Solution of the Week: PERS reform
PERS: Structure of Benefits
When taxpayers’ contingent liability for Nevada’s Public Employees Retirement System is accounted for — through a market-based accounting technique — the system’s unfunded liability currently approaches $41 billion.[1]
That amount is nearly seven times the annual payroll of all state and local governments that participate in PERS. Put another way, PERS’ unfunded liability is slightly larger than all spending from the state general fund between FY 1986 and FY 2010 — a period of 25 years.
Obviously, an unfunded liability of such size means that Silver State taxpayers face a tremendous challenge in meeting obligations promised to Nevada’s current and past public-sector workers. Moreover, given such a burden, Silver State taxpayers cannot allow PERS’ unfunded liability to continue growing.
To arrest or even reverse the growth in unfunded pension liabilities will require a significant restructuring of benefits.
Key Points
Defined-benefits (DB) pension plans leave taxpayers vulnerable. The growing unfunded liability to which Nevada taxpayers are exposed stems from the fact that the pension benefits promised to retirees are certain whereas PERS investment returns are not. When a year’s investment returns fall short, PERS increases taxpayers’ required annual contributions to make up the difference. Thus, taxpayers — in addition to bearing the risk on their own retirement savings — are forced to bear PERS investment risks as well.
Defined-contribution (DC) retirement plans offer taxpayers greater assurance. DC plans inoculate taxpayers from PERS investment risk. Similar to a private-sector 401(k), a DC plan would have taxpayers contributing a set amount into government workers’ personal retirement accounts, with government workers assuming their own investment risk — as do most private-sector workers.
DC plans benefit government workers in addition to taxpayers. If Nevada shifted to a DC retirement system, government workers would see many important benefits. First, DC plans are both personal and portable. Under the current, collectivized DB system, workers cannot take their retirement savings with them if they change jobs, resulting in “job lock.” Portability of retirement benefits can thus make public service more attractive to younger workers.
Second, retirement savings in a DC account are a tangible asset that retirees can pass on to their children, upon death. This is not true of a DB plan. In the case of early or untimely death, retirees in a DB program lose their claim to full pension benefits even though they may name a “survivor” to receive partial benefits. In this case, retirees can become net losers, having contributed more money into the collectivized system than they and their survivors will ever receive.
Shifting to a DC plan can be costly in the short term. As PERS administrators have noted, an abrupt, not-well-planned shift to a DC plan could accelerate the amortization schedule of the unfunded liabilities that Nevada’s DB plan has already incurred. Such a shift would require larger taxpayer contributions until PERS collects enough assets to cover its accrued liabilities. Although already destined to incur these costs, taxpayers would have to do so on a shorter timeline.
A hybrid approach allows such short-term costs to be avoided. Utah lawmakers created one such hybrid plan in 2010. It allows workers to participate in either a DB or DC retirement plan but it limits taxpayer contributions in either case to 10 percent of the workers’ pay. Because Utah will continue its DB plan on an optional basis, its taxpayers will be able to avoid an accelerated amortization schedule for the DB system’s accrued unfunded liability.
Recommendations
Restructure pension benefits around a Utah-style hybrid system. Nevada lawmakers should protect Silver State taxpayers from the open-ended liabilities associated with DB pension plans by adopting pension reform along the lines of Utah’s hybrid system. Utah’s system was put in place with the enactment of Senate Bill 63 from Utah’s 2010 General Legislative Session, which should serve as a model to guide Nevadans.[2]
- Initial contributions. State employees contribute a percentage of their salary toward retirement and that amount is matched by state taxpayers. These contributions currently total to 25.75 percent of wages for regular employees and 40.5 percent of wages for police and firefighters.
At the local government level, retirement contribution rates are subject to collective bargaining agreements and, in many cases, retirement benefits are completely funded by taxpayers with public employees making no contribution toward their own retirement.
- Return on investment. PERS administrators invest the retirement fund contributions made by employees and taxpayers in a combination of stocks, bonds and private equities in order to gain capital earnings. Currently, PERS’ targeted rate of return is eight percent per annum, although PERS average annual yield over the past 10 years has been only 3.8 percent.
- Liabilities. PERS is responsible for paying retirement benefits to participating employees calculated as a percentage of their highest-earning 36 consecutive months of employment. Calculating the total future liability facing PERS can be difficult because so many variables are involved, including: length of career, life expectancy, future pay raises, etc.
- Contingent liability. Any time PERS’ investment earnings fall short of its annual 8 percent target, its assets fail to keep track of its accrued liabilities (the retirement promises made to government workers). As a result, a corresponding share of PERS liabilities becomes “unfunded.” To account for this unfunded liability, PERS increases the mandatory taxpayer contribution rates in subsequent years. Over time, retirement contributions grow to consume an ever larger proportion of state and local government finances — especially within local governments whose collective bargaining agreements exempt workers from contributing to their own retirement.
