Covering your local pension plan It took me three years and two - PDF document

Covering your local pension plan It took me three years and two dozen stories to really figure out how to tell if a public pension plan is healthy or not. Here are the tips and shortcuts to save you the time. By David Milstead davidmilstead@q.com 303-800-6423 Part One: Introduction Defined benefit plans: Known as “pensions,” it’s the benefit that’s defined, usually as a specific amount per month, in retirement. It’s the plan manager’s responsibility to invest the money that comes in to make sure the benefit can be paid. Defined contribution plans: Like a 401(k), it’s the contribution – what goes in – that’s defined. What comes out at retirement is whatever is in the account after years of investing. Typically, these accounts shift the investment risk to the individual – for better or worse. This presentation is about defined benefit plans run by the public sector – governments like states, school systems, and cities. Non-governmental entities, like for-profit corporations, run defined benefit contribution pension plans as well. There are special issues with corporate pension plans, like accounting rules and the tax benefits from the contributions, that we will not cover here. Also, these non-governmental plans are covered by the Federal ERISA (Employee Retirement Income Security Act), and the employers can walk away from the plans in certain circumstances and turn the over the Pension Benefit Guaranty Corp., the federal pension insurer. Public pensions are generally regarded as contractual relationships between the public employer and the employee – meaning public pension promises must be kept. Part Two: Pension cash flow Contributions + Investment Income = Expenses + Benefits (hopefully) A defined benefit plan takes in cash each year from the employer and, typically, from the employee as well. These are the “contributions.” Contributions are typically expressed as a percentage of pay. In Colorado, the state school employers of PERA members paid 13.85 percent of salaries into the plan, up from 10.15 percent several years ago. Employees had been paying 8 percent of their salaries; recent changes increased that figure to 10.5 for some. Other plans require higher contributions. When I did my study in 2005, one West Virginia pension plan had an employer contribution rate exceeding 22 percent – more than twice what Colorado taxpayers paid at the time. (Many pension members reject the idea that “taxpayers contribute” anything to their plan, even though they are employed by a governmental entity. Excerpt from an e-mail from a PERA member: “The 10.1% contribution of the employer and 8% from the employee are both part and parcel of the employee's overall wage and benefit compensation earned for work performed and services rendered. That money is twice removed from the taxpayer and no longer any of their business.” Former New York Times reporter David

Cay Johnston made a similar argument earlier this year in a blog post in which he lambasted journalists for using language he considered supportive of efforts to cut back pensions.) The contributions go to work as investments – stocks and bonds, and to a lesser extent, real estate, venture capital, private equity, hedge funds and timber. Some of these assets – dividend-paying stocks, bonds, real estate funds that distribute rental income or sales proceeds – throw off cash, or investment income , every year. That cash can be used to pay benefits or can be reinvested in new assets. Each pension fund has certain expenses that must be paid each year. All plans have certain administrative costs, and all plans have investment costs as well. Some plans, like PERA, manage a significant amount of their money in-house, and employ more people. This arrangement may be cheaper than paying asset-management fees to outside money managers, which many plans do to a certain extent. Plus, PERA, for example, also manages 401(k)-style accounts and a health-care plan, which adds to its expenses. Expenses can be examined as a percentage of assets in the pension plan, (an “expense ratio”) and that number seems very small, perhaps 0.50 percent of assets. And the ways in which the plans are structured can cause the number to be higher, or lower, without it being wasteful or inefficient. Also, all plans have fixed costs, so a smaller plan will have a higher expense ratio. Each year, the plan must pay benefits to its retired members. A member that has retired with full eligibility for a pension gets what’s called an “unreduced” benefit. (My editors don’t like that word, so I call it a “full” pension, which is not an official pension term and, consequently, angers pension members.) A typical pension benefit is expressed as a percentage of salary, which is then multiplied by years of service. Or: Benefit = Salary X percentage X years of service The salary is typically a “highest average” or “highest annual.” Some plans take the three, or five, highest annual figures. Others take the highest 24, 36, or 60 months. Others take final salary on last day of employment. The method of calculation is important because a pension payment can be manipulated when the salary period is small. Some public safety plans with loose rules have “chief for a day” problems, where police officers or firefighters get a one-day promotion, a $20,000 raise for pension purposes, and a much more golden retirement. In Colorado, am unreduced pension is equal to 2.5 percent of HAS, times years of service, with a cap of 100 percent of HAS. A retiree with 30 years of service and a HAS of $50,000 would get $50,000 X .025, or $1,250, times 30 years, for $37,500. A 40-year employee would get $50,000 X .025, or $1,250, times 40 years, for $50,000. As you can see, any years worked over 40, with the 100% cap in place, yields no extra pension benefit. Benefits are then typically adjusted each year in retirement for increases in the cost of living. Some increases are set year-by-year, or are linked directly to a measure of the Consumer Price Index. Others plans, like PERA until recent reforms, are fixed. PERA retirees’ benefits were to increase 3.5 percent per year, a decision that was made in 2000 when PERA was overfunded. Recent changes now tied the COLA to the lesser of the Consumer Price Index or 2 per cent. Many plans with an older retiree population may actually be cash-flow-negative, which means they have to sell off assets in order to pay benefits. Not a good sign. Questions to know the answers to: • What are the employer and employee contribution rates for this pension plan? How much are taxpayers putting into the plan each year in employer contributions? • What are the plan’s expenses, as a percentage of assets? How does that compare to plans of similar size? Is there something about the plan’s structure, like how much of the plan’s investments are managed in-house, that affects the comparison? • What is the plan’s formula for calculating benefits? Is there any limit to what a member can earn in retirement?