Susan Combs, Texas Comptroller of Public Accounts. Path to Stability: ERS at the Crossroads

Susan Combs, Texas Comptroller of Public Accounts Path to Stability: ERS at the Crossroads

EMPLOYEES RETIREMENT SYSTEM: THE BASICS The Employees Retirement System of Texas (ERS), established in 1947 by constitutional amendment, manages a defined benefit (DB) pension plan that serves state employees, elected officials and law enforcement/custodial officers. 1 Under a DB pension plan, the value of a retiree s annuity is determined by a formula based on the employee s age, years of service and average salary. Unlike a 401(k), in a DB pension plan individual contributions are pooled for investment and the plan pays out specified benefits, so participants do not rely on their individual investment returns or account balances. To be considered balanced or fully funded, a plan must meet the following rule: INVESTMENT EARNINGS + CONTRIBUTIONS = BENEFITS + EXPENSES For ERS and many other pension systems across the country, however, this formula is not in balance. For example, the actuarial value of ERS assets the left side of the equation above was $25.4 billion, according to its fiscal 2014 valuation. The actuarial accrued liability the right side of the equation was estimated at $32.9 billion. According to ERS projections, this $7.5 billion difference between the two, also known as the unfunded actuarial accrued liability (UAAL), is expected to grow unless remedial action is taken. MEASURE STANDARD ERS Funded Ratio: The ratio of a plan s total projected assets to the projected cost of all benefits earned, as well as other liabilities. 100% funded ratio for defined benefit plans recommended by the Government Finance Officers Association and other professional organizations. 2 80% the federal government s standard for determining if a private pension plan is at risk. 3 77.2% fiscal 2014 funded ratio. 5 If no changes are made, ERS funded ratio is projected to fall to 60% by 2036. 6 Amortization Period: The time needed to pay down the total projected unfunded liability. Net Rate of Return: The increase in the value of a fund s investments. Actuarially Sound Contribution (ASC) Rate: Rate required to pay off projected unfunded liability and the cost of new benefits earned within a 31-year amortization period. Unfunded Actuarial Accrued Liability (UAAL) as Percentage of Covered Payroll 60% several credit rating agencies consider funded ratios below this point to be weak. 4 30 years GASB s recommended maximum amortization period. 40 years the Texas Pension Review Board s (PRB s) recommended maximum amortization period, with 15 to 25 years being a more preferable target. 8 8% ERS assumed long-term future rate of return for actuarial funding purposes. 11 18.76% contribution rate projected by ERS actuaries that would be required to make the plan fiscally sound in fiscal 2015. 13 Steady or declining one of PRB s recommended guidelines for actuarial soundness. 15 Infinite fiscal 2014 amortization period. 9 ERS unfunded actuarial accrued liability is increasing by about $500 million each year. 10 14.58% fiscal 2014 one-year net rate of return. 10.23% fiscal 2014 five-year net rate of return. 5.77% fiscal 2014 15-year net rate of return. 12 14.9% fiscal 2015 total contribution rate.14 121.4% UAAL as a percentage of covered payroll for fiscal 2014. 58.4% UAAL as a percentage of covered payroll for fiscal 2009. 12% UAAL as a percentage of covered payroll for fiscal 2004. 16 2 Texas Comptroller of Public Accounts December 2014

A LOOK AT ERS FINANCIAL FUTURE Based on ERS fiscal 2014 actuarial valuation, if current assumptions hold, the trust fund will be insolvent by 2063. With every year that passes without additional reforms, the ERS trust fund s slide toward insolvency becomes more expensive to reverse. The plan s unfunded liability is projected to increase by approximately $500 million each year, while the actuarially sound contribution (ASC) rate is projected to increase by more than 0.1 percent annually. INACTION WILL INCREASE COST OF FUTURE REFORM ACTUAL PROJECTED On Aug. 31, 2014 2015 2016 2017 2018 2019 Funded Ratio 77.2% 76.4% 76.0% 75.7% 75.2% 74.8% Unfunded Actuarial Accrued Liability (in billions) Actuarially Sound Contribution Rate $7.5 $8.0 $8.4 $8.8 $9.2 $9.7 18.76% 19.05% 19.21% 19.34% 19.46% 19.58% SOURCE: Employees Retirement System of Texas, Annual Actuarial Valuation Funding as of August 31, 2014 It should also be noted that the Governmental Accounting Standards Board (GASB) an independent organization that sets standards for public accounting and financial reporting is implementing new requirements for pension plans. While these reporting requirements will not fundamentally change the funding status of the ERS trust fund, they will present an alternative way to measure the plan s long-term unfunded liability the net pension liability. 