MRSC has joined with Tracey Dunlap, Director of Finance & Administration at the City of Kirkland, Mike Bailey, Finance Director, City of Redmond, and Glenn Olson, Deputy County Administrator, Clark County, to bring you the "Finance Advisor" column. The "Finance Advisor" will feature a new article each month with timely local government finance information and advice you can use.*

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Pension Problem Primer

December 2009

By Glenn Olson, Deputy County Administrator, Clark County

Amidst all the budget woes in Olympia these days, the one that will probably affect us the most is one that we hear the least about. That is our brewing pension problem. You can expect your employer PERS2 rates to nearly triple over the next several years unless some very dramatic solutions come out of the next two legislative sessions. This article is a primer on that problem.

Background

The State of Washington (the State) has 13 State agencies¹ and numerous local agencies that administer 15 pension plans. All of these plans are becoming more costly. There are many causes for these cost increases. Some, like longer lifespans or lower investment returns, are outside of policy makers’ control. Most of the cost increases, however, stem from only three root causes, and these are the direct results of policy decisions:

1. Many benefit improvements have been granted to workers in mid-career, or even after retirement. Normally investment returns fund the majority of benefits’ costs, and contributions pay a relatively small portion. But these retroactive benefits improvements are funded mainly by contributions² and therefore are extremely costly.
2. Plans were under-funded during the late 1990s, when extraordinary stock market returns and weak funding policies let employers cut contribution rates far too deeply.
3. Budget writers under-funded rates during revenue shortfalls, usually at the same time poor market performance would dictate rate increases. This is the case today.

Only two plans of Washington’s 15 plans (PERS 1 and TERS 1) are under-funded, but these two plans account for 35 percent of total plans’ assets. If they were fully funded they would account for 48 percent of the assets in the trust fund.³ This is a huge shortfall. Both of these plans are closed, with few active employees left, so the cost of their under-funding is borne solely by State and local government employers.

The remaining 13 plans are adequately funded, but investment losses, contribution reductions, and unfunded benefit improvements make it likely that soon these plans too will be under-funded. These funding shortfalls will be borne by both employers and (plan 2) employees. The rate increases needed to make up for these losses will dramatically strain budgets in the near future, to the point that some plans may not be sustainable.

Problem

Most of the plans in Washington’s pension system are at risk, and some plans may already be too costly to keep. Ironically, for all the money we are paying for these plans, they may not be meeting our future needs very well either.

Virtually all the reasons for these problems – and their resolution – have to do with shortcomings in one of two policy areas:

1. Funding Policy: Plans 2 and 3 likely will be disbanded unless the State substantially increases employer contribution rates to, or provides direct funding increases for, the under-funded legacy plans (Plans 1). Even if it manages through the current crisis, Washington will find itself in the same position again, unless it also adopts policies to sustain funding. These must be compulsory, include rate floors and prudent methods of recognizing gains and losses, and yet must flex to acknowledge budget reality.
2. Plan Design Policy: There is no clear and overarching policy to guide plan design.⁴ This means there is no definition of what the State wants for its employee’s retirements. Without policies to elicit what the State wants from plan changes, employee interest groups drive the process with constant pressure for they want: increased benefits. At the same time, already-granted benefits cannot decrease because case law⁵ forbids that, and it virtually forbids any other changes that are not explicit improvements.
   
   This structure paves the way for a constant flow of narrowly focused, interest-driven proposals. Without policy guidance – some standard against which to compare these proposals – policymakers can only react to them in a piecemeal, out-of-context fashion. There are few incentives for policymakers to deny these proposals.
   
   Once an improvement has been granted it creates a perceived disparity in the workforce. Then policymakers are faced with more proposals to address the disparity, and the same changes are granted to a broader membership in the name of parity. This is the ‘disparity/parity cycle,’ in which narrowly-granted benefit improvements ‘leapfrog’ across plans.
   
   Under this structure all interests align to increase costs. This does not only cause problems for the State and for local government employers. It costs workers too. Mid-career benefit improvements are a windfall for senior workers, but that windfall is funded at the expense of younger workers whose rates increase disproportionately. In the long run this structure ‘kills the goose’ with the golden eggs; since benefits cannot be reduced, policy makers ultimately have only one choice to control costs. They replace plans that become too expensive with cheaper ones. When they do, the next generation of employees works with peers that have greater benefits. This triggers the disparity/parity cycle, and the process starts all over again.

