State's public pensions: A worse-case scenario

'You've got to be very careful if you don't know where you're going," Yogi Berra once famously said. "Because you might not get there."

Berra's characteristically unique advice is worth keeping in mind for anyone addressing the issue of public pensions.

Lots of uncertainty, to say the least, comes into play in guaranteeing lifetime retirement incomes for hundreds of thousands of Minnesota public employees -- past, present and future. And wherever we do arrive in this effort will have profound implications for government employees and taxpayers, and for the future of public services in our state.

According to the latest data on the condition of Minnesota's public pension funds, the bleeding has stopped but there is still considerable work to do.

As of last summer, the three major statewide pension plans that provide pensions for the bulk of Minnesota's public employees -- the Minnesota State Retirement System for state workers, the Public Employees Retirement Association for local workers and the Teachers Retirement Association for teachers -- were, altogether, $10.5 billion short of meeting their long-term obligations.

Put another way, for every dollar of pension benefits these three plans have promised to pay in the years ahead, they currently have about 79 cents of assets. If specialty plans for public-safety retirees are included, the shortfall increases to $12 billion.

However, these figures -- and pension reporting generally -- convey a misleading sense of precision about where we stand and about how sustainable these plans are. Accounting practices have a lot to do with this, since they dramatically influence how healthy pension plans appear to be on paper.

Pension funds use the investment returns they expect to earn as the discount rate on their liabilities. It's a practice found nowhere else, only in the world of pension finance.

Minnesota's discount rate is based on the assumption that investment portfolios will earn 8.5 percent annually, on average, forever. It's the highest assumed return in the nation according to a national survey by the National Association of State Retirement Administrators.

According to the survey, the most frequent return assumption used by public plans around the country is 8 percent, and more than a third of the plans use even lower rates.

If Minnesota's pension plans assumed "just" an 8 percent return on their investments over the "forever" timeline, the biggest three statewide pension plans would immediately report an additional $2.9 billion in unfunded pension liabilities.

Another source of accounting distortion is the time period pension plans have to restore themselves to full funding. Public pensions are unique in that legislators can simply choose to extend this time period -- like extending the time to pay off a loan -- if meeting the existing deadline for tackling unfunded pension liabilities is too costly.

A new 30-year payoff period was an important part of a sustainability fix for the state employee plan, enacted as part of a broader pension bill in 2010. One smaller local plan, for teachers in St. Paul, receives a new 25-year payoff period each and every year.

In response to concerns that such practices distort the financial condition of pension plans and shift the cost of current obligations to future taxpayers, the Government Accounting Standards Board has developed new accounting and reporting standards for public pensions. Their adoption, expected later this year, is already causing major tremors here and in state capitols around the country.

A recent study by the Boston College Center for Retirement Research concluded that, had these changes been in place in 2010, public plans nationally would have reported having just 53 cents for each dollar of pension liability, instead of the 77 cents they actually reported.

But even these accounting disputes can distract from the root cause of uncertainty -- the unpredictability of the future. The real cost of running a sustainable defined-benefit pension plan depends on many things government simply cannot predict or control.

Chief among these is future investment performance. Many are quick to note the state's impressive long-term performance on its pension investments: an annual average return of 9.7 percent over the past 30 years. But, as the advertisements say, past performance is no guarantee of future results.

Failure to meet investment returns means contributions must be increased -- more money must be paid in by employees, by governments, or both. Legislators deserve credit for requiring additional employee and employer contributions as part of the 2010 legislation to repair Minnesota's public pensions.

However, according to testimony before the state's pension commission, these new higher contribution levels -- and those scheduled to go into effect over the next several years -- are still not enough to keep the pension plans from falling even further behind if the average 8.5 percent return fails to materialize.

While public pensions lack certainty, there's no shortage of risk. Risk to public services, when pensions need more government resources. Risk to future taxpayers, as courts have consistently ruled that benefits promised under these plans must be paid. Risk to current public employees, as higher contributions eat into take-home pay even as the long-term sustainability of today's benefit levels becomes more doubtful.

Pension reform should seek to reduce these risks while ensuring a quality retirement plan for public employees. Calls for reform should not be based on envy or hostility toward dedicated public employees. They should be rooted in principles of sustainability, sound risk management and good government.

What are the building blocks of reform? Here are three key elements:

An assessment of what adequate retirement security actually looks like. In combination with Social Security, Minnesota's public pensions are designed to replace 85 percent to 90 percent of the income career public employees make during peak earning years. A strong case can be made that this policy seeks not retirement security and dignity but a taxpayer-guaranteed preservation of preretirement lifestyles. Pension policy ought to be more strongly linked to senior spending needs.

A serious investigation into hybrid plans. It's been said there is no such thing as an unaffordable defined benefit plan, only unaffordable promises. A "hybrid" pension plan combines a defined-benefit plan -- with a more modest guaranteed lifetime benefit -- together with a now more familiar defined-contribution plan, in which an employer contributes to participants' retirement accounts. There are many different approaches to choose from, but all have the benefit of reducing taxpayer risk and long-term funding costs. Importantly, hybrids offer this potential without incurring the budget-crippling costs associated with closing a defined-benefit plan altogether.

Pension reform can take many forms, but the journey begins by viewing the topic through the broad lens of the public interest rather than the narrow lens of retirement interests. Reducing taxpayer risk and avoiding harm to governments' operating budgets and their delivery of public services are legitimate goals in designing a retirement system that truly works for everyone.

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