PUBLIC SECTOR PENSIONS

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1 IAFF LEGISLATIVE FACT SHEET PUBLIC SECTOR PENSIONS The IAFF opposes the Public Employee Pension Transparency Act (H.R. 567/S. 347). BACKGROUND Public sector pensions for state and municipal employees traditionally are governed at the state and local level. The federal government generally does not intrude upon the sovereign rights of states and local governments to manage their pension plans. The Public Employee Pension Transparency Act (H.R. 567/S. 347) would undermine this history by creating an unprecedented federal intrusion into state and local government affairs while undermining the retirement security of fire fighters and other hard working public sector employees. Introduced by Representatives Devin Nunes (R CA), Paul Ryan (R WI), and Darrell Issa (R CA) in the House and Senator Richard Burr (R NC) in the Senate, PEPTA would require new federally mandated reporting requirements on states and local governments, require certain information to be made public on a website, and prohibit the federal government from providing any financial assistance or bailouts to public pension funds in the future. Failure to comply with the bill s new requirements would result in states or local government losing their ability to issue tax exempt bonds. Although the bill s title sounds harmless, the transparency requirements would actually undermine public confidence in defined benefit pension plans. For the first time ever, the federal government would force states and local government to list pension fund liabilities based on risk free rates, which would be equivalent to the interest earned on Federal Treasury bonds, currently at 4%. In contrast, traditional actuarial accounting standards use an expected rate of return based on a 25 year yield of past performance, which is around 8%. By forcing public pension funds to use the lower Treasury bond rate, the overall pension liability will appear drastically larger, scaring politicians and the public into making unnecessary cuts or worse, disbanding pensions altogether in favor of 401(k) style defined contributions plans. The truth is that the alleged public pension crisis is overblown. Only about 3% of state budgets are devoted to pensions, and most pension plans are in sound financial shape, even after the stock market collapse of Since March 2009, pension fund asset values have been steadily growing with current assets valued at approximately $2.4 trillion. Overall, the Government Accountability Office found that public pensions are financially secure and positioned to meet their long term pension obligations. While there are some instances in which plans are dangerously underfunded, these states have been moving aggressively to change their systems and return to solid financial footing. The Public Employee Pension Transparency Act also represents a fundamental lack of understanding regarding the strong accounting rules and strict legal constraints already in place that require open and transparent governmental financial reporting and processes. This legislation conflicts with existing governmental accounting standards, increases state and local government costs, and undermines investor confidence in the municipal bond market. CONGRESSIONAL ACTION On February 9, 2011 and March 15, 2011, the House Committee on Oversight and Government Reform Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs held hearings on state and municipal debt, focusing on attacking public pensions. On April 14, 2011, the House Committee on Oversight and Government held a hearing on state and municipal debt with Governor Scott Walker as a witness. On May 5, 2011, the House Ways and Means Subcommittee on Oversight and Investigations held a hearing on PEPTA. On December 8, 2011, Republicans on the Joint Economic Committee released the first of a series of reports, attacking public sector pensions: States of Bankruptcy Part I: The Coming State Pensions Crisis. In January 2012, Senator Orrin Hatch, the Ranking Member of the Senate Finance Committee, released a report attacking public sector pensions: State and Local Government Defined Benefit Pension Plans: The Pension Debt Crisis that Threatens America Alfred K. Whitehead Legislative Conference V. 1

