Public pension funding could be in trouble due to the recession caused by the COVID-19 pandemic, which has put the squeeze on state and local governments. Now a new study on innovative funding strategies is offering ideas for managers during what could be a difficult time for public pensions.
Dan Doonan and Tyler Bond of the National Institute on Retirement Security looked at a number of innovative and "lesser-known" pension funding strategies that have been used in the public sector to address legacy costs and create more stable costs over time.
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Liability partitions as a public pension funding strategy
The first strategy involves developing separate funding strategies for legacy costs and ongoing plans. Doonan and Bond used Indiana's recovery strategy as an example for this strategy. Indiana was late to transition to prefunding, but the separation of the Teachers' Retirement Fund and the Public Employees' Retirement Fund before 2011 helped with this issue. Indiana now has a AAA credit rating from all three major ratings agencies, being one of just 13 states with that distinction. The state's public pensions are also well-funded compared to those of other states.
The funding strategy created a new tier for teachers hired after June 30, 1995. It used the same benefit formula as the other plan, but it created two funding strategies. One was for newly hired teachers, and the other was for those who would remain in the pay-go system that was previously enacted.
The new tier was prefunded from inception, so it created a fresh start for the pension system to move away from a funding strategy that was no longer working. Meanwhile, the plan continued to fund legacy costs on a pay-go basis. The pay-go tier is now only 25.7% funded, but it's no longer the main driver of the state's pension plans for teachers. Obligations in that tier are also reduced by benefit payments that have been made. The newer tier is well-funded, which wouldn't have happened without the partition between the old and new plans.
Utilizing side accounts
Donnan and Bond also looked at the use of side accounts to gain control over pension costs. The strategy addresses the problem that local governments have no control over their retirement systems, which are driven by decisions made at the state level.
Some statewide retirement systems have implemented side accounts to allow local governments more control over their plans. Side accounts enable governments to contribute more than the minimum amount into the plan and keep those extra contributions and the interest they earn to use as credits in future years.
This ensures that total contributions will always meet or exceed the minimum contributions even though the actual contribution for a particular year could be less than the required minimum contribution. Side accounts make sense because they allow governments to contribute more money when they have plenty of cash on hand in preparation for the lean times. Oregon, California, New York and Pennsylvania are some states that utilize side accounts.
Pension obligation bonds for funding
Doonan and Bond note that pension obligation bonds have been talked about quite a bit in the conversation about public pension funding. They explained that one of the benefits of these bonds is saving money over the long run, but there are other benefits, like having more clarity about the timing of costs. However, a big mistake can be made with pension bonds.
They point out that the term of pension bonds plays a major role in the likelihood that returns will exceed borrowing costs. Doonan and Bond note that stock market returns over five or 10 years are highly volatile and may be in the negative, but returns over 20 or 30 years are less volatile and always positive.
They explain that longer-term pension bonds reduce the chance that the equity risk premium will be lost due to poor timing. To add timing diversification, thus reducing this risk even further, Doonan and Bond suggest issuing a series of smaller pension bonds over years rather than in a large one-time issuance. Another strategy is to invest the proceeds from a larger bond issuance over several years instead of all at once.
Contribution collars and withdrawal liability
Doonan and Bond also looked at Maine's Public Employee Retirement System, which made several changes in recent years. One of the concerns was that local governments could leave the pension plan without paying for their portion of unfunded liabilities, which could cause problems for sustainability. Legal protections for workers were also much weaker than those in other states.
The two public pension funding reforms Doonan and Bond focused on were the addition of a withdrawal liability policy and changes to how contributions are set in the future. The state legislature required local governments to make withdrawal liability payments if they decide to leave the pension system.
The reforms also set contribution floors and limits for employees and local governments participating in the pension plans.
Dedicated revenues for public pension funding
Finally, Doonan and Bond discussed the practice of dedicating certain revenue to states' pension plans to strengthen them. They said the feasibility of dedicating revenues will vary from state to state, but it is worth investigating for jurisdictions that have severe challenges in public pension funding.
They point out that a number of cities and states have dedicated revenue from certain types of legalized betting and gambling to fund their pension contributions. For example, Kentucky House Bill 137 introduced this year in the state legislature would legalize sports betting and dedicate 95% of the revenues to paying down the state's unfunded pension liabilities. The bill wasn't passed during the 2020 session, but it may be introduced again because several lawmakers and the governor have indicated support for using sports betting revenue to fund pension contributions.
Oregon Senate Bill 1049 dedicated sports betting revenue to fund contributions to the Oregon Public Employees Retirement System. Illinois also passed a bill that would allow more casinos and legalize sports betting. Several other states have also dedicated certain revenues to pension contributions.
Doonan and Bond note that most public pension plans are well-funded and sustainable, but some are up against very serious funding challenges. Next year could bring problems for all public pension funds due to unprecedented tax revenue shortfalls by state and local governments. Thus, now seems like a good time to review some potential changes to public pension funding strategies. To read more on these public pension funding strategies, you can check out the full study here.