AFP's Presentation to the Texas House Pensions and Investments Committee

August 12, 2008

Note to the members of the Texas House Pension and Investments Committee from AFP-Texas Director Peggy Venable:

This paper was presented by Dr. Poulson at a recent ALEC conference. Attached to this paper is another paper Dr. Poulson wrote which also includes some recommendations and highlights what some other states are doing. We hope this material is helpful to you as you consider this important public policy issue of how to deal with liabilities. AFP promotes transparency in government and conservative fiscal policies. Though Texas’ economic outlook is more favorable than many other states’, we have concern that local government debt is currently growing five times faster than Texans’ paychecks. AFP’s mission is to promote policies which will not leave future taxpayers with a legacy of debt. We at AFP-Texas have concern that the OPEB liabilities simply add to this legacy of debt.

Dr. Barry W. Poulson

Americans for Prosperity Distinguished Scholar

Introduction

This is proving to be a difficult year for state governments. State legislators must cope with the negative impacts of recession, falling home prices, and volatile credit markets. The recession and falling home prices have significantly reduced sales tax revenues, property tax revenues, and other sources of revenue. Volatile capital markets have also reduced the income generated by taxes on capital gains.

State budgets that appeared to be in good shape a year ago are now encountering revenue shortfalls. State legislatures have responded by raising taxes and fees, cutting spending, and using rainy day funds to offset revenue shortfalls.

Nonetheless, many states have been forced to turn to credit markets at a time of great instability in those markets. States that issued short term debt with variable rate funding have encountered wild swings in their financing costs. Many states have turned to long term fixed financing as an alternative, even though the costs of longer term debt may be higher.

This is also proving to be a difficult year for taxpayers. State and local tax burdens are at an all time high. State and local governments are capturing a larger share of personal income than at any other time in the nation’s history. The higher tax burdens are driven by unconstrained growth in state and local spending.

State and local governments have imposed higher tax burdens at a time when taxpayers are experiencing greater stress. A slowing economy has been accompanied by higher unemployment, stagnant wages and incomes, tighter credit, and higher inflation.

Taxpayers are asking the obvious question: if they must tighten their belts, why can’t state and local governments learn to live with a leaner budget? The alternative to increasing tax burdens is for governments to cut spending in response to revenue shortfalls. Taxpayers are also demanding greater transparency in state and local finance.

As governments meet demands for full disclosure of their costs, they are discovering a hidden cost in their budgets, the large and growing cost of funding pension and other post employment benefits (OPEB) for retirees. Indeed there is a gorilla in the backyard of virtually every state and local government in the form of unfunded liabilities in pension and OPEB plans. These liabilities are now estimated at more than one trillion dollars and growing. Politicians have promised public employees retirement benefits that they can’t possibly pay for. Taxpayers are now demanding reforms in pension and OPEB benefits to reduce and eliminate these unfunded liabilities.

Unfunded Liabilities in State and Local Pension Plans

State and local governments have a long history of providing pension and other post employment benefits to their employees. Defined benefit pension plans were established to set aside funds to pay retirement benefits to employees. These benefits are financed from contributions of employers and employees, and the investment income derived from such contributions. Some states have a single public employee retirement system for public employees: while others have multiple systems for different groups of employees.

Some of these state pension plans date back to the early 20th century. Many of them operated initially on a pay as you go basis. However, over time most states attempted to prepay the cost of pension benefits for employees. All states now report on their pension plans in financial statements following guidelines established by the Government Accounting Standards Board (GASB).

The best measure of the success of states in pre-funding their pension obligations is the funding ratio. The funding ratio is equal to the actuarial value of assets divided by actuarial accrued liabilities. Unfunded liabilities are that portion of accrued liabilities not offset by assets in the plan.

In the course of the 20th century states made significant progress in pre-funding their pension obligations. By the 1970’s the funding ratio reached 50%; in the 1990’s the ratio was 80%; and in 2000 the ratio was slightly above 100%. With a booming economy and the run up in the stock market in the 1990’s, most states were able to eliminate unfunded liabilities in their pension plans.

This success in eliminating unfunded liabilities in state pension plans was short lived. When recession hit in 2001 the fall in the stock market brought significant losses in assets held by these pension funds. During the boom years of the 1990’s many states made grievous errors in managing their pension funds. They increased the share of assets in stocks versus fixed income assets, exacerbating the losses when the stock market collapsed. Many states extended very generous benefits to public employees, the costs of which would be borne over many years. Some states reduced and suspended employer contributions to their pension funds.

Demographic and lifestyle changes also increased liabilities in state pension funds. More public employees chose early retirement, often in response to inducements offered by states to retire early. Employees also lived longer in retirement.

By 2006 the funding ratio of state pension plans had fallen to 81%; and, unfunded liabilities in these plans accumulated to almost 360 billion dollars. Prospects for improving the funding ratio and reducing unfunded liabilities in these pension plans are not very promising. Earlier this year Standard and Poor’s projected that the funding ratio would remain roughly constant. However, even that projection now appears to be optimistic. Since then the stock market has fallen sharply in the first quarter, and the economy appears to be headed for recession. Demographic changes will continue to increase liabilities in these plans as employees continue to retire earlier and live longer in retirement.

As of 2006 unfunded liabilities in state pension plans had accumulated to 360 billion dollars, up from 330 billion dollars in 2005. The magnitude of these unfunded liabilities has most likely increased since 2006.

A small handful of states have eliminated unfunded liabilities in their pension plans. These include: Delaware, Florida, New York, North Carolina, and Oregon. At the other extreme are states where the funding ratio has fallen below the average of 81% for all states. These underperformers include: Alaska, Colorado, Connecticut, Hawaii, Illinois, Indiana, Kansas, Kentucky, Louisiana, Maine, Massachusetts, Michigan, New Mexico, Oklahoma, Rode Island, South Carolina, Virginia, Washington, and West Virginia.

