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February 17, 2006

OPEB: The 800 Pound Gorilla in the Room

Rick Mattoon, Senior Economist and Economic Advisor
Federal Reserve Bank of Chicago

State and local governments are facing other retirement-related issues as well as the problem of funding pensions. The Government Accounting Standards Board (GASB) has established new guidelines that require governments to account for their “other post employment pension” (OPEB) obligations (GASB no.35 and no.45). Large state and local governments will be required to begin accounting for these obligations on December 15, 2006. OPEB obligations are primarily for retiree health care costs but also can include other benefits such as insurance. Currently OPEB obligations are paid for out of current revenues on a pay-as-you-go method. The annual cost of OPEB is what it costs to cover specific retirees in that year without regard to how this obligation might change as the number of retirees changes or the cost of providing the benefits changes in the future.

The new GASB regulations are intended to improve transparency in government accounts by making it easier to know what the future liability for OPEB expenses will be for a given government and to assess whether they have a strategy for meeting these requirements. The GASB regulations are patterned after similar requirements that FASB placed on private firms in 1992 (SFAS 106). As was the case for private firms, this new accounting standard for governments raises many challenges. For example:

• estimating the total OPEB liability is an accounting nightmare. Unlike pensions where actuarial estimates can be at least somewhat understood, OPEB requires making guesses about things like health care and prescription drug inflation and utilization. One estimate suggests the unfunded liability is around $700 billion, but this is a back of the envelope guess. Other estimates suggest that OPEB exposure could range from five to ten times current outlays for retiree health care.

• managing OPEB costs is tricky. In most cases, retiree health care is not a contractual responsibility like pensions. It is a voluntary benefit offered by the employer. However where it is a contractual responsibility, the ability to require retiree contributions, increase co-pays or cut benefit coverage is limited. Where retiree health insurance can be modified, a concern is that when these liabilities are reported, some governments may choose to abandon or significantly reduce coverage, forcing the federal government to serve as the health care insurer of last resort.

• There are strategies for managing OPEB costs. Efforts to contain health care costs and slow increases in health insurance premium costs can help. Shifting more costs to retirees can be an option, along with trying to limit future OPEB obligations by changing benefit packages for new employees. One strategy that is popular (and essentially required) for addressing OPEB costs is to set up a trust fund. A trust fund meets the new accounting standard requirement that an irrevocable source is identified for meeting OPEB obligations. It also has the advantage of allowing governments more flexibility in the use of investment options. Like pension funds, OPEB trust funds would permit investments in equities and other potentially higher yielding investment vehicles. A potentially attractive option that a trust fund may allow is the ability to issue OPEB bonds to cover part or even all of a government’s OPEB liability. Like pension bonds, these are essentially an arbitrage strategy, where the bond issuer anticipates that the investment yield they will receive from the bond assets will exceed the interest that will be paid to bond holders. Also like pension bonds, the OPEB bonds are not free from federal taxes so they must carry slightly higher interest rates than tax-free investments.

• The impact on credit ratings for governments is another real concern. Once this liability is recognized, some governments’ finances might appear more fragile. To date, several of the major rating agencies have indicated that they will judge the creditworthiness of these governments based on whether their plan for meeting OPEB liabilities appears prudent rather than on the size of the liability on the balance sheet when it is first recognized. Credit agencies do expect OPEB liabilities to be largest in the Northeast and Midwest, where government entities have large unionized work forces and slightly older workers on average than in other areas.

• Finally, OPEB is still a major concern for the private sector. It is estimated that for the 337 companies in the S&P 500 that have OPEB obligations, the funding ratio is around 27% (versus 88% for pensions). For the 282 companies with the most complete financial records, the unfunded liability in 2005 was estimated at $292 billion versus an unfunded pension liability of $149 billion. OPEB liability is concentrated in Ford and GM. Their unfunded liability alone is $94 billion, representing 32% of the S&P 500’s total. (These two companies also have 13% of the total pension underfunding.) Telecom is the other industry where OPEB is a significant issue.

In the end, dealing with OPEB will require considerable skill, particularly if governments are intent on trying to reduce retiree benefits or increase retiree contributions. Neither option will be politically popular, and both have the potential for reducing the appeal of public service to potential workers. OPEB will also further squeeze state and local budgets, making reductions in discretionary programs such as economic development and higher education more likely. For the U.S. economy as a whole, a concern is that any reduction in public sector health care coverage will place further burdens on the Medicare system. What is clear is that the combination of pension and OPEB liabilities will be the source of much discussion in state capitols and town halls for some time to come.