17 In its fiscal 2014 Comprehensive Annual Financial Report, ERS states that its net pension liability is $14.5 billion, almost double its unfunded actuarial accrued liability. OPTIONS FOR ACHIEVING ACTUARIAL SOUNDNESS THROUGH LEGISLATIVE APPROPRIATIONS According to ERS, if no further plan changes are made and its actuarial assumptions hold true, a continued state contribution rate of 11.94 percent would be required to fully fund ERS. This contribution rate was projected to cost $1.4 billion over the 2016-17 biennium and would pay down the plan s unfunded liability by 2046. STATE CONTRIBUTION RATE 2016-17 BIENNIAL COST (ALL FUNDS IN MILLIONS) 7.5%, the current state contribution rate $910 1.5% 10% $1,213 35.4% 11.94%, the actuarially sound state contribution rate $1,449 61.6% NOTE: The 2016-17 biennial cost figures above are based on ERS fiscal 2013 valuation. SOURCE: Employees Retirement System of Texas, Legislative Appropriations Request for Fiscal Year 2016-17 % ABOVE 2014-15 BIENNIAL FUNDING Other policy decisions, such as additional changes to the plan or to member contribution rates and fees, also could affect the cost of fully funding ERS. December 2014 Texas Comptroller of Public Accounts 3

UNDERFUNDED PENSION SYSTEMS HAVE AFFECTED CREDIT RATINGS IN OTHER STATES Recent credit rating downgrades in Illinois, Pennsylvania and New Jersey have been attributed in part to insufficient action to address their growing public pension obligations. Illinois: Since June 2010, Illinois has experienced eight downgrades. After several failed attempts at pension reform, one credit agency warned that while it is unusual for a state rating to fall into the BBB category, lack of action on pension reform and upcoming budget challenges could result in further credit deterioration. 18 Illinois State Employees Retirement System: 34.2% funded ratio Made 88% of annual required contributions UAAL comprised 539.25% of covered payroll SOURCE: State Employees Retirement System of Illinois, Annual Actuarial Valuation as of June 30, 2013 Pennsylvania: Since 2012, Pennsylvania has experienced five downgrades. Rating agencies specifically cited the State Employees Retirement Systems rapidly growing pension cost burden following years of underfunding and marketdriven investment declines as a contributing factor to their decisions. 19 Pennsylvania State Employees Retirement System: 59.2% funded ratio Made 60.2% of annual required contributions UAAL comprised 303.5% of covered payroll SOURCE: Commonwealth of Pennsylvania State Employees Retirement System, December 31, 2013 Actuarial Valuation - Key Results New Jersey: Since 2011, New Jersey has experienced eight downgrades, and the state s inaction in the face of its Public Employees Retirement System s financial difficulties was listed as a key reason behind some of them. As a result, the rating agencies have noted that options have become more limited as the state s fixed cost burden grows. 20 New Jersey Public Employees Retirement System: 48.1% funded ratio Made 28.9% of annual required contributions UAAL comprised 237.1% of covered payroll SOURCE: Public Employees Retirement System of New Jersey, Fifty-Ninth Annual Report of the Actuary Prepared as of July 1, 2013 Texas pension obligations have received some attention in its recent credit ratings. For example, although Standard & Poor s affirmed Texas AAA rating in November, it noted that the state has historically failed to make actuarially sound contributions and that should this trend continue, it could result in downward pressure on the rating. 21 To be clear, credit agencies assign ratings based on a broad view of a state s financial outlook, including its economic strength, management, long-term liabilities and financial flexibility. While Texas currently does not face many of the same economic obstacles as the states described above, that may not always be the case. Any rating downgrade would increase the cost of state agency borrowing for public infrastructure, reducing revenue available for contributions and other public purposes. 4 Texas Comptroller of Public Accounts December 2014

