crisis in public sector pension plans: blueprint for reform in n j
TRANSCRIPT
-
8/8/2019 Crisis in Public Sector Pension Plans: Blueprint for Reform in N J
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working
paper
The crisis in public secTor pension plans: a blueprinT
for reform in new Jersey
By Eileen Norcross and Andrew Biggs
n. 10-31
J 2010
The ideas presented in this research are the authors and do not represent ofcial positionso the Mercatus Center at George Mason University.
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1
Pensionplansoperatedbystategovernmentsonbehalfoftheiremployeesareunderfundedbyan
estimated$452billionaccordingtoofficialreports,1withtotalliabilitiesof$2.8trillionandtotalassets
of$2.3trillionin2008.However,manyeconomistsarguethateventhesedauntingliabilitiesare
understated.Current
public
sector
accounting
methods
allow
plans
to
assume
they
can
earn
high
investmentreturnswithoutanyrisk.Usingmethodsthatarerequiredforprivatesectorpensions,which
valuepensionliabilitiesaccordingtolikelihoodofpaymentratherthanthereturnexpectedonpension
assets,totalliabilitiesamountto$5.2trillionandtheunfundedliabilityrisesto$3trillion.2Theabilityof
governmentstopayfortheretirementbenefitspromisedtopublicsectorworkersrunsupagainstthe
realityoflimitedresources.
Inthisstudy,weconsiderthecaseofNewJersey,whichoperatesfivedefinedbenefitpensionplansfor
stateemployees.3TheNewJerseySenateunanimouslypassedlegislationinFebruary2010thatwould
putaquestionontheNovemberballottoconstitutionallyrequirethestatetobegintomakeitsfull
annualpaymenttothestatespensionsystem.4Thebillrequiresthestatetocatchuptopayingitsfull
1TheTrillionDollarGap:underfundedstateretirementsystemsandtheroadstoreform,ThePewCenteronthe
States,February2010,23.Wecalculatethesizeoftheunfundedliabilityapplyingadiscountrateof3.5%,the
yieldonTreasurybondswithamaturityof15yearsasofMay27,2010.
2
Novy
Marx,
Robert
and
Joshua
Rauh,
2009.
The
Liabilities
and
Risks
of
State
Sponsored
Pension
Plans,
Journal
ofEconomicsPerspectives23(4),191210,p.42.Thisresultisbasedonthepremise,derivedfromModiglianiandMiller(1958),thatafutureobligationshouldbediscountedattheinterestrateonaportfoliothatmatchesthe
timingandriskofitspayments.Modigliani,FrancoandMertonH.Miller,1958,TheCostofCapital,Corporation
Finance,andtheTheoryofInvestment,AmericanEconomicReview48:261297.3ThesearetheTeachersPensionAnnuityFund(TPAF),thePublicEmployeesRetirementFund(PERS),thePolice
andFiremensRetirementSystem(PFRS),theStatePoliceRetirementSystem(SPRS),andtheJudicialRetirement
System(JRS).Inaddition,thestateoperatestwodefinedcontributedplans,theAlternativeBenefitPlan(ABP),and
theDefinedContributionRetirementPlan(DCRP).Therearetwoexistingdefinedbenefitplansclosedtocurrent
workers,theConsolidatedPoliceandFiremensPensionFund(CPFPF),andthePrisonOfficersPensionFund
(POPF).
See,
the
State
of
New
Jersey,
Department
of
the
Treasury,
Division
of
Pensions
and
Benefits,
http://www.state.nj.us/treasury/pensions/.
4Theproposalrequiresthestatetocontributeatleast1/7
thoftheAnnualRequiredContribution(ARC)in2011and
increasethestatesannualpaymentbyatleast1/7th
foreachofthefollowingsixyearstopermitthestateto
graduallyadjusttoappropriatingthefullamountneededtocontributethetotalARC.FortextofSenate
ConcurrentResolution1,seehttp://www.njleg.state.nj.us/2010/Bills/SCR/1_I1.HTM
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obligationbyFY2018.5Fromthatyearforwardthestatewillbeconstitutionallyrequiredtomakethe
fullpaymenttoitspensionsystemseachyearascalculatedbyplanactuaries.Thestatereportsthatits
pensionsystemsareunderfundedby$44.7billion,whenliabilitiesarediscountedatthe8.25percent
annualreturnthatNewJerseypredictsitcanachieveonfundsinvestmentportfolios.
However,whenplanliabilitiesarecalculatedinamannerconsistentwithprivatesectoraccounting
requirements,methodsthateconomistsalmostuniversallyagreearemoreappropriate,6NewJerseys
unfundedbenefitobligationrisesto$173.9billion.7Thisamountisequivalentto44percentofthe
statescurrentGDP8and328percentofitscurrentexplicitgovernmentdebt.Thiscalculationappliesa
discountrateof3.5percent(theyieldonTreasurybondswithamaturityof15years)toreflectthe
nearlyriskfreenatureofaccruedbenefitsforworkers.Itisestimatedifstatepensionassetsaveragea
return
of
8
percent,
New
Jersey
will
run
out
of
funds
to
meet
its
pension
obligations
in
2019.
If
asset
returnsarelowerthan8percent,theywillrunoutoffundssooner.9Stateactuariesestimatethatunder
certainassumptions,NewJerseyspensionplanswillrunoutofassetstomakebenefitpayments
beginningin2013.10
5http://www.newjerseynewsroom.com/state/njpensionreformbillsapprovedbysenatecommittee
6Currentpublicsectorpensionaccountingruleseffectivelyviolatewellacceptedeconomicpreceptssuchasthe
ModiglianiMillerresultsincorporatefinance,theBlackScholesformulaforoptionspricing,andthegenerallaw
ofoneprice.
7Authorscalculations.Waring(2008)findsthatthemidpointofapublicpensionsstreamoffuturebenefit
paymentsisaround15yearsinthefuture.Thus,alumpsumpayment15yearshencecanbetreatedasan
approximationoftheannualbenefitliabilitiesowedbyaplan.FollowingRauhandNovyMarx,wecompoundthe
reportedpresentvalueliabilityforwardfor15yearsattheexpectedrateofreturn,thendiscountbacktothe
presentattheTreasuryinterestrate.Waring,M.Barton,Liabilityrelativeinvesting,JournalofPortfolioManagement30(4).8In2008NewJerseysGrossDomesticProductwas$390.35billionandstatedebtwas$52.785billion.
9JoshuaD.Rauh,AreStatePublicPensionsSustainable?WhytheFederalGovernmentShouldWorryAbout
Pension
Liabilities,
National
Bureau
of
Economic
Research,
May
15,
2010
p.
3.
10AccordingtoNewJerseysactuarialreports,thestatePERSplanwillrunoutofassetstomakeitsbenefit
paymentsin2013.Theplansforteachers(TPAF),judges(JRS),andlocalPERSemployeeswillrunoutofassets
between2014and2015.ThePoliceandFiremensplansandtheStatePolicePlanrunoutoffundsbetween2018
and2019.Thiscalculationisbasedontheassumptionsthattheplansexperiencenogainsfrominvestment
income,nostateandemployeecontributions,andnochangestothesizeofbenefitpayments.
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Giventhecostsandrisksinherentinthedefinedbenefitplantotaxpayers,aswellasthepolitical
incentivesforlegislatorstooverpromisebenefitstopublicsectorworkerswhileshirkingonthestates
contributions,thestateshouldclosethecurrentdefinedbenefitplantonewworkersandexpandthe
existingdefinedcontributionplansforallnewstateandlocalworkers.Shiftingemployeestoadefined
contributionplanwouldensurethatNewJerseyspensionsystemforitspublicsectorworkforceis
sustainableinthelongtermandrewardyoungerworkerswithaguaranteedemployercontributionto
theirindividualretirement.
NewJerseycurrentlyoperatestwodefinedcontributionplans.TheAlternativeBenefitPlan(ABP)serves
17,000facultyandadministrativestaffinthestatesuniversitiesandcolleges. Inaddition,in2007the
state
established
the
Defined
Contribution
Retirement
Program
(DCRP)
with
limited
eligibility
for
elected
andappointedofficialsandcurrentparticipantsinthePublicEmployeesRetirementSystem(PERS)and
TeachersPensionAnnuityFund(TPAF).Eithercouldserveasamodelforafuturedefinedcontribution
planforallpublicsectoremployees.