Suggested reading on OPEB:
The GASB 43 and 45 Reporting Guidelines For Other Post Employment Benefits: A Civic Federation Issue Brief

The Economist, “Clearly Unhealthy”, 7/2/2005, Vo. 376, Issue 8433, pp 65-66.

Standard & Poor’s, “Funding OPEB Liabilities: Assessing the Options”, December, 14, 2005.

Fitch Ratings, “The Not So Golden Years: Credit Implications of GASB Statement No. 45.”

Posted by Mattoon at 03:42 PM | Comments (1)

February 13, 2006

Public pensions in the Midwest

Rick Mattoon
Senior Economist and Economic Advisor
Federal Reserve Bank of Chicago

The aggregate unfunded balance for state and local pensions has been pegged at as high as $700 billion by Barclays Global Investors 1 Estimates of actuarial pension balances are by nature imprecise and often controversial. Actuarial estimates change as interest rates and investment returns change and demographics of future and current pensioners are revised. Further, the appropriate actuarial funding ratio or fund balance is highly related to the economic and fiscal conditions in the state or locality. Lower funding levels can be perfectly acceptable in jurisdictions with high revenue growth.

Still, while estimates of $700 billion deficits speak to the magnitude of the problem facing the public pension system, they fail to show that many public pensions are in fact well funded and positioned to meet their benefit obligations. A recent survey of 103 public retirement systems—representing roughly 88% of the public sector employees in pension programs—found public pensions holding $2.1 trillion in assets, with slightly more than 70% of public pensions having actuarial funded levels exceeding 80%.2 In aggregate, the funding levels for all plans combined (assets minus liabilities) was 87.8% in FY2004. The range for funding levels is quite broad. The Florida Retirement System has a funding ratio of 112% and is carrying a surplus of assets over liabilities of over $11 billion. At the other end of the spectrum is the West Virginia Teachers Pension Fund that has an actuarial funding ratio of only 22%. The fund has only $1.4 billion in assets with actuarial liabilities of over $6 billion.

How do state and local governments in the Midwest rank? There is considerable variation even among plans within the same state. Figure 1 provides FY2004 actuarial values for many funds of Seventh District states. In general, Illinois funds are facing the greatest challenge with three plans having funding ratios below 70%. An interesting case of in public pension funding contrasts within a state is in Indiana. While Indiana’s state employees fund is actually slightly overfunded, its teachers fund is underfunded by $8.3 billion. In aggregate, the 12 pension funds represented in this table have assets of roughly $232 billion and liabilities of slightly over $288 billion, leaving an aggregate unfunded liability of $56 billion.



Click to enlarge images.

For those pension plans with funding ratios below 80%, the real challenge is devising a funding strategy that will close the gap. Given that most of these Midwestern states are not characterized as having rapid tax base growth, dedicating a large share of state or local revenues for pensions is bound to squeeze other government programs or require new revenues. Further, options for reducing benefit payouts are quite limited. Public pensions in 40 states are protected by state laws or the state constitution.

Another issue for public pensions is the cost of living or other payment escalators. In Illinois, public pension funds get a 3% annual post-retirement increase and are exempt from state income taxation. In Indiana, annual increases are on an ad hoc basis granted by the legislature, and benefits are taxable. In Iowa, benefits can be increased by excess earnings of the pension fund but is capped at 3% regardless of fund performance. The first $6,000 of benefits is exempt from state income taxation in Iowa. In Michigan, two plans have 3% annual increases (although one is capped at $300), while other funds are dependent on employer agreement. Finally, in Wisconsin, increases in the state pension are based on excess earnings from pension investments; however, pension reductions are possible if investment returns fall. Pension income is exempt from taxation for some in Wisconsin.

It’s clear from this brief survey that there are significant disparities in public pension funding among, and even within, state and local governments; pensions are (or will become) a significant problem for you depending a great deal on where you live.

1McGraw-Hill Companies Inc., 2005, “Sinkhole!” BusinessWeek Online, June 13, available at www.businessweek.com/magazine/content/05_24/b3937081.htm
2Keith Brainard (preparer), 2005, “Public fund survey, summary of findings for FY 2004,” National Association of State Retirement Administrators, report, September, available at http://www.publicfundsurvey.org/Summary%20of%20Findings%20FY04.pdf

Posted by Diez at 03:57 PM | Comments (1)

February 08, 2006

Thinking about pensions—Where to start

Rick Mattoon, Senior Economist and Economic Advisor
Federal Reserve Bank of Chicago

Trying to address pension issues can seem quite daunting by their sheer complexity. Funding pensions is far more than just a public finance problem. Here, I would like to review a selected set of issues on funding pensions raised in the academic literature.

