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October 2013 Policy Study, Number 13-6

   

Iowa Legislature and Governor Need to Focus on Pension Reform

   

Iowa's Current Situation

   

 

The Morningstar and Moody’s rating of the Iowa pension system reflects a system which is not in trouble, but should have further reforms.

 

The Iowa Public Employees’ Retirement System (IPERS) was originally set up in 1953 and is a traditional defined benefit (DB) system. This means that the amount an employee receives in retirement is based on “years of service, a multi-year average covered wage, and a multiplier.”[22]

 

The money in a DB system comes from that originally put in by employers and employees, and the growth in that money through investments in stocks and bonds. This money must be equal, in the long run, to the money promised to be paid out. Changes in any of the three factors, money in, money growth, and money out, are critical to long-term success.

 

IPERS covers a wide range of government employees, including those working for public schools, state agencies, counties (99), cities, and townships. The majority (53.4 percent) are school employees, including the Regent universities.

 

As of FY 2012, there were 164,200 active working employees, down almost 1,500 from 165,660 two years earlier (FY 2010),[23] and 101,948 retired employees, up almost 8,250 from 93,700.[24] The proportion of working employees to retirees and the continuing decrease in number of workers to number of retirees is a critical part of the risk of the IPERS system.

 

The increase in retirees supported and reduction in employees paying into the system creates a significant risk for Iowa taxpayers because a DB plan is basically a Ponzi scheme – if the previously allocated money does not earn enough to pay the current beneficiaries, the new money is used to pay those beneficiaries. With fewer employees, there is less new money coming in to pay the retirees. The chart below outlines this data.

 

 

The Iowa Legislature made changes to IPERS in 2010 which took full effect in FY 2012. Major changes for employees in the “Regular” category included increasing the employment time required for full vesting to seven years, using the “high-five” compared to a control year in figuring average pay used to determine retirement payments, increasing the benefit reductions for early retirement, and increasing the total contribution amount to 13.45 percent, with the government paying 8.07 percent and the employee 5.38 percent.[25]

 

The maximum wage covered by IPERS as of 2013 is $245,000, set by the federal government.[26] A “Regular” category worker who makes $245,000 or more per year – of which there are many – would have $13,181 withheld from their paychecks and deposited to IPERS. That individual would have another $19,771 contributed directly by their employer, the government, for a total of almost $33,000 per year.[27]

 

A major change in 2010 was that the contribution rate can now be adjusted either up or down each year, by a maximum of 1 percent, to attempt to meet the amount recommended by the actuarial expectations. Much of the Iowa shortfall is because previously the contribution rate had been set by the Iowa Legislature and since 2001 had been set at less than the actuarially recommended amount – as the Legislators used current incoming money to fund other, more important, items.

 

Allowing the rate to be set by the IPERS board, based on the actuarial recommendations, will result in contributions moving closer to the amount needed to meet the promises made to employees under their contract. This can be seen in the FY 2012 employer contribution report, which shows a 98.1 percent rate compared to previous years. This is detailed in the table below.

 

 

This change will not, however, address the long-term result of poor investment returns, such as those earned in 2008, 2009, 2012, and other years. A poor investment return, or even loss, in one year compounds the negative result for succeeding years – as it must be made up before further growth is achieved.

 

As long as the pension plans are DB plans, with a promise to pay X amount no matter what, state government and future taxpayers retain significant risk.

 

The amounts contributed for employees in the County Sheriff and Protection Services employee categories are quite a bit higher than those of the regular class of employees. This is because their maximum retirement payout is higher, 72 percent instead of 65 percent, and because their plans are currently significantly underfunded.[28]

 

County Sheriff employees and the government both pay 9.83 percent, for a total of 19.66 percent. Protection Services employees pay 6.65 percent and the government pays 9.97 percent, for a total of 16.62 percent.[29]
At this time there is no upper-end limit on the amount the special services group contribution rate can increase each year. Hopefully these higher contribution rates will address the UAAL shortfall.

 

The Iowa Sheriff’s plan is only funded at 61 percent of its liability of $480 million, with a shortfall of almost $190 million. The Protection Services/Judicial Retirement system subset of IPERS has a $53 million shortfall, at 68.9 percent funded.[30] Though these are lesser amounts, in the overall pension discussion they are still important and must be addressed.

 

The contribution rate for all IPERS groups is now determined in November of each year and begins the next July with the new fiscal year. Both employer and employee rates can be adjusted by the IPERS board if necessary to meet the actuarial projections within the 1 percent change limit.

 

Importantly, the recent changes only apply to new hires, not previous hires already in the system. These changes were expected to increase the overall viability of the IPERS system and to some extent have. For example, IPERS has now reached a 30-year full funding projection. This means that IPERS is expected to be 100 percent funded in 30 years, or 2043, but not before.

 

It is important to recognize that the contributions to IPERS come from state taxes paid by private-sector workers. In Iowa, government employees make contributions to their own retirement from their paycheck, but all of the money originally comes from the taxpayers via the government.

 

Further, even if the amount of money in IPERS isn’t sufficient to pay the promised benefits, that amount is still owed to employees according to their negotiated contract and will have to be made up by taxpayers. This is a key difference between a DB retirement plan and a DC plan.

 

No matter how much money is originally put in and how much (or little) it grows, the payout is still the same based on the salary level, number of years worked, and age at retirement.

