by Kevin Nicholson
Special to the MacIver Institute
With a report listing Wisconsin’s among the best-funded and healthiest pension systems in the nation, and another warning against major changes to the system, state pension beneficiaries and policymakers are likely feeling good about where the Wisconsin Retirement System (WRS) stands. Despite this news, Wisconsin policymakers, public pension beneficiaries and taxpayers must remain cautious and forward-thinking about the overall financial health of WRS.
As explained in a paper I recently co-wrote, the accounting practices used to value the assets and liabilities of a pension plan can have a dramatic impact on a plan’s funded ratio (see Sections 2 & 4 of our paper). Let’s start with looking at liabilities (or future promised pension payments).
Liabilities – How Best to Value?
Historically, many state and local governments have discounted their future liabilities with an assumed rate of return on their assets; they often use a rate of roughly 8% (that is, they project a return of 8% on investments, and then use that rate to discount their liabilities). As of 2010, Wisconsin used a slightly more conservative rate of 7.2%.
However, there is a fair amount of debate between those in the financial and political arenas as to how governments should discount their future pension liabilities. Recently, the Government Accounting Standards Board approved new rules that will move state and local public pension plans toward using a lower discount rate. The use of a lower discount rate will swell the size of Wisconsin’s (and other states’) pension liabilities.
At its root, this is a debate about risk tolerance, and the attempt to properly size promises of future payments. Discount rates are a financial tool used to account for the risk associated with future payments (recognizing that money in the hand today is worth more than money promised tomorrow). The rate used to discount a future guaranteed pension payment should reflect the risk associated with that payment (i.e., how likely it is that the payment will actually be made).
If the payment is highly likely to be made, the discount rate should be low (e.g., the rate of U.S. Treasury Bonds), and the present value of the future liability will be relatively large. If the future payment is relatively uncertain, the discount rate should be high, and the present value of the future liability will be relatively small.
The long-standing government approach of using a projected rate of investment fund returns does not reflect the above concept (i.e., projected investment returns are not indicative of the risk associated with future promises). In practical terms, this means that even Wisconsin’s discount rate of 7.2% will be seen as too high by many financial experts.
Assets – Optimistic Growth Projections and Varied Reporting Standards
Most public pension sponsors invest in securities in order to pre-fund their pension obligations. It is the projected return on these investment assets that governments use to discount their liabilities (as explained above).
Discount rates aside, it should be noted that projecting 8% returns on investments (in perpetuity) is an extremely optimistic forecast. Some states will justify their projections with selected historical performance data, but 8% returns do not last forever. Moreover, when investment funds fail to perform in keeping with overly optimistic projections, plan sponsors are often left pursing even riskier investment strategies in search of greater returns. The result can be a vicious and potentially unstable cycle.
When it comes to valuing and reporting these pension plan assets, there is a fair degree of latitude in standards. Most state and local governments report the actuarial, or “smoothed”, value of their public pension investment funds. This smoothed value will average the value of a given investment fund over a matter of years.
Assets can also be reported as their market value, or whatever the market is willing to pay for the security in question on a given day (an option not typically taken by public pension plan sponsors). Needless to say, market values can vary wildly depending on market activity. Recent market volatility has resulted in actuarial asset valuations typically being greater than market asset valuations over the last several years (See Section 2 of our paper). This factor can help inflate public pensions’ reported funded ratios.
What Does This Mean for Wisconsin?
While Wisconsin’s system is reported as well-funded, it is clear that the use of different accounting criteria than that employed in the state’s financial statements would likely yield a different result.
For example, in 2008, Wisconsin reported its pension plan assets as being worth $62.2 billion, while its pension liabilities were stated as worth $82.9 billion (a 75% funded ratio in the midst of the financial crisis). When plan liabilities were discounted at the more conservative Treasury rate, plan liabilities ballooned to $153.3 billion, yielding a funded ratio of 41%. (See our paper, Appendix Figure A.) This 34% decrease in funded ratio indicates the tenuous nature of a “well-funded” public pension plan.
Should Wisconsin Consider a 401K-Style Defined Contribution Plan for public employees in the Future?
Financial planning entails accepting and accounting for risk. As of now, the structure of WRS places the risk of retirement planning on the shoulders of the state and its taxpayers. If the state’s assets were to devalue to the extent that investment earnings could not cover the cost of pension payments, taxpayers would be legally obligated to make up the difference. In this case, the benefit payment is “defined” (hence the term “defined benefit” or DB plan). Conversely, if my 401K devalues after retirement, I must live with the result. Only my employer’s initial contribution is “defined”, not the end payout or benefit (hence the term “defined contribution” or DC plan).
DB plans once played a larger role in the private sector, but have since faded in prominence. Society has largely accepted the fact that most of us need to personally plan for much of our own retirement, and shoulder the burden of financial risk that comes with such planning. Is it reasonable to expect the same of most public employees? If not, why not?
A very powerful argument can be made that public safety officials (e.g., police officers, firefighters, state troopers, sheriffs, etc.) should be compensated with DB retirement plans given the dangerous nature of their work, the physical toll on their bodies, and the sacrifices that they make to keep society civil and safe (similar to career military veterans who receive a full pension after 20 full years of honorable service). But an equally logical argument can be made that a full DB plan, with an annual Cost of Living Allowance (COLA or compounding annual increases in payments) is not the only acceptable type of retirement plan for all public employees.
Options should be kept on the table for Wisconsin’s future, to include hybrid retirement plans (small pensions combined with larger DC plans). Our paper runs through a series of public pension “Progress Anecdotes” in Section 9, and more “Potential Solutions” in Section 10.
The recent report that advised against instituting a DC plan in Wisconsin is likely correct in stating that an additional DC option (on top of the existing DB plan) would increase taxpayer costs. Certainly, in the short-term, implementation of a full DC plan would also do little to alleviate unfunded pension liabilities given that those liabilities have already been promised to existing system participants (and will likely remain on the books for the duration of beneficiaries’ lives).
Retirement planning – both for individuals and for governments – is a long-term process that does not lend it self to quick changes. Instead, any revisions and reforms should be carefully considered and weighed. Just like the rest of society, public employees deserve well-planned and well-structured compensation in exchange for their work. Arguably, many public employees across the country are not receiving such a deal from their currently underfunded and often poorly conceived DB retirement plans. In the end, nobody stands to gain more from intelligent and far-sighted public pension reform than do the beneficiaries of public retirement plans.
Given all that’s happened in Wisconsin recently, it may be that this is not the right time to institute reforms to WRS. But the recently issued report should not stop Wisconsinites from considering future options, discussing this important issue, and thinking about the best path forward for our state. Our future depends on making sound decisions today, and we have little to gain from shelving such an important topic as our state’s fiscal health.
Kevin Nicholson lives in Wauwatosa, Wisconsin with his wife and two children. He works as a management consultant and is a recent graduate of a joint degree graduate program at the Harvard Kennedy School of Government (Master of Public Administration) and the Dartmouth Tuck School of Business (Master of Business Administration). Before graduate school, he served for five years in the U.S. Marine Corps, deploying to both Iraq and Afghanistan; he was awarded the Bronze Star for his service in Afghanistan. Kevin attended the University of Minnesota as an undergraduate.