Born Broke: Our pension debt problem
by J. Scott Moody and Wendy P. Warcholik, Ph.D.
AUGUST 2014
EXECUTIVE SUMMARY
Connecticut’s public pension system is one of the most expensive in the nation – which may explain why it is drowning in debt. The state says it owes an already-whopping $24.5 billion to teachers and state employees. But the truth is even more sobering: Our study, conducted by economists Dr. Wendy P. Warcholik and J. Scott Moody, shows that by using overinflated earnings estimates the state is grossly underestimating the size of its
pension debt.
Connecticut’s actual unfunded pension liability is $76.8 billion. That’s more than three times the amount the state claims to owe.
Connecticut offers a host of other benefits to retirees – including healthcare and life insurance – but there are virtually no savings to pay for these ever-mounting costs. In addition to its unfunded pension liability, Connecticut owes another $22.7 billion in unfunded benefit obligations to retired teachers and state employees.
When the two figures are combined, it becomes clear that:
- The state owes almost $100 billion in unfunded pension and benefit liabilities.
- That’s $27,668 of pension debt for every man, woman and child in Connecticut.
The state’s estimate of $24.5 billion in pension liabilities significantly underestimates Connecticut’s pension debt. First, economists dispute the method the state uses to determine how much it will owe in the future because it omits future benefit obligations. Second, on the future promised benefits they did value, the state assumes that its pension savings will earn between 8 and 8.5 percent each year. That projection is unreasonably optimistic – the 2013 state treasurer’s report shows that, historically, the pension funds have earned significantly lower rates of return.
What’s more, Connecticut has not kept up with the payments it promised to make when it revamped the pension system in 2012. Even now, the dramatic shortfall in the state’s pension system forces difficult choices on Connecticut’s citizens:
With public pensions and retiree benefits eating up a greater portion of the state’s budget, steep tax increases or deep cuts to government services are the only ways to achieve fiscal stability. In light of these facts, the Yankee Institute for Public Policy recommends the immediate adoption of a defined contribution pension plan, both to offer public workers greater flexibility and to safeguard the hard-earned dollars of Connecticut’s taxpayers.
– Yankee Institute Staff
INTRODUCTION
A new analysis of Connecticut’s unfunded pension liability shows it is much, much greater than the $24.5 billion reported by the state, and has increased significantly since our last study was published in 2010.
Pension and other retiree liabilities are being dramatically underestimated because the state’s estimates are based on unrealistic assumptions about discount rates and rates of return, and because the state does not include its retiree healthcare and other costs in its figures.
This new study finds that the real unfunded pension liability is $76.8 billion, or 213 percent higher than current forecasts, with other retiree benefit liabilities coming in at $22.7 billion. Add the two obligations to retirees together and Connecticut’s total unfunded retiree (pension plus OPEB) liability clocks in at $100 billion. For comparison, that figure is five times the amount the state collects in revenues per year.
Additionally, as of 2009, the City of Hartford has a $700 million unfunded pension liability.
Connecticut’s state government administers retirement benefits for state employees, teachers, and those in the judicial system. These three groups include 174,300 working or retired people. Of those, 76,420 drew pension benefits in Fiscal Year (FY) 2012.
Did you know?
The largest teacher pension in the state of Connecticut goes to someone who hasn’t even retired yet!
Bruce Douglas, head of the Capitol Region Education Council (CREC), receives a $198,000 yearly pension in addition to the $130,000 annual salary he earns for running CREC. Douglas, 66, started collecting his pension in November 2011. Before his “retirement,” CREC paid Douglas a little less than $250,000 per year. But state law allows Douglas to collect both his pension and salary only as long as his salary was cut to 45 percent of the maximum level for the assigned position. Just by retiring and taking a voluntary “pay cut,” Douglas actually increased his pay from $250,000 to $328,000. Between his 33 year tenure in the state education system and his time at CREC, Douglas’ pension payments have peaked: After 37.5 years, teachers earn a pension equal to 75 percent of their salary, the maximum allowed.
One state lawmaker transformed an election loss into an opportunity to collect both a pension and a salary!
After losing the 2008 election, Rep. Al Adinolfi, R-Cheshire, retired and began collecting his legislative pension of about $450 a month. When he was reelected in 2010, he started receiving his legislative salary again – along with his pension!
It is not surprising that New Haven’s recently-elected mayor, Toni Harp (a Democrat and former state senator) said she supports pension reform! New Haven spends more on employee pensions, as a percentage of its budget, than any other major city in Connecticut.
