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October 2013 Policy Study, Number 13-6

   

Iowa Legislature and Governor Need to Focus on Pension Reform

   

Moody's Investors Service Review

   

 

Moody’s takes a new and different approach in reviewing state pension plans. Its report, “Moody’s on Pensions: Sub-sovereign Credit Risk,” issued in mid-September 2013, reviews not only the pension plans of U.S. states, but of Canadian, Australian, and German sub-sovereign units. According to them, the U.S. underfunding is the most significant of the four developed countries, with only 48 percent of the promised benefits funded. Many of the “states” in the other countries are using either pay-as-you-go models or have switched to defined contribution (DC) plans.[9]

 

The 48 percent figure means that the states have only 48 cents available for every dollar in pensions promised. This is a significantly lower figure than that generated using the UAAL method, which was at basically 73 cents on the dollar (72.6 percent).

 

In evaluating the pensions, Moody’s uses an adjusted net pension liability (ANPL) model, which factors money currently held in the pension funds and a bond market-determined discount interest rate against the current resources, or taxes, available to pay the pensions. This model helps to gauge whether or not potential investors think the state can pay the money promised.[10] This more realistic evaluation means that state governments have a significantly higher risk of bankruptcy than originally thought.

 

Under this evaluation model, Nebraska has the strongest pension plan, with a ratio of 6.8 percent, while Illinois is the worst at 241 percent. This means that Illinois needs almost two and a half times more money than it currently has available in annual revenues in order to pay the pensions promised.

 

The problems in Illinois are recognized by everyone except the Illinois Governor and State Legislature, as evidenced by the Pew Center report in July that the Illinois pension situation “threatens the delivery of essential government services.”[11]

 

Both evaluation models, Morningstar and Moody’s, place Illinois at the bottom of the pack, it’s just a question of how bad the problem is.

 

In contrast Iowa ranks in the top five best plans, after Nebraska, with a ratio of 14.4 percent. The others are Wisconsin (14.4%), Idaho (14.8%), and New York (16.6%).[12] Other strong states are South Dakota, Tennessee, and North Carolina.[13]

 

Nebraska, for example, could pay retirees pensions using less than 7 percent of their annual money. However, even in Nebraska good government advocates in the Platte Institute for Economic Research are questioning the potential liability and risk to taxpayers.

 

In a June 2013 study Platte Institute notes that the pension plan for Nebraska state and county government employees hired after January 2003 is a cash balance (CB) plan, where the pension money put into the fund earns a fluctuating rate of return, which is guaranteed to be no less than 5 percent – with principle and interest paid out during retirement.

 

Those hired before 2003 were given the option of converting to the CB plan or remaining in the defined contribution (DC) plan. In the DC plan, the employee may invest their money in a variety of mutual fund options, potentially earning either larger – or smaller – returns than in the cash balance plan. In either plan the money belongs to the employee, not the government, and may be rolled over into a traditional IRA or 401k plan if the employee leaves government for another job.[14]

 

However, the other three plans managed by the state of Nebraska – the schools, judges, and state patrol – are all traditional defined benefit (DB) plans, with varying levels of underfunding and debt. In addition, the plans of large cities such as Omaha are DB plans, with substantial liabilities on future taxpayers. The Platte Institute recommendation is that these plans be gradually converted to the cash balance/DC plan type, to fully remove long-term taxpayer liability.

 

After Illinois, the other states facing problems are Connecticut (189.7 percent), Kentucky (140.9 percent), New Jersey (137.2 percent), and Hawaii (132.5 percent).

 

In Moody’s opinion, the reasons these pension plans are in trouble include long-term historical annual underfunding, the extremely high level of benefits promised to workers, and inclusion of education and other local government pensions, which are outside of state control, but funded by the state government.

 

One Governor working to address these problems is Chris Christie, who convinced the New Jersey employee unions in 2011 to take a $120 billion “haircut” over the next few years by agreeing to increased worker contributions, a higher retirement age for new workers, and no cost-of-living increases for retirees.[15] This is significant reform in a heavily unionized state.

 

On the positive side, the soundest pension plans after Nebraska – as ranked by Moody’s – are Wisconsin (ranked first by Morningstar) at 14.4 percent, Idaho at 14.8 percent, Iowa at 16.1 percent, and New York at 16.6 percent, as noted earlier.[16]

 

The evaluation of state pension plans by Moody’s and Morningstar is critical because these groups are highly influential in setting the bond ratings for the states – a lower bond rating, such as Illinois’ A3 negative, means that the interest rates charged for state bonds is higher and taxpayers will end up paying more in taxes to cover the interest charged to the state. The bond ratings of six of the ten states with significant pension underfunding have been downgraded in the last few years.[17]

 

   

 

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