Governor Focuses On Pension Funding Issues

For the past several weeks, Governor Malloy has been pitching a proposal to restructure Connecticut’s state employee pension funds which has generated a lot of media attention and questions from CSEA members. Our pension’s funding problems were created by the unilateral actions of the state government prior to the advent of collective bargaining of the pension in the late 1970s and exacerbated by actions insisted upon by various governors since then, especially John Rowland.  As part of the Coalition of State Employee Unions which bargains pensions – SEBAC — CSEA is committed to discussing with the administration options to address that problem.  This however is a delicate matter because making the wrong choice could lead to significant problems down the road.  As such, CSEA along with other state employee unions will insist upon careful analysis and due diligence for any proposal before embracing or rejecting it.

It is important to understand that everything at this point is just a proposal, and that over the course of the next several months there will be many more proposals both good and bad.  By law, no changes can be made to the state employee pension unless both the administration and the State Employees’ Bargaining Agent Coalition (SEBAC) agree.

In this article we attempt to give you the basic 101 information to better understand the conversation about the state pension and explain the administration’s proposal.

In order to understand the Governor’s proposals, there are some basic facts about the pension plan that need to be understood.  The State Employee Retirement System (SERS) is Connecticut’s primary state employee pension system. It is administered by the Office of the Comptroller, and is a defined benefit pension plan that has four different tiers: Tier I, Tier II, Tier IIA, and Tier III. Employees fall into different tiers based on when they were hired. Each tier has different terms for the pension benefits it provides (although hazardous duty benefits have changed little between the Tiers and so are not covered below).

• Tier I includes employees hired before July 1, 1984, most of whom are now retired. It provides the most generous benefits. The benefits provided by SERS for this tier were not pre-funded at all until 1971 and not funded reliably until the advent of collective bargaining in the late 1970s. Until then, benefits were paid each year from the State’s general revenues.  Employee contributions to Tier I were 2%

• Tier II encompasses state employees hired on and after July 1, 1984 and before July 1, 1997. Tier II benefits are more modest than Tier I benefits.  Tier II has no required employee contribution outside of hazardous duty employees who pay 4%.

• Tier IIA covers state employees hired on or after July 1, 1997. Tier IIA provides the same benefits as Tier II, but unlike Tier II, Tier IIA requires employees to make a contribution toward their pensions. That contribution is two percent (2%) of their total wages, unless they are in a position designated as hazardous duty in which case the contribution is five percent (5%) of your total wages.

• Tier III covers most state employees hired after July 1, 2011. Tier IIIs contribute the same as Tier IIA, but its pension benefit is calculated off of an individual’s highest 5 year average salary and there is 10 year vesting rather than 5.   Tier 3 also has a higher normal retirement age than for Tier II and IIa.

Connecticut’s Unfunded Liability

The liability of a pension fund is the estimated total cost of its financial commitments to those state employees who have earned a pension. This number includes state employees who have earned a pension but will not collect for many more years. The unfunded liability is the portion of that total financial commitment for which the state does not currently have money in the pension fund. Because the state paid pension benefits directly out of the general fund until 1971 there was no long term planning despite CSEA’s objections. Additionally, past governors made decisions to deliberately under-fund the pension and offer some employees early retirement in order to balance the state budget, which exacerbated the unfunded liability in the process.  It is our unfunded liability that drives much of our costs — money the state should have set aside and invested years ago for Tier 1 employees who are mostly retired today, but did not.

How Is Our Pension Funded?

State employee pensions are funded through a combination of investment returns (44%), employee contributions from Tiers IIA & III (8%), state contributions which come from tax dollars (38%), and federal dollars paying the pension costs of state employees working on joint federal state projects, largely transportation projects in the Department of Transportation (10%).  These percentages are from the

State Treasurer’s 2013 Annual Report

Key Facts

In discussing the funding of the state’s pension system, the administration highlighted a few key facts from a November 2015 report by Boston College that are important to reiterate:

  • Our pensions are, in fact affordable.  The average cost for SERS for active employees is 10.2% of payroll, compared to the national average of 13.6%.
  • The unfunded liability drives much of the pension’s costs.
  • Because so much of the annual pension cost is for the unfunded liability, any changes made to the pension benefits for new or active employees will only make a marginal change in the state’s annual required contribution. This is why conversion to a defined contribution, 401K-type plan would not help control costs, as many have suggested. A new pension structure going forward would not wipe out debts racked up over generations of state workers.
  • Connecticut courts have held that pensions, once awarded at retirement, are the property of the pensioners.  The state cannot diminish or take those pensions away without compensating the pensioners who own them, any more than the state can take other property without compensation.