In fact, New Haven is ranked 27th out of 173 cities nationwide for its pension spending, which eats up about 10.2 percent of the city’s annual revenues, according to a study by the Center for Retirement Research. If that’s not enough, the city has about $500 million in pension liabilities, too.
By state estimations, pension obligations for active and retired state employees, teachers and judges total $48.2 billion in FY 2012. Yet, the state has only set aside $23.7 billion in assets to pay for these obligations. The pension system reports an unfunded liability of $24.5 billion. But our study shows the liability is more than three times that amount.
And that’s just the pension liability. On top of that is Connecticut’s Other Post-Employment Benefits (OPEB) system, such as healthcare and life insurance, which is in even worse shape. In FY 2013, the OPEB system has nearly zero assets ($144 million) set aside to pay for $22.7 billion in obligations. Without offsetting assets, the OPEB system operates on a “pay-as-you-go” basis, which maximizes the tax burden on the shoulders of Connecticut’s taxpayers.
The public retiree problem is so bad that Connecticut’s state government, in FY 2008, resorted to issuing $2 billion in General Obligation Bonds (GO) for the Teachers’ Retirement System (TRS) to make up for lost ground. However, this gamble has not paid off and such risk arbitrage is simply not a sustainable way to deal with this unfunded pension liability.
Overall, there are two basic options available to policy makers to solve Connecticut’s massive pension and OPEB crisis. One option is for policymakers to dramatically raise taxes. However, raising taxes would weaken Connecticut’s economy and jeopardize the state’s ability to ever meet its pension and OPEB obligations.
A better option is to reform the pension and OPEB system. As we recommended in our first study in 2010, Connecticut should replace its traditional defined benefit system with a defined contribution system for new employees.
As such, normal turnover in the workforce will begin to bring down the unfunded pension liability to more manageable levels.
UNDERSTANDING THE UNFUNDED RETIREE LIABILITY
Since the last study we published in 2010, when we examined the pension figures for FY 2008, public pension health has eroded.
The funded ratio for the pension system in FY 2012 was a dismal 42.3 percent for SERS, compared to 51.9 percent in FY 2008, 55.2 percent for TRS in FY 2012 compared to 70 percent in FY 2008, and 54.7 percent for JRS in FY 2012 compared to 71.8 percent in FY 2008.
Despite our earlier recommendations, Connecticut is still using a “defined benefit” system for its public employees, which is designed so that a member, such as a state employee, is paid a fixed level of income upon retirement. The level of income is based on such factors as length of service and average level of compensation. The private sector has largely turned to a “defined contribution” system, in which the employer and employee contribute a set amount of funds into a retirement plan, usually based on a percentage of income. In this system, the employee makes her own investment decisions and chooses how much to take out during retirement.
Connecticut’s defined benefit pension system consists of three separate retirement systems: the State Employees Retirement System (SERS); the Teachers’ Retirement System (TRS); and the Judicial Retirement System (JRS). They will hereafter be referred to as the “Connecticut pension system.” As of June 30, 2012, SERS had 91,755 active and retiree members, TRS had 82,102 active and retiree members and JRS had 443 active and retiree members, for a total of 174,300 people.
Of those, 76,420 drew pension benefits in FY 2012, up from 71,781 in FY 2008.
Under SERS, 43,887 retired members received annual benefits of $1,424,477,046, or an average of $32,458 per retiree. In FY 2008, annual benefits were $1,047,479,000. Under TRS, there were 32,294 retired members drawing annual benefits of $1,531,493,000, an average of $47,423 per retiree. In FY 2008, annual benefits under TRS were $1,231,069,368. Under JRS, there were 239 retired members drawing annual benefits of $20,519,302, or an average of $85,855 per retiree, up from $17,789,740 in FY 2008.
Additionally, there are the State Employee OPEB Plan (SEOPEBP) and the Retired Teacher Healthcare Plan (RTHP) that both deal with Other Post Employment Benefits (OPEB), such as healthcare and life insurance, and will hereafter be referred to as the “Connecticut OPEB system.”
The health of Connecticut’s pension and OPEB system is based on two elements—assets held versus liabilities accrued:
Assets: The market value of stocks, bonds and other investments that are held by the pension system. Each year assets grow in one of two ways. First, the value of the assets change and, second, the Connecticut state government pays an annual contribution.
Liabilities: The present value of pension benefits to be paid out to current and future retirees. Each year liabilities grow based on a number of assumptions such as expected salary increases, mortality, turnover and other factors.
