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Public pension funds: a balancing act.

After a decade of double-digit investment returns, the state and local government retirement nest egg has grown to $800 billion in assets. This happy result has drawn attention to public plans and sparked a renewed interest in funding policy among government officials. Many elected officials, who must balance the needs of all taxpayers, are questioning the fiscal wisdom of current retirement system funding practices, among across the country hard choices must be made to compensate for falling revenues, increased pressure for services and a sluggish economy. Taxes have been raised, work forces reduced and programs slimmed down or eliminated. Public officials performing with the agility of high-wire performers and the tenacity of lion tamers have had to orchestrate budget decisions much like a ring master at a circus. And often in a similar atmosphere.

This "step-right-up" attitude, however, has government workers and retirees concerned over the safety of their retirement savings. Given the fact that public employees contribute between 3 and 10 percent of their salaries toward retirement, their concern is justified. Great strides have been made in improving public employee retirement systems' (PERS) funding levels since the 1970s. Indeed, "underfunding" was the most cited complaint about PERS until the 1980s, when a bull market and a serious commitment on the part of public employers to fund retirement benefits combined to substantially improve the funding of these plans. By 1988, as seen in Exhibit 1, PERS with more than $1 billion in assets could meet 83 percent of their future liabilities. Smaller plans, those with assets under $50 million, covered approximately 69 percent of their long-term obligations.


The concern is that PERS may fall victim to their economic success in an era when some public officials ask, "Why should our government continue to fund a retirement system when it has enough assets to meet its benefit obligation to current retirees and when there are so many competing needs?" In the view of public employees, there are four important reasons why: * continued funding of retirement systems

assures that resources will be available,

independent of revenue trends, to pay

future retirees' benefits; * it permits the fund to act as a buffer

against fluctuating political support; * it serves as a public acknowledgment to

both participants and taxpayers of the

financial obligations accruing that must

be paid in the future; and * current funding allocates the pension

costs of government employees to those

taxpayers who are the most immediate

beneficiaries of their services.

Raids of Sound Policy?

There have been a series of changes in the funding of state and local government pensions this fiscal year. Called raids by some and sound fiscal policy by others, these changes range from revising actuarial assumptions to withdrawing assets from the pension fund.

The most common change has been where employers, seeking to reduce contributions to the pension fund, adjust certain assumptions used in an actuarial funding method or change the method itself. By changing the (assumed) rate of investment return upward, by moving the rate of inflation downward or by some combination of these actions, funding requirements can be changed drastically. For example, the State of Rhode Island estimates that it saved $12 million in fiscal year 1990-91 by raising the assumed rate of investment earnings of its PERS from 7.5 percent to 8.0 percent. Interest rate assumptions have been raised recently in New York, Connecticut, Vermont, Louisiana, Missouri, Minnesota, and in numerous cities and counties.

A change in the funding method of the New York State and Local Employees Retirement System from one that requires level contributions over the career of an employee to one that increases the rate of funding over the employee's career completely eliminated the state's fiscal year 1991 $429 million contribution.

The savings from assumption changes are typically not shared with the employee. The perception is that such changes serve two purposes: to reduce current employer costs and to forestall pressure for benefit increases. Clearly, prudent practice in pension fund management requires regular review of the validity of assumptions. Prudent practice also has relied on historical investment returns as the basis for future expectations. Plan participants and the plans' administrators are concerned, however, that some changes being made now are premature. Remembering the market crash of October 1987, the lower investment returns of the 1970s and the economic downturn experienced in the first year of the decade, critics liken today's hasty assumption revisions to walking a tightrope without a safety net. On the other hand, these changes allow governments to realize current savings that can be used for other purposes. What is the long-term cost?

Obligations and Fairness

In the public sector, the employer, or in reality the taxpayer, is on the hook to pay the promised benefits to employees and retirees. This is because the vast majority of state and local government retirement systems - 93 percent - are defined benefit plans. Under this arrangement the employer is obligated to pay to vested employees a retirement benefit based on a number of factors. These include the retiree's salary in the year(s) before retirement, the number of years worked and an accrual factor for each year of service. These factors, applied in a formula, determine retirement benefits. If money has not been put aside to make these payments the taxpayers eventually will have to pay.

