Michael Starn, Editor

(from Maine Townsman, December 2009)
By Michael Starn, Editor

Most state and local government public pension systems have an unfunded actuarial accrued liability (UAL). In fact, most state and local government pension systems have a growing UAL that has worsened in the past two years due primarily to the poor return on pension fund investments.

The good news is that the Participating Local Districts (PLDs) component of the Maine retirement system is a fully-funded benefit program, with no UAL.

The bad news is that the state employees and teacher programs of the retirement system are underfunded and state legislators will have to find money to fill the gap.

Maine’s UAL for the state worker/teacher retirement system, including future state pension and health insurance liabilities, is about $6.3 billion, according to State Senator (and Republican gubernatorial candidate) Peter Mills.

Maine’s UAL has created a financial conundrum for the upcoming legislative session, and more so, for the legislative session that begins in January, 2011.

State constitutional amendments passed by the State Legislature and Maine voters in the mid-1990s will not allow the state legislature to ignore this UAL issue. Those constitutional provisions require that Maine fully fund its retirement benefits for state employees and teachers by 2028 (more on this issue later).

The State’s UAL payment for teachers and state employees is about $223 million for FY 11, according to MainePERS (Maine Public Employees Retirement System). Some state officials are predicting that this number could double in the following fiscal year.

What is a UAL?

The MainePERS website defines “actuarial accrued liability” as: “the present value of the estimated cost of benefits payable to active and retired members covering service rendered prior to the date of an actuarial valuation as determined by use of assumptions about the future and an actuarial cost method”. The “unfunded” element of this definition is the extent to which the accrued liability exceeds the assets of the system.

A more simplistic definition of UAL might read, “the degree to which the estimated liabilities exceed the estimated assets of a retirement benefit program”. In other words, a UAL is the difference between what a pension or health insurance plan promises to pay and what funds (or assets) have been set aside to fulfill those promises. Of course, those assets will be invested and expected to grow. Liabilities will also change based on the demographics of the retiree population (including any benefit changes). So, a UAL is a moving target, but one that the State is constitutionally-required to fund.

State Budget Implications

According to information provided by MainePERS, as of June 30, 2009 the Maine retirement system’s one-year investment return was down 18.5 percent. Other information from MainePERS reveals that the UAL for the Maine retirement system increased by almost $1 billion between June 30, 2008 and June 30, 2009 (a 31.6% jump). In round numbers, the UAL (for pensions) went from $3 billion to $4 billion [the higher the number, the bigger the problem!].

Every two years, MainePERS does a Valuation Report on the funding needed to pay the current benefits of retirees and reduce the UAL. This Valuation Report, done by an actuary for MainePERS, provides a budgetary number that the state legislature must incorporate into its biennial budget. The Valuation Report that impacts the state’s FY 12-13 budget is to be available on June 30, 2010. This state budget begins on July 1, 2011 and will be deliberated and ultimately adopted during the First Session of the 125th State Legislature. [Actually, the “Valuation” is done annually, but has budgetary implications only in the year that the biennial budget is adopted]

According to information provided by Kathy Morin of MainePERS (see Table on page 27), the state’s UAL payment for state employees was $75,050,000 for FY 10 and $78,614,875 for FY 11; for teachers the UAL was $130,735,107 for FY 10 and $136,945,025 for FY 11.

Senator Peter Mills says that given current stock market conditions, the UAL for pensions could nearly double for the FY 12 state budget. “This is a huge budget issue on top of everything else,” says Senator Mills.

Paying Off the UAL

Maine is one of the few states that has constitutionally-required amortization of its unfunded pension liability, says Kathy Morin of MainePERS.

The constitutional mandate is found in Article IX – General Provisions, Section 18 (see sidebar on page 26). The amendments (A & B) to Section 18 were enacted in the November election of 1995. Over 70% of Maine voters supported the amendments.

It seems probable that the supporters of the constitutional changes envisioned a 30-year straight-line amortization of the UAL as it existed on June 30, 1996. In some of the early years of the UAL pay down, the state was contributing extra monies to the effort, reducing the expected timeframe for the amortization. The recession and state budgetary problems that arose in the early 2000s put an end to that practice.

Karl Turner, who was in the state legislature from 2001-2008, says the methodology used in addressing the UAL payments was “very rational” at the beginning. He says that the “extra payments” made by the state created a situation similar to when a homeowner with a 30-year mortgage pays additional toward the principal shortening the life of the loan.