2 IAFF LEGISLATIVE FACT SHEET BACKGROUND MANDATORY SOCIAL SECURITY COVERAGE The IAFF opposes mandatory Social Security coverage for non covered public sector employees. When the Social Security system was created in 1935, government employees were expressly excluded. Even when state and local governments were given the option to join the system in the 1950s, many fire departments were still legally barred from electing Social Security coverage until Because of this long exclusion from the Social Security system, local governments created pension systems for fire fighters to address their retirement needs without Social Security. An estimated 75 percent of all fire fighters are covered by pension plans that are independent of Social Security. These comprehensive plans are tailored to meet the unique needs of fire fighters by taking into consideration the early retirement ages and high rates of disability retirement that are characteristic of public safety occupations. Over the years, Congress has considered various proposals to bring all public sector workers into the Social Security system, but decided each time to maintain the current practice of allowing public employees the option to join Social Security or retain their separate pension systems. Recently, the issue has been resurrected as a way to generate additional revenue for the Social Security Trust Fund. In 2010, two separate national commissions on reducing the deficit included identical proposals in their recommendations to bring all newly hired public employees into Social Security beginning in the year While the need for additional revenue is the primary reason for bringing all public employees into Social Security, proponents make two additional arguments. First, they contend that most non covered public employees qualify for Social Security benefits, either from a second job or a spouse. They argue that workers who receive Social Security benefits should be required to pay into the system throughout their career. A second, more recent, argument contends that public pension plans are unstable, and Social Security coverage would provide public employees with retirement income if their pension plan went bankrupt. Opponents of mandatory coverage believe that forcing all public employees into Social Security even if it is only new hires would undermine existing pension systems that provide superior benefits and reflect the unique circumstances of public safety work. They argue further that the overwhelming majority of public pensions are on sound financial footing, and rumors about plans going bankrupt are not supported by the facts. Opponents also note that any influx of funding to the Social Security Trust Fund would have a negligible and temporary impact on the Fund s long term solvency. Moreover, Congress already fully addressed concerns about people receiving benefits without paying in their fair share. The Social Security benefits of people who also receive a pension from non Social Security covered employment are significantly reduced. CONGRESSIONAL ACTION Congress continues to examine ways to reduce the deficit through budget resolutions and other proposals. One plan from a bipartisan group of six Senators, called the Gang of Six, would reform Social Security. Although the Gang of Six did not release specific details, some Members of Congress hope to introduce legislation based on its recommendations, which could include mandatory social security coverage for public sector employees. Other plans to reform social security are also expected. V Alfred K. Whitehead Legislative Conference

3 IAFF LEGISLATIVE FACT SHEET NORMAL RETIREMENT AGE The IAFF supports H.R and encourages Members of Congress to cosponsor the bill. BACKGROUND In 2007, the Internal Revenue Service issued regulations requiring all public sector pension plans to identify a specific, chronological normal retirement age, and label any retirement options that allow retirement before that age as early retirement in plan documents. The IRS also defined minimum ages that could be used as a plan s Normal Retirement Age, ranging from 55 to 62, but included a specific public safety safe harbor allowing pension plans that cover fire fighters and law enforcement officers to identify a normal retirement as low as 50. Any requirement eligibility that permitted fire fighters to leave before age 50 would have to be designated as early retirement. However, this public safety safe harbor only applied to pension plans if substantially all of the participants are qualified public safety employees. Currently, public sector pension plans vary greatly in how they determine the eligibility criteria for when public safety officers can begin receiving an unreduced pension benefit. Some plans use a straight years of service requirement like 25 years and out, while other plans use a combination of years of service and age like age 50 with 20 years of service. Rather than explicitly stating a normal retirement age, some plans opt to enforce an implicit retirement age by reducing the pension benefit for those who leave early. Under the IRS regulations, these various options would be impermissible and would jeopardize a pension plan s tax exempt status. Moreover, most fire fighter pension plans would not qualify for the public safety safe harbor because public safety officers are in a pension plan that includes other municipal workers. Due to objections raised by the IAFF and other organizations, the IRS has twice delayed the implementation date of the new rules, which are now scheduled to go into effect on January 1, The IRS has indicated they are working on revisions to the rule, which they hope will address the problems the IAFF has identified. In addition to encouraging the IRS to amend their rules, the IAFF is also asking for a further delay to allow plans sufficient time to comply with any new regulations. The IAFF is also asking Congress to intervene to make the necessary changes in case the IRS fails to act in a timely fashion. Failure to act would require state legislatures to change pension plans by the end of the year to comply with the regulation. Public sector pension plans have been under attack at state capitols and city halls all across America. Opening a new debate would give opponents of defined benefit pension plans another opportunity to undermine the retirement security of hard working fire fighters and other public sector employees. CURRENT LEGISLATION U.S. House: Summary: H.R. 3561, legislation to reduce administrative burdens and encourage retirement plan formation and retention Sponsor: Representative Ron Kind (D WI) Among other changes to laws governing defined contribution and IRA plans, the bill would provide a special rule for determining normal retirement age for certain existing defined benefit plans. CONGRESSIONAL ACTION On December 5, 2011, H.R was introduced in the U.S. House of Representatives and referred to the Committees on Ways and Means and Education and Workforce Alfred K. Whitehead Legislative Conference V. 3

