1. 1 The Cost of Pension Benefits Scope of Problem and Suggested Solutions Joseph Adler David Boomershine MAPS Trustee Education Conference June 9, 2011

2. 2 Private Sector vs. Public Sector IssuesImpacts: Private SectorPublic Sector Pension Retiree MedicalPension Retiree Medical Federal Legislation Accounting Asset Losses Result: Increased cost and liability volatility for Private Sector Pension Plans Recent Changes

3. 3 Actuarial Cost Viewpoint Three Phases for Pension and OPEB Plans  Baseline Actuarial Cost  Funding Alternatives  Plan Design Alternatives Concerns/Interested Parties:  Budgets  Taxpayers  Unions  Bond Rating Agencies

4. 4 Actuarial Funding  Actuarial Valuation Demographic data Assets Actuarial Method/Assumptions Plan Design  Annual Costs/Funding Approach Normal Cost Amortization of Unfunded Actuarial Liability

5. 5 Demographic Data - Public Sector  Maturing plan population – shorten amortization period?  Hiring freezes, reductions – reduces plan costs as $ amount, not as % of payroll  Work furloughs, reduced hours → reduced compensation – reduces plan costs  Pay reductions – reduces plan costs  Reduced employee contributions – net out of cost reductions  Overall – reduced plan costs but not necessarily as a % of payroll

6. 6 Assets  2008 Asset losses – significant cost increase  Asset recovery for past few years – helping to stabilize costs  Asset smoothing – typically, 5 year smoothing of investment gains/losses Dampens cost fluctuations Impact of prior losses continue to phase-in  Overall – increased plan costs

7. 7 Actuarial Method/Assumptions  Actuarial Method – Entry Age Normal, Unit Credit  Demographic: Retirement: mixed Termination:increase Mortality: decrease Disability: increase  Economic – KEY! Interest Rate:decreasing from 8% towards 7.5% Salary Increases:within 3% below Interest Rate COLA’s: decreasing

8. 8  Impact Public Sector: Pension Plans: due to asset losses OPEB Plans: due to new accounting requirement  Alternatives (check State restrictions) Amortization basis – Level % of pay Amortization period – to 30 years Asset corridor – to 130% of Market Value Asset smoothing – to 10 years Phase-in funding increase: 5 years ? Funding Relief Alternatives

9. 9 Plan Design Changes  Increase employee contribution levels  Retirement eligibility  COLA’s  Revise benefit structure  Final average pay  DROP’s Other  Soft Freeze – State Protections?  DC Plan  Hybrid Plans Cash Balance Basic DB with supplemental DC plan Pension Plan Design Changes – significant cost/liability impact:

10. 10 Plan Design Changes - Summary  Soft Freeze – typical current approach  Increase employee contributions – typical current approach  Other plan provision revisions – for current active participants – some attempts  Hybrid Plan – Basic DB plan with supplemental DC Plan  Hard Freeze – private sector approach – the Atlanta challenge

11. 11 Actuarial Funding: Case Study  Funding Approach: Normal Cost (NC) + mixed 15/30 year Amortization of UAL  Actuarial Valuation Baseline Results ($ in thousands): 2011 Actuarial Liability (AL)$800,000 Plan Asset Value*680,000 UAL120,000 Total NC - Employee Contributions - Net NC 15,000 5,000 10,000 Amortization of UAL**12,000 Total22,000 - % of payroll17% * Includes 5 Year Smoothing/+ 20% corridor **Uses Level $ Amortization

12. 12 Funding Approaches: Case Study Comparative Results: Annual Cost as % of Payroll Current Valuation17% Level % of Pay Amortization14% 30 Year Amortization Period15% 130% Asset Corridor15% 10 Year Asset Smoothing15% 5 Year Phase-in*13% *Note: expected increases for 5 years

