11/14/2013 - At the end of 2007, ominous economic clouds were gathering. Earlier in the year, the meltdown of subprime real estate signaled an end to a historic housing boom. Stock markets slid and in December, the National Bureau of Economic Research declared that the economy had slipped into what would become known as the Great Recession.
During this time, The Pew Charitable Trusts was examining the pension and retiree health care promises states had been making to their retirees, and whether enough money was being set aside to meet those promises. On Dec. 17 came the 73-page Pew report, “Promises with a Price: Public Sector Retirement Benefits,” that warned of growing dangers in public-sector retirement benefits. The conservative estimate of state retirement liabilities starting in fiscal 2006 and stretching over the next three decades—for pensions, health care, and other retirement benefits—amounted to $2.73 trillion. Although the states had put away 85 percent of the bill—that was the good news—they still owed $731 billion. More importantly, the report pointed out, those national numbers showed great variation state to state. Twenty states had put aside less than 80 percent and at least five had experienced “troubling drops in their funding ratios.” And, as the report warned, the seemingly good economic times of the previous decade had led states to boost benefits and reduce contributions.
Pensions, with their arcane accounting and financial complexities, do not often stir interest from the public and politicians, which explains some of the inaction. But it was a sign of profoundly uneasy times that “Promises with a Price,” with its state-by-state numbers and explanations of the range of factors that affect the health of pensions and other retirement benefits, received widespread media attention and put the retirement crisis on the already crowded agenda of deteriorating fiscal problems as 2008 dawned.
“Promises with a Price,” the first of a succession of Pew reports on retirement benefits in the states, highlighted a problem that had been building, as silently as a financial bubble, for years. It was one that was about to get far worse. The implosion of the markets hammered pension investments, driving down returns. State governments mired in recession-related fiscal woes cut contributions. Health care costs continued rising, and every month more baby boomers retired and began to collect their long-awaited benefits.
By February 2010, that difference between what the states had put away and what they would eventually have to pay out elicited another report, the eye-opening “The Trillion Dollar Gap: Underfunded State Retirement Systems and the Roads to Reform,” which garnered even greater attention.
Those early reports on retirement benefits have led Pew to a much deeper and more policy-oriented involvement with the problem, providing technical support in states where policymakers are struggling to cope with ballooning liabilities. In at least one state, Kentucky, Pew has been able to use its expertise to help forge a bipartisan agreement on what needs to be done. Efforts in other states and cities continue.
“Offering a strong retirement system is essential for helping states and cities recruit and retain a talented workforce,” says David Draine, a senior Pew researcher on pension issues. “Pew has always wanted to help governments be more effective and efficient, and attracting top workers is central to that.”
Tackling retirement benefits involves several challenges: the complexity of the problem and the difficulty of getting a firm grasp—particularly in terms of data—on its sheer scope and variety. With the exception of the occasional short recession, market performance during the 1980s and the run-up in dot-com stocks in 2000, was spectacular, and fund coffers, fueled by beneficial demographics, swelled. Most state retirement funds invested heavily in the stock market. As “Promises with a Price” noted, “Because equity investment was a relatively new phenomenon in the 1990s [for pension funds], decision-makers may have ignored the idea that what goes up also comes down.”
The technology bust in 2001 was a warning about the fragility of the system, but it was one few heard. It wasn’t just the sharp market downturn and recession that followed. That had occurred before with markets swinging briskly back into recovery. This time the recovery did come, but the rapid growth that had marked the ’80s and ’90s was running out of gas. And, as “Promises with a Price” pointed out, states had spent the surplus of the ’90s on benefit increases, leaving no cushion against an economic downturn. “In some states, retiree benefits have been vulnerable to a buy-now, pay-later mentality,” the report said. “In bad budget times, retirement benefits become easy substitutes for salary increases because states can put off the bills. In good times, feelings of legislative largesse can create new retirement benefit policies that have costly long-term price tags.”
States hobbled by mounting budget woes, particularly as taxes were cut, also found it easy to cut the outlays their own actuaries told them they needed to contribute annually to keep their funds healthy. A less-than-robust recovery put even greater pressure on states. The funding hole, year by year, deepened.
The public attention stirred by Pew’s first reports, and the deteriorating pension situation, convinced the institution’s leadership that more could be done than just research, reporting, and compilation of data. “We saw a steady softening of conditions in 2008,” says Kil Huh, an early member of Pew’s pension group who is now director of state and local fiscal health research. “At some point we began to think that there was something we could do to help lawmakers.” Lori Grange, now a senior director of emerging issues for Pew who was overseeing the work at the time, recalls how “The Trillion Dollar Gap” led to more active conversations between Pew and state officials, organizations such as the National Conference of State Legislators, and the media. More reports followed.
States slowly began to address the challenge. “After 2008 or so, there were a series of reforms in some states,” says Gregory Mennis, who now directs Pew’s pension work. In fact, some 43 states between 2009 and 2011 made changes, mostly benefit cuts or increased employee contributions. “But they were very incremental,” he says. “Policymakers needed to think about this in a more comprehensive way.”