Other Post Employment Benefit (OPEB) Liabilities

While most states are struggling to fulfill their pension obligations, they are finding it even more difficult to meet other post employment benefit (OPEB) obligations. OPEB includes health insurance, life insurance, and other non pension benefits for retirees. OPEB benefit obligations have been increasing for the same reason that pension benefits have increased. States have offered more generous OPEB benefits over the years. Employees eligible for these benefits have retired earlier and are living longer. However, the cost of the largest of these OEB benefits, health care benefits for retirees, has increased at an alarming rate. This reflects improvements in the health care provided to retirees, and higher prices for these health care services.

States are only beginning to measure the size of these OPEB obligations. This is the result of new accounting rules adopted by the General Accounting Standards Board (GASB). This new guideline, Statement 45, requires every state and local jurisdiction to report the full actuarial required contribution needed to meet their OPEB obligations. The fiscal 2008 deadline for all jurisdictions to meet this standard is rapidly approaching.

Unlike pension obligations, most states continue to fund their OPEB obligations on a pay as you go basis. The new GASB guidelines do not require states to pre fund these obligations. However, a number of states have begun to pre fund OPEB obligations by establishing trust funds to accumulate assets.

The following table summarizes the most recent data for OPEB liabilities. The magnitude of OPEB liabilities has come as a shock to most states. For the 40 states that have now reported their OPEB liabilities the total is in the range of 357 to 394 billion dollars. For most states, OPEB liabilities exceed unfunded liabilities in their pension plans. When all states have reported their OPEB liabilities it is likely that the total unfunded pension and OPEB liabilities will exceed a trillion dollars. That is five times the debt accumulated in the states. OPEB liabilities are likely to increase rapidly in future years with increases in the cost of health care provided retirees.

The magnitude of OPEB liabilities varies considerably in the states: from a low of 52 million dollars in North Dakota, to a high of 58 billion dollars in New Jersey. The average state OPEB liability is about 10 billion dollars. States with OPEB liabilities significantly above average face the greatest challenge in meeting these obligations. These states include: California, Connecticut, Georgia, Maryland, Massachusetts, New Jersey, New York, North Carolina, and Ohio. As other states meet GASB guidelines in reporting these obligations this list of states with significant OPEB liabilities will surely increase.

There is a wide range in OPEB liabilities among the states. In only a handful of states are OPEB liabilities below unfunded liabilities in pension plans. These states include: Iowa, Minnesota, Montana, North Dakota, Rhode Island, South Dakota, and Virginia.

In most states OPEB liabilities exceed liabilities in pension plans. In several states OPEB liabilities exceed unfunded liabilities in pension plans by orders of magnitude. These states include: Alabama, Delaware, Florida, Georgia, Maryland, New Jersey, New York, North Carolina, Oregon, Tennessee, and Vermont. Note that some states with significant OPEB liabilities have small unfunded liabilities in their pension plans.

Conclusion

The new evidence provided for OPEB liabilities in the states has come as something of a shock. For most states the magnitude of OPEB obligations exceeds unfunded liabilities in their pension plans. Even states that have had success in pre funding their pension plans are only beginning to cope with the burden of financing their OPEB obligations.

The states which appear to be particularly challenged are those with significant OPEB liabilities and unfunded liabilities in their pension plans. Based on the preliminary estimates this includes: Alabama, Arkansas, California, Connecticut, Georgia, Hawaii, Kentucky, Maine, Maryland, Massachusetts, Michigan, Nevada, New Hampshire, New Jersey, New Mexico, Ohio, Pennsylvania, South Carolina, Tennessee, Washington, and West Virginia. As more states meet the GASB guidelines for reporting OPEB obligations, this rogue’s gallery of states will certainly be expanded.

A number of states have begun to implement strategies designed to reduce and eliminate OPEB liabilities. Some states have established task forces or commissions to recommend solutions to the problem.

Unlike pension obligations, most states continue to finance OPEB obligations on a pay as you go basis. However, some states have begun to pre fund OPEB obligations by establishing trust funds to accumulate assets. These states include: Alabama, Delaware, Georgia, Kentucky, Maryland, Massachusetts, Ohio, South Carolina, Utah, Vermont, and West Virginia. While Ohio has one of the highest levels of OPEB liabilities, it has also been one of the most aggressive in attempting to reduce these liabilities. Ohio has accumulated 12 billion dollars in assets to offset these liabilities, while at the same time attempting to better manage the cost of health benefits for retirees.

Several states have modified benefits available in their OPEB plans. For example, North Carolina has increased vesting periods, and changed benefit levels for new employees. Utah has pursued the most aggressive reforms in OPEB benefits, capping and eliminating certain benefits.

Several states have increased actuarial required contributions to the OPEB plans. Virginia has increased OPEB funding to reduce liabilities. Utah has also been the most aggressive in increasing OPEB funding to eliminate this liability from their balance sheet.

Most states are only beginning to get a handle on OPEB liabilities. When they get past the shock of these numbers, they usually begin to pursue policies to address the problem. However, a few states have taken a head in the sand approach to the problem. The worst of these is Texas. Not only has Texas failed to report OPEB liabilities, Texas has passed a law prohibiting state and local jurisdictions from meeting the new GASB guidelines.

This head in the sand approach is surely self defeating. Standard and Poor’s, and other bond rating agencies, take into account the success of states in meeting GASB standards in their financial reports. Failure to report OPEB liabilities and to meet GASB standards will certainly reduce bond ratings for the debt issued by these jurisdictions. Taxpayers will be saddled with higher taxes to pay for the interest cost on this debt, as well as the taxes required to finance OPEB liabilities.