As with Cars, a Hybrid Pension System Will Cost More

The complexity of the pension problem comes in the multiplicity of angles from which the numbers can be presented. When it comes to the cost of current employees’ pensions, General Treasurer Gina Raimondo’s hybrid pension system will cost more than the system that’s already strangling Rhode Island.

The headline grabber — because it’s such a large figure — has been the unfunded liability. Essentially, that’s the difference between the benefits promised over the amortization period and the accumulated resources expected to be available to pay them.

It’s critical to realize that both sides of that equation are predictions. General Treasurer Gina Raimondo induced her recent shock to the pension system by leading the Pension Board in a reduction of the predicted annual market return on the system’s investments of just 0.75%, from an 8.25% expected return to a 7.5% expected return. In tweaking its assumptions, the board effectively increased the unfunded liability of state worker and teacher pensions from $5.40 billion to $6.83 billion, according to the most recent actuarial report. The overall problem, however, requires predictions about everything from a female desk clerk’s life expectancy upon retirement in twenty years to the average raise that RI school committees will give to their teachers over the next several decades.

Although interested parties like to pick and choose from among them, various factors have contributed to the existence of the liability. Given the lag time between a particular year’s pension payments and its full effects on the system, elected officials have had plenty of incentive to promise future benefits that outstripped the budget dollars that they were actually willing to put aside in the present, and union leaders have been happy to play along, expecting those promises to be fulfilled somehow, someway.

Another factor has been the market. Even responsible officials, who put aside every penny that the actuaries called for would have wound up underfunded, because the actuaries were basing their predictions on an 8.25% return, when the system has only realized 2.51% per year, considered over the past five years, 2.28% over the past 10 years, and 6.57% annually since 1995.

And then there are all those predictions. The actuaries currently expect a female teacher who retired last year to live for 24.2 more years. They predict that the same teacher retiring in 2030 will only expect an additional 1.1 years of life,  or 25.3 years of retirement. With the rate of advancement in medical technology, does that really seem plausible?

The incentives and unpredictability of pension planning are what make defined-contribution option so attractive. With a defined benefit, the employer promises employees a certain amount of future income, and it is up to the employer (or, in the public sector, the taxpayer) to make sure that the money is there; with a defined contribution, the employer promises to put a certain amount of money aside, and future income will depend on the plans and investment returns of the specific employee. The dollar amounts may turn out to be exactly the same, but it isn’t a “liability” in that the employer hasn’t pledged to make up the difference for unmet expectations.

Leading up to the release of Treasurer Raimondo’s pension reform proposal, advocates for public workers and retirees have been downplaying the importance of reducing this liability by separating the theoretical cost of pensions for current employees from the amount that municipalities and the state have to put aside to catch up on the current debt. The mechanism for this argument is the “normal cost” of a current employee’s pension — that is, the percentage of payroll that must be invested in order to fully fund pensions as if the past liability did not exist.

For teachers, the “normal cost” is now pegged at 11.82% of payroll, and since the teachers contribute 9.5% from their own paychecks, the city and state combined only have to put in another 2.32%. That’s what NEA-RI Executive Director Robert Walsh meant when he wrote in the Providence Journal that “for the vast majority of existing employees, the facts support no further changes” to the pension system. Get over the liability hump, in other words, and it’ll be clear sailing for public-sector retirees.

The question that hasn’t been asked, yet, is what Raimondo’s hybrid defined-contribution/defined-benefit plan will do to public costs when calculated in these terms. The answer is that it will actually increase them, as the following table shows.

RI State Pension Employee and
Employer Contribution Rates (% of Payroll)
Current Employees Defined Benefit
Current Employees Defined Contribution
Liability Amortization
Subtotal
Total
Employee
Employer
Normal Cost
Employee
Employer
Employee
Employer
Employee
Employer
State workers – current system
Prior assumptions
8.75
0.60
9.35
0
0
0
25.95
8.75
26.55
35.30
Assumptions in effect July 2012
8.75
2.64
11.39
0
0
0
33.70
8.75
36.34
45.09
After 2029 amortization
8.75
2.64
11.39
0
0
0
0
8.75
2.64
11.39
State workers – proposed system
2029 amortization
3.75
5.44
9.19
5
1
0
18.94
8.75
25.38
34.13
2035 amortization
3.75
5.44
9.19
5
1
0
14.91
8.75
21.35
30.10
After 2029 amortization
3.75
2.49
6.24
5
1
0
0
8.75
3.49
12.24
After 2035 amortization
3.75
2.49
6.24
5
1
0
0
8.75
3.49
12.24
Teachers – current system
Prior assumptions
9.50
0.50
10
0
0
0
25.71
9.50
26.21
35.71
Assumptions in effect July 2012
9.50
2.32
11.82
0
0
0
32.93
9.50
35.25
44.75
After amortization
9.50
2.32
11.82
0
0
0
0
9.50
2.32
11.82
Teachers – proposed system
2029 amortization
3.75
4.84
8.59
5
1
0
16.34
8.75
22.18
30.93
2035 amortization
3.75
4.84
8.59
5
1
0
13.27
8.75
19.11
27.86
After 2029 amortization
3.75
2.42
6.17
5
1
0
0
8.75
3.42
12.17
After 2035 amortization
3.75
2.42
6.17
5
1
0
0
8.75
3.42
12.17
Notes
1) Prior and current data from Employees’ Retirement System of Rhode
Island Actuarial Valuation Report as of June 30, 2010

2) Proposal data from “Actuarial Analysis of the Rhode Island Retirement
Security Act of 2011”
3) Amortization is currently scheduled for 2029; 2035 represents reamortization.
4) The proposed system continues the assumptions that will be in effect
as of July 2012.
5) Liability amortization includes current retirees’ pensions and the portion of current employees’ pensions not covered under normal costs.

Reformers should be wary of two facts that emerge from these eye-glazing numbers:

  1. Five percent of current retirees’ contributions will be entirely insulated from any problems that might arise with the defined-benefit component of the system — whether they be low investment returns, proof of unrealistic predictions, or a failure to meet recommended funding.
  2. Combining the defined-benefit and defined-contribution payments, the amount of money that state and local governments will spend on the retirements of current employees every year will increase — more than doubling until such time as grandfathered employees leave the system and continuing on at a higher rate even then.

This means that the savings of the overall pension reform rely entirely on changes to the existing system (e.g., COLAs and retirement age), because the hybrid will cost tens of millions of dollars more every year… even when the “pension crisis” is completely resolved and even if the assumptions prove accurate. And changes to the existing system are precisely the controversial elements that have battle lines being drawn.

With all the lines on the field and the questionable allegiances, taxpayers should be sure that somebody is defending their interests.