The growing deficit in the public pension fund is a massive overhang on Oregon’s budget and its future.
Government employers – and ultimately taxpayers – will see their required contributions soar over the next six years, sucking some $12 billion out of public coffers to mostly pay for legacy costs tied to older members and retirees. That’s about double what the bill would be at current rates.
At least that’s the scenario if the pension fund’s investments perform as expected. If they don’t, the deficit and contributions could get even bigger.
As lawmakers meet this session to determine what can be done to reduce the Public Employee Retirement System’s funding deficit, there is misunderstanding and misinformation about the topic and options for dealing with it.
Here are some of the common myths around PERS, as well as some areas of debate.
The unfunded liability is $22 billion
That’s the official number as of December 2015, but it’s debatable. The actual figure depends on your assumption about future investment earnings. The higher the assumption, the lower the deficit, because it means PERS will need to sock away less money to meet its future obligations.
Right now, fund managers assume they’ll earn 7.5 percent a year. Historically, the system has crushed that. But not recently. It earned 6.9 percent last year but only 2.1 percent the year before. In the past decade, annual returns have averaged 5.5 percent. If PERS applied that 10-year figure, the pension fund’s deficit would be closer to $50 billion.
Many experts believe the PERS board is living in a fantasy land because of its current earnings assumption and because it has kept required contributions artificially low. Its own consultants say the current portfolio is unlikely to meet the 7.5 percent threshold in the next two decades. Meanwhile, the mammoth public pension system in California, CalPERS, just announced plans to lower its rate from 7.5 percent to 7 percent.
The PERS board will meet in July to consider a new earnings assumption. Its members have already signaled that the current rate is unrealistic and probably will be lowered.
“Can’t we rip the Band-aid off and deal with reality?” real estate investor Katy Durant said last fall, just before she stepped down from the Oregon Investment Council. “We keep stacking more and more on because we’re unwilling to deal with reality.”
The 2008 market crash caused this problem
The stock market crash exposed this iceberg, much like extraordinary investment returns in the 1990s and mid-2000s masked it. This is a structural problem, not an earnings problem. Consider this: Since 1970, PERS investment returns have averaged 10.3 percent.
The funding problem stems from outsize pensions granted under the system’s lucrative money match formula, and the failure of the PERS board to set contribution levels high enough to fund those pensions, PERS director Steve Rodeman told lawmakers at a hearing last week.
Randall Pozdena is an economist who served on the Oregon Investment Council, which manages the pension system’s investments. In the 1990s, he had a close-up view of the crisis in the making, a problem he attributes to the “heads-we-win, tails-you-lose arrangement” that lawmakers and the PERS board set up for public employees hired before 1996.
In 1975, legislators made a guarantee: The returns on employee accounts would match the pension system’s assumed earnings rate – no matter how the investments actually performed. At the time, the assumed rate was 7 percent, though it’s gone as high as 8 percent.
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Then, during the unprecedented stock market boom from 1979 to 1999, a PERS board that was stacked with public employees voted to credit most of the system’s excess earnings to member accounts. During that two-decade span, returns averaged 15 percent a year and the PERS board credited employee accounts 12 percent, on average.
At retirement, employers (and taxpayers) had to match those workers’ account balances, then pour the total into an annuity that uses the same generous interest rate of 7 to 8 percent. That’s far higher than an annuity in the private sector would pay out.
The resulting pensions far exceeded the legislature’s goal of replacing 50 percent of a worker’s final salary. Indeed, in 2000, the payout for career employees peaked at 100 percent of their final pay. That’s an average, which means some people collect far more in retirement than they did at work. The pensioners also are entitled to a 2 percent cost of living adjustment and social security benefits.
The 2003 reforms fixed the problem
The legislature managed to stop the bleeding by creating a less generous pension tier, redirecting employee contributions into accounts outside the pension system, and stopping overflow investment earnings from going into employee accounts. But that didn’t fix the problem.
Everything’s fine as long as the pension is 80 percent funded
This notion has been around for a while – that a pension system is financially sound if it has 80 cents in assets for every dollar in liabilities. It’s supposedly an industry standard. It’s not.
The only real standard for public pension funding, according to the American Academy of Actuaries, is that they be fully funded or have a plan to get there soon. That means employers are covering their retirement obligations as workers accrue them, not kicking the can down the road so current debts are paid by future generations.
