In the 1990s, the Swedish government realized it had a pension problem. Sweden relied on two primary pension mechanisms. The first was a pay as you go, defined-benefit plan financed through a payroll tax on employers. This was supplemented with an occupational pension that was part of collective bargaining agreements between different classes of workers and their employers. Given changing demographics and generous pension benefits, the Swedish government recognized that the pension system would go bankrupt in 20 to 25 years without significant tax increases. At the heart of the problem was the linking of benefit increases to price changes rather than wage growth. This tended to make benefits rise faster than wages and contributions during periods of slow productivity growth.

To address this problem, the Swedish government wanted to restructure its pension system to respond to the increased longevity of the population and reflect economic conditions. In 1998, the Swedish Parliament abandoned the traditional defined-benefit pension plan in favor of a new notional defined contribution (NDC) plan. The new plan has two components—a notional account for each worker and a private account referred to as the premium pension. The contribution level is 18.5% of earnings with 16% going to the notional account and 2.5% to the premium account. So far this doesn’t sound all that radical. However, the notional defined contribution plan is fundamentally different from other traditional pension structures. Contributions to the NDC are recorded in each individual’s personal account and accumulate based on their earnings. However, the contributions are only “notional” in the sense that the money that is being collected today is used to finance current obligations of retirees. The individual’s fund balance grows on paper even though there is no real money in the account. The rate of growth is determined by the employee’s contribution and a defined rate of return that is tied to the national per capita real wage growth. In doing so Swedish officials wanted to stabilize pension funding and insure pension sustainability.

Workers can then choose to retire as early as age 61. When they retire annual benefits are calculated by dividing the account balance by a divisor. The divisor is set to the cohort’s age 65 life expectancy and an imputed rate of return based on the long-term real growth rate of the economy (assumed to be 1.6%). Benefits are then adjusted each year for inflation take into account the imputed rate of return.

The ability to cap total payouts and adjust benefits to reflect economic and demographic changes significantly improves the financial stability of the Swedish pension system. However, the system is still a pay as you go plan and as such the Swedes decided it was wise to build in buffer funds to protect against shortfalls. The buffer funds are critical because given the structure of notional accounts, raising contributions levels only has the effect of increasing future benefit promises. One of the clear goals of the reform was to take the politics out of pensions by making the system more transparent and making adjustments driven by formula rather than politics. In addition it encourages workers to postpone retirement since benefits continue to accrue based on annual earnings.

Individuals are also required to carry “Premium” pension accounts. These supplemental individual accounts require a mandatory contribution of 2.5% of annual earnings. The funds are then invested by the individuals in a large range of fund types including equities, balance funds, life-cycle funds, and interest-earning accounts. In addition the government established a low-risk default fund for investors who did not feel comfortable making an investment choice. A key component of the individual accounts was investor education. The government undertook a significant program of financial education.

The transition to the new structure has gone well according to most reports. Individuals will be phased in over a 16-year period based on cohorts. Only workers born in 1954 or later will fully participate in the new system In contrast, the first cohort, those born before 1938, will receive only one-fifth of their benefit from the new system while receiving four-fifths from the old defined benefit system. In the end, the biggest advantage of Sweden’s reform can be found in pension fund sustainability. While the notional accounts structure is designed to adjust future benefit levels based on economic and demographic conditions it runs the risk of providing benefit levels will be inadequate if economic conditions are sufficiently adverse. In this case the system might unravel under political pressure. What is clear is that the Swedish system now makes individuals far more responsible for planning for their own retirement and given pension pressures facing many governments, NDCs will continue to receive attention.

To find out more about NDCs:

The Economist, “More Than a Notional Improvement” Economic Focus, February 18, 2006.

Annika Sunden, “The Future of Retirement in Sweden” in Reinventing the Retirement Paradigm, Robert L. Clark and Olivia S. Mitchell, editors, Oxford University Press, 2005.

