. In 2004, for example, California Assemblyman Keith Richman called for a reexamination of the state's various public retirement plans, including the California Public Employee Retirement System (CalPERS), the nation's largest state retirement fund. CalPERS is generally considered to be well-funded, at more than 87 percent of its actuarial target.

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Public pension fund critics such as Richman believe that public systems should follow the lead of the private sector and move to a defined contribution model, which would limit the growth of future liabilities and create more portable personal accounts that tend to be popular with younger, more mobile employees.

He proposed redesigning CalPERS and other state retirement systems on a 401(k)-like model, with individual investment accounts controlled by individual participants. The bill, ACA 5, was aggressively opposed by CalPERS and other systems, and died in committee.

Last year, Richman backed off the strict defined-contribution approach and proposed restricting public funds to defined-contribution or hybrid models, a move that Richman's chief of staff, Daniel Pellissier, says was a "failed compromise" designed to give state plans some choice in plan design, but restrict the growing liabilities.

The more recent bill, ACA 23, is also dead for the present term, Pellissier says, but may be revived next year if Richman succeeds in his bid to be elected state treasurer.

The defined benefit/contribution debate continues to heat up in the public sector, says Cathie Eitelberg, national director for public-sector-retirement consulting for the Segal Co. in Washington.

As legislatures look at the wide range of programs that require funding, rising retirement costs present an uncomfortable dilemma: Alienate employees and retirees with underfunding or benefit cuts, ignore more politically popular social programs or raise taxes.

A few funds, including the Alaska state employee fund, have switched to a defined-contribution model for new employees, to cap liabilities, but NASRA's Brainard says the move is generally built on some false assumptions.

"Defined-contribution plans are not necessarily less expensive than defined-benefit plans," he says." Many state laws would require jurisdictions to continue defined-benefit plans for present employees, so a switch to defined-contribution would require establishing a second retirement plan at a significant administrative cost.

"Savings may not be realized for 10 to 15 years until present employees begin to retiree and cease incurring additional liabilities for the defined benefit plan."

Hybrid Plans

Brainard says defined-contribution plans may also be inappropriate for public-sector organizations, which generally want to encourage longevity and career employees.

Hybrid retirement plans, which combine defined-contribution features with the investment control of defined-benefit plans, may be one answer, Segal's Eitelberg says. A handful of public plans offer new employees an option of choosing the old defined-benefit plan or a newer defined-contribution plan and balance the contributions with a hybrid funding model.

"Career employees could choose the DB plan for maximum accrual of benefits and employees that expect more mobile careers could choose the DC plan and build more portable accounts," she says.

Hybrids are not a new idea. The Austin-based Texas Municipal Retirement System (TMRS), for example, provides retirement benefits for 818 cities with as few as five employees.

The system mandates government contributions ranging from 5 percent to 7 percent and matching contributions from participating employees. The funds are not invested by participants, but are controlled by the system, which invests exclusively in very stable fixed-income instruments to meet a benefit target, similar to a defined benefit plan.

TMRS Executive Director Gary W. Anderson says the hybrid model was originally enacted to protect small municipalities from incurring huge, unpredictable liabilities while providing stable, secure benefits to employees. The system is funded at about 83 percent of its actuarial target level, according to Public Fund Survey. "It's important that underfunding does not get out of control," Anderson says.

Anderson agrees with Missouri's Findlay that public funds are not just investment vehicles but also serve social goals. "More so than any other employment situations, you want people to stick around in public service. You want employees who understand their jurisdictions, know the people, the roads and the infrastructure of their communities."

However, Anderson admits that longevity is not a universally positive human resource goal. "Healthy institutions require some turnover. If benefit levels are inadequate, employees may not feel secure enough to retire, and so stay on the job past their productive years."

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