In most states and the majority of localities, employers are not permitted to reduce benefits to current employees. Plan sponsors also bear all the investment risk.

Integenerational fairness is one of the most compelling arguments for continual and consistent funding of pension obligations. Some contend that it is not fair to make one generation of taxpayers pay the pensions of workers who rendered services to a previous generation of taxpayers.

A look at the demographics of U.S. society underscores this point. Although much attention has been focused on the magnitude of the assets held by public funds - estimated to top $1 trillion by the year 2000 - less attention has been paid to the size of the obligation that these funds must support - the future retirement of an estimated 12.9 million active state and local government workers and 3.7 million current retirees. Both the number of plan participants and the number of retirees grew by one million over the past decade. Early in the next century, the number of new workers will be outstripped by the increase in retirees, leaving fewer workers to contribute to retirement funds while more employees join the ranks of the retired. That may be why pension funds are concerned about their "cash cow" image.

Agreements have been worked out between governments and pension funds to assist in times of fiscal crisis, while still earmarking PERS dollars for future retirement benefits. For example, as the City of Philadelphia struggled with a $129 million deficit early in 1991, the Pennsylvania teachers and city workers loaned the city $75 million to meet its January and March payrolls. The money has been paid back - with interest.

Pension funds are more often involved in combative situations. California lawmakers, faced with a $14.3 billion deficit in 1991, passed legislation sponsored by the governor to remove money from the California Public Employees Retirement System (CALPERS) to help close the budget gap. This withdrawal of $1.6 billion from a CALPERS account that funded cost-of-living increases for retirees clarified the issue for workers and retirees, many of whom likened the governor's actions to that of a corporate raider. This California State Employees Association has filed suit in state court to stop the transfer of funds. California officials defend their action as an effort to prevent laying off more than 22,000 state employees. The court will decide whose interests are to be protected.

Control of the assets is not the only controversy. Under this big top the action is in three rings: assets, assumputions and board composition. The new California law also would move the actuarial function from the CALPERS board to an actuary hired by the governor who would assume all fiduciary obligations pertaining to actuarial assumptions. Thus, this actuary would not only propose interest rates and other assumptions but also would decide solely on their adoption. There was also a move - which failed - to replace the existing 13-member board, six of whom are elected by the plan beneficiaries, with a nine-member board, five of whom would be appointed by the governor.

Continuing Tensions

Governments are continuing to wrestle with budget gaps and the downturn of the economy, layered on top of massive reductions in federal aid to states and localities since 1980. The fiscal picture continues to look bleak, and this can only result in more tension between retirement systems and the employers that sponsor them.

This brewing controversy has not been missed by federal policy makers. "The proposals before the (California) legislature, if implemented, would mirror the actions of corporate pension plan raiders who divert the retirement savings of workers and retirees and leave them with empty promises," said Congressman Edward Roybal (D-CA), chairman of the House Select Committee on Aging. The proposals were passed in California, and Congress can be expected to hold hearings on this recent round of public retirement system funding battles. It may not stop there. Legislation that would restrict the use of pension assets to exclusively providing benefits to and being invested for the sole interest of the plan participants could show up early next year.

The greatest show in state and local government, the balancing of needs, continues. Thoughtful review of pension funding is an important part of finding common budgetary ground. Competition for funds is not going to disappear. Indeed, management guru Peter Drucker has told the Los Angeles Times that pension funds are going to be the hottest subject of the next 10 years. A fresh start, however, that would include discussions among workers, retirees, elected representatives and pension administrators would lead to a better understanding of the issues and solution.

Author Cathie Eitelberg is the director of GFOA's Pension & Benefits Program.
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Author:Eitelberg, Cathie
Publication:Government Finance Review
Date:Dec 1, 1991
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