A good starting place for addressing pension issues is by assessing what the optimal level of funding should be for any particular pension fund. Depending on local factors, it may be prudent for some pension funds to carry balances in excess of 100% of liabilities. In other cases, lower balances are perfectly fine if the local tax base is growing aggressively and outstripping growth in pension liabilities. Stephen D’Arcy, James Dulebohn, and Pyungsuk Oh have an interesting paper on this topic in which they model optimal funding levels for all 50 states.1 Their study finds that the optimal funding level is highly related to the relationship between the rate of growth of pension costs and the tax base within each state. The study also finds that interest rates and intergenerational equity play a role in pension funding. Interest rates can affect the return on pension assets, while issues of intergenerational equity involve whether pension costs are borne by current workers or shifted to future workers. The authors’ concern is that pension funding decisions are too often driven by the condition of the current state budget and do not pay enough attention to fundamental economic and demographic variables that should dictate an appropriate funding strategy.

Another key determinant of pension fund solvency concerns the investment performance of fund managers. In their paper, Tongxuan Yang and Olivia Mitchell2 examine how investment performance is related to several structural and governance features. One key finding from their study is that the move by government pension funds to hold greater stock positions has been a double-edged sword. While public funds benefited from the run up in stocks in the 1990s, the authors estimate that the 30% drop in the S&P 500 from 2000 to 2002 cut public pension investment returns by 12 percentage points. Given that the real annual rate of return over the 1990s averaged 8%, this loss had a substantial impact. The authors also find a relationship between investment performance and stock funding ratios. Better investment performance leads to higher stock funding ratios that in turn positively affect flow funding ratios. Governance factors that seem to support this positive relationship include more independent and professional fund managers and the issuance of reports on financial, actuarial, statistical, and investment information. Factors depressing fund performance include having active or retired employees on the pension investment board. In addition, having a dedicated revenue source such as a particular tax source, does not appear to enhance funding.

Coronado, Engen, and Knight3 examine the investment performance of pension funds operated by state and local governments on behalf of their employees. Their study compares these plans run by state and local governments to private plans and finds that after controlling for differences in asset allocation, certain kinds of political interference in the former may reduce returns on their assets. Some of the political restrictions they examine in their paper include requirements to invest in-state to spur local economic development and limitations on investments in certain countries or industries. The authors also examine governance issues, including the percentage of the pension board that is elected.

The final issue I review here is the relationship of pension benefits to total employee compensation in both the public and private sectors. Much has been made about the withdrawal from defined benefit pension programs by private sector employers. In defense of the termination of these programs, many employers note that a pension model based on an employee working a lifetime for a single company is no longer suitable. Benefits that are portable, such as defined contribution programs, better serve the needs of today’s work force. However, this logic has been questioned when applied to public sector employees whose longer job tenure is still more common. Furthermore, defined benefit programs for public employees have long been seen as an important tool for recruiting and retaining workers in the public sector. A related question is what is the total compensation structure for public employees versus private employees and how do pension benefits relate to their total compensation. A report by the Employee Benefit Research Institute4 found that overall compensation costs were 46% higher for state and local employees ($34.72 per hour) versus private sector employees ($23.76). Driving this disparity were differences in work force composition and occupations. A large percentage of state and local workers are in occupations such as teachers, university professors, police officers, and fire fighters. These professions either require greater levels of education or entail physical risk, and therefore, they are more highly compensated than private sector positions that tend to be dominated by retail sales and office occupations. Public sector workers are also more likely to be enrolled in benefit plans than private sector workers. Public sector employee benefits as a percentage of total compensation run 60% higher than private sector employee benefits. This has led some analysts to suggest that more accurate assessments of compensation differentials can be found when comparing public and private workers in the same industry, such as health care. With regard to public and private pay in areas such as construction, transportation and utilities, and health services, the wage differential is much smaller and even favors the private sector employee in some cases.

In future blog entries, I will discuss other issues that are affecting public pensions. I encourage you to share your thoughts on public pensions as well. What pension issues concern you the most?