4 REPUBLICAN STAFF COMMENTARY STATES OF BANKRUPTCY Part I: The Coming State Pensions Crisis December 8, 2011 State and Local Government Pensions While private businesses have shifted away from defined-benefit retirement plans and toward definedcontribution retirement plans in recent decades, virtually all state and local government employees still participate in defined-benefit plans. These plans are funded by contributions from employees as well as the government (i.e., taxpayers). In 2010, employee contributions to state and local pension plans represented 30% of total contributions while taxpayers were responsible for the remaining 70%. 1 Even if the contributions that state and local governments and their employees make to defined-benefit pension plans and the investment income such contributions generate fall short of the funds necessary to pay promised pension benefits, state and local governments are nonetheless required to pay promised benefits in full by either raising taxes or cutting other spending. While no large state public pension fund has yet to run dry and test what would happen in the absence of available pension assets that will soon change as a number of plans are projected to run out of money in just over five years based on private sector accounting standards. 2 Deterioration in State and Local Pension Finances Deterioration in state and local government pension plans began in the late 1990s when high investment returns during the stock market bubble made pension plans appear fully or even over-funded. As the stock market boomed, many states and localities reduced their contributions, increased benefits, and goosed their assumptions going forward. The bursting of the stock market bubble and, later, the housing bubble, caused significant deterioration in the financial status of state and local government pension funds. Based on data from the Pew Research center, the average state pension funding level (the Jec.senate.gov/republicans V Alfred K. Whitehead Legislative Conference

5 percent of promised benefits that are projected to be payable by existing assets) declined from 98% in 2000 to 76% in Improper Accounting Methods Understate Pension Liabilities According to their own figures, state and local pension systems are in trouble but those numbers barely scratched the surface of the true scale of the shortfalls, as the map of the United States shows below. The left map details what states admit their unfunded pension liabilities are but under private sector accounting methods, as shown by the right map, the situation is much worse. Unlike retirement plans offered to the employees of private businesses or the federal government, state and local government pension plans are not required to abide by any particular set of accounting standards. Most states and localities conform to the General Accounting Standards Board (GASB). The problem with GASB, however, is that unlike FASB (the Financial Accounting Standards Board) and ERISA (the Employee Retirement Income Security Act), which govern private sector pensions and accounting, GASB primarily specifies disclosure standards and other guidelines as opposed to strict rules. For example, GASB allows states desiring higher investment returns to assume those returns simply by investing in riskier asset. It also allows plans to delay full accounting and reporting of assets over a number of years to minimize the impact of large market swings (as a result, the consequences of the downturn will not be fully reported on pension balance sheets until as late as 2014). According to the National Association of State Retirement Administrators Public Fund Survey, the 126 large plans (which make up about 85% of state and local pension assets and participants) represented in the survey had a combined unfunded pension liability of $767 billion for FY The $767 billion gap amounts to an aggregate funding ratio of 77%, meaning current assets are projected to provide only 77% of promised benefits. Even with this inaccurate accounting and overly generous assumptions, nine large state and local pension plans in 2010 were less than 50% funded. 5 These plans included: the 2012 Alfred K. Whitehead Legislative Conference V. 5

6 Joint Economic Committee Republican Staff Commentary Illinois State Employees Retirement System (37%), the Kentucky State Employees Retirement System (40%), the Missouri Department of Transportation and Highway Patrol Employees Retirement System (42%), the Indiana State Teachers Retirement Fund (42%), the Connecticut State Employees Retirement System (44%), the Illinois State Universities Retirement System (46%), the West Virginia Teachers Retirement System (47%), the Oklahoma Teachers Retirement System (48%), and the Illinois Teachers Retirement System (48%). The average rate of return assumed by state and local government plans is 8%. While this may not be far off from historical returns, the recent financial crisis and predicted slower-than-normal future economic growth in the U.S. and industrialized world is likely to produce a much lower rate of return. Economists Joshua Rauh of the Northwestern University Kellogg School of Business and Robert Novy-Marx of the University of Rochester calculate a one-third probability that a portfolio which has an expected return of 8% will actually achieve that return, while the probability of achieving a return of 6% or lower is 50%. 6 If states were forced to use private sector market value liabilities (MVL), their projected unfunded liabilities would rise exponentially over time. The market value liability of a plan refers to the amount the market would charge in order to take on the liabilities of a plan, including its assumed rate of return and other parameters. If states were forced to use market value liabilities, they would have to report their funding status of their pension funds based on the market value of their assets, not on risky assumptions of high returns. Even the CBO has endorsed the use of market value liabilities to assess the true amount of budget shortfalls. Current accounting methods assume pension funds can earn high investment without risk, typically 8%. When pension liabilities fall short, taxpayers are required to make up the undisclosed difference. Unfunded Pension Liabilities Rise Under Realistic Expectations A study by the Congressional Budget Office (CBO) looked at the effects of using different discount rates on states pension liabilities. With an 8% discount rate, unfunded liabilities amounted to $700 billion for state and local pension plans. If the discount rate were 5%, the unfunded liability more than triples to $2.2 trillion (55% funded) and with a discount rate of 4%, the unfunded liability more than quadruples to $2.9 trillion (less than 50% funded). 7,8 To put the magnitude of overly generous return assumptions into perspective, consider a new worker who is deciding how much to save for retirement. Suppose that worker earns $60,000 a year and wants to retire with Jec.senate.gov/republicans V Alfred K. Whitehead Legislative Conference