Thus began the migration of Pew’s retirement project from a set of reports to a more ambitious education and policy initiative. The early benefit reports are crammed with suggestions, some very detailed; and later reports simplified the presentation with a letter grade format. For instance, hybrid and cash balance plans—which try to combine the strengths of defined benefit and defined contribution plans—made their appearance in “Promises with a Price.” Such plans—which offer workers the safety of a defined benefit plan with lower risk while providing the state the greater cost certainty of a defined contribution plan—would later fuel bipartisan compromise in Kentucky. “The Trillion Dollar Gap” included a section that looked at what it called “the groundswell for reform” driven by budget problems and a growing awareness of a gap between public defined benefit and private defined contribution plans. The report examined the difficult politics of addressing retirement costs, offered a menu of reforms, and analyzed states that had performed well.
In 2011, Pew and the Laura and John Arnold Foundation began to talk about areas of mutual interest. The foundation, launched in 2008, targets projects that promise to create “transformational change.” By the beginning of 2012, Arnold and Pew began to partner on retirement benefits and policy assistance to the states.
“We recognize that each state has unique policy preferences and budget challenges,” says Mennis. “There is no one-size-fits-all solution.”
Kentucky had pushed through some reforms in 2008. Like many states, Kentucky had a surplus as late as 2002. But by 2010, Pew rated Kentucky as one of the worst-off of the states (joined by Connecticut, Illinois, and Rhode Island, which was already tackling its own wide-ranging reforms), with less than 55 percent of its liabilities funded, a result of years of partial funding and falling returns. The 2008 reform, which focused on cutting benefits for new workers, did not solve the problem; in 2012, the shortfall amounted to $23.6 billion, more than twice Kentucky’s annual tax revenue.
Kentucky, like many states, suffered from political gridlock. David Adkisson, CEO of the Kentucky Chamber of Commerce who had begun warning of pension problems in 2006, notes that Kentucky was one of only three states with divided two-house legislatures: Democrats controlled the House of Representatives, Republicans the Senate. Democrats stressed protecting older workers, a concern that focused on the continuation of the defined benefit plan. Republicans sought predictability and lower costs through a 401(k) approach. The two sides were at an impasse.
Finally, in 2012, driven by a strong desire to reach a long-term solution that both sides could agree on, a senior Democrat in the General Assembly introduced legislation to create a bipartisan task force that would investigate the problem and make recommendations for reform.
“Around then we introduced ourselves to them,” says Draine. The first meeting of the task force took place in July in Frankfort, Kentucky’s small-town capital in the heart of bluegrass country. Draine and the team made presentations on Pew’s research on the states. “We were optimistic at the start,” he says. “There was the usual blame and relitigating of the past. But there was an interest in discussing policy. We tried to help them through that. We wanted to make the process open and transparent.”
In August, the task force assembled all the interested groups—unions, business, taxpayers—to offer suggestions, with recommendations due by year’s end.
“Pew brought the stakeholders to the table,” says Adkisson. “Pew attracted them because of its expertise and prestige and because of the nonpartisan way it operated. The plan that emerged was not what we were advocating. But we became convinced that it would address the problem.” Damon Thayer, the Senate majority leader and co-chair of the task force, describes Pew’s contribution as indispensable. “Pew brought a level of credibility that allowed us to get the bill through a divided General Assembly,” he says. “I don’t think it would have happened otherwise.”
The task force developed a set of recommendations, voting 11-1 for a proposal that included renewed full pension payments in the next budget; a requirement to pay for any future cost-of-living adjustments when they are offered; and a hybrid cash-balance plan, in which new workers would get an individual retirement account with a 4 percent guaranteed return and a share of any investment returns above that. The plan went to the General Assembly and debate began after New Year’s. The biggest challenge was how to pay for it. That was addressed when legislators agreed on $100 million in new annual revenue—an increase in various taxes and fees and a reduction in spending on roads—and the legislation passed the House and Senate resoundingly on March 26, 2013.
Kentucky Governor Steve Beshear, a Democrat, signed it into law on April 4.
For Kentuckians, the reforms are a start, but it will take many years to return the system to full health, and the cost will be steep; the state is still short some $34 billion. For Pew, the effort meant a long and active engagement with the state’s problems and politics, much of it on the ground. But the end of the Kentucky effort is just the start elsewhere. Many other states, and increasingly cities—Pew’s research includes an in-depth look at the retirement challenges facing 61 major American cities—continue to struggle, resulting in cost increases that can crowd out needed public investments and government services and push salary freezes and layoffs of public-sector workers. Among the hardest hit: Illinois, with a shortfall of $100 billion; Pennsylvania and Connecticut; as well as a number of major cities, including Charleston, WV, with only 24 percent of its costs funded; and Chicago, New Orleans, and Philadelphia (cities are particularly far behind on funding health care liabilities, meeting only 6 percent of their obligation). And, of course, there is bankrupt Detroit.
In many states and cities, the complexity and scale of the reform task seem daunting. Not surprisingly, some stakeholders want to solve the pension crisis with only tax increases, and others want to use only benefit reductions. A long-term answer demands democratic consensus and compromise. Pew has found that deals made behind closed doors—a common approach—are often counterproductive, because they fail to get public buy-in. “Pew’s style is independent and nonpartisan and committed to transparency,” Draine says. “Our job is to ask the right questions and present options.” Given the size of the benefit hole, that should be a role with a very long run.
Robert Teitelman is a veteran financial journalist who was the founding editor-in-chief of The Deal and previously was editor of Institutional Investor magazine.
For more information, go to pewstates.org/pensions.