Oregon’s system isn’t at 80 percent anyway; under existing earnings assumptions, it has 71 cents in assets for every $1 in liabilities. So it’s in danger of falling below a trigger point – 70 percent – that would force the system to increase required contributions to protect the system’s funded status. If investment returns aren’t strong in 2017, that’s a possibility in 2019.
The stock market will bail us out of the pension deficit
Don’t count on it, experts say.
“It’s ignorance and wishful thinking to say we can earn our way out of this,” Durant said. “It’s not possible.”
PERS already pays out far more in benefits than it takes in contributions each year. Contributions totaled about $1 billion last year, while benefits payments came to $4.5 billion. Imagine trying to earn your way out of a big loss in your 401(k) while using it to cover daily living expenses. Not a great strategy.
Durant said the way the PERS portfolio is set up doesn’t lend itself to a return to the big returns of the late ’90s, either. The need for diversification, both to reduce risk and maintain enough cash equivalents to pay ongoing benefits, means the fund has to invest in some assets that return almost nothing. Meanwhile, in today’s low interest rate environment, the pension fund’s bond portfolio, once a solid contributor to earnings, brings in very little. Finally, returns from its riskiest, swing-for-the-fences investments – private equity partnerships – have come down to earth due to increased competition in that sector.
We can refinance the pension debt
This is a strategy that crops up routinely and has been employed in the past with some success. Some believe public employers should issue more pension obligation bonds (they already have about $5.5 billion outstanding) and refinance the $22 billion deficit at the low interest rates currently available.
Though backers call it “refinancing,” what they have in mind is very different from a homeowner’s refi. In fact, it’s a speculative bet, as borrowed money would be deposited with PERS and invested alongside existing pension assets. If the returns don’t exceed the interest rate on the bonds, it’s a losing proposition.
OIC official: ‘This is becoming a moral issue’
Using a different technique, PERS could extend the period in which employers are required to pay off the deficit from the current 20-year rule to say, 30 years. Extending the repayment period would make the annual cost more manageable.
But that only delays the problem and adds risk. Because of the complicated economics of pensions, that extension would result in “negative amortization” for the first decade, with the pension deficit climbing, and no real reduction in it for 20 years. It’s like making the minimum payment on your credit card and watching the balance go up. In the end, it would increase the total cost by more than 40 percent.
The average PERS benefit is only $29,720 year
Though true, it’s not a very useful measure of the system’s generosity. That’s because it counts everyone who is vested in the system, whether they have 5 years of service or 35. Many retirees only work at a public job for a few years, then let their pensions ride with PERS while they seek employment elsewhere.
In 2015, the average annual PERS benefit for someone with 30 years of service, was $45,252.
Oregon’s retirement system has been downsized to the point that it’s really only a 401(k) program
The state retirement system is a hybrid that still provides employees with a defined benefit plan, a defined contribution plan and social security.
For those hired before August 2003, the defined benefit portion – the pension – was intended to provide career employees with half of their final salary, though it is typically more generous. For employees hired after August 2003, the target for career employees is 45 percent of final pay.
Employees also are required to contribute 6 percent of their earnings into a separate account that belongs to them and is invested alongside the pension fund assets. This is more like a 401(k), except that 70 percent of public employees historically have had this contribution paid by their employers. Few 401(k) plans have an employee’s entire contribution covered by the company.
In Oregon, public employers also pay into the social security system, so employees get that benefit too. This is not the case for public employees in many other states.
There are no reforms left that are both legal and economically significant
This is a mantra among Democratic leaders, frequently repeated by Gov. Kate Brown. But it’s questionable. The Oregon Supreme Court was quite specific when it rejected the legislature’s last round of public pension reforms in 2015. It said PERS can’t claw back benefits that have already been earned. But it can change benefits going forward.
There are several prospective changes that could bring significant savings, according to analyses from the system’s actuary, Milliman Inc. Though any change is likely to face legal challenge, state lawyers say some of those changes could pass muster.
Any changes in future benefits will bump up against complaints the state is trying to break a promise to public employees.
The other question, and one that lawmakers rarely debate in public, is whether it’s fair to reduce the compensation of current employees, most of whom already have lower pensions, to pay for the legacy costs of retirees and older active employees.
There is always the possibility of a tax increase to cover these extra costs. But voters decisively rejected a November ballot measure that would have raised corporate taxes by $3 billion a year.
-Ted Sickinger
tsickinger@oregonian.com
503-221-8505; @tedsickinger
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