"New normal" retirement plan designs: re-engineering and installing sustainable pension and OPEB plans.

• Author: Miller, Girard
• Position: Cover story

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The national economic malaise and the 2007-2009 bear market in stocks have combined with a decade of mistaken optimism to create the "perfect storm" in public-sector retirement finances. Some public officials who once thought their benefits plans were affordable are now imposing layoffs, salary freezes, service reductions, and furloughs to maintain those plans.

A number of employers with pension plans that were flush during the Internet bubble years of 1998-1999 awarded unsustainable, irreversible benefits increases to employees on the mistaken presumption that the financial markets would deliver double-digit returns forever. Instead, the absolute returns on many public pension portfolios in the past decade approached zero, falling far below their actuarial assumptions. Meanwhile, a decade of procrastination in the funding of retiree medical benefits (now known as OPEB, for "other postemployment benefits") has left many state and local governments with no money saved to meet their rapidly rising retirement benefits payments--which are likely to double or triple in the coming decade.

Finance officials and the municipal bond community might have less cause for concern if the U.S. economy were expected to rebound sharply from its deep recessionary troughs and generate resurgent taxes and revenues that would enable governments to make higher retirement plan contributions--steeply higher, in some cases. Likewise, the pension funding problem might be manageable it depressed stock markets were to recover quickly to the 2007 peak levels and restore pension plans from their current 65 percent funding levels to the 85 percent average that prevailed then. Yet few economists hold out much hope for a simultaneous V-shaped recovery in tax revenues and financial markets. From their recent bottom, stock markets have already rallied back to their 83-year long-term average returns of 10 percent compounded, so the historical averages suggest that they are fairly valued, not undervalued. Hence, a reflexive return to 2007 bubble levels is implausible.

THE NEW NORMAL VERSUS THE OLD INERTIA

Looking ahead, the property tax revenue base of most municipalities is unlikely to return to peak market levels any time soon. Without the easy credit once available from home equity loans and mortgage refinancing, domestic consumption is unlikely to generate sales tax revenues at 2007 levels for several years. With national unemployment figures near double digits and investors' portfolios suffering deeply embedded losses that preclude capital gains tax revenues for years to come, the income tax revenues of public employers are also unlikely to provide sufficient funding to meet the mounting bills for retirement plans.

Throughout the past year, many public finance officials have operated in emergency mode, making budget cuts and deferring expenses where possible just to avoid deeper deficits. In some cases, these retrenchment efforts have included early retirement incentives, which shifted employees from the payroll and onto pension rolls and thereby raised the unfunded liabilities of the pension funds. Layoffs have reduced the salary base, which, ironically, increases the required pension contribution rates. In some jurisdictions, elected officials have opted for pension contribution holidays, failing to make timely annual payments to retirement plans as actuarially required. For retiree medical benefits, the vast majority of state and local governments have continued to pay as they go rather than prefunding an OPEB trust on actuarial principles. The logic has been that the OPEB funding problem is 25 years old, so it can wait another year or two--even though procrastinating simply makes the liabilities mushroom.

THE LEADERSHIP VOID

The problem of zero-funded OPEB plans is often ignored. Pension plan officials usually focus exclusively on their immediate fiduciary responsibility to the pension plan, as they have been instructed by their attorneys. Many elected officials suffer from policy myopia, a condition that limits their vision to their term in office. Union leaders typically slough off the responsibility for severely underfunded retirement plans as management's fault and the taxpayer's problem. Nobody seems willing to assume responsibility for addressing the entire scope of their organization's retirement problems. The situation requires prompt action, however, to avoid burdening the next generation of workers and taxpayers with a legacy of overlapping pension and OPEB debt as Baby Boomers approach retirement. It is finance officers, who deal regularly with longer-term financial forecasts, debt repayment schedules, and capital improvement plans, who can best address the big picture.

According to an old adage, when you're up to your "ears" in alligators, you don't have time to drain the swamp. That's exactly where the public finance profession stands today with regard to retirement benefits plan sustainability Many jurisdictions know they have a problem, but few have the time to focus properly on finding solutions and implementing them. But there are ways to achieve sustainable financing of retirement plans in the new normal world of post-malaise public finance. Key milestones along the way include:

* Identifying all the key metrics

* Forming a multidisciplinary team

* Doing a sustainability assessment

* Creating a strategic map for benefits redesign

* Conducting labor negotiations

* Implementing the strategy

SUSTAINABILITY METRICS

In the simplest terms, the sustainability of a retirement plan depends on the capacity and willingness of the employer to make actuarially required contributions on a consistent, ongoing basis. This requires two sets of metrics: the actuarial projections of annual required contributions (ARC) and the revenue and fiscal capacity of the plan sponsor (the employer). Quite often, this information resides in separate offices.

The actuarial projections for many pension plans are undergoing major revisions because of the dramatic investment losses in 2008. Many public retirement systems employ actuarial smoothing, averaging investment gains and losses over several years (often five) in order to avoid dramatic fluctuations in employer contribution rates over short-term business cycles. For many employers in today's unprecedented capital markets situation, this also means that next year's ARC will understate the ARCs that will be required in subsequent years, once the delayed effects of smoothing work their way through the system. Unless financial markets rebound to prior levels quickly and unexpectedly, a smoothing process camouflages the ultimate long-term costs when a recession is deeper and longer than a normal business cycle. The financial officer must look three to five years into the future and ask what is the likely trend and level of future required employer contributions. In the state of New York, for example, the controller recently projected that employer contributions will triple to...