Of these two problem areas, funding policy is the most urgent and needs quick resolution. However, the lack of strong plan design policy underlies all the system’s problems, including funding.

Just solving the funding problem will actually make the plan design problem worse. Without clear goals for what we are buying, better funding just fuels the parity/disparity cycle. This does not mean funding policies should be ignored while we reinvent pension policy and the pension system. On the contrary, funding is the pension system’s most urgent and most important problem. It simply means that funding is only the first step in a process to fix a larger problem. If we just “throw more money” at the problem and ignore the next steps in the process, the State’s pension system soon will be facing the same issues again.

The following summarizes the problems that are either affecting the pension system or being caused by it. The Select Committee for Pension Policy’s Risk Assessment Advisory Group is charged with solving these problems over the 2010 interim.

Problem Summary - Problems Affecting the Pension system

1. Funding Policy: Plans 2 and 3 will be disbanded unless the State substantially increases employer contribution rates to, or provides direct funding increases for the under-funded legacy plans (TERS and PERS Plans 1).
2. Plan Design Policy: There is no clear and overarching policy to guide plan design, which means there is no definition of what the State wants for retirements. In the breach, interest groups define outcomes. This underlies every other problem.
3. Complexity: The number of plans managed by multiple authorizers is costly to an unknown extent and it exacerbates funding and policy issues.
4. Cost: The constant pressure to increase benefits is structural, hence irreversible, and in the current environment, unaffordable. Resulting layoffs create a downward spiral.
5. Retention: Late-career inducements to retain senior employees are disproportionately costly to the retirement system, yet other inducements do not exist.
6. Recruitment: Recent benefit improvements do not help attract high-quality recruits; the next generation of workers wants flexibility and portability.
7. Succession: A sudden, massive exodus of senior baby boom employees will be accelerated by recent benefit improvements, disrupting the succession of critical public services.
8. Hiring: Governments cannot pay better to get better recruits. This is an old dilemma, but it will get worse. Traditionally it has been benefits like retirements that help governments attract and keep the more highly qualified candidates
9. Parity: Employee trust is compromised by parity issues. This fuels the disparity/parity cycle.
10. Employee Welfare: Employers cannot protect employee welfare after retirement if retirement plans are not stable, sustainable, and flexible.

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Mike Bailey is currently the Finance Director for the city of Redmond. Previously he worked as Administrator of Finance and Information Services for the city of Renton and as the Director of Finance for the city of Lynnwood. Mr. Bailey also served as president of the Washington Finance Officers Association and is the Vice Chair of the GFOA Budget Committee. An experienced CPA and GFOA budget reviewer, Mr. Bailey co-founded the annual Budget and Fiscal Management Workshops held each summer. Mr. Bailey conducts numerous workshops and has authored various articles on local government finance, including Effective Budgeting in Washington State Cities published by the Association of Washington Cities.

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Tracey Dunlap, P.E. is the Director of Finance & Administration at the City of Kirkland. Prior to joining Kirkland in 2006, she was a principal and shareholder in FCS Group, a regional financial and management consulting firm (14 years). An industrial engineer registered in the state of Washington, she has worked with jurisdictions throughout the Northwest to develop and implement cost recovery and fee strategies, set utility rates, and improve organizational efficiency and effectiveness. Tracey's experience also includes working for a large defense contractor (5 years) and a major financial institution (3 years). She has presented on a wide array of topics for organizations including WFOA, APWA, APA, WABO, and AWC.

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Glenn Olson is the Deputy County Administrator for Clark County. He has been in Clark County since 1997, serving in various leadership positions during his tenure there. Previously Mr. Olson served 15 years in the Governors Office of Financial Management overseeing budget forecasts. Mr. Olson chaired the Washington State Public Works Board for Governor Locke. Currently he is the gubernatorial appointee representing local governments on the Select Committee for Pension Policy and on the Law Enforcement Officers and Fire Fighters Plan 2 (LEOFF2) Board, and he is the president of the Washington County Administrators Association.

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*The Articles appearing in the "Finance Advisor" column represent the opinions of the authors and do not necessarily reflect those of the Municipal Research & Services Center.

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