TofundthedebtowedtocurrentDBparticipants,thestatemusttakeimmediateaction.Thisincludes
someorallofthefollowing:cappingsalaries,increasingemployeecontributions,reducingtherateof
theaccumulationoffuturebenefits,reducingannualcostoflivingadjustments(COLAs),andincreasing
theretirement
age.
These
measures
will
reduce
the
size
of
the
future
benefits
funding
burden
and
thus
enablethestatetobettermanageitspensionobligationstoemployeesvestedinthesystem.
ThealternativeistocontinuetheDBgamblepromisingbenefitstopublicsectorworkerswhile
concealingthesizeofthatobligationtotaxpayers.ThecurrentlevelofunderfundingindicatesthatNew
Jerseywillhaveadifficulttoimpossibletaskinkeepingitscommitmentstocurrentpublicsector
workers.Tocontinueaddingworkersandliabilitiestothedefinedbenefitplansisnottenableand
representsapromisethatthepubliccannotafford.I. PublicSectorPensions:theDefinedBenefitPlan
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Therearetwogeneraltypesofretirementplans:definedbenefitplansanddefinedcontributionplans.
MoststateandlocalgovernmentsintheUnitedStatesofferdefinedbenefitpensionplanstotheir
workers.
Underadefinedbenefit(DB)plan,theemployerpromisesemployeesaregularpensionpayment(i.e.,
anannuity)overtheworkersretirementyears.11Theamountofthebenefitpaymentdependsonthe
workersage,yearsonthejob,andameasureoftheirfinalsalary.12Morespecifically,benefitformulas
generallypayagivenpercentageoftheemployeesfinalsalarymultipliedbythenumberofyearsof
employment.Inadefinedbenefitplan,investmentriskisbornebytheemployersincetheemployers
paymentisindependentoftheinvestmentreturnearnedbythepensionsfund.
In
a
defined
contribution
plan
(DC),
workers
and
employers
make
contributions
to
an
investment
account,suchasa401(k),403(b),orthefederalThriftSavingsPlan.Workersownandgenerallymanage
theseaccountsandbearthetradeoffsbetweenriskandrewardentailedbytheinvestmentsthey
choose.
Becausedefinedbenefitretirementpaymentsareguaranteedbystatelawsorconstitutionsbut
financedwithaportfolioofriskyinvestmentssubjecttomarketrisk,definedbenefitplanspresenta
distinctfiscalrisktotaxpayers.Definedbenefitplansobligatetheemployertopayoutbenefits
regardlessof
the
financial
status
of
the
pension
system
when
the
employee
retires.
Current
actuarial
practiceandaccountingstandardshavecontributedtoasystematicunderestimationofthesizeofthe
obligationowedtopublicsectoremployees,creatingamoralhazardproblem.Legislatorsareableto
overpromisebenefits,oftennegotiatedbypublicsectorunions,whilepassingthecostofthesepromises
ontofuturetaxpayers.Sincemoststateconstitutionstreatpublicsectorpensionsasaformofdebt,itis
11
Edwin
S.
Hustead
and
Olivia
S.
Mitchell,
Public
Sector
Pension
Plans:
Lessons
and
Challenges
for
the
21
st
Century,p.6,inPensionsinthePublicSector,ed.OliviaS.MitchellandEdwinC.Hustead,PensionResearch
CouncilTheWhartonSchooloftheUniversityofPennsylvania,UniversityofPennsylvaniaPress,Philadelphia,
2001.
12OliviaS.Mitchell,DavidMcCarthy,StanleyC.WisniewskiandPaulZorn,p.11DevelopmentsinStateandLocal
PensionPlansinPensionsinthePublicSector,eds.MitchellandHustead,2001.
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unlikelythatstatescandefaultonpensionobligationstoemployeeswithoutconstitutional
amendments.13
Thereare222definedbenefitplansoperatedbythestatescovering90percentofpublicsectorworkers
inthestates.Theseplanscover20millionemployeesandsevenmillionretirees.14
Inaddition,thereare
2,434plansoperatedbylocalgovernmentsservingasmallerportionofpublicsectorworkers.15
Afewstateshaveelectedtomovetheiremployeestothedefinedcontributionplan.Michiganclosedits
DBplantonewentrantsin1997.AndAlaskamovedtoaDCplanin2003.Florida,Nebraska,andOhio
offerhybridplans. (SeeAppendix1)
Why
Are
Plans
Underfunded?
Themagnitudeofunderfundingstemsfromhowpensionobligationshavebeenactuariallyvaluedand
howgovernmentshavechosentomanagepensionfundingandbenefitlevels.Thedramaticdownturnin
marketperformanceinthelastfewyears,whileharmful,isnottheprimarycauseofunderfundedpublic
sectorpensionplans.
Pensionplanshavebeensystematicallyweakenedbyinteractionsbetweenactuarialpracticethe
tendencyforgovernmentstomakeunrealisticpromisestoemployees,andthechoiceofgovernments
tocontribute
less
than
what
plan
actuaries
recommended
to
fund
plans
over
aperiod
of
years.
Publicpensionactuarialpracticesassumethatplanassetscanearnhighratesofreturn,leading
actuariestocalculateemployercontributionsatalowerlevelthanneededtofundplanliabilities.In
additiontounderstatingrequiredemployercontributionamounts,becauseGASBfundingrulesfor
13ItisestimatedthatNewJerseysannualpayouttoretireeswillreach$15billion,halfofthestatescurrent
budget,in2017.Inthiscase,thestatemaybeforcedtoreexaminetheconstitutionalprotectionsthatpreventthe
reductioninaccruedbenefitstoretirees.SeeYes,aPublicPensionCanbeForfeited,JohnBury,NJ.com,June28,
2008.(http://blog.nj.com/njv_johnbury/2008/06/yes_public_pension_can_be_forf.html)
14U.S.GovernmentAccountabilityOffice,StateandLocalGovernmentRetireeBenefits:CurrentFundedStatusof
PensionandHealthBenefits,GAO08223,January2008,p.1,http://www.gao.gov/new.items/d08223.pdf.
15GovernmentAccountabilityOffice,StateandLocalRetireeBenefits,GAO071156,p.18,
http://www.gao.gov/new.items/d071156.pdf.
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publicpensionsarearecommendationandnotarequirement,manystategovernmentshaveroutinely
putasidelessthanwhatwasrecommendedbyplanactuariestomeetfutureobligations.16Inother
words,pensionaccountinglowersthestandardforplanfunding,andeventhen,manystate
governmentshavefailedtomeetit.
HowDefinedBenefitPublicPensionPlansAreFundedandValued
Publicsectordefinedbenefitplansarefinancedbycurrentemployerandemployeecontributionsand
thereturnsontheinvestmentofthoseassets.17Typically,thesecontributionsareinvestedinamixof
stocks,bonds,andotherfinancialinstruments.Inrecentyears,planshaveincreasinglyturnedtomore
exoticinvestments,includinghedgefundsandprivateequity.18Pensionplaninvestmentsaremanaged
by
financial
managers
selected
by
the
pension
board.
Theamountcontributedbytheemployerandtheemployeetofundthepensionsystemiscalculatedby
actuarieswhodeterminethesizeoftheobligationpromisedtoemployees. Actuariesvalueapension
planbasedondemographicandeconomicassumptions,suchasestimatedageofretirement,mortality
rates,salarygrowth,andinflation,toarriveatanAnnualRequiredContribution(ARC).Iftheactuarial
assumptionsarereasonable,theARCapproximatestheamountthatneedstobecontributedannually
(byemployersandemployees)toensurethepaymentoffutureobligations.
Theseactuarialassumptionsandpracticesplayalargeroleindetermininghowmuchgovernmentsmust
contributetoensureawellfundedplan.Inaccurateassumptionsorunsoundpracticecanresultinan
16AccordingtoThePewCenterontheStatesthecollectiveliabilityforpensionobligationsinthestatesis$2.77
trillion,andstateshavecontributed$2.31trilliontowardsthisobligation,leavinga$452billiongap.However,
whenadjustingthesenumberstoreflecttherisklesscharacteristicsoftheseliabilities,thetotalliabilityrisesto
$5.2trillionandtheunfundedliabilityrisesto$3trillion.SeeTheTrillionDollarGap:UnderfundedState
RetirementSystemsandtheRoadstoReform,ThePewCenterontheStates,February2010,p.15.
17Typicallystateandlocalgovernmentsoperateseparatefundsfordifferentoccupations(e.g.,teachers,public
employees,police,andfiremen).
18AsofApril30,2010,NewJerseyhadinvested$10.6billionof$68.9billioninassetsinalternativeinvestments.