7 $1,000,000 (in today s dollars). If that worker assumes he will earn 8% annual returns, he needs to contribute $3,638 towards his retirement each year. However, if he assumes he will only earn 4% per year, his required annual contribution amount more than doubles to $9, So, by assuming an 8% return rather than a 4% return, the worker contributes about $5,400 less per year. If the worker bases his contributions on an 8% return assumption but only achieves a 4% return, he will be left with less than $400,000 in retirement, rather than the $1,000,000 he had hoped for and assumed. States will soon face similar shortfalls in their pension systems as a result of their unrealistic return assumptions. According to CBO, the appropriate discount rate was 4% in 2010 and 5% in 2006 before the financial crisis. CBO estimates the total 2009 unfunded liability of state and local pensions to be $2-$3 trillion, based on an accounting approach that, more fully accounts for the costs that pension obligations pose for taxpayers. 10 Other economists have similarly estimated state and local unfunded pension liabilities of around $3 trillion. Professor Joshua Rauh of Northwestern University estimates an unfunded liability of more than $3 trillion. 11 Eileen Norcross of the Mercatus Center at George Mason University estimates an unfunded liability of $3.5 trillion. 12 And Andrew Biggs of the American Enterprise Institute (AEI) estimates that the combined 2009 unfunded liability of state and local pension funds was $3.0 trillion Alfred K. Whitehead Legislative Conference V. 7

8 Joint Economic Committee Republican Staff Commentary The Magnitude of Unfunded Pension Liabilities Measuring states unfunded pension liabilities as a percentage of state GDP provides perspective on states abilities to handle these unfunded pension liabilities. Using Biggs estimates of market-based unfunded liabilities and 2009 state GDP, the median pension debt-to-gdp ratio among the states was 21%, with Nebraska having the lowest ratio of 9% and Ohio having the highest at 41%. Given the deterioration in most state pensions since 2009, as well as budget cuts contributing to a decline in the number of state employees paying into pensions, proper accounting standards are likely to show that some states unfunded pension liabilities are already approaching 50% of GDP. Because these unfunded liabilities are essentially sunk costs, they can effectively be added on to states existing debt levels, which in 2009 had a median value of 17.5% of GDP. Thus, the combined median level of existing debt plus unfunded pension liability debt was 38.5% of GDP. The combination of existing state debt, unfunded pension liability debt, and the 100% of GDP federal debt makes the U.S. debt load worse than that of Europe. Which States Are In the Worst Trouble? The day of reckoning for state pension plans is rapidly approaching. According to estimates by Joshua Rauh, pension plans in five states Louisiana, Oklahoma, New Jersey, Illinois, and Connecticut will run dry by 2018, and half of all state pension plans will run dry within twelve years (see chart on following page). 14 Yet even these projections are likely overly optimistic, as they assume the funds will achieve 8% returns and that the plans will be fully funded going forward (that is, that new contributions will fully offset new Jec.senate.gov/republicans V Alfred K. Whitehead Legislative Conference