 

In a DC plan, money is put in and allowed to grow over time, then removed during retirement. The amount paid out is determined by the amount put in and how much it grows. There is no predetermined monthly retirement check. In a DC plan, the final retirement amount could be either higher or lower than in a DB plan. State government and taxpayers, however, do not have continued liability over a 30-40 year time period for shortfalls under the DC plan.

 

The most recent IPERS financial report, for FY 2012, shows current funding for Regular category payable benefits at less than 80 percent (79.9 percent) of the long-term requirements using the UAAL method.[31]

 

This means that if IPERS was cashed out today, only 80 percent of all the money owed to both current retirees and current employees based on what they’ve been promised is available. The State of Iowa would only be able to pay them $4 of every $5 promised.

 

The question is, “Where will the rest of the money come from?” The answer is current taxpayers and future taxpayers: us, our children, and our grandchildren.

 

Using the Moody’s ANPL method, state government would have to use just over 16 percent of annual revenues to pay the pension shortfall.

 

In contrast to the horrible situation in Illinois, Iowa taxpayers would only owe $2,041 per capita if we needed to make up the IPERS shortfall. However, this could change tomorrow, depending on investment returns.

 

Though it has recently stabilized in the 80 percent range, the IPERS funding ratio has been on a fairly steep downward trend for the last thirteen years. From a high of 97.9 percent funded in 2000, IPERS is at a low of 79.9 percent in FY 2012. DB pension plans operate on the presumption of both additional incoming funds and growth in currently held and invested funds. The effect on the IPERS funding ratio of the 2008 recession and drop in the stock market was significant.

 

Some of the Great Recession losses were made up this past year, as the stock market was up significantly in early 2013. But in FY 2012, the investments did poorly, resulting in loss of ground made up in FY 2011.

 

The FY 2013 financial report, due out in December, will show a 10.12 percent return compared to only 3.73 percent for FY 2012. As of June 30, 2013, IPERS had almost $25 billion in assets ($24.83), up from $23.24 billion in June 2012.[32]

 

Unfortunately, the liability remains greater than the assets on both an actuarial and a cash basis. The key number is the unfunded accrued actuarial liability (UAAL) that the Morningside analysis references.

 

This number is generated by the actuaries whose legal job it is to take all retirement and life expectancy factors into statistical account, determine as accurately as possible exactly how long retirees will live, and calculate how much money the state will have to pay them between their retirement and death.

 

The total IPERS actuarial liability as of FY 2012 for both retirees and current employees is $29.44 billion, with an actuarial value of the paid-in money plus investment profits on assets at $23.53 billion.[33]

 

This is $5.91 billion less than is needed, or about a full year of the state’s current budget – with no money to spend on anything else, from education to healthcare. To emphasize, to make up the shortfall in the current Iowa DB pension plan would take a full year’s state tax budget, without paying for anything else.

 

The following table shows the dollar amount of unfunded pension liabilities. Note that this has been increasing every year for the last five fiscal years, to a current high of almost $6 billion. Note also the significant impact in FY 2009 of the drop in the stock market from the Great Recession. This $2.2 billion dollar increase in liabilities is an example of how the ability of the state government to meet the promises of a DB pension plan is dependent upon factors outside the IPERS managers’ control.

 

 

In contrast, once a DC plan is funded, the future risk to the state and to taxpayers is removed.

 

One way the financial report views this number is that after current retirees were paid 100 percent of the money they’ve been promised through their expected death, and current employees have 100 percent of the money returned to them that they’ve paid in, the state would still owe current employees almost 50 percent of the money they have been promised.[34] That amount for FY12 is the $5.91 billion shown in the table below.

 

The December 2013 Financial Report, which will show updated actuarial liabilities, will likely show this gap narrowing following the 10.12 percent investment returns through June of 2013. However, one of the problems with the Iowa – and all state pension plans – is the volatility of the stock market. The up and down of the stock market makes the rollercoaster at Adventureland look like a walk in the park.

 

The goal for the average annual return of IPERS is 7.5 percent. As of FY12 the ten-year average return was only 3.98 percent, not the estimated, and needed, 7.5 percent.[35] When viewed on a 20 and 30-year basis the overall annual return is in the famous and often quoted 10 percent range. As financial advertisements and advisors remind us, “previous results are no guarantee” of future returns. Yet the ability to pay the promised pensions is highly dependent on the investments reaching this 7.5 percent every year.

 

Some experts have recommended using an expected return rate ranging from 5.22 percent, the private-sector corporate bond interest rate standard, to 4.38 percent, the return rate on a 30-year Treasury bond.[36] Using these figures, which may be more realistic, will result in significant increases in the amount of unfunded liabilities and require larger initial contributions from both the state and the employee.

 

Accordingly, significant increases in state budgets and state contributions to IPERS will be needed to make up the difference.

 

One place where IPERS is at risk is in the category of county and city employees. The contracts with these employees are negotiated at the local level, where it is often harder for the elected county supervisors and city council members to manage salaries and hours worked. This is reflected in the increasing amount of monthly benefits paid to these groups of workers.

 

For example, in FY12 the average monthly amount paid to city and county retirees increased from about $1,390 to $1,550, or by almost $160 per month, while the payments to teachers, state government workers, and utility workers either dropped or stayed the same.[37]

 

The state government and State Legislators have little impact or influence on salary decisions at this level yet are expected to fully fund the resulting bills.

 

   

 

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