SeeNewJerseyDepartmentoftheTreasury,DivisionofInvestment,http://www.state.nj.us/treasury/doinvest/,
andalso,NewJerseyTopsAnotherList,JohnBury,Nj.com,June13,2010.
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underfundedplan.Iftheactuarialassumptionscloselyreflectactualoutcomes,thenpayingtheARCin
fullshouldresultinawellfundedpensionsystem.
Todeterminethefundingstatusofpensionplans,actuariesperformannualactuarialvaluations
measuring
the
plans
accrued
liabilities
and
compare
liabilities
to
the
value
of
the
plans
assets.
Comparingplanliabilitiesandassetsallowsactuariestodeterminethedegreetowhichtheplanis
fundedandabletopayoutpromisedbenefits.Actuariescalculatetwobasicmeasuresofpensionplan
performance.Thesearethefundingratiotheplansassetsdividedbytheplansliabilitiesandthe
unfundedliabilitytheplansassetsminustheplansliabilities.Plansthatare100percentfundedand
havenounfundedliabilitiesareconsideredfullyfunded.19
HowReliableIstheARC?TheRoleofActuarialMethods
Accordingto
the
Government
Accounting
Standards
Board
(GASB),
the
ARC
is
to
be
calculated
so
that
it
coversannualbenefitaccrualsandspreadsanyunfundedliabilityovera30yearamortizationperiod.20
Onepracticethathascontributedtothepensionfundinggapistheselectionofanimproperdiscount
ratewhenvaluingpensionplanliabilities.Discountingallowsonetovalueafuturebenefitintodays
dollars.Itasks,Howmuchisneededtoputintothepensionsystemtodayinordertopayouta
promisedbenefitinthefuture?AccordingtotheGovernmentAccountingStandardsBoard(GASB)
ruling25andActuarialStandardsofPractice(ASOP)item27,publicpensionliabilitiesaretobe
discountedbytheexpectedrateofreturnonpensionassets.Typicallypublicpensionfundsassumethey
willearnnominalreturnsofaround8percentannually,usingthisinterestratetodiscountfuturebenefit
liabilitiesbacktothepresent.
However,mosteconomistsbelievethisapproachtobefundamentallyflawed,runningcontrarytoboth
financialtheoryandthepracticeoffinancialmarkets,whichholdthatthemeansbywhichaliabilityis
financedisirrelevanttothevalueofthatliability.Forinstance,DonaldKohn,theViceChairmanofthe
FederalReserveBoard,recentlystatedthat
Whileeconomists
are
famous
for
disagreeing
with
each
other
on
virtually
every
other
conceivableissue,whenitcomestothisonethereisnoprofessionaldisagreement:Theonly
19Ibid,AndrewG.Biggs,TheMarketValueofPublicSectorPensionDeficits,April2010,p.2.
20Amortizationistheprocessofpayingoffaloan,spreadingthecostofpayingtheprincipleandinterestovertime.
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appropriatewaytocalculatethepresentvalueofaverylowriskliabilityistouseaverylowrisk
discountrate.21
Discountingpublicsectorpensionliabilitiesattheexpectedrateofreturnonpensionassetsviolatesa
number
of
economic
precepts,
including:
TheModiglianiMillertheorem,whichholdsthatthevalueofaninvestmentprojectisindependentofhowitisfinanced;
TheBlackScholesoptionspricingformula,whichshowsthatguaranteesagainstmarketriskgrowmoreexpensiveoverlongperiodsandwhentheunderlyingassetismorevolatile(public
pensionaccountingholdsthatlongtimehorizonsjustifyignoringmarketriskandthatholding
riskier,higherreturningassetsimprovesapensionsfundinglevel);
TheArrowLindtheorem,whichholdsthatgovernmentscanignoretheriskofinvestmentsonlywhentheinvestmentsaresmallrelativetoanduncorrelatedwiththesizeofthetaxbase;and
Thegenerallawofoneprice,whichholdsthattwoinvestmentsproducingsimilarincomestreamsshouldcarrysimilarprices(publicpensionaccountingimpliesthatgovernmentscan
producethesamelevelofpensionbenefitsatroughlyhalfthecostofaprivatefirm).
Forconsistencywitheconomictheory,thepracticeoffinancialmarkets,andrulesappliedtoprivate
sectorfirms,
liabilities
should
instead
be
valued
according
to
the
risk
inherent
in
those
liabilities.To
do
otherwiseimplieslimitlesspossibilitiesforrisklessarbitrage,producingpotentiallyabsurdresults.22
Fromtheperspectiveofworkers,definedbenefitpensionsinthepublicsectorareriskfree;theyare
guaranteedbenefitsbythestate,whichhasthepowertotax.Thismeans,ofcourse,thatfromthe
perspectiveofthetaxpayer,theliabilityisanearcertainty.Thediscountratechosentovaluefuture
21Kohn,DonaldL.,StatementattheNationalConferenceonPublicEmployeeRetirementSystemsAnnual
Conference.
New
Orleans,
Louisiana,
May
20,
2008,
http://www.federalreserve.gov/newsevents/speech/kohn20080520a.htm
22Forinstance,ifgovernmentscanguaranteehighinvestmentreturnswithoutriskorcostduetotheirlongtime
horizons,therewouldbeenormouswelfaregainsbyhavingallinvestmentsheldandguaranteedbythe
government.Likewise,taxescouldbeeliminatedifthegovernmentborrowedsufficientamountsandinvested
thesesumsinhighreturningassets.
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liabilitiesintheplan,therefore,shouldreflectthelowriskcharacterofthebenefitspromisedto
workers.23
Fromthegovernmentsperspective,itisappealingtouseahigherdiscountratetoestimateplan
liabilities
because
it
produces
a
lower
annual
contribution.
By
contrast,
a
low
discount
rate
will
result
in
ahigherannualcontributionrequiredbytheemployer(inthiscase,thegovernment)tofundpension
obligations.
Overthepastdecade,statepensionliabilitieshavebeenvaluedusinganaveragediscountrateof7.97
percent.24Thismayseemreasonable,sincethemedianinvestmentreturnforpensionassetsoverthe
past20yearshasbeenaround8percent.However,returnsonmarketinvestmentsarenotguaranteed,
asthemarketdownturnof20012002andthecrashof2008demonstrate.25Evenifplansaccurately
predicted
average
market
returns
over
a
very
long
period,
the
majority
of
plans
obligations
are
payable
overthenext15years,inwhichaveragemarketreturnswouldbemoreuncertain.Thereisasignificant
possibilityandinsomecases,aprobabilitythatafullyfundedplanwouldbeunabletomeetits
obligationseveniftheplanaccuratelyprojectedaveragemarketreturns.26
23JeffreyR.BrownandDavidW.Wilcox,DiscountingStateandLocalPensionLiabilities,AmericanEconomic
Review:Papers&Proceedings2009,99:2,p.538.
24
See
Novy
Marx
and
Rauh
(2008).
The
median
(and
modal)
discount
rate
for
108
of
the
112
state
pension
plans
withassetsgreaterthan$1billionin2005was8percent.
25AccordingtothePewCenterStudy,theFinancialAccountingStandardsBoard(FASB)whichgovernsrulesfor
pensionsintheprivatesectorrecommendsthatinvestmentreturnsbediscountedmoreconservativelyand
suggestsusingtherateofreturnoncorporatebonds.Asof2008,thetop10privatepensionshadanassumedrate
ofreturnof6.36%.
26Itisunclearwhetherinvestmentreturnsfrompublicplansarepresentedassimpleaverages(thearithmetic
mean)orastheprojectedcompoundreturn(thegeometricmean).Thecompoundreturnislowerthanthesimple
averagereturntothedegreethatannualreturnsvaryfromyeartoyear.Aplanthatwasfullyfundedassuminga
givenprojectedrateofreturnwouldneedtoachieveacompoundreturnatthatleveltobeabletopayitsliabilities
inpractice.Ifaplanprojecteditsfuturereturnasacompoundreturn,thengivenmarketvolatilityonecould
expectafullyfundedplantohavea50percentprobabilityofbeingabletopayitsliabilitiesinpractice.However,if
theplansreturnwasprojectedasasimpleaverageasseemstobethecaseforsomeplansthenonecould
expectabelow50percentprobabilityofafullyfundedplanbeingabletomeetitsobligations.Publicpension
accountingrules,whichconsidertheaveragereturntoplanassetsbutnottheriskofsuchreturns,donotillustrate
therangeofoutcomesthatarepossible.
