News: CJ Exclusives

National Pension Study Questions State Funding Levels

Conservative returns estimated by N.C. still may overstate actual funding

RALEIGH – A new national study questions the adequacy of public pension funding, as Treasurer Janet Cowell’s office defends the way North Carolina is handling its obligation to pay for teachers’ and other state employees’ retirements.

The Pew Center on the States says unfunded liabilities in state pensions grew 26 percent in the most recent year data are available. The study highlights the challenge governments will have in keeping retirement promises to public workers, as many rely on a projected rate of return that may exceed realistic expectations. North Carolina’s rate is 7.25 percent, far exceeding real historic returns.

“Our assumed rate of return is conservative among public pension plans across the country,” a spokeswoman for Cowell said.

N.C. State University economics professor Robert Clark says that assumption is well within the guidelines established by the Governmental Accounting Standards Board. Most states assume returns of between 7 percent and 9 percent, he said, “In that regard, North Carolina is a little on the conservative side,” Clark said. “Which is good, but still, 7 percent is a lot higher than 4 percent.”

The 4 percent Clark referenced is approximately what Treasury bonds earn. The Pew study explains why such an expected rate of return would be a safer long-term assumption for states to make: “Some experts recommend that states employ a ‘riskless rate’ that might be analogous to a 30-year Treasury bond when valuing their pension liabilities, arguing that pension obligations are legally binding and guaranteed to recipients.” GASB may soon urge states to move toward something closer to a riskless rate.

Cowell agrees the pension obligations are like a contract, giving the state few options other than paying all the benefits it has promised. The contractual nature is a major reason it’s important for states to have an accurate accounting of their pension funds.

Pew released its study Monday, updating a larger study last year that identified a $1 trillion gap between the benefits states have promised workers and the money set aside to keep those promises. The update estimated that gap grew to $1.26 trillion by the end of fiscal year 2008-09. It’s the most recent data available for every state and includes both pension and health care benefits.

Pew noted that Cowell said the pension system was 97 percent funded at the end of the 2008-09 fiscal year.

Eileen Norcross, a pension expert at George Mason University, encourages states to use “riskless” return rates. She recommends pension systems tie their expected rates of return to something like the 15-year Treasury bond.

“It’s urgent to get the accounting right,” Norcross said. “There’s this idea if you sort of gloss it over, it will go away. The longer they fail to recognize it, the longer they fail to contribute accurately.”

The new Pew study showed how much changing to a riskless rate would affect states’ long-term balance sheets. “Based on the Treasury bond’s rate of 4.38 percent as of mid-March 2011, the states’ cumulative liability for pension benefits would grow to $4.6 trillion, with an unfunded liability of 2.4 percent,” the study said.

North Carolina’s retirement system is divided into several pension funds. The largest is the Teachers’ and State Employees’ Retirement System. TSERS’ assets were worth $72.4 billion as of December 31, 2010, according to Cowell.

At the time, Cowell also reported the pension fund’s investment performance. The one-year returns showed 11.61 percent growth, easily surpassing the 7.25 percent goal. Taking a longer look, however, the pension fund has missed the 7.25 percent goal regularly. The 10-year return was only 4.99 percent. It also lost 1.85 percent in its “alternatives” investment class over the 10-year window.

The pension fund’s 10-year performance is pretty close to the “riskless rate” Norcross and other experts recommend.
Even so, the treasurer’s spokeswoman points out, “As the boards evaluate a number of potential changes to the systems, a change to the assumed rate of return has been discussed, but no changes have been made.”

The TSERS Board of Trustees voted earlier this year not to lower the assumed rate of return because doing so would reveal the retirement systems to have a much lower funding rate, requiring the state to pony up substantially more cash to finance state employees’ retirements.

“If you lower the discount rate or assumed rate of return that would lower the funding ratio, and then the way they calculate the annual required contribution is to move back toward full funding,” NCSU’s Clark said. “It would, of course, make that number bigger.”

During a meeting earlier this year, the TSERS actuary presented the board with two options for reducing the expected rate of return — to 7 percent or 6.75 percent. Those rates of return would have shown TSERS to be about 90 percent or 85 percent funded, respectively, in fiscal year 2011-12. Changing the rates would also require the state to pay between $1 billion and $1.5 billion in fiscal year 2012-13 to balance the fund.

Fully funding the pension is not a statutory requirement, but the state is obligated to pay the benefits it has promised to retired teachers and state workers.

Using a more realistic rate of return would be costly at first, but Norcross says it’s imperative to correct mistakes instead of letting them get bigger.

“If they get the numbers right today, they’re going to make much better choices about how much money they actually need to set aside,” Norcross said. “Rather than say, ‘Hey, we’re going to go with this rosy scenario and worry about it tomorrow.”

For TSERS’ first 70 years, the state always paid its annual required contributions. Then the recession hit, and the General Assembly had committed far more in spending than it was willing to finance with taxes. For the first time last year, the state did not make 100 percent of its contribution to the pension.

The shortfall in the current budget is about $176 million, according to the treasurer’s office. The TSERS board voted not to recommend the General Assembly make up that shortfall this year. Instead, it recommended a $785 million contribution to the pension system — nearly $200 million lower than the shortfall plus interest, which the treasurer’s office says amounts to roughly $973 million.

The House Republican budget now being debated for 2011-12 would contribute $785 million. That’s more than the roughly $600 million Gov. Bev Perdue recommended in her budget proposal.

Anthony Greco is an associate editor of Carolina Journal.