CONTRIBUTING FACTORS TO ERS FINANCIAL CHALLENGES The ERS pension plan s current state is largely the result of investment losses and inadequate contribution rates. INVESTMENT RETURNS ARE NOT ENTIRELY PREDICTABLE As with many state pension systems, the Great Recession resulted in lower-than-expected investment returns. ERS investment returns were below its 8 percent target for three years, although returns have exceeded the target each year since 2011. FY 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 One-Year Investment Return Rates (Market) 12.7% 8.8% 13.9% -4.6% -6.6% 6.7% 12.6% 8.2% 10.1% 14.7% SOURCE: Employees Retirement System of Texas, Annual Actuarial Valuation Funding as of August 31, 2014 According to ERS, these weak investment returns resulted in a loss of $3.9 billion nearly 20% to the trust fund s market value from 2007 to 2010. However, ERS actuaries have reported that this impact has been significantly lessened by the fund s strong investment returns in recent years, leaving inadequate contribution rates as the primary cause of the projected growth of the plan s unfunded liability. CONTRIBUTION RATES HAVE NOT BEEN ADEQUATE According to ERS, the combined state and member contribution rates have met the full funding rate only once in the past 20 years. The difference between the actuarially sound contribution (ASC) rate and the contribution rates approved by the Legislature will be 3.71 percent by 2017, based on actuarial assumptions (Figure 1). Figure 1. Full Funding Rates Vs. Actual Contribution Rates 20% 18% 19.21% 16% 14% 15.50% 12% 10% 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 Normal Cost Actuarially Sound Contribution (ASC) Actual Contribution Rate NOTE: There was no unfunded liability from 1996-2003, so full funding only required covering normal costs, i.e., the cost of benefits accrued in the current year. SOURCE: Employees Retirement System of Texas Despite the recent contribution rate increase approved during the 2013 legislative session, contributions are still below actuarially sound levels and will result in an estimated increase of $2.5 billion in ERS unfunded liability over the next five years, based on actuarial assumptions. Furthermore, with every biennium of underfunding, the cost of restoring ERS climbs higher. In its Legislative Appropriations Request for the 2014-15 biennium, ERS estimated that raising the state s contribution rate to 10 percent would have been enough to pay down the plan s unfunded liability over 55 years. Now, however, increasing the state s contribution rate to 10 percent today would merely delay the fund s depletion, not prevent it. December 2014 Texas Comptroller of Public Accounts 5

COMPARING ERS BENEFITS TO OTHER STATE EMPLOYEE PLANS Texas state retirees received an average annuity of $18,946 in 2013 the lowest among the four largest states. However, when adjusted for regional price differences its value climbs to $19,464. STATE FY 2013 AVERAGE ANNUITY Texas (ERS) $18,946 $19,464 Florida (FRS) $19,230 $19,633 New York (NYSLRS) $20,766 $17,995 California (CalPERS) $35,016* $30,689 AVERAGE ANNUAL BENEFIT ADJUSTED FOR REGIONAL PRICE DIFFERENCES *CalPERS CAFR only reports an average monthly benefit over fiscal 2013. This figure was annualized to arrive at an average annual benefit. NOTE: State cost-of-living adjustments were made using the Bureau of Economic Analysis 2012 Regional Price Parities. SOURCES: Employees Retirement System of Texas, Florida Retirement System, New York State and Local Retirement System, California Public Employees Retirement System and Bureau of Economic Analysis. When determining the size of an annuity, most defined benefit plans follow a simple formula: YEARS OF SERVICE x BENEFIT MULTIPLIER x FINAL AVERAGE SALARY The following table shows how the variables in this formula compare for new hires 22 in Texas and other large states. Benefit Multiplier: Multiplier set by the pension plan. Final