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Inadditiontounderstatingfundingrequirements,usingahighdiscountratetovaluepublicpension
liabilitiesencouragesplanmanagerstoinvestinhigherriskportfoliosinordertotargettheexpected
rateofreturn,producingbadincentivesinthemanagementofpensionassets.27 Instead,financial
theorysuggestspensionsshouldbediscountedaccordingtothelowerrisk(andlowerreturn)Treasury
bondratingof3.5%.28
Whenapplyingamuchlowerdiscountrate,basedonthereturnonTreasurybonds,thesizeofpension
obligationsisfarlargerthanstateestimates,29risingfrom$2.8trillionnationwideto$5.2trillion.30In
otherwords,thesizeoftheobligationowedtopublicsectorworkerswillrequireafarlarger
contributionthancurrentactuarialreportswouldsuggest.
Boom
and
Bust:
Pension
Asset
Investments
Byassumingahigherrateofreturnonpensionassetsinvestments,statespursuedinvestmentstrategies
thatfavoredhigherrisk,highervolatilityinvestments.31Beforethe1980smostsystemsheldtheirassets
mainlyinfixedincomesecurities.Investmentchoiceswererestrictedbylegallists.Inthe1980slegal
listswerereplacedwiththeprudentpersonrule.32Movingtothisstandardallowedpensionsystems,
27Wilcoxnotesthatthelinkbetweendiscountratesandinvestmentreturnsisremarkablebecauseitsuggests
thatplansponsorscanreducetheirfundingobligationsbyinvestinginriskiersecurities,whereasconventional
financetheorywouldsuggestthatagivenlevelofbenefitsecuritycanbemaintaineddespiteashifttoriskier
investmentportfolio
by
increasing,
rather
than
reducing,
contributions
to
the
plan.
See,
Brown
and
Wilcox,
DiscountingStateandLocalPensionLiabilities,2009,p.538.
28AccordingtoBrownandWilcox,Theidealsetofdiscountrateswouldbederivedfromsecuritiesthatdeliver
fullytaxablecashflows;thatdeliverthosecashflowswithahighdegreeofassurance;thattradeinmarkets
withoutextraordinaryliquiditycharacteristics;andthatarefreeofflighttoqualityeffects.p.541.
29Ibid.NovyMarxandRauh,PublicPensionPromises,2010,p.2.
30Ibid.NovyMarxandRauh,PublicPensionPromises,2010,p.42.Wearriveatatotalliabilityof$5.2trillion,by
discountingthetotalliabilityforstatepensionssystemsof$2.8trillionin2008reportedbythePewCenterusing
the3.5%yieldon15yearTreasurybondsasofMay27,2010.Thisissubtractedfromthetotalreportedassetsin
2008of
$2.31
trillion
to
arrive
at
atotal
unfunded
obligation
of
$3
trillion.
31J.FredGiertz,TheImpactofPensionFundingonStateGovernmentFunds,StateTaxNotes,August18,2003,p.
511.
32TheprudentpersonrulewascodifiedwiththeEmploymentRetirementIncomeSecurityActof1974(ERISA),
whichestablishedstandardsforprivatesectorpensions.
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aslongasstandardsofdiversificationandprudenceweremet,toholdlargerpercentagesofequities
andcapturethehigherreturnsbeinggeneratedinaboomingmarket.33
Duringboomyearstheeffectofhighreturnsonpensionassetsmayhaveinducedotherbehavioral
changesinthemanagementofpensionassetsandencouragedmorerisktakingwithpensionassets.
BecausetheI.R.S.codestatesthatnopartofplanassetsmaybeusedforpurposesotherthanthe
exclusivebenefitofemployeesandbeneficiariestheguaranteedbenefitcoupledwiththeworkers
claimonsurplusescompoundthemoralhazardprobleminthemanagementofpublicpensions.Where
accountingmethodsbasepensionassetvaluationsonahighriskexpectedrateofreturn,political
pressuremayresultinexcesssurplusesofpensionassetsbeingdistributedtopublicemployeesas
enhancedbenefits.Thismagnifiestheincentivetotakerisksinpensionassetinvestmentsinorderto
apply
surpluses
as
expanded
benefits,
particularly
in
plans
that
have
heavy
employee
representation.
34
Thisisborneoutinthechangingmakeupofpublicpensionassetsinvestments. Followingtheadventof
theprudentpersonrule,theseinvestmentshaveincreasinglybeeninvestedinhigherreturnand
higherriskvehicles.
In1990,40percentofpublicsectorpensionassetswereheldinequities,risingto70percentin2006,
roughly10percenthigherthantheallocationofpensionassetstoequitiesinprivatepensionsystems.35
33OliviaS.Mitchell,DavidMcCarthy,StanleyC.Wisniewksi,andPaulZorn,DevelopmentsinStateandLocal
PensionPlans,Chapter2inPensionsinthePublicSector,eds.OliviaS.MitchellandEdwinC.Hustead,UniversityofPennsylvaniaPress,Philadelphia2001,p.14.
34J.RichardAronson,JamesA.DeardenandVicentC.Munley,PublicEmployeeDefinedBenefitPensionSystems:
theImpactofExplicitSurplusSharingContractsandStakeholderInfluenceonInvestmentStrategies,February
2007(LehighUniversity)p.3.
35AndrewG.Biggs,TheMarketValueofPublicSectorPensionDeficits,RetirementPolicyOutlookNo.1,
AmericanEnterpriseInstituteforPublicPolicyResearch,April2010,p.2.
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TheEmployer:HowPublicPensionPlansareOverpromisedandUnderdelivered
Inthecaseofmanystatepensionplans,governmentsmaychoosetopaylessormorethantheARC.36
TheARCisarecommendation,notarequirement.Asweoutlinedabove,ARCscalculatedundercurrent
pensionaccountingrulesareinadequatetoguaranteethatplanscanmeettheirobligations.Andmany
stategovernmentsfailtopayeventheARCsthatarecalculated,leavingplanfundingwellshortofwhat
istrulyneeded.Theresultisgreatercostsandgreaterriskshiftedontofuturetaxpayers.
Theamountcontributedtothepensionsystembythegovernmentistheemployercontribution,
sometimesreferredtoasthestatutorycontribution.Inmanystates,theannualcontributionmadeto
pensionsystemshasbeenbelowtheARC.Thesechoicesmadebymanystategovernmentsinclude
puttingoffpaymentsintothepensionsystempensiondeferralsorpensionholidayscontributing
lessthantheARCinordertoexpandspendinginotherareasortoavoidtaxincreases,andawarding
increases
in
retirement
benefits
for
public
sector
employees
in
lieu
of
salary
increases.
All
of
these
result
fromtheincentivesfacingtheemployerthestateaspensionplansteward.
Intheprivatesectortheemployermayalsopassontheriskofanunderfundedpensionplan.Private
sectorpensionsareguaranteedbythePensionBenefitGuarantyCorporation(PBGC).Thisguarantee
createsthepotentialformoralhazardinhowprivatesectorpensionsareinvested.Sincebenefitsare
partiallyguaranteed,privatesectorpensionmanagersfortroubledfirmsmaybeincentivizedto
embraceahigherriskinvestmentstrategy.37Fromthepointofviewoftheworkercoveredundera
privatesector
DB
plan,
ahigh
risk
investment
strategy
may
not
be
as
appealing.
If
aprivate
employer
defaultsontheirpensionobligationtoemployees,theamountpaidoutbythePBGBmaybelessthan
theamounttheemployerpromised.38
36GovernmentAccountabilityOffice,StateandLocalRetireeBenefits,GAO08223,p.9.
37SeeJeffreyR.Brown,GuaranteedTrouble:TheEconomicEffectsofthePensionBenefitGuarantyCorporation,
JournalofEconomicPerspectives,Volume22,No.1,Winter2008,pp.177198.Brownfindsthefinancial
deteriorationofthePBGCtoagovernmentorganizationwithadeficitin2006of$18.9billionisduetodesignflaws
leading
the
PBGC
to
a)
fail
to
properly
price
insurance
and
thus
encourage
excessive
risk
taking
by
plan
sponsors,
b)
failtopromoteadequatefundingofpensionobligations,andc)failtopromotesufficientinformationdisclosureto
marketparticipants.
38JeffreyBrown,GuaranteedTrouble,Winter2008andalso,AndrewBiggsandJeffreyBrown,Reformingthe
PensionBenefitGuarantyCorporation,forthcomingchapterinPublicInsuranceandPrivateMarkets,JeffreyR.Brown,ed.,AEIPress,2010.
