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When Will We See an
End to Contradictions
in Pension Funding?

L. Mason Neely
By L. Mason Neely
Chief Financial Officer
East Brunswick Township

Governors and legislators for years have cut off funds to the pension system thereby starving the pension system, while at the same time decrying the large unfunded liability which has resulted. Should they be able to cry, “There’s no money in the pension system!” and at the same time play the hand which created the financial crisis?

The concept of a Defined Benefit Pension Plan is recognized by Economics 101. A group pension can provide benefits at a lower cost than individual private 401(k) can offer. For this reason the State of New Jersey adopted the various pension systems. When those systems were adopted it was based upon the balanced assumption that 5 percent of salary contribution would come from the employees and the state or local government would be required to contribute 5 percent of salary. Had both parties contributed their portion each year the system would be fully funded and there would be adequate assets to meet the benefit structure defined by the system.

A pooled benefit system allows for enhanced investments, smoothing of longevity risk, optimal portfolio diversification and low administrative costs. These are simple economic realities. If followed, there would be no inadequacy with regards to current or future liabilities. However, the political powers under the gold dome in Trenton determined to manipulate the pension fundamentals. They called it “property tax relief” and today they say it is a crisis.

calculator, pen, glasses and Statement of Account

Changes to actuarial methodology were implemented in order to allow the state to lower their employer annual contribution. Changes were made to the interest rate assumption used to calculate plan liabilities. The Entry Age Normal method (EAN) was modified to use the less demanding actuarial assumption of Planned Unit Credit method (PUC). The amortization period for unfunded accrued liabilities was reset from 30 years to 40 years. This change must be questioned because other than police and fire officers, who are today retiring at the average of 49/50, there are no other system retirees where prior employees are generally living 30 years beyond retirement.

Other modifications were made to lower the COLA assumptions and reduce the average salary scale. All modifications were designed to reduce the employer contribution to various pension plans. These changed actuarial assumptions, coupled with the drastic financial year of 2008-2009 where $17 billion of assets were lost as a result of the equity and housing markets collapse, resulted in a major funding gap for all systems. Such changes in actuarial assumptions are still in existence today. Therefore when the actuaries prepare the annual valuation which is used by the Division of Pensions for billing purposes, the employer’s required contribution is significantly reduced. All employees currently pay 5.5 percent of salary as their contributions.

Beyond the fact the employer contribution was reduced, the state, for the past 13 years, has paid nothing or very little by way of state employers contribution to fund pension obligation. The net result is pension systems under direct state control are significantly underfunded. It becomes a self-fulfilling prophesy, because the false temporary gains equal higher long term costs. The act of making minimal payments in light of the actuarial modifications had a significant impact on pension unfunded liabilities.

Local Governments have not skipped paying their pension obligations. For the most part they have made payment which reflects the bills issued by the Division of Pensions based upon mandated state legislation. Assuming the valuation reports prepared by the actuaries are meritorious then the pension obligations for Local Governments are reflected in two pension systems. Those systems are the Police and Fire Retirements System (PFRS) and the Public Employees Retirement System (PERS). These systems were designed as balanced systems to provide normal funding, thereby guaranteeing adequate assets at the time of retirement. The pension systems, as designed, were 5 percent employer and 5 percent employee based on annual salary.

The following table shows how the systems have become skewed. Recognizing methodology changes which were made to the accounting process used by the actuaries show the balance plan is very much out of skew. The table (right) reports only the normal funding requirements. The requirement to support unfunded liabilities is not reported here. The normal funding of the system’s funding as reported by the actuarial consultant, ending the last fiscal year June 30, 2009 is in the table.

Chart 1

It only takes a quick viewing to see the planned “balance system” is significantly out of balance. The employer’s cost to fund the PFRS is more than three times greater than the original design of 5 percent. This is alarming because the enriched benefits which have been granted by the state Legislature, over the objections of local governments and the League of Municipalities, have caused this funding dilemma.

At the same time, the often criticized PERS, which was designed to be a balanced 5 percent/5 percent demonstrates particularly at the local government level, the employer is paying below the amount originally designed. This reflects the changes referred to earlier, changing the method of assumption have obtained the desired results, ie: lower contribution requirements by the employer. Does anyone really believe such manipulation, in the long run, results in property tax relief? No, it is called “kick the can down the road.”

The PERS and PFRS charts (right) demonstrate that local mayors have properly budgeted, based upon the bills received by the Division of Pensions. When contributions (employee and employer) are made it has resulted in the local PERS being funded at a 71.2 percent ratio. This occurred in spite of the fact the State Investment Council had negative PERS investment returns of multiple billions of dollars ($3,787,350,299) as a result of the downturn in the market in the prior year. The chart also reflects the PFRS investment loss of $2,735,834,440 by the Investment Council. The funding ratio for the local PFRS is at 72.85 percent. Local mayors and employees have not been starving the system through lack of funding.

The contradiction is frustrating. The public is told, on the one hand, to rely upon the actuarial valuations which are commissioned by the Division of Pensions to determine the solvency of the pension systems. But the public is also told by academic institutions that manipulation of the methodology renders such valuations meaningless when one looks at the “true unfunded obligations” confronting taxpayers.

The contradiction continues to be frustrating because representatives from the Governor’s office and state Legislature express a dire situation confronting the state budget as they continue to starve the pension system by not appropriating funds. Meanwhile both employer and employees at local governments are making their required contributions. The positive impact of making payments is shown in the above graphs. A frustrating part of this picture is the constant criticism by identifying local systems with those of the state which have a very much greater problem.

If followed, basic economic principles hold true. Local mayors, governing bodies and employees have honored their commitments. By doing such the local systems are more reasonably funded. At the same time there is no one who does not recognize a need for modifications to the PFRS system. The PFRS benefits are very rich and, on a proportional basis they cost property tax payers 7.5 times more per employee than it cost to fund PERS retirement benefits. The diversity between systems is a contradiction and a reasonable coherent approach by the Governor and Legislature is necessary.

It begins with binding arbitration change and flows through to modifications of retirement age and benefit design. This next year the PFRS will cost taxpayers $0.316 for every dollar of pay. Add to that Social Security, Medicare and other benefits and one can quickly see the need for a change in binding arbitration.

The actuarial methods used by New Jersey have been changed in order to modify or lower the employer’s liabilities. If one were to look at this on an empirical basis one would use Projected Value Benefits (PVB) and measure what is going to ultimately be owed at the time of retirement. Said actuarial changes resulted in the desire outcome, i.e.: lower contributions required by the employer. Can the state go on trying to fool the public or will they at last make changes?




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