1Stephen D’Arcy, James Dulebohn and Pyungsuk Oh, 1999, “Optimal funding of state employee pension systems,” Journal of Risk and Insurance, Vol. 66, No. 3 pp. 345–380.
2Tongxuan Yang and Olivia Mitchell, 2005, “Public pension governance, funding, and performance: A longitudinal appraisal,” Pension Research Council, working paper, WP 2005-2.
3Julia Coronado, Eric Egen, and Brian Knight, 2003, “Public funds and private capital markets: The investment practices and performance of state and local pension funds,” National Tax Journal, Vol. 56, No. 3, September, pp. 579–594.
4Employee Benefit Research Institute, 2005, EBRI Employee Benefit Research Institute Notes, Vol. 26, No. 4, April, available at www.ebri.org/pdf/notespdf/0405notes.pdf

Posted by Diez at 03:04 PM | Comments (0)

February 01, 2006

State and Local Government Pension Forum

Welcome to the State and Local Government Pension Forum Blog site. Through this page we will provide you with updates about the conference, links to useful articles and studies and solicit questions and opinions on what pension issues are of greatest interest to you. Check back periodically as we add information to this page and try and answer your questions and inquiries.


Conference Announcement

February 28, 2006
Federal Reserve Bank of Chicago
3rd Floor Conference Center
Co-sponsored by the Civic Federation and National Tax Association

The Federal Reserve Bank of Chicago, the Civic Federation and the National Tax Association will sponsor a half-day forum examining growing concerns about the health of state and local government public pension system. In 2003, it was estimated that the largest state and local public pensions were under-funded by over $270 billion and this number was growing rapidly. The 14 million public servants and 6 million current retirees are owed an estimated $2.4 trillion by more than 2,000 different states, cities and municipal agencies. Many states and localities are finding themselves having to divert greater shares of current revenues to meet pension obligations reducing funding for other public programs. This forum will discuss trends in pension funding and administration and policies for managing growing pension obligations.

Please click to see the agenda or registration form.


Websites and data sources

The Pension Research Council (Wharton School, University of Pennslyvania)
http://prc.wharton.upenn.edu/prc/prc.html

Wilshire Research, 2005 Wilshire Report on State Retirement Systems: Funding levels and Asset Allocations
http://www.wilshire.com/Company/2005_State_Retirement_Funding_Report.pdf

Wisconsin Legislative Council, 2004 Comparative Study of Major Public Employee Retirement Systems
http://www.legis.state.wi.us/lc/

Public Pension Coordinating Council, source for comprehensive survey data (PENDAT)
http://ppcc.grsnet.com/

The Civic Federation, Status of Local Pension Funding: Fiscal Year 2003
http://www.civicfed.org/articles/civicfed_185.pdf

The Civic Federation, Governor’s Pension Commission Recommendations
http://www.civicfed.org/articles/civicfed_184.pdf

The Civic Federation, Recommendations on State Pension Reform in FY2006
http://www.civicfed.org/articles/civicfed_188.pdf


Selected academic articles

Tongxuan (Stella) Yang and Olivia S. Mitchell, “Public Pension Governance, Funding and Performance: A Longitudinal Appraisal”. Pension Research Council Working Paper
PRC WP 2005-2

Julia L. Coronado, Eric M. Engen and Brian Knight, “Public Funds and Private Capital Markets: The Investment Practices and Performance of State and Local Pension Funds”. National Tax Journal, Vol LVI, No.3, September 2003. pp. 579-594.

William R. Voorhees, “Counting Retirement Expenditures Before they Hatch: GASB and the Proposed Reporting Requirements for New Postemployment Benefits”. Public Budgeting and Finance, Vol. 25 No. 4, Winter 2005, pp. 59-71.

Stephen P. D’Arcy, James H. Dulebohn and Pyungsuk Oh, “Optimal Funding of State Employee Pension Systems.” The Journal of Risk and Insurance, 1999, Vol. 66, No. 3, pp.345-380.

Gene E. Mumy, “The Economics of Local Government Pensions and Pension Funding”, Journal of Political Economy, Vol. 86, Issue 3 (1978) pp. 517-527.


Other articles

Government Finance Review, December 2005

“Strategies for Funding OPEB Liabilities”
“The DB-DC Dilemma”
“A Closer Look at Deferred Retirement Option Plans”


News articles

Chicago Tribune, January 22, 2006. “Retiree health-care accounting rule may become bitter pill”, Barbara Rose

Fortune, January 13, 2006. “Tick, tick…boom! Terror alert: America’s pension time bomb is ready to explode”, Geoffrey Colvin

USA Today, January 17, 2006, “Public workers’ pensions swelling”, Dennis Cauchon.

Business Week, June 13, 2005 “Sinkhole”

Posted by Diez at 08:08 PM | Comments (0)