At one point, Turner says, the UAL was down to a 17-year pay off. But, responding to state budget shortfalls, the legislature decided to re-amortize the UAL payments back to the constitutional 31-year plan (ending in 2028).

MainePERS’s Kathy Morin says the state’s UAL payments are stretched as far as they can get. The bad economy has created a serious UAL funding problem, but the state legislature has no choice but to continue making payments.

The only way around the constitutional mandate is to change the constitution and that would require a 2/3 vote of the state legislature followed by an affirmative statewide referendum vote.

Investments and Cost Savings

Another way of reducing the UAL is through more investment income or cost savings on the benefits side, but these alternatives are challenging as well.

The UAL is a fluid number. It is affected by investment return and the changing demographic data on the retiree population.

The annual state government payment to the retirement system is based on the aforementioned Valuation Report. This valuation considers all actuarial information related to the retiree population – an accounting of what those retirees will receive in benefits for the two-year state budget period. On top of this “normal costs” calculation, the actuary adds in the UAL amortization payment and the “experience losses” that according to the constitution must be retired over a 10-year period. Under the current pension system structure, there appears to be very little wiggle room with the “normal costs” calculation and the UAL amortization.

The asset side of the equation is impacted by the return on investment. The entire retirement system has a current investment portfolio of about $9.3 billion. When the investment market is hot, the assets increase substantially; when the market is down, those assets decline. The UAL is inversely tied to the investment return (the greater the return, the lower the UAL, and vice versa).

Return on investment assumptions are built into the Valuation Report and projections of the UAL. The current rate of return assumption for the retirement system investments is 7.75%. The long-term investment return for the retirement system (since January, 1977) has been 9.7% which is almost two percentage points over the “anticipated” return rate.

More recent investment returns are the problem. The one-year investment rate of return, as of June 30, 2009, was -18.5%, as previously noted. According to the MainePERS website, the three-year return rate was -1.0%; the five year return, 3.9%; and the 10-year rate of return, 3.7%.

The expenditure side of the equation, what retirees receive in benefits, also has some constitutional protections. The state constitution (Article IX, section 18) clearly states that funds put into the retirement system are to be used to pay the benefits of retirees.

While arguable that this does not guarantee a fixed benefit level, it does present a constitutional hurdle, along with the political hurdles that exist, for those who believe that benefit curtailments for current employees must be included in the discussions regarding UAL pay down. Nationally, most governmental pension reform proposals do not target current or retired employees. From an online article of the National Conference of State Legislature, Ron Snell, NCSL’s pensions and retirement expert, says that “it is very difficult or impossible to reduce pension benefit packages because of various constitutional and statutory guarantees and judicial decisions. Once granted, a pension is a contractual obligation of the employer.”

The situation is clearly a quandary for state legislators, who, on one hand, want to honor “benefit promises” made to current retirees and employees, and, on the other hand, must fulfill the “constitutional promise” made to the Maine people to pay down the UAL.

During the last session of the Maine Legislature, LD 1431 was enacted and it creates a task force that is looking at retirement benefits for “new” state employees and teachers who join the retirement system after January 1, 2011. That task force has been asked to design a unified health and retirement plan that coordinates with or includes Social Security benefits for only state workers and teachers. The task force is supposed to have its report ready by March 1, 2010.

Artile IX, Maine State Constitution

The National UAL Problem

Retirement benefit programs are of two types: defined benefit plans and defined contribution plans (see “The Changing Face of Retirement Benefits”, February 2007 issue of Maine Townsman).

A defined benefit plan is the traditional pension system where the employer agrees to provide a fixed benefit to its retirees for as long as they live. The employee often, but not always, contributes to this plan. The obligation to pay the agreed upon benefit rests with the employer.

The defined contribution is a retirement plan where the employer and the employee jointly contribute to an account for the employee to access when he/she retires. The employer does not have any risk or make any promises regarding the performance of retirement funds after making the employer contribution. The UAL issue only applies to defined benefit plans.

In 2006, almost 80 percent of state and local government workers were covered by a retirement plan, and 80 percent of those employees had a defined benefit plan. The percentage of Maine local government workers covered by a defined benefit plan, according to the February ’07 Townsman article, is well below the national average coming in somewhere between 33 and 50 percent.

Nationwide, retirement plan assets for state and local governments were about $3.2 trillion in 2007. Since October of 2007, state pension funds have fluctuated significantly as investments markets have been very volatile.