 

The Governor’s Proposal

In response to the current budgetary struggles of the state and a report by Boston College on Connecticut’s retirement system, the administration is proposing several changes to deal with what it sees as a potential funding crisis down the road. In a letter to the Governor regarding the Boston College report, budget director Benjamin Barnes stated, “the headline of the report is that the combined systems, if funded under the current approach and if investment returns meet our assumptions, will require that our contributions double from $2.5 billion now to about $5 billion as we approach 2032.  In my opinion, this scenario, while optimistic about investment returns, still presents the greatest long-term budget challenge facing the state.  However, if investment returns fall short of our 8-8.5% expectations, the future becomes alarming.”

The Malloy Administration is proposing several changes:

•  Reducing investment return assumptions from 8% to 7%.  This more cautious approach carries a significant cost, and the administration believes it will result in a reduction of the widely reported “funded ratio”.

•  Change the way the state calculates its annual contribution.

•  Split the SERS system into two funds, a closed plan for Tier 1 retirees for whom most of the unfunded liability applies, and an open plan for active employees, mostly from Tiers 2, 2A, and 3.  The closed Tier 1 plan would then be funded on a pay-as-you go basis out of the state’s general fund with annual required appropriations sufficient to cover benefit payments, while the other open plan would continue to be pre-funded on an actuarial basis.  For Tiers 2, 2A, and 3 this proposal would dramatically reduce the unfunded liability of the pension.  The benefit for the state is that the proposal would dramatically change the state’s future payments to SERS.  There are unanswered questions as to how this change would fully affect Tier 1.

 

Concerns & Unanswered Questions  

Lawyers for the state treasurer have questioned whether paying benefits to some retired workers out of the state budget — and not out of the pension fund — would require federal Internal Revenue Service approval.  Speaking to CT Mirror, a lawyer for Denise Nappier said, “This question needs to be answered to ensure the federal tax advantages afforded to state pension recipients are not affected. There’s a potential liability for those beneficiaries.”

Comptroller Lembo also asked in a letter to the Governor:

[Your proposal to separate Tier 1 retirees from the SERS plan and funding it on a pay-as-you-go basis] has some strengths.  It creates a well-funded retirement system for non Tier 1 employees, which will have less demand for liquidity and will allow the Treasurer to more aggressively invest the assets to achieve higher returns.  However, your proposal does raise important questions, some of which were highlighted by Secretary Barnes in a recent letter to you, including: 

  • What is the impact on federal and other fund fringe benefit recoveries?
  • How will credit markets react to splitting Tier 1 members into a pay-as-you-go plan?
  • Are there legal constraints on the method of separating the assets between the two groups?
  • Will there be an impact on the pre-tax status of Tier 1 member pension contributions?
  • What is the long-term cost to the state in foregone investment returns as a result of abandoning a prefunded strategy for Tier 1 employees and retirees? 

Obtaining answers to some of the above questions may be challenging as there are few state-level examples to reference.  In fact my office has only been able to find one state-level pension fund that has a pay-as-you-go portion, the Indiana Teachers’ Retirement Fund.  It includes a pay-as-you-go system for a closed group of teachers who retired prior to 1996 and is bolstered by a dedicated revenue stream.  Generally states have moved away from pay-as-you-go funding systems as they are not actuarially sound and require greater contributions in the long run.

…Our state faces unsustainable future pension payments under our current system.  I am in full agreement with your assessment of the problem and the need for action.  I propose we engage the plans’ actuaries to investigate the potential for a traditional solution to our current funding problems that will meet generally accepted actuarial best practices, retain market confidence and create a predictable payment schedule that establishes a clear path to paying off our past obligations.    

The Comptroller’s office has since announced that it is working on its own alternative proposal.

Where We Go From Here

The current debt payment program – which requires that all of the errors of past legislatures and governor’s be paid off no later than 2032 – is not written in stone.   But it is written in contract.   We will carefully consider constructive suggestions for alternatives that are in everyone’s interest.  But by law, no changes can be made to our pensions unless both the administration and the State Employees’ Bargaining Agent Coalition (SEBAC) agree.  As this is a developing story, CSEA will work to keep you informed of any significant developments.

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