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Inthecaseofpublicsectorplans,thestatespassonthecostassociatedwiththeguaranteeoffull
benefitstothetaxpayer.Sincethestatehasthepowertotax,fromtheworkersperspectivethisisthe
equivalentofa100percentguaranteedbenefit,regardlessofthefinancialconditionofthepensionplan
whentheyretire.Taxpayersareresponsibleforpensiondeficits,butworkersoftenhaveaclaimon
pensionsurpluses.Howplansurplusesaretreatedmayinfluenceinvestmentandfundingchoicesof
governments.Forexample,plansurplusesmaybesharedbetweentaxpayers(intheformofareduced
statecontribution)andemployees(asenhancedbenefits).39Duringabullmarket,pensionsmay
experiencesurplusesevenwhencontributionsarezero,creatinganincentiveforpublicsector
employeestofavorheavierinvestmentofpensionassetsinhighriskassets.40
The
magnitude
of
the
pension
crisis
in
the
states
points
to
the
inadequacy,
and
fiscal
dangers,
of
offering
definedbenefitplanstopublicsectorworkers.ActuarialmethodsinformedbytheGovernment
AccountingStandardsBoardareflawedandreflectinadequateunderstandingofthepropertreatment
ofpensionliabilities.Governmentsasemployersandpensionstewardsfaceverydifferentincentives
thanemployersintheprivatesector,sinceliabilitiesareguaranteedbytaxpayersat100percentoftheir
value.Stateshaveeffectivelymisusedpensionfundsunderfundingobligationstobalancebudgetsor
expandspendingwhileoverpromisingbenefitstoworkers.
TheAlternative:
The
Defined
Contribution
Plan
Inadefinedcontributionplantheemployerandemployeegenerallyeachcontributeacertain
percentageoftheemployeespaytoanindividualpensionaccount.Thesecontributionsareinvestedin
acombinationofstocks,bonds,andotherinstruments,andgrowovertime.Thekeydifferencebetween
theDCplanandtheDBplanistheassignmentofrisk.InaDCplan,theriskorrewardofvarying
investmentperformanceisbornebytheemployee,whoreceivesahigherorlowerpensionbasedupon
thereturnsgeneratedbyinvestmentsheldinhisaccount.Theemployersobligationsaretomanagethe
planandtomakeannualcontributionsaspromised;theemployerbearsnocontingentliabilityregarding
39Ibid,J.RichardAronson,JamesA.Dearden,andVincentG.Munley,PublicEmployeeDefinedBenefitPension
Systems,p.4.
40 Ibid,J.RichardAronson,JamesA.Dearden,andVincentG.Munley,PublicEmployeesDefinedBenefitPension
Systems,pp.78.
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theperformanceofplanassets.Theriskistransferredfromtheemployer(orinthecaseofthepublic
sector,thetaxpayer)totheemployee.InaDCplan,theemployersfinancialobligationceaseswhenthe
requiredcontributionismadetotheindividualemployeesretirementplan.
Therisksbornebytheemployerinadefinedbenefitpensionareonereasonwhy,beginninginthe
1970s,theprivatesectorbegantoswitchtoofferingitsemployeesdefinedcontributionplans.Between
1979and1998,theshareofemployeescoveredbyDBplansfellby17percentandtheshareofthose
coveredbyDCplansroseby12percent.41
AsecondreasonthattheprivatesectorswitchedtotheDCsystemisthatitoffersemployeesgreater
mobility.BenefitsarelessportableinaDBsystem.InmostDBsystems,anemployeesaccrued
benefits
depend
on
their
final
salary
at
the
time
they
terminate
employment.
If
an
employee
moves
jobs
multipletimestodifferentpensionsystemsandhasmultipleDBaccruedbenefits,thetotalofallvested
benefitsislessthanwhatthebenefitswouldbeiftheemployeestayedinonesystem.42Oncevestedin
aparticulardefinedbenefitpensionplan,theemployeeriskslosingasignificantamountofbenefit
incomebyterminatingtooearlyormovingaroundtoooften.43ThismakesDBpensionslessattractiveto
younger,moremobileworkersthatemployersmightwishtoattract.
41StephanieAaronsonandJuliaCoronado,AreFirmsorWorkersBehindtheShiftAwayfromDBPensionPlans?,
FinanceandEconomicsDiscussionSeries,DivisionsofResearch&StatisticsandMonetaryAffairs,FederalReserve
Board,Washington,D.C.,February2005,p.1.
42KarenSteffen,StateEmployeePensionPlans,inPensionsinthePublicSector,eds.OliviaS.MitchellandEdwin
C.Hustead,PennsylvaniaUniversityPress,Philadelphia2002,p.52.
43FirmpreferencesandtheenactmentofERISA(TheEmployeeRetirementIncomeSecurityAct)in1974areoften
citedasreasonsforthegrowingshiftawayfromDBplansandtowardsDCplansintheprivatesector.Another
factorisincreasedworkerdemandforDCplans.AaronsonandCoronadofindthatchangingworkforce
characteristicsincludingtheinfluxofwomenintheworkforceandconcomitantincreaseindualincomeearner
householdsmayhaveincreasedthedemandforflexibilitybyworkers.Womenascaregiversmayhaveless
attachmenttospecificemployersandthelabormarket.Dualincomehouseholdsmustengageinjointdecision
makingadjustingtheiremploymentinresponsetoachangeinemploymentofaspouse.See,Aaronsonand
Coronado,AreFirmsorWorkersBehindtheShiftAwayfromDBPensionPlans?,FederalReserveBoard,February2005,pp67.
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CanaStateCatchUp?
Ifstatepensionplanswerefrozentodaywithnonewemployeeseligibleforbenefits,wouldstatesbe
abletocatchuptotheirobligationstocurrentbeneficiaries?Withlowerassetvaluesthaninprioryears
andrisingnumbersofretirees,statesnowfacedifficultpolicyoptionsastheyattempttocatchupon
pensionfundingcontributionsduringaperiodofprolongeddecreasesinrevenues,evenasemployees
continuetoaccruerightstofuturebenefits.Sincestatesareeitherconstitutionallyorstatutorily
obligatedtopayoutbenefits,thesizeofthatunderfundingmeansthateitherbenefitamountsand
salariesmustbereduced,taxationmustbesignificantlyincreased,orstatesmaybefacedwithadefault
scenario.
II. CaseStudyNewJerseyTheStateofNewJerseyoperatesfivedefinedbenefitpensionplans.44TheseincludetheTeachers
PensionAnnuityFund(TPAF),thePoliceandFiremenRetirementSystem(PFRS),PublicEmployees
RetirementSystem(PERS),StatePoliceRetirementSystem(SPRS),andtheJudicialRetirementSystem
(JRS).45
Intotal,NewJerseysfiveactivedefinedbenefitplanscover770,869workers.InFY2010theplanspaid
out$5.85billionto265,296retireesandbeneficiaries.
Theactuarial
assumptions
used
to
value
New
Jerseys
pensions
include
an
assumed
rate
of
return
on
pensionassetsof8.25%.TheassumedrateofreturnisestablishedbytheStateTreasurer,notbyplan
44Inaddition,thestateoperatestwoplansthatareclosedtonewmembers.ThesearetheConsolidatedPoliceand
FiremensPensionFund(CPFPF):L.1952,c.266andPrisonOfficersPensionFund(POPF):L.1941,c.220.
45NewJerseysstatepensionsystemsdatetothecreationoftheTeachersRetirementFundin1896,astatewide
contributoryannuityplan.Theplanmadenoprovisionsforthefundingofpensionliabilities,leadingtoitsnear
collapse.In1919theNewJerseylegislatureinstitutedtheTeachersPensionandAnnuityFund(TPAF)toensure
thatthesystembeestablishedonascientific(actuarial)basis.Between1941and1973,theremainingsix
retirementsystemswereestablished.ThePERS,PFRSandCPFPFplans,allowedlocalgovernmentstomovefrom
theirunfundedpensionstoStateadministeredplansthatallowedcentralizedadministrationofthesebenefitsand
fundingonanactuarialreservebasis.TodaytheprocessofconsolidatingpublicretirementbenefitsinaState
administeredplanisnearlycompleted.Afewlocallyadministeredsystemsremain,includingtheEmployees
RetirementSystemofNewJerseyandasmallnumberofspecialfundsforlifeguardsinafewbeachfrontcities.
See,TheNewJerseyPensionSystem,TomBryan,inPensionsinthePublicSector,eds.OliviaS.MitchellandEdwinHustead,UniversityofPennsylvaniaPress,2001.