Average Salary: The period of employment used to determine the final average salary. TEXAS FLORIDA NEW YORK CALIFORNIA 2.3% Average of highest-salaried 5 years 1.6%-1.68%, depending on age and years of service Average of highest-salaried 8 years 1.66%-2%, depending on years of service Average of highest-salaried 5 consecutive years 2.5% Average of highest-salaried 3 consecutive years SOURCE: Employees Retirement System of Texas, Urban Institute s State and Local Employee Pension Plan database But, there are other important details to consider when comparing benefits across pension systems. While certainly not an exhaustive list, the following table highlights some of these for newly hired employees. Employee Contribution Rate Vesting Period: Years of service required for benefit eligibility. Automatic Cost-of- Living Adjustments: Adjustments made to annuities after retirement. Social Security Coverage Early Retirement Penalty TEXAS FLORIDA NEW YORK CALIFORNIA 6.9%* 3% 3%-6% depending on salary 0-3%, depending on salary 10 years 8 years 10 years 5 years No No Yes, 1%-3% Yes, 2% in second year of retirement, with additional changes tied to CPI Yes Yes Yes Yes 5% reduction for each year retiring before age 62 5% reduction for each year retiring before age 65 *The contribution rate for fiscal 2015. The employee contribution rate will increase to 7.5% by 2017. 6.5% reduction for each year retiring before age 63 SOURCE: Employees Retirement System of Texas, Urban Institute s State and Local Employee Pension Plan database 4% reduction for each year retiring before age 67 6 Texas Comptroller of Public Accounts December 2014

RECOMMENDATIONS Unfortunately, options for putting the ERS trust fund on a sound path are limited. Simply put, lawmakers must choose one or both of the following: Reduce plan liabilities by modifying benefits Legislation in 2009 and 2013 created additional benefit tiers that applied only to new hires after the effective date of the legislation. To have a larger impact, future legislative changes could apply to existing employees, not just new hires. 23 However, any positives of benefit reductions should be weighed against negative impacts these changes may have on the state s ability to hire and retain its workforce. Increase assets by adjusting contribution rates or fees As mentioned previously, contribution levels have not met actuarially sound contribution rates in 19 of the past 20 years, and projections show this gap continuing for the foreseeable future. This failure to fully fund ERS is causing the unfunded liability to increase by approximately $500 million each year. Increasing state and/or member contributions or fees would help close this gap. To preserve Texas long-term fiscal health, inaction is not an option. The problems facing ERS will continue to grow if we do not pursue additional reforms immediately. As seen in states such as New Jersey, Pennsylvania and Illinois, the failure to deal with unsustainable pension costs has only worsened already difficult financial circumstances and contributed to downgrades in their credit ratings. For these reasons, Texas lawmakers should work with ERS to set the system on the right path, and ensure that we keep the promises made to current and future generations of Texas public servants. ADDITIONAL CONSIDERATIONS Statements in this report that future funding, contribution rate or other metrics will exist or be required in future years are the projections of independent actuaries under contract with ERS, not statements of fact or guarantees. These projections of actual and required funding and contribution levels in future years are based on assumptions including the average rate of return on ERS investments; the size, retirement age, salary and life expectancy of the covered workforce; and other details that are difficult to predict. If the ERS trust fund s plan experience differs from those assumptions, the funding status of the plan could change and required funding and contribution rates in future years could differ from those described in this report. Potentially important factors could include higher or lower investment returns; demographic changes in the state employee workforce, including more/fewer employees, higher/lower salaries, longer/shorter expected service and sooner/later retirement; and changes to the expected mortality rate. December 2014 Texas Comptroller of Public Accounts 7