For the pension and OPEB system to be considered “fully funded,” assets must equal liabilities. Unfortunately, the pension and OPEB system is far from being fully funded and is currently running a large deficit called the unfunded pension liability. For example, in FY 2012, the SERS system had assets worth an estimated $9.7 billion while liabilities are estimated to be $23 billion. This leaves an unfunded pension liability (liabilities minus assets) of $13.3 billion.
A common way to show the unfunded pension liability is the “funded ratio” which is assets divided by liabilities. Table 1 and Chart 1 show the funded ratio for the pension system while Table 3 and Chart 2 show the funded ratio for the OPEB system. The funded ratio for the pension system in FY 2012 was a dismal 42.3 percent for SERS, 55.2 percent for TRS and 54.7 percent for JRS.
More disturbingly, the OPEB funded ratio in FY 2013 was 0.6 percent. The state has setaside virtually nothing ($144 million) while facing a staggering liability of $22.7 billion.1
The state government’s contribution to the pension and OPEB system is already quite sizable. As shown in Table 2, the annual required contribution to the state retirement system was $1.7 billion in FY 2012, compared to $1.248 billion in FY 2008. As shown in Table 4, the annual required contribution to the state OPEB system was $1.405 billion. To put this into perspective, the FY 2012 state pension and OPEB contribution combined ($3.103 billion) would consume most of the sales tax revenue ($3.8 billion in FY 2012).2
Unfortunately, the state government has not been living up to the annual required contributions. If the state had been making its full contribution, then the funding ratios would not be nearly as bad as they are. For instance, the TRS was underfunded by $249.2 million between FY 1999 and FY 2007. This shortfall is actually much larger considering the foregone compounding of the investment.
ARBITRAGE: GAMBLING USING GENERAL OBLIGATION BONDS TO FUND THE PENSION SYSTEM
Due to this underfunding, the state government decided in FY 2008 to issue $2 billion in General Obligation Bonds (GO) for the TRS to make up for the contribution shortfall.
The goal was to boost the funded ratio and reduce the long-term cost of the TRS. In the short-run, Table 1 shows that the funded ratio did improve from 59.5 percent in FY 2006 to 70 percent in FY 2008—due to a 50 percent increase in assets to $15.3 billion in FY 2008 from $10.2 billion in FY 2006.
However, whether or not the GO bonds will reduce the long-term costs of the TRS is an open question. In fact, the state government is playing a game of chance that could leave taxpayer’s facing an even larger pension burden. Put simply, the returns earned on investing the borrowed money must exceed the costs of borrowing the money, commonly referred to as “risk arbitrage.” This is the equivalent of homeowners taking a second mortgage on their houses to invest in the stock market in the hope that the investments pay more than the cost of the mortgage.
The GO bonds were issued with a favorable average interest rate of 5.85 percent for the majority of the issuance. If the assumed rate of return, at the time of the GO bond issuance, of 8.5 percent under TRS comes to fruition, then the pension system will have netted 2.65 percentage points. However, that is a big “if.” Recent economic conditions remind us that one never knows when the economy might take a nosedive, or how long it may take to recover.
Economist James B. Burnham, the Murrin Professor of Global Competitiveness at Duquesne University, in an article about risk arbitrage summed up the political situation by saying, “As attractive as this plan [risk arbitrage] may appear from a budgetary perspective, the issuance of pension bonds generally carries significant risks that are often downplayed in light of immediate fiscal pressures and the concerns of pensioners.”3
Now that we are 4 years beyond the GO bond issuance, it appears that the state government is losing the bet. Between FY 2008 and FY 2012, the value of assets in the TRS has fallen by 10 percent to $13.7 billion from $15.3 billion. Combined with a growing pension liability, the TRS funded ratio has continued to deteriorate to 55.2 percent in FY 2012 from 70 percent in FY 2008.
CONNECTICUT’S OFFICIAL PENSION AND OPEB LIABILITIES ARE DRAMATICALLY UNDERESTIMATED
Complicating matters is that official pension and OPEB liabilities are being dramatically underestimated based on current actuarial methods. The problem revolves around the “discount rate” or “interest rate” used.
For example, a 5 percent interest rate means that a $100 today grows to $105 a year from now ($100 times 1.05 percent), while a 5 percent discount rate means that $105 a year from now is worth $100 today. In effect, the discount rate is the opposite of the interest rate.