13. 13 Plan Design Changes – Case Study Selected Alternatives:  A: Soft Freeze with revised DB plan for new employees including: NRA, Final Average Pay, Benefit %, COLA and employee contribution revised provisions  B:Maintain DB plan, increase employees contribution rate by 2%  C: Revise current DB plan for current employees, including: NRA, Final Average Pay, Benefit %, COLA and employee contribution revised provisions  D:Hybrid Plan: Basic (reduced) DB plan with supplemental DC plan (3% employer contribution)  E:Hard Freeze, with a replacement DC plan (6% employer contribution)

14. 14 Plan Design Changes – Case Study Projected Comparative Plan Costs – as a % of payroll Year Current Plan Alternatives ABCDE 201117% 15%10% 8% 201218% 16%11% 9% 201317% 15%11%10%8% 201417% 15%10% 8% 201516% 14%10% 8% 201616%15%14%9%10%8% 201716%15%14%9%10%8% 201816%15%14%9%10%8% 201916%15%14%9%10%8% 202016%15%14%9%10%8%

15. 15 Plan Design Changes – Case Study Projected Comparative Cost Savings vs. Current Plan ($ in millions) Period Alternatives ABCDE 5 Years$.6$14$49$50$64 10 Years$4$32$112$105$137 Notes: Sample Plan: 3,700 participants 2011 payroll $127,000,000

16. 16 Why is this an issue?  Subprime mortgage debacle and near collapse of financial system causing a contraction of U.S. economy  Steep decreases in tax revenue for most state and local governments  Poor investment choices, underfunding or non-funding of pension obligations

17. 17 Magnitude of Problem  Pew Research Center estimated that the gap between assets and future legal liabilities for US state plans is at least 1.26 trillion dollars

18. 18 Other grim statistics  Pension funding shortfalls accounted for $660 billion of the $1.26 trillion gap, and unfunded retiree health care costs accounted for the remaining $607 billion.  States had only about $31 billion, or 5 percent, saved toward their obligations for retiree health care benefits.  State pension plans were 78 percent funded, declining from 84 percent in 2008

19. 19 Comparison of some Mid Atlantic States Funding Levels  New York 101%  Pennsylvania 81%  New Jersey 66%  Delaware 94%  Maryland 65%  W.Virginia 56%  Virginia 80%

20. 20 Reasons for underfunding  Power of public unions  Profligate politicians  Lack of managerial influence in financial area  High debt ratios  Lack of professional support for legislature  Public employee density—positive correlation

21. 21 Focus on Maryland  350,000 current and future retirees  Steep losses in 2008 and 2009 saw the funded ratio drop from 78% to 65% (actuarial)  In real market terms the funded ratio fell to 54%

22. 22 Focus on Maryland—decisions  Quality Teacher Incentive Act-1999 pumped $14 million toward local schools— portion was used for salary enhancements  Governor’s Teacher Salary Enhancement Grant—2000, made upwards of $55 million available for instructional staff salary increases.

23. 23 Focus on Maryland-decisions, continued  Bridge to Excellence Act (Thornton Act) 2002. committed $1.3 billion in new state aid towards local school systems  The Act also mandated that the state pick up the cost of pensions for teachers paid by certain grants—previously paid by local governments

24. 24 Focus on Maryland—decisions, continued  State Employees’ and Teachers’ Retirement Benefit Act of 2006  Increased multiplier from 1.4 to 1.8% retroactive to 1989  Member contributions increased from 2% to 5% phased in over three years

25. 25 Avoid dark corridors  In 2002 the state abandoned the traditional technique of funding and adopt the “corridor method”.  Instead of making an annual payment based on its payroll number which is then multiplied by the actuarial certified contribution rate, the legislature replaced it with a system which froze the contribution rate at the FY 2002 rate as long as the funding ratio remained in a “corridor” between 90 and 110 percent. Moving to the corridor scheme allowed the state to legally underfund its payment as long as the investment returns were robust, and the five year smoothing method disguised the true funding ratio of the pension system.

