Incorporating an active policy discussion about pension funding into the budget process – even in well-funded cities – is important, because the earlier pension funding problems are confronted, the less costly they will be overall, and the less burden will be placed on future generations of taxpayers.
This is a guest post by Les Richmond. This is the fourth post in a series on NLC’s public sector retirement initiative.
Fiscal year 2016 marked the second consecutive ugly year for investment returns on public sector pension funds. Most funds target a long-term return on assets between seven and eight percent. In the fiscal year ending June 30, 2015, the median return was three to four percent, and in FY 2016 the median is anticipated to be closer to one to two percent.
Why this Matters
Poor investment returns typically mean increased pension contribution requirements for cities, which in turn create (or worsen) budget pressures. Case in point: 71 percent of cities reported in NLC’s recent City Fiscal Conditions survey that the cost of pensions increased over the past year; 30 percent reported that these costs were one of three top negative budgetary stressors. As a result, government bond rating agencies and other stakeholders will be monitoring the actions of local government leaders closely on this issue.
The policy debate has already begun in cities with well-known pension challenges, such as Houston, Texas, and Jacksonville, Florida. Similarly, the FY 2018 budgeting process can provide a wealth of opportunities for actions in cities across the country that can improve, or stabilize, a city’s pension situation. Incorporating an active policy discussion about pension funding into the budget process – even in well-funded cities – is important, because the earlier pension funding problems are confronted, the less costly they will be overall, and the less burden will be placed on future generations of taxpayers.
City leaders will likely be called to consider a number of actions during these discussions. Here’s what they mean:
Funding policy decisions: Governments whose investment returns underperformed their expectations are likely to see their costs increase. In some cases, the investment return shortfall may even lead to a conclusion that the plan faces a “depletion date” (an actuarial projection that the pension fund assets may be completely exhausted at some point in the future), which must be disclosed in a city’s financial statements under government accounting standards.
Financial analysts prefer to see cities continue to contribute in accordance with their established funding policy, because it provides tangible evidence of the sustainability of the plan. It is also important how the additional spending is covered in the budget, with recurring revenues or sustainable cost cuts (whether from within the pension plan or elsewhere in the budget) favored. These items, which have a lasting impact, are preferred because the FY 2015 and 2016 poor asset returns will influence contribution rates for years to come.
Funding policies should amortize or pay off (like a mortgage) the city’s unfunded pension liability over a reasonable number of years (certainly no more than thirty years, with a shorter period preferred). The city should work with its actuary to determine that any changes to funding policy will not only demonstrate that the contributions will continue to sustain the plan (prevent fund depletion), but also help the plan to thrive.
Reduction of the investment return assumption: The median return assumption among public pension funds is still between seven point five and eight percent. But pressure to reduce those estimates is likely to climb, as more large, high-profile pension funds join CalPERS and the Illinois Teachers’ Retirement System in reducing their return assumptions. Ratings agencies, bond insurers and other stakeholders generally view a reduction in the investment return assumption positively, because it should improve plan funding by increasing contribution requirements and perhaps stimulate less risk-taking with plan assets.
Consideration of new pension reforms: There’s probably no stronger impetus for pension reforms than an unaffordable pension contribution requirement. A thoughtful approach to pension reform can be viewed positively from the perspective of a bond holder, with a strong preference for benefit adjustments that have an immediate impact on liabilities, or enhanced contributions backed by recurring revenues. Headline-grabbing reforms that adjust benefits only for new employees are less meaningful, because they can take many years to have a material impact on unfunded liabilities.
These are just a list of options to consider in the current financial environment. There are no one-size-fits-all answers, and it is always important to consider the effects on your city’s workforce before taking action.
About the author: Les Richmond analyzes public pensions nationwide as the in-house actuary for Build America Mutual (BAM), a leading insurer of municipal bonds for cities. BAM is an NLC business partner and NLC’s preferred provider of municipal bond insurance.