Over 150 people attended the February 28, 2006, State and Local Government Pension Forum cosponsored by the Chicago Fed, the Civic Federation, and the National Tax Association. Presenters offered a wide range of perspectives on trends affecting pension funding and solvency, as well as discussing the potential impact that recognizing future OPEB liabilities will have on government finances.

I will summarize the conference discussions in an upcoming Chicago Fed Letter. Meanwhile, here are some of my impressions. By the end of the program I think a pretty firm consensus had emerged that:

• while not a crisis, pension funding and OPEB liabilities will be the largest fiscal challenge to many state and local governments in some time. Financial commitments for these programs are growing much faster than the rate of revenue growth.
  
• these commitments cannot be avoided. Even the OPEB liabilities may be a contractual obligation that must be met.
  
• the secondary impact on state and local governments will be significant. Program reductions and higher taxes are likely.
  
• if somehow the state and local governments can get out of their OPEB programs, this will have a negative impact on an already overtaxed Medicare system.
  
• this is a major political problem since there is little reason for any governor, mayor or legislature to fix the problem.
  
• The strength of the state and municipal workers unions (as shown, for example, by the recent NYC transit strike) suggests that negotiating concessions will be difficult.
  
• The rating agencies are unlikely to significantly downgrade public debt when OPEB liabilities are reported. As long as the government under analysis can demonstrate a plan for meeting OPEB liabilities, they will be held harmless.
  

The conference had many excellent presentations. I provide a brief description of each presentation here and a link to the relevant powerpoint or speech.

The Impending Pension and Health Plan Crisis and the Impact of an Aging Work force on Talent Management
Tim Phoenix and Lance Weiss, Deloitte Consulting

Tim Phoenix and Lance Weiss discussed the aging demographics of the government work force and stressed that any change in pension or health care plans must consider issues of talent retention and talent attraction. They also provided a comprehensive history of the Illinois pension system and recent efforts to address underfunding.

An Independent View of the Credit Risks of Pension Underfunding
Richard Ciccarone, McDonnell Investment Management
John Kenward, Standard & Poor’s
Paul Nolan, Moody’s Investors Service
Joe O’Keefe, Fitch Ratings

Richard Ciccarone moderated a panel of rating agency analysts, who examined how state and local governments are handling pension liabilities and the impact that OPEB liabilities might have on government credit ratings. The analysts stressed that a primary concern is whether state and local governments have recognized their future liabilities and have a plan for meeting them.

The Regional Perspective on Pension Issues
Michael Moskow, Federal Reserve Bank of Chicago

Michael Moskow offered his perspectives on improving pension solvency and the impact of pension underfunding in the Midwest.

Are Public Pension Funds Able to Break from the Path of Social Security and the Private Sector?
J. Fred Giertz, University of Illinois and National Tax Association

Fred contrasted the relative liability of the Social Security and Medicare system to private and state and local government pension exposure. He examined resources that each sector might have to meet future expenses.

If the Pension Bomb Stops Ticking, What Happens Next?
James Spiotto, Chapman and Cutler

James Spiotto described the legal protections surrounding pension funds as well as the limits on state and local governments to restructure pension and even health care liabilities.

The Organized Labor Perspective on Pension Issues
Hank Scheff, AFSCME Council 31

Hank Scheff described why defined benefit pension programs are often best for government workers. He noted that nearly one-quarter of state and local government workers do not receive social security benefits, making pension income that much more important. He also described recent problems in Illinois pension funding.

Best Practices for Reforming Pension Governance
Lise Valentine, The Civic Federation

Lise Valentine examined governance structure for pension fund boards and spoke of the importance of having independent and citizen member representatives. She stressed that pension boards should focus on protecting the funds assets and not lobbying for any particular stakeholder group.

Finally, if you have any questions after you look over the presentations, let me know. I’ll get in touch with the presenter and try to get you an answer.

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.”

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.

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

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?

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.

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”