The Amazing, Obscure, Complicated and Gigantic Pension Loophole

“The bottom line is that claiming the unfunded liability cost as part of an officer’s compensation is grossly and deliberately misleading.”

– LAPPL Board of Directors on 08/07/2014, in their post “Misuse of statistics behind erroneous LA police officer salary claims.”

This assertion, one that is widely held among representatives of public employees, lies at the heart of the debate over how much public employees really make, and greatly skews the related debate over how much pension funds can legitimately expect to earn on their invested assets.

Pension fund contributions have two components, the “normal contribution” and the “unfunded contribution.” The normal contribution represents the present value of future retirement pension income that is earned in any current year. For example, if an actively working participant in a pension plan earns “3% at 55,” then each year, another 3% is added to the total percentage that is multiplied by their final year of earnings in order to determine their pension benefit. That slice, 3% of their final salary, paid each year of their retirement as a portion of their total pension benefit, has a net present value today – and that is funded in advance through the “normal contribution” to the pension system each year. But if the net present value of a pension fund’s total future pension payments to current and future retirees exceeds the value of their actual invested assets, that “unfunded liability” must be reduced through additional regular annual payments.

Without going further into the obscure and complicated weeds of pension finance, this means that if you claim your pension plan can earn 7.5% per year, then your “normal contribution” is going to be a lot less than if you claim your pension plan can only earn 5.0% per year. By insisting that only the cost for the normal contribution is something that must be shared by employees through paycheck withholding, there is no incentive for pension participants, or the unions who represent them, to accept a realistic, conservative rate of return for these pension funds.

This is an amazing and gigantic loophole, with far reaching implications for the future solvency of pension plans, the growing burden on taxpayers, the publicly represented alleged financial health of public employee pension systems, the impetus for reform, and the overall economic health of America.

Governor Brown’s Public Employee Reform Act (PEPRA) calls for public employees to eventually pay 50% of the costs to fund their pensions, this phases in over the next several years. But this 50% share only applies to the “normal costs.”

In a 2013 California Policy Center analysis of the Orange County Employee Retirement System, it was shown that if they reduced their projected annual rate of return from the officially recognized 7.50% to 4.81%, the normal contribution would increase from $410 million per year to $606 million per year. In a 2014 CPC analysis of CalSTRS, it was shown that if they reduced their projected annual rate of return from the officially recognized 7.50% to 4.81%, the normal contribution would increase from $4.7 billion per year to $7.2 billion per year.

The rate of 4.81% used in these analyses was not selected by accident. It refers to the Citibank Liability Index, which currently stands at 4.19%. This is the rate that represents the “risk free” rate of return for a pension fund. It is the rate that Moody’s Investor Services, joined by the Government Accounting Standards Board, intends to require government agencies to use when calculating their pension liability. As can be seen, going from aggressive return projections of 7.5% down to slightly below 5.0% results in a 50% increase to the normal contribution.

No wonder there is no pressure from participants to lower the projected rate of return of their pension funds. If under PEPRA, a public employee will eventually have to contribute, say, 20% of their pay via withholding in order to cover half of the “normal contribution,” were the pension system to use conservative investment assumptions, they would have to contribute 30% of their pay to the pension fund.

Moreover, these are best case examples, because the formulas provided by Moody’s, used in these studies, make conservative assumptions that understate the financial impact.

In another California Policy Center study, “A Pension Analysis Tool for Everyone,” the normal contribution as a percent of pay is calculated on a per individual basis. One of the baseline cases (Table 2) is for a “3.0% at 55” public safety employee, assuming a 30 year career, retirement at age 55, collecting a pension for 25 years of retirement. At a projected rate of return of 7.75% per year, this employee’s pension fund would require 19.6% of their pay for the normal contribution. Under PEPRA, half of that would be about 10% via withholding from their paychecks. But at a rate of return of 6.0%, that contribution goes up to 31%. Download the spreadsheet and see for yourself – at a rate of return of 5.0%, the contribution goes up to 41%. That is, instead of having to pay 10% via withholding to make the normal contribution at a 7.75% assumed annual return, this employee would have to pay 20% via withholding at a 5.0% assumed annual return. The amount of the normal contribution doubles.

This why not holding public employees accountable for paying a portion of the unfunded contribution creates a perverse incentive for public employees, their unions, the pension systems, and the investment firms that make aggressive investments on behalf of the pension systems. Aggressive rate of return projections guarantee the actual share the employee has to pay is minimized, even as the unfunded liability swells every time returns fall short of projections. But if only the taxpayer is required to pick up the tab, so what?

Adopt misleadingly high return assumptions to minimize the employee’s normal contribution, and let taxpayers cover the inevitable shortfalls. Brilliant.

Public employee pension funds are unique in their ability to get away with this. Private sector pensions were reformed back in 1973 under ERISA rules such that the rate of return is limited to “market rates currently applicable for settling the benefit obligation or rates of return on high quality fixed income securities,” i.e., 5.0% would be considered an aggressive annual rate of return projection. If all public employee pension funds had to do were follow the rules that apply to private sector pension funds, there would not be any public sector pension crisis. And when public employees are liable through withholding for 50% of all contributions, funded and unfunded, that basic reform would become possible.

This is indeed an obscure, complicated, amazing and gigantic loophole. And it is time for more politicians and pundits to get into the weeds and fight this fight. Especially those who want to preserve the defined benefit. Until incentives for public employees and taxpayers are aligned, pension funds will cling to the delusion of high returns forever, until it all comes crashing down.

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Ed Ring is the executive director of the California Policy Center.