Economists Robert Novy-Marx and Joshua Rauh were among the first to point out this actuarial fiction. They discovered that, using data from FY 2008, the median discount rate used by pension systems was 8 percent, which, conversely, means that these pension systems anticipate earning 8 percent annually.4 For instance, in FY 2012, Connecticut’s pension system uses discounts rates of 8 percent under SERS and JRS and 8.5 percent under TRS. A new study by State Budget Solutions that utilizes the methodology of Novy-Marx and Rauh found that nationally, in FY 2012, the unfunded pension liability was $41 trillion— see Table 6.5 Connecticut’s $47.9 billion stated pension liability increases to $76.8 billion. Adding insult to injury, Connecticut’s pension funded ratio falls to 25 percent—the 2nd worst ratio in the country.
As shown in Table 7, Connecticut’s pension liability on a per capita basis is $21,378 and is the 4th highest in the country. As a percent of Gross Domestic Product it is 33 percent and is the 12th highest in the country.
In addition to the state government pension burden, the City of Hartford has also accrued a significant pension burden. Economist Novy-Marx and Rauh have estimated that Hartford’s pension liability is $1.6 billion as of June 2009. With assets of $900 million, Hartford has an unfunded pension liability of $700 million, or $561 per capita.6
Unfortunately, there is no study that examines the state of unfunded OPEB liabilities. However, the adjustment to Connecticut’s OPEB liability may not be as extreme as for the unfunded pension liability because the assumed discount rate is already a much lower 5.7 percent for the State Employees OPEB plan and 4.5 percent for Retired Teachers Healthcare Plan.
AN ECONOMICS LESSON: WHAT IS DEADWEIGHT LOSS?
With Connecticut’s state government facing daunting unfunded pension and OPEB liabilities, the political temptation would be to raise taxes to pay for
the short-fall.
However, this approach would only compound the economic problems posed by these liabilities by weakening Connecticut’s economy. Higher taxes mean higher “deadweight losses” on the economy.
It is well established that people respond to tax incentives and disincentives. For example, they may buy a larger house than they otherwise would because they can deduct the mortgage interest from their federal income taxes.
Since the behavior is tax-induced, it harms the economy; if not for the tax break, the taxpayer would have made other choices about how to use the extra money.
“Deadweight loss” is a term used by economists to describe economic activity forgone by consumers and producers because of the higher relative price of goods as a result of the tax. Taxpayers may respond to the proposed higher tax rates by reducing their work effort, lowering their consumption, or even leaving the state in order to avoid the higher tax bill. In other words, the very process of transferring resources from the private to the public sector results in a permanent loss of current and future economic output.
Chart 3 graphically shows how economists are able to estimate deadweight losses where Quantity (Qe) and Price (Pe) show the market equilibrium. The addition of a tax has the same effect as an artificial price increase. The new price point of intersection with the Demand (P+Td) and Supply (P+Ts) curves is at Quantity (Qt). The rectangle formed by the new intersection is the revenue gained by the tax. The resulting triangle represents the deadweight loss — the value of trade that would have occurred without the tax, but is now forgone because of the tax. Deadweight loss can be estimated by calculating the area of the triangle.
However, estimating the deadweight loss is subject to the degree to which taxpayers change their behavior. If, in fact, taxpayers buy significantly more expensive homes because the mortgage interest is deductible, then the deadweight loss is large. Economists refer to this as the “tax elasticity” (TE). The example given above is an example of “high tax elasticity.” Graphically, in Chart 3, TE is shown by the steepness and curvature of the supply
and demand curves.
Based on this standard economic methodology, Harvard economist Martin Feldstein pioneered the empirical estimations of deadweight loss. In Feldstein’s own words:
“The appropriate size and role of government depend on the deadweight burden caused by incremental transfers of funds from the private sector. The magnitude of that burden depends on the increases in tax rates required to raise incremental revenue and on the deadweight loss that results from higher tax rates … recent econometric work implies that the deadweight burden caused by incremental taxation (the marginal excess burden) may exceed one dollar per one dollar of revenue raised, making the cost of incremental government spending more than two dollars for each dollar of government spending.”7
In two exhaustive studies, Feldstein finds, based on actual taxpayer behavior derived from IRS data, that the TE is 1.28.8 That is, a 1 percent change in marginal tax rates yields a 1.28 percent change in taxable income.
PUBLIC POLICY OPTION #1: RAISE TAXES AND CREATE A DRAG ON THE ECONOMY
In a recent study, economists Novy-Marx and Rauh have estimated the increased pension contribution necessary to close the unfunded pension gap. Based on FY 2010 data, all states would have to increase their combined pension contributions by $163.2 billion—or $1,385 per household.