ENDNOTES 1 The plan analyzed in this report does not included teachers or judges. These groups are served by the Teacher Retirement System and the judicial retirement systems, respectively. 2 Government Finance Officers Association, Sustainable Funding Practices of Defined Benefit Pension Plans, October 2009, http://www.gfoa.org/sustainable-funding-practices-defined-benefitpension-plans. 3 The Pension Protection Act of 2006, 29 U.S.C. 303(i)(4)(A)(i). 4 National Association of State Retirement Administrators, The 80-Percent Threshold: Its Source as a Healthy or Minimum Funding Level for Public Pension Plans, by Keith Brainard and Paul Zorn, January 2012, p. 2, http://www.nasra.org/files/topical%20reports/funding%20policies/80_percent_funding_threshold.pdf. 5 Employees Retirement System of Texas, Annual Actuarial Valuation: Funding as of August 31, 2014, by Gabriel Roeder Smith & Company (Irving, Texas, 2014), p. 2, http://www.ers.state.tx.us/ About_ERS/Reports/Actuarial_Valuation/2014_ERS_Pension_Plan_Valuations. 6 Data provided by the Employees Retirement System of Texas, November 21, 2014. 7 Governmental Accounting Standards Board, Guide to Implementation of GASB Statements 25, 26, and 27 on Pension Reporting and Disclosure by State and Local Government Plans and Employers (Norwalk, Connecticut, 1997), p. 14, http://www.gasb.org/jsp/gasb/page/gasbsectionpage&cid=1176163026371. 8 Texas Pension Review Board, 2013 Guide to Public Retirement Systems in Texas (Austin, Texas, 2013), p. 10, http://www.prb.state.tx.us/files/reports/2013%2002%2008%20web%20-%20final.pdf. 9 Employees Retirement System of Texas, Annual Actuarial Valuation Funding as of August 31, 2014, p. 2. 10 Data provided by the Employees Retirement System of Texas, November 14, 2014. 11 Employees Retirement System of Texas, Annual Actuarial Valuation Funding as of August 31, 2014, p. 15. 12 Data provided by the Employees Retirement System of Texas, November 14, 2014. 13 Employees Retirement System of Texas, Annual Actuarial Valuation Funding as of August 31, 2014, p. 2. 14 Employees Retirement System of Texas, Annual Actuarial Valuation Funding as of August 31, 2014, p. 2. 15 Texas Pension Review Board, 2013 Guide to Public Retirement Systems in Texas, p. 10. 16 Data provided by the Employees Retirement System of Texas, November 14, 2014. 17 More information about net pension liability and GASB Statement No. 67 can be found in Governmental Accounting Standards Board, Statement No. 67 of the Governmental Accounting Standards Board, June 2012, http://www.gasb.org/jsp/gasb/document_c/gasbdocumentpage?cid=1176160220594&accepteddisclaimer=true. 18 Standard and Poor s, Illinois General Obligation Debt Rating Lowered To A- From A On Weakened Pension Funded Ratios; Outlook Negative, by Robin Prunty and John Sugden. January 25, 2013, http://www.standardandpoors.com/ratings/articles/en/us/?assetid=1245346672998. 19 Fitch Ratings, Fitch Downgrades Commonwealth of Pennsylvania s GOs to AA- ; Outlook Stable, by Eric Kim, Laura Porter and Marcy Block, September 23, 2014, https://www.fitchratings. com/creditdesk/press_releases/detail.cfm?pr_id=879314. 20 Fitch Ratings, Fitch Downgrades New Jersey GO & Appropriation Ratings; Outlook Negative, by Marcy Block, Karen Krop and Douglas Offerman (New York, New York, 2014), https:// www.fitchratings.com/creditdesk/press_releases/detail.cfm?pr_id=828449. 21 Standard & Poor s, Texas; Appropriations; General Obligation; General Obligation Equivalent Security, by Kate Choban and Henry Henderson, November 2014. 22 Plan details from the following tiers were used: Texas ERS Employee Class Tier 3 (Hired on/after 9/1/2013); Florida FRS Regular Class (Hired on/after 7/1/2011); New York-NYSLRS Tier 6 (Hired on/after 4/1/2012); and California CalPERS State Miscellaneous Members Tier 1 (Hired on/after 1/1/2013). 23 Changes could apply to benefits that accrue as a result of future service by existing employees or, subject to any legal limitations, their past service. ON THE WEB: http://www.texastransparency.org/files/pathtostability.pdf FOR ADDITIONAL COPIES: Texas Comptroller of Public Accounts 111 E. 17th Street Austin, Texas 78774-0100 Publication #96-1775 Printed December 2014