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managersoractuaries.Applyingthisrateofreturn,NewJerseypensionsfaceanunfundedliabilityof
$45.8billionasofJune30,2009.Whenapplyingtherateofreturnoninvestmentsthatreflectstherisk
freecharacterofpensionobligations,suchasthecurrentTreasurybondrateof3.5%,theunfunded
liabilityinNewJerseysstatepensionsincreasesto$173billion.46
Giventhecurrentmarketvalueofassetsandthepreviousyearsbenefitpayments,stateactuaries
calculatethatNewJerseyspensionplanswillstarttorunoutofmoneyin2013.47Thisprojectionis
basedonaspecificscenario,onethatexcludesgainsfrominvestmentincome,stateandemployee
contributions,andchangestothesizeofbenefitpayments.(SeeAppendix2fortheunfundedliability
andyearsuntilbenefitsareexhaustedineachplan.)
HowPensionsHaveBeenManagedandPromisedinNJ
The
implicit
debt
facing
New
Jersey
in
its
underfunded
pension
plans,
as
with
most
states,
was
encouragedbytheactuarialmethodsusedtovaluetheplansandthechoicesoflegislatorsoveraperiod
ofyearstoextendgenerousbenefitswhiledeferringpaymentstothepensionfunds.Morestringent
accountingruleswouldhaveencouragedgreaterfundingandmorerestrainedbenefitgrowthovertime.
Severalchangesundertakeninthe1990schangedhowtheNewJerseypensionsystemwasvalued,
allowingthestatetoloweritsannualcontribution.In1992underGovernorJimFlorio,thePension
RevaluationAct(PRA),(L.1992,C.41)changedtheinterestrateassumptionusedtocalculateplan
liabilities,replacingthebookvalueinterestrateassumptionof7percentwiththemarketvalueinterest
rateassumptionof8.75percent.48Ahigherassumedrateofreturnonfundsallowedlocalitiestoreduce
46 Authorscalculations.
47PublicEmployeesRetirementSystemofNewJersey,55
thAnnualReportoftheActuary,July1,2009,p.21,
http://www.state.nj.us/treasury/pensions/pdf/financial/2009
actuary
report
pers.pdf.
See
also,
Actuaries
Going
Ballistic,JohnBury,nj.com,February28,2010.
48See,TheHallInstituteofPublicPolicy,HistoryandFutureofNewJerseyPensions,p.3.Additionalactuarial
assumptionswerechanged.Theaveragesalaryincreaseassumptionwentupfrom4.75percentand5percentto
6.25percent.TheCOLAinflationassumptionincreasedfrom2.25percentand2.5percentto3percent.SeeTom
Bryan,TheNewJerseyPensionSystem,inMitchellandHustead,pp.337338.
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theirpensioncontributionsinFY1992andFY1993by$1.5billion.Thelegislationwasintendedtohelp
balancetheFY1993budgetandpayforunfundedcostoflivingadjustmentsadoptedinthe1970s.49
In1994,thePensionReformAct(L.1994,C.62)requiredthestatetoswitchthemethoditusedtovalue
the
fund
from
the
Entry
Age
Normal
method
(EAN)
to
the
less
demanding
Projected
Unit
Credit
Method
(PUC)andresettheamortizationperiodfortheunfundedaccruedliabilityfrom30to40years.
Additionalchanges,includingadownwardrevisionintheCOLAassumptionandareductioninthe
averagesalaryscale,ledthestatetoreducestateandlocalemployercontributionstothepensionplans
by$547.4millioninFY1994,andby$946.8millioninFY1995,allowingGovernorChristieWhitmanto
reducetaxesandpresentabalancedbudget.50
Thesegainsweretemporary,theresultsofassumptionchangesratherthanreality.Theswitchin
methodology
and
changed
assumptions
led
to
an
underestimation
of
contribution
amounts,
producing
a
fundinggap.Toclosethegap,in1997ThePensionSecurityPlanpermittedthestatetoissue$2.8billion
inpensionobligationbondswhichwereusedtopartiallyeliminatea$4.25billionunfundedliabilitythat
hadsurfaced.51Theproceedsofthebondsaleweredepositedintothepensionsystem.
FullannualcontributionsweremadetoNewJerseyspensionsuntil1997,butstatesmaydefer
paymentstopensionsystemswhentheycontainexcessassets.Duringthisperiodthepensionsystem
investedheavilyintechnologystocks.52In2000,technologystockscomprised32percentofthepension
49TheHallInstituteofPublicPolicy,HistoryandFutureofNewJerseyPensions,p.3andTomBryan,TheNew
JerseyPensionSystem,p.337.AnnualCOLAbenefitshadbeenprovidedtoretireesandbeneficiariesbeginningin
1969onapayasyougobasis.ThestatehadbeenpayingthefullcostofhealthbenefitscoverageandPartB
Medicarepremiumsforitsqualifiedretireesandtheireligibledependentssince1972.In1987,theNJEA
successfullylobbiedforlegislationrequiringthestatetopayforteacherhealthbenefits.
50SeeTomBryan,TheNewJerseyPensionSystem,inHusteadandMitchell,p.343foradetaileddescriptionof
theeffectsofeachalterationtothepensionsystemandtocontributionsfortheperiodbetweenFY1994andFY
1998.
51EileenNorcrossandFredericSautet,InstitutionsMatter:CanNewJerseyReverseCourse?MercatusCenter
WorkingPaperNo.0930,July2009,p.22.
52In2000NewJerseysfivelargestinternationalcommonstockinvestmentswereconcentratedininformation
technology:Nokia(AB)Oy,Ericsson(LM)Tel.,Alcatel,VodafoneGroup,NortelNetworksCorp.SeeHistoryand
FutureofNewJerseyPensions,TheHallInstituteofPublicPolicy,p.5.
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planscommonstockallocations.53Theboominhightechstocksduringthelate1990scoupledwiththe
pensionbondgavethetemporaryappearanceofafullyfundedplan.
Onceexcessassetswereexhausted,thepensionquicklyreturnedtoitsunderfundedstatus.Pension
deferrals
also
weakened
the
system.
While
deferring
payments
provides
short
term
budgetary
relief
to
stateandlocalgovernments,italsocreatesafiscalillusion.Intheshortterm,governmentsadjusttheir
behavior,dedicatingrevenuesmeantforthepensionsystemtootherareas.Whenscheduled
contributionsresume,governmentsfindtheyareunabletopaythefullamountbecausetheyhave
adjustedtheirspendingbehaviorbytreatingtemporarypaymentreductionsaspermanent.This
necessitatesagradualphaseinoffullcontributions.
In2003,localgovernmentsgraduallybegantoincreasetheircontributionsatincrementsof20percenta
year
until
they
reached
100
percent
of
the
calculated
local
contribution
for
the
ARC
in
2008.
Phase
ins,
bycontinuingtodelayfullcontributionstothesystem,increasetheamountneededtofullyfundthe
pensionsystem.
Inadditiontodeferringtheemployerspayment,thestatereducedtheamountrequiredforemployees
tocontributetotheirretirement.InJanuary1998,theStateTreasurerreducedtheemployee
contributionrateintheTPAFplanfrom5%to4.5%through2001.Theratewasfurtherreducedto3%
untilDecember31,2003.InJanuary2004,theTPAFemployeecontributionratereturnedto5%.
53TheHallInstituteofPublicPolicy,HistoryandFutureofNewJerseyPensions,September2009,5,
http://www.hallnj.org/index.php/component/content/article/90publicpension/421pressreleasestructurla
changesinnjpensioninvestmentsystem?directory=216.
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InthePERSplantheemployeecontributionratewasreducedto3%fromJanuary1,2000throughJune
30,2004,atwhichtimeitrevertedbacktothe5%contributionforstatePERSemployees.The3%
employee
contribution
rate
remained
in
effect
for
local
PERS
employees
until
January
2005.
Deferredcontributionsandaccountingchangeswerecoupledwithaseriesofpensionenhancements.In
1999benefitswereextendedtosurvivingspouses,increasingliabilitiesby$500million.In2001several
billswerepassedthatincreasedbenefitsforcurrentandretiredemployeesby9.12percentbychanging
thepercentageusedtocalculatebenefits,effectivelyraisingthepercentageofaveragesalarybeing
replacedintheannualbenefit.54Thisactcoincidedwiththebustofthedotcombubbleleadingtoa
significantincreaseinthesizeoftheplansunfundedliabilities.