Keith Brainhard, research director of the National Association of State Retirement Administrators, said in a recent online article that state/local retirement systems lost $800 billion in 2008.

According to the Center for Retirement Research at Boston College, a sampling of state and local retirement plans showed that they were 87 percent funded in 2007. By October 2008, if assets were valued at market, the ratio would have declined to 65 percent.

An online Washington Post article dated October 11, 2009, said that state/local retirement systems had lost $1 trillion on their investments. A Pricewaterhouse Coopers analysis, according to the article, has projected that in 15 years the state/local retirement systems would have less than half the funds needed to pay their pension benefit obligations.

All eyes were on California last year when a “Pension Prop 13” was proposed to amend the state constitution with a major overhaul of the state’s retirement benefit program.

The petitioners did not get enough signatures to get the proposal on the 2008 ballot, but many think with California’s current state budget chaos this issue might resurface in the near future.

The proposal would have amended the state constitution to:

• Preserve the basic structure of a defined pension benefit based upon the final salary and years of service of public employees.

• Cap benefits below present levels.

• Increase eligibility ages, except for public safety employees, to Social Security levels, and increase the eligibility age as it increases for Social Security.

• Take Social Security benefits into account when calculating state or local pension payments.

• Replace the current base of pension calculation—the last year of employment for some California public employees—with an average of the last five years.

• Exclude overtime, bonus and severance pay, as well as pay for unused vacation and sick leave, from the base for calculating pensions.

• Provide medical insurance only to people who reach full retirement age.

Advocates of this proposal said it would save California more than $500 billion over 30 years.

Stat Pension Costs for State Employee and Teacher Retirement Programs

Retiree Health Insurance

On top of the pension fund liabilities, the State of Maine also has unfunded liabilities for health insurance benefits. For state employees and retirees, the health insurance benefit paid by the state is 100% for the individual. For teachers, the benefit the state pays is 45% of individual coverage.

The cost to the state for retiree health insurance alarms some state leaders more than the UAL for the state pension system.

“It’s a ‘pay-as-you-go’ system, says Karl Turner. He realizes that many long-service state and local government employees won’t be eligible for Medicare and many of the current retirees are not Medicare eligible.

But, “it’s an ugly mess”, says Turner. He criticizes the legislature for letting people retire early with full health insurance benefits.

Changes to retiree health insurance benefits are not constrained by the state constitution, as with the pension benefits. Health benefit changes for retirees are affected by state employee labor contract negotiations. In fact, the state labor contracts do not distinguish between active and retired employees when it comes to health insurance benefits. What this means is that the state retiree gets the same health insurance benefit as the active state employee.

The UAL for the Health Plan differs from the pension system’s UAL. Because it is a “pay-as-you-go system”, there are no assets to compare with the liabilities. And, there is no mandated (statutory or constitutional) liability for the state.

The Governmental Accounting Standards Board (GASB) which provides financial reporting directives to state and local governments says there is a “unfunded liability” for state and local governments that provide health benefits to retirees. GASB 45 advises state and local governments to include actuarial post-employment benefits, specifically health insurance benefits, in their financial statements.

While not legally mandated, GASB pronouncements are used extensively by government auditors and financial bond rating agencies and are widely accepted as “best practices” in governmental accounting and financial reporting.

Conclusion

Although the UAL problems with the state retirement and health plan for state employees and teachers does not have a direct effect on municipalities, they are a ‘clear and present’ danger to the state budget. Unfortunately for municipalities, state budget problems have a way of turning into municipal budget problems.

Another former state legislator, Richard Woodbury, an economist by profession, says the “political system is very good at deferring obligations.”

Unfortunately for the politicians who run the system they seem to be out of sync with the electorate who voted overwhelmingly in 1995 for a constitutional amendment that forces the state to pay down its promised pension benefits. And, the highly-regarded Governmental Accounting Standards Board is telling state and local governments that they have to show their post-employment (retiree) benefit obligations in their financial reports.

Geoff Herman, director of State & Federal Relations at MMA, says, “An effort seems to have begun at the legislative level to orchestrate a shift in obligation from state government to local government to pay-off at least some of the enormous unfunded liabilities that have accrued at the state level. The local governments and the property taxpayers who support them should not be asked to pay-off outstanding liabilities associated with pension benefits local government did not design, promise, implement or have responsibility for financing. The accrued liabilities in the state retirement system is a Titanic we are not comfortable attaching our dinghy to.”