26. 26 Reaction by Trustees of the Plan  The Board of Trustees of the State Retirement and Pension System began to sound the alarm in 2005, a year when the returns were in the double digits, and has repeatedly called for the abandonment of this funding method.

27. 27 Policy Options  Option one: Shift the cost to local governments.—have counties and Baltimore pick up some or all of the cost of teachers’ pensions.-$850 million shift  Option two: Eliminate or reduce defined benefit pension plans for current employees.

28. 28 Options, continued  Option 3: Reduce future liabilities by increasing participant contribution rates and introducing a two tiered system Existing employees and teachers would be allowed to remain in the defined benefit plan, albeit with a higher contribution rate, and new employees hired after July 1, 2011 would be in a modified defined contribution plan. In 2010 nine states increased participant contribution rates as one step in reigning in their future funding obligations.

29. 29 Options, continued  Montgomery County’s Retirement Savings Plan (RSP) and Guaranteed Retirement Income Plan (GRIP) In 1994, Montgomery County required all new nonpublic safety employees to enroll in the RSP, a defined contribution plan, whereby the employee contributes a percentage of their salary, which is matched by the county and invested in an instrument selected by the employee. The investment choices are selected and monitored by an official fiduciary, the Board of Investment Trustees, made up of representatives of employee unions, county officials, and members of the public.

30. 30 GRIP  In 2008, the County introduced the cash balance concept. Members in the RSP and newly hired employees can select an option, (GRIP) whereby they relinquish making the investment choices to the BIT for a guaranteed 7.25 percent rate of return

31. 31 DB Plans-Can They Survive?  Long term trends transforming the national economy and reorienting the social contract between employers and employees point away from traditional pension plans. In the private sector, for example, the number of traditional defined benefit plans have declined greatly. In 2007 only 32 percent of households had an employer provided defined benefit pension plan. From 1990 to 2007, the number of active participants in such private sector plans fell by 26 percent, even as the workforce increased by 22 percent.  Source, United States Government Accountability Office, letter to Senator Herb Kohl,  April 28, 2010, p.6. Accessed through http://www.gao.gov/new.items/d10632r.pdf. December 4, 2010http://www.gao.gov/new.items/d10632r.pdf

32. 32 Changes to Maryland’s Pension Plans Enacted by 2011 General Assembly  Cost-of-living Adjustments For service credit earned after June 30, 2011, the COLA will be linked to the performance of the SRPS investment portfolio. If the portfolio earns its actuarial target rate (7.75% for fiscal 2011), the COLA is subject to a 2.5% cap. If the portfolio does not earn the target rate, the COLA is subject to a 1% cap.

33. 33 Changes, Continued  Member Contributions : Beginning July 1, 2011, member contributions for current active members of EPS and TPS increase from 5% of earnable compensation to 7% of earnable compensation. Member contributions for current active members of LEOPS increase by 4% to 6% in fiscal 2012 and from 6% to 7% beginning in fiscal 2013.

34. 34 Changes, continued  Future SRPS Members Vesting Increases from5 to 10 years Average 5 highest years- up from 3 Multiplier decreased to 1.5% from current 1.8% Normal service retirement will be 65 years old and at least 10 years of service-compared to 62 and 5 Early retirement—62 and 15 instead of 55

35. 35 Policy Changes—narrowing the corridor  The pension reform provisions of the BRFA of 2011 establish a goal of reaching 80% actuarial funding within 10 years by reinvesting a portion of the savings generated by the benefit restructuring into the pension system in the form of increased State contributions above the contribution required by statute. In fiscal 2012 and 2013, all but $120 million of the savings generated by the benefit restructuring are reinvested, with the $120 million dedicated to budget relief each year.  Beginning in fiscal 2014, the amount reinvested in the pension fund is subject to a $300 million cap, with any savings over that amount dedicated to budget relief.

36. 36 Light at the end of the tunnel?

37. 37  Questions???