In2007,GovernorJonCorzinepromisedseriousrestructuringofthepensionsystem.Afewminor
changesweremade.ThePublicEmployeePensionandBenefitsReformActof2008increasedthe
54Chapter133,P.L.2001,S2450,http://www.state.nj.us/treasury/pensions/pdf/laws/c133pl01.pdf.
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retirementagefrom60to62,55andincomeeligibilityrequirementsforateacherspensionwere
increasedto$7,500.InMarch2009,thelegislatureapprovedthegovernorsproposaltoallow
municipalitiestodefer,forthenextyear,halfoftheirpaymentsintothepensionsystemtopreventan
increaseinpropertytaxes.
GovernorChrisChristiesignedlegislationonMarch22,2010toreducethesizeoftheunfundedliability.
Thesemeasuresincludecappingpaymentsforunusedsickdays,banningparttimeworkersfrom
receivingpensions,andrequiringgovernmentworkerstocontribute1.5percentoftheirsalariestoward
healthcare.Legislationalsoadjustedtheformulausedtocalculatebenefits,returningtothepre2001
formulawherebenefitsequalled1.7percentoffinalsalarytimesnumberofyearsofservice,versus1.8
percentoffinalsalaryintheTPAFandPERSplans.Also,membersoftheseplanswouldhavetheir
retirement
allowance
calculated
based
on
the
final
five
years
of
service,
instead
of
the
final
three.
However,thesechangestobenefitswouldapplyonlytonewlyhiredpublicemployees.Currentworkers,
eventhosewhorecentlyenteredthejobrolls,wouldbeabletocontinueunderthecurrentbenefit
formulafortherestoftheircareers.56
Thesemeasureswillhelpatthemarginsbutdolittleornothingtoaddressthesizeoftheliabilitythat
hasalreadybeenaccrued.Therateofaccrualofbenefitswillhavetobereducedfurther,andemployees
willhavetocontributemoretotheirplans.Thestatemustrecognizethataddingmoreworkerstoa
systemthat
is
underfunded
by
$173
billion
by
market
standards,
representing
over
40
percent
of
New
JerseysGDP,isnotatenableoption.
Recommendations
55Chapters92and103,P.L.2007andChapter89,P.L.2008changedtheenrollmentandretirementcriteriafor
PERSmembersenrolledatcertaindates,creatingmembershiptiers.Tier1members,thoseenrolledpriortoJuly1,
2007,andTier2members,thoseeligibletoenrollbetweenJuly1,2007andNovember1,2008,areeligiblefor
retirementat
age
60.
Tier
3members,
those
eligible
to
enroll
after
November
2,
2008
are
eligible
for
retirement
at
age62.
56Chapter1,P.L.2010,http://www.state.nj.us/treasury/pensions/newlaw10.shtml#chap1,also,
http://www.state.nj.us/treasury/pensions/epbam/exhibits/pdf/coltr0410chapter1perstpaf.pdf.
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1)ExtendtheDefinedContributionPlan.TheStateofNewJerseymadeadecisiontoofferaDCoption
tostateemployeesin1965whenitcreatedtheAlternativeBenefitPlan(ABP)foruniversityfacultyand
administrativestaff.TheABPisataxdeferred,definedcontributionsysteminwhichuniversity
employeescontribute5%oftheirbasesalarytoataxdeferredinvestmentaccount.Thisismatchedby
an8%employercontribution.57
Inthisplan,participantsarevestedafteroneyearofparticipationinthe
system.Asadefinedcontributionplan,itoffersworkforcemobilitytoemployeessinceretirementfunds
canbecarriedtoafutureemployerorrolledintoanIRA.
Thestatemovedfurthertowardthismodelin2007whenitcreatedtheDefinedContribution
RetirementProgram(DCRP).58TheDCRPprovidesmemberswithasupplementalretirementtothe
existingDBplans.TheDCRPisataxsheltereddefinedcontributionretirementbenefit.Eligibilitywasat
firstrestrictedtostateandlocalofficialsandemployeesofthePERSorTPAFsystemswhoearninexcess
ofthe
established
maximum
contribution
limits.
In
FY
2009/2010
this
maximum
wage
was
established
at
$106,800.Employeesearningabovethemaximumareautomaticallyenrolled(unlesstheywaive
participation.) In2008,eligibilitywasexpandedtothoseTPAFandPERSemployeeshiredafter
November2,2008whodonotearntheminimumannualsalaryof$7,700.59
Employeescontribute5.5%oftheirsalaryandthestatecontributes3%.Thefundsareinvestedinan
accountestablishedwithPrudentialFinancial,whichadministerstheDCRP.
2)Reducetheliability.Thestateshouldmovetoreducetherateofaccumulationofbenefitsfor
workersgoingforward.Thisincludesadjustingthesalaryreplacementfactorsusedtocalculatethefinal
benefit.Chapter1,P.L.2010changedtheformulatocalculatebenefitsintwoimportantways.First,
pensionbenefitsarenowequalto1/60thoffinalsalaryforeachyearofemployment(fromapriorvalue
of1/55th);second,finalsalarywasincreasedfromthehighestthreetothehighestfiveyearsofservices,
fornewhires.TheStateshouldconsidergoingfurtherthanthis;thesestandardsshouldbeappliedto
currentparticipants,andnotsimplyappliedtonewhires.
57TheemployeemayhavesomeoptioninchoosingamongauthorizedcarriersincludingAIGVALIC,AXAFinancial
(Equitable),TheHartford,INGLifeInsuranceandAnnuityCo,MetLifeandTIAACREF.
58Chapter92,P.L.2007andChapter103,P.L.2007,expandedinChapter89,P.L.2008.
59Seehttp://www.state.nj.us/treasury/pensions/epbam/exhibits/factsheets/fact82.pdf.
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Toreducethesizeoftheunfundedliability,thestateshouldconsiderreducingorfreezingcostofliving
adjustments(COLAs).Forinstance,a1percentagepointreductioninannualCOLAswouldreducethe
plansaccruedliabilitybyapproximately10percent.60
Alternately,
COLA
payments
could
be
limited
to
the
currently
projected
rate
of
1.8
percent
per
year,
basedontheformulawhereCOLAsareequalto60percentofthechangeintheConsumerPriceIndex.
Thiswouldlimitplanpayoutsinthecaseinflationweretoexceedprojectedrates.
3)TransitionnonvestedworkerstotheDCplan.Currently,thereare274,380workerswhoarenotyet
vestedintheirbenefits.Theseworkersshouldbeshiftedtothedefinedcontributionplan.Theswitch
willaccomplishtwoobjectives.Itwillguaranteenewworkerswithacurrentcontributiontotheir
retirement.Andinthelongrun,itwillreplacetheDBsystemwithonethatissustainablewhileshifting
risk
away
from
the
taxpayer
and
removing
the
moral
hazard
associated
with
the
states
management
andstewardshipofpublicworkerinvestments.Accordingtostateactuarialreports,between5and18percentofaccruedbenefitsarenotyetvested.61
ShiftingnonvestedemployeestoaDCplancouldreducetheseliabilities,evenifemployee
contributionstotheDBplanwerepartiallyorfullyrefunded.YoungeremployeesoftenpreferDCplans
overDBpensionsforreasonsofportability,soitmaybepossibletocometoanagreementwithcurrent
nonvestedemployees.Suchachangecouldsignificantlyreduceplanliabilitieswhilemorequickly
movingtoasustainablepensionfinancingmodel.
Thesestepswouldnotsignificantlyreducecurrentpensionliabilities.Accruedpensionbenefits,bethey
intheprivatesectororthepublicsector,arerarelyreducedtoanysignificantextent.However,shifting
employeestoadefinedcontributionsystemand/orreducingbenefitaccrualratesforemployeeswho
remaininthedefinedbenefitprogramswouldbetterinsurethatunfundedliabilitiesdonotcontinueto
growovertime.Whentheprogramsunfundedliabilitiesarecapped,thestatecanbetterplanhowto
60ThiscalculationisbasedonamodeloftheSocialSecuritypopulationandsocoulddiffersomewhatbasedonthe
characteristicsofpublicsectoremployeesandretirees.Thereductioninplanliabilitiesisroughlylinearandso
couldbescaledupordown.
61Thepercentagesare4.6percentforPERS,5.5percentforSPRS,12.5percentforJRS,and18percentforPERS.
NovalueisreportedforTPAF,thoughwecaninferthatitlieswithinthatrange.
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payoffthesedebtsovertime.Withoutreforms,though,itislikelythatunfundedpensionobligations
willcontinuetogrow,eventuallytoanunsustainablelevel.