To close the gap, Connecticut would have to increase its pension contribution by $2 billion—or $1,459 per household.9
Combined with the OPEB contribution shortfall of $808 million, Connecticut will have to increase its pension and OPEB contribution by $2.808 billion. The following analysis assumes that this tax increase will be funded entirely through the individual income tax. As such, this would require an increase in the top individual income tax rate from 6.7 percent to 9.25 percent—and tax rate increase of 38 percent.
Such a large rate increase would yield a permanent deadweight loss to Connecticut’s economy of $309 million per year, every year.
In present value terms, the total deadweightloss to Connecticut’s economy is a staggering $10.305 billion.10 In effect, such a tax hike creates a hole in Connecticut’s economy; if this deadweight loss had never occurred, private companies with streams of output into perpetuity would have filled this hole. Instead, we’re left staring into an empty hole.
Quantifying deadweight losses shows the magnitude of the negative economic impact of taxes on the economy and strongly suggests that reducing government spending is the better option relative to increases in taxes. Recent economic studies, at the international, national and state-level, further support this point.
First, Harvard economists Alberto Alesina and Silvia Ardagna examine the economic effects of fiscal policy in countries that constitute the Organization for Economic Cooperation and Development from 1970 to 2007. They find that:
“[a]s for fiscal adjustments, those based upon spending cuts and no tax increases are more likely to reduce deficits and debt over GDP ratios than those based on tax increases. In addition, adjustments on the spending side rather than on the tax side are less likely to create recessions.”11
Second, UC Berkeley economist David Romer and Christina Romer (former Chair of the Council of Economic Advisors to President Obama), examine the economic effects of U.S. fiscal policy since 1947. They find that:
“The resulting estimates indicate that tax increases are highly contractionary. The effects are strongly significant, highly robust, and much larger than those obtained using broader measures of tax changes. The large effect stems in considerable part from a powerful negative effect of tax increase on investment.”12
Finally, economists Stephen Brown, Kathy Hayes and Lori Taylor examine the economic effects of fiscal policy of U.S. states. They find that:
“If anything, most public services do not appear to justify the taxes needed to finance them . . . this finding would seem to imply that other state and local public capital has been increased to the point of negative returns, perhaps because a growing stock of other public capital is indicative of an increasingly intrusive government.”13
POLICY OPTION #2: SWITCH TO DEFINED CONTRIBUTION SYSTEMS
Rather than raising taxes, more and more states are moving away from the traditional defined benefit pension systems and towards a defined contribution system similar to the 401(k) system that is popular in the private
sector.
Currently, fourteen states have moved to defined contributions in one of three ways with varying levels of cost savings.14 Connecticut should join this movement in order to reduce the long-term costs of the pension system.
First, the largest cost savings can be achieved by moving all new government employees into a defined contribution system. Currently, three states (Michigan [1997], Alaska [2006], and Utah [2011]) and the District of Columbia fall into this category.
Second, the next largest cost savings can be achieved by having both defined benefit and defined contribution systems. Currently, four states—Indiana, Oregon, Georgia, and West Virginia–fall into this category. Finally, many states allow for their employees to choose between a defined benefit plan or a defined contribution plan. Depending on the specifics of each plan, there could be a lot of choice (both plans yielding very similar benefits) or very little choice (one plan yielding substantially greater benefits).
As such, choice and, correspondingly, cost savings can vary by state. Currently, seven states (Washington, North Dakota, Montana, Florida, South Carolina, Ohio and Colorado) fall into this category.15
Given Connecticut’s large unfunded pension liabilities, the state should go directly to the most effective option, which is to follow in the footsteps of Michigan, Alaska, Utah and the District of Columbia. At the very least, putting new employees into a defined contribution plan will not add further to the unfunded pension liability. As long as the state meets its annual required contribution, normal turnover in the workforce will begin to bring down the unfunded pension liability to more manageable levels.
CONCLUSION
Overall, this study exposes the true extent of Connecticut’s pension crisis, which is at least $47.9 billion and may be as high as $100.2 billion.
On a per capita basis the pension bill could be as high as $21,378 or up to $21,938 if you live in Hartford. Combined with the OPEB liability, the public retiree bill climbs to $27,668 for every man, woman, and child currently living in Connecticut.
Minor changes to the current defined-benefit system may buy some extra time but will not fundamentally solve this crisis. In the end, only two options are available to policymakers to solve Connecticut’s public retiree crisis: 1) raise taxes; or 2) fundamental changes to the pension and OPEB systems.
Raising taxes would only serve to weaken Connecticut’s economy and jeopardize the state’s ability to ever meet its pension and OPEB obligations. The best option is to reform these systems by switching to a defined contribution program.