9 Joint Economic Committee Republican Staff Commentary accrued benefits). More realistic assumptions suggest state pension funds could begin to run dry within a few years. The chart to the left shows Professor Rauh s estimates of when the combination of all state funds runs dry based on 6%, 8%, and 10% returns. The states standard 8% return assumption results in the combined state funds running dry in about 2027 whereas a more realistic (yet perhaps still optimistic) 6% return moves that date up about four years to According to estimates by Professor Rauh, the cost of providing pension benefits in Oklahoma and Louisiana in 2018, the year after the funds are projected by Rauh to run dry, would amount to 31% and 28% of each state s respective tax revenues. 15 And in the three states of Illinois, New Jersey, and Connecticut, which are projected to run dry the following year (2018), their pension payments will equal an average of 39% of incoming tax revenues. Additionally, the recent decline in state and local employment caused by the recession may hasten the pension crisis. From a peak in August of 2008, state and local employment has declined by 639,000 (3.2%). 16 Fewer employees mean fewer pension contributions that can be used to pay benefits to current and near-retirees. When pension funds run dry, states and localities will be hard pressed to come up with the additional revenue needed to keep their pension promises without imposing massive tax increases and spending cuts. In the near future, then, taxpayers in these states will find themselves paying for two or even three government bureaucracies at the same time one that actually administers the government, and one or two shadow bureaucracies of retirees who used to. And unfortunately, states with the least fiscally sound pension plans often also have among the worst overall economic and fiscal outlooks: high debt levels and high interest payments on debt, lower credit ratings, high tax rates, low employment growth, and low economic growth. These states most in peril will be least prepared to deal with unfunded pension liabilities when they come due. Jec.senate.gov/republicans 2012 Alfred K. Whitehead Legislative Conference V. 9

10 Joint Economic Committee Republican Staff Commentary The combination of massive unfunded liabilities and poor economic policies are setting many states up for a Greek-style fiscal death spiral. Attempting to close fiscal gaps and meet unfunded liabilities through higher taxes will drive away the most productive individuals and businesses, leaving those states with even less economic dynamism and a smaller tax base than before. Over time, states who try to solve large fiscal problems with large tax increases will be left with a citizenry comprised of public sector workers and pensioners, but no private sector job-creators and taxpayers to pay for them. Future Reports The state pension crisis is virtually unavoidable, but the federal government s role in bearing the burden of irresponsible states can be mitigated through preemptive actions that will help prevent a taxpayer bailout of state pension systems. Future reports will examine the prospects for pension reform (including promising measures to confront existing unfunded liabilities and to establish fully sustainable pension plans), roadblocks that have prevented credible reform, and possible preemptive actions by the federal government to prevent a taxpayer bailout for irresponsible state and local governments. 1 Congressional Budget Office, The Underfunding of State and Local Pension Plans, May 2011, In 2010, contributions to the 100 largest state and local pension plans (representing 90 percent of state and local plan assets) totaled $117 billion, of which 70% came from employer contributions and 30% from employee contributions. 2 Joshua Rauh, The Day of Reckoning for State Pension Plans, March 22, 2010, Jec.senate.gov/republicans V Alfred K. Whitehead Legislative Conference

11 3 Pew Research Center Pension Funding Levels accessed through Haver Analytics. These funding levels are likely higher than estimates made by economists using private sector accounting methods as the Pew Center reports a total unfunded state pension liability of $1 trillion in comparison to the approximately $3 trillion unfunded liability estimated by other economists. 4 National Association of State Retirement Administrators, Public Fund Survey, 2010, In this survey, 48 states report FY 2010 figures while Hawaii reports FY 2008 and Rhode Island reports FY Ibid. 6 Joshua Rauh, Statement of Professor Joshua Rauh for the hearing on The Role of Public Employee Pensions in Contributing to State Insolvency and the Possibility of a State Bankruptcy Chapter, Congressional Testimony before the Subcommittee on Courts, Commercial, and Administrative Law, Monday, February 14 th, 2011, 7 CBO defines fair value accounting as, what a private insurance company operating in a competitive market would charge to assume responsibility for those obligations. 8 Congressional Budget Office, The Underfunding of State and Local Pension Plans, May 2011, Table 1, 9 Calculations based on the following assumptions: the worker is age 22 and will retire at age 65. He has annual nominal income growth of 5% over his working career. Inflation is 2.5% annually. 10 Congressional Budget Office, The Underfunding of State and Local Pension Plans, May 2011, 11 Joshua Rauh, Public Pension Promises: How Big are They and What are They Worth?, October 8, 2010, 12 Eileen Norcross, State and Municipal Debt: The Coming Crisis?, Testimony before the House Committee on Oversight and Government Reform, February 9, 2011, 13 Andrew Biggs, The Market Value of Public-Sector Pension Deficits, American Enterprise Institute, April 2010, 14 Joshua Rauh, The Day of Reckoning for State Pension Plans, March 22, 2010, 15 Ibid. 16 Bureau of Labor Statistics, data based on data through November Alfred K. Whitehead Legislative Conference V. 11