Conclusion
Publicsector
pension
plans
around
the
country
face
significant
funding
shortfalls,
facilitated
by
accountingpracticesthatunderstatetrueliabilitiesandstateandlocalgovernmentsthatoftenfailedto
meettheirfinancialobligationsevenunderthesemorepermissiveaccountingstandards.When
measuredonamarketvaluationbasis,whichisrequiredofprivatesectorplansandwhicheconomists
universallybelievetobetheappropriatestandard,publicsectorpensionsnationwideareunderfunded
bymorethan$3trillion.Stateandlocalgovernmentsaroundthecountryfacemassivefiscal
consolidationsasthesebillscomedue.
NewJerseys
public
pensions
are
emblematic
of
pension
funding
problems
across
the
country.
Over
the
pasttwodecades,NewJerseysplansloosenedaccountingstandardsandincreasedinvestmentrisk
whilethegovernmentoftenfailedtomeetitsrequiredcontributions.Asaresult,NewJerseyplansare
underfundedbymorethan$100billiononamarketvaluationbasis.NewJerseyhasrecentlypassed
reformsthatwouldincreasefundingandreducebenefitsfornewlyhiredpublicemployees.Thesesteps
areusefulbutmustgomuchfurtherifapotentialfiscalcrisisistobeaverted.
WeoutlineseveralstepsNewJerseypolicymakersmayconsider.First,allnewlyhiredemployeesshould
beshifted
to
adefined
contribution
pension
model
based
upon
the
plan
already
offered
to
New
Jerseys
universityemployees.Adefinedcontributionmodelismoreattractivetotheyoung,mobileemployees
stategovernmentsseektoattractandprovidesaclearmeasureofthestatesfundingobligations.
Second,currentreformsloweringpensionreplacementratesshouldbecontinuedand,ifpossible,
extendedtocurrentemployees.Allvestedbenefitsshouldbehonored,buttherateatwhichfuture
benefitsareearnedshouldbereduced.Suchachangeiscommonplaceintheprivatesectorandthereis
noreasonpublicemployeesshouldbeexemptedfromsuchchanges.
Third,NewJerseypensionsshouldconsiderreductionsorfreezesinCOLApayments,whichcouldreduce
futurebenefitliabilitiesandspreadtheburdensofreformmoreevenlybetweentaxpayers,newlyhired
employeesandcurrentemployees,andretirees.
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Finally,currentemployeeswhoarenotyetvestedintheirbenefitsmightbeshiftedalongwithnewly
hiredemployeestoadefinedcontributionplan.ThisstepcouldproducesavingstoexistingDBplans
whilemovingmorequicklytoasustainablepensionmodelforpublicemployees.
Additionally,
New
Jersey's
pension
reports
contain
useful
and
detailed
information
on
plan
liabilities
and
thedistributionofbenefitsbyage,experience,andearnings.However,thesereportscanbeimproved,
inparticularbymakingpubliclyavailableamoredetailedanalysisoftheassumptionsinvolvedin
projectinginvestmentreturnsinthepensionassetsportfolio.Mostpublicpensionfinancialandactuarial
reportsmakeonlyacursoryefforttojustifytheirinvestmentreturnassumptions.Thisisparticularly
importantgiventhecrucialrolethediscountrateplaysinpublicpensionaccounting.
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Appendix1:PensionPlansintheStates
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Appendix2:CurrentFundingLevelsandContributionamountsinNewJerseysPensionPlans
TeachersPensionAnnuityFund(TPAF)
CurrentEmployees Participants TotalPayroll
ActiveMembers 157,109 $10,353,262,361TotalPensions
Annuitants 78,782 $2,849,806,472
ActuarialValue
ofAssets
(a)
ActuarialValue
ofLiabilities
(b)
MarketValueof
Liabilities(3.5%
discountrate)
(c)
ActuarialValueof
UnfundedLiability
(ab)
MarketValueof
UnfundedLiability
(ac)
Actuarial
Funded
Ratio
(a/b)
Market
Value
Funded
Ratio
(a/c)
$34,708,001,341 $53,418,328,576 $104,713,728,495 ($18,710,327,235) ($70,005,727,154) 65% 33%
MarketValueof
Assets
Accumulated
Contributions
NetAssets AnnualPayouts YearsLeftfor
assetstocover
benefits
payments
$24,973,886,910 ($8,516,171,922) $16,457,714,988 $2,842,667,672 5.8
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N.J.PoliceandFiremensRetirementSystem(PFRS)
CurrentEmployees
Participants
Total
Payroll
TotalActiveMembers 45,150 $3,747,580,414
TotalPensions
Annuitants 34,364 $1,482,924,846
ActuarialValue
ofAssets
(a)
ActuarialValue
ofLiabilities
(b)
MarketValueof
Liabilities(3.5%
discountrate)
(c)
ActuarialValue
ofUnfunded
Liability
(ab)
MarketValueof
Unfunded
Liability
(ac)
Actuarial
Funded
Ratio
(a/b)
Market
Value
Funded
Ratio
(a/c)
$22,937,837,757 $32,442,101,245 $63,555,697,190 (9,484,263,568) (40,617,859,433) 71% 36%
MarketValueof
Assets
Accumulated
Contributions
NetAssets AnnualPayouts YearsLeftfor
assetstocover
benefit
payments
PFRS
State
$1,742,699,083 ($365,634,110) $1,377,064,973 $159,495,927 8.6
PFRS
Local
$16,283,683,457 ($2,609,938,624) $13,673,744,833 $133,573,198 10.3
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N.J.PublicEmployeesRetirementSystem(PERS)
CurrentEmployees Participants TotalPayroll
ActiveMembers
316,849
$12,945,484,573
TotalPensions
Annuitants 150,523 $2,289,727,172
ActuarialValue
ofAssets
(a)
ActuarialValue
ofLiabilities
(b)
MarketValueof
Liabilities(3.5%
discountrate)
(c)
ActuarialValueof
UnfundedLiability
(ab)
MarketValueof
UnfundedLiability
(ac)
Actuarial
Funded
Ratio
(a/b)
Market
Value
Funded
Ratio
(a/c)
$28,879,176,416 $44,470,403,155 $87,173,482,327 ($15,591,226,739) ($58,294,305,911) 65% 33%
MarketValue
of
AssetsAccumulated
ContributionsNet
Assets
Annual
Payouts
Years
Left
for
assetstocover
benefitpayments
PERS
State$7,973,790,423 ($3,926,154,800) $4,047,635,623 $965,453,712 4.2
PERS
Local$13,395,099,723 ($5,869,939,115) $7,525,160,608 $1,308,332,821 5.75
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N.J.StatePoliceRetirementSystem(SPRS)
CurrentEmployees Participants TotalPayroll
TotalActiveMembers 3,016 $287,267,502
TotalPensions
Annuitants 2,585 $1,333,573,198
ActuarialValue
ofAssets
(a)
ActuarialValue
ofLiabilities
(b)
MarketValueof
Liabilities(3.5%
discountrate)
(c)
ActuarialValueof
UnfundedLiability
(ab)
MarketValueof
UnfundedLiability
(ac)
Actuarial
Funded
Ratio
(a/b)
Market
Value
Funded
Ratio
(a/c)
$2,067,242,877 $2,825,455,368 $5,538,623,073 ($758,212,691) ($3,471,380,196) 73% 37%
MarketValueof
Assets
Accumulated
Contributions
NetAssets AnnualPayouts YearsLeftfor
assetstocover
benefits
$1,564,180,409 ($178,485,658) $1,385,694,751 $133,573,198 10.3
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N.J.JudiciaryRetirementSystem(JRS)
CurrentEmployees Participants TotalPayroll
TotalActiveMembers 422 $70,133,372
TotalPensions
Annuitants 485 $38,566,144
ActuarialValue
ofAssets
(a)
ActuarialValue
ofLiabilities
(b)
MarketValueof
Liabilities(3.5%
discountrate)
(c)
ActuarialValueof
UnfundedLiability
(ab)
MarketValueof
UnfundedLiability
(ac)
Actuarial
Funded
Ratio
(a/b)
Market
Value
Funded
Ratio
(a/c)
$2,067,242,877 $2,825,455,368 $5,538,623,073 ($758,212,691) ($3,471,380,196) 73% 37%
MarketValueof
Assets
Accumulated
Benefits
NetAssets AnnualPayouts Yearsleftfor
assetstocover
benefits
$261,751,336 ($38,208,152) $223,543,184 $38,472,184, 5.8