A proposed set of “sustainability fixes” that just came out for the state’s biggest public employee pension plans should go a long way toward reducing the unfunded liabilities of the plans.
The maneuvers should take the funding level up to 100 percent or more of liabilities for the biggest plans by 2045 or so, according to a joint presentation of the proposals by the plans.
It could work out that well. There’s at least a chance — if everything goes exactly right in plans that depend, in part, on the investment markets.
Of course there is always risk. A summer hailstorm could flatten the vegetable patch at any time, but why be pessimistic? Well, if pessimism means enough food gets set aside to still get through the winter, that seems to be a sensible way to farm.
To understand the risk in the state’s public employee pension plans you need to start with two numbers, or maybe just one, because it’s the same number: 8 percent.
That’s the expected rate of return on the money invested to pay pension liabilities down the road, and it’s also the number used to discount future payments to arrive at how much needs to be set aside.
While it might seem to make sense to have them be the same, with the nice sound of symmetry, that’s not the way it’s done in the private sector. General Mills still has pension plans, and its expected rate of return last year was 8.5 percent.
To arrive at an estimated pension liability, on the other hand, it used a weighted average discount rate of 4.38 percent. Something like 8 percent simply won’t be allowed by the accounting rules.
Discount rates admittedly seem exotic, and it’s probably true that most Minnesotans should be able to live a happy life without ever needing to use one. On the other hand, they are only a tool to get some precision around a common sense idea: that it’s far better pay a debt a year from now than it is to pull a dollar from your pocket now.
Pension plan administrators have to pay lots of dollars, every month and for years. It would be a good thing to know right now how big that future liability is. A discount rate is one tool to determine that.
Here is how they work:
I might settle a $1,000 debt today for $800 if the borrower is my old graduate school classmate Lars, who never seemed to pay a bill on time. On the other hand, if U.S. Bank owes me $1,000 next year, I wouldn’t take less than $970 now.
That’s the discount rate in action. Low-risk U.S. Bank gets one of 3 percent. High-risk Lars gets 20 percent. The lower the risk, the lower the discount rate should be.
This simple example was only for a payment one year out, but different discount rate assumptions can swing the value a lot when you have payments that have to be made over decades, like in a pension fund.
One of the disclosures in the pension plan reports for the last fiscal year shows how the liability changes with a change in the assumed discount rate. In one of the plans, taking it down one percentage point boosts the liability from $23.8 billion to $26.7 billion.
Of course, even then the discount rate wouldn’t be within shouting distance of what’s required of corporate plan administrators, with discount rates closer to 4 percent.
Again, a discount rate tries to capture uncertainty. The only way to justify a discount rate as high as 8 percent would be if there were genuine questions whether these payments would be made at all or how much they would be. That’s just simply not the case here. They have to be paid.
The good news for the plans is that the State Board of Investment has invested the pension money well, with returns of not quite 8 percent over the last 10 years.
But over that same period, the unfunded actuarial liability, the cumulative hole in Minnesota’s public employee plans, grew by about $9.6 billion to $16 billon. That’s according to an analysis just put together by the Minnesota Center for Fiscal Excellence (MCFE), a nonpartisan group in St. Paul that digs deep into government finance.
Some of the items identified by the MCFE actually improved the situation, including previous pension plan fixes adopted by the legislature. But the big factor is a shortfall in investment income.
Part of the explanation, MCFE executive director Mark Haveman said, goes back to this discount rate issue. If you persistently underestimate how much money to set aside, money that should have been compounding in earning assets wouldn’t have gotten collected in the first place.
“When you discount that high, you are basically building in a policy of chronic pension underfunding,” Haveman said, and by his count it’s 12 years in a row.
Haveman said last week that he wonders whether it’s time to rethink the whole structure of the public employee pension system. Maybe hybrid plans are the way to go, he said, combining some features of the employee contribution plans like 401(k) with the guaranteed income of a pension plan.
Maybe policymakers could debate that, said Commissioner Myron Frans of Minnesota Management & Budget, the state’s finance office. But his job, along with that of the plan administrators, it’s to “manage these as best we can do given that they are what they are.”
He described that approach of getting to 100 percent funding, including the changes proposed for this year, as “methodical.”
He said he understands that the discount rate for estimating future liability could be adjusted, but he sure doesn’t think it should be done abruptly. That would only make employees, retirees and the state’s bond holders nervous about the health of a system that’s actually sound.
Frans has a point. To criticize the way the state manages its public employee pension plans does almost seem unfair. Minnesota is a beacon of responsible government compared with how so many other states have mismanaged their public employee plans.
In Illinois, New Jersey and other states, the pension crisis has arrived. In Minnesota, the problem is only chronic.
Haveman wasn’t impressed. As he put it, “why would you want to benchmark your health against the health of people who have already been put in intensive care?”