The South Dakota Retirement System (SDRS) board has met repeatedly since March to discuss how best to weather the economic turmoil created by the coronavirus pandemic. In particular, the trustees have focused on whether current state policies will be sufficient or additional measures will be needed to ensure that the public employee pension system can maintain full funding.
Their transparent process helps to shed light on how one of the best-funded pension systems in the country is effectively managing market risk and navigating economic uncertainty. At a June 3 meeting, advisers informed the board that based on improved returns through the end of May, they did not expect the fiscal year 2020 results to require immediate action.
As of 2019, SDRS has reported a 100% funded ratio, meaning that plan assets match accrued liabilities.
In addition to making the contributions to the system required by actuarial calculations each year, South Dakota has benefited from implementing predefined cost-sharing policies that manage the plan’s exposure to market risk.
SDRS trustees discussed this variable benefit design—put in place before the last recession—at meetings on April 2 and May 7. Board members and advisers at the sessions talked through ideas on how best to manage the stock market uncertainty associated with COVID-19 while ensuring continued retirement security for workers and retirees.
How the SDRS cost-sharing policies work
The SDRS cost-sharing provisions are based on statutorily fixed employer and employee contribution rates of 6% of payroll for each. If returns on investments fall short of expectations or exceed plan targets, the predefined variable benefit policies automatically adjust to ensure that the plan remains 100% funded—without increasing contribution rates. Under this structure, the annual cost-of-living adjustments (COLAs) are tied to the consumer price index. The adjustments are capped automatically within a range of 0.5 to 3.5% based on what will be needed to maintain full funding.
The system also assumes a lower rate of return on plan investments, 6.5% compared with a national average of 7.25%. That helps reduce the risk of missing the return target and incurring unexpected costs during market downturns. SDRS also regularly publishes stress test analyses—which examine possible scenarios—to educate stakeholders about the potential impact of an economic downturn on the plan and workers. The trustees can use this information to better understand the potential impact of the pandemic.
Potential responses to economic downturn
In April, the board of trustees discussed the current economic situation and the possible impact on the system’s fiscal health. SDRS actuaries reported that returns that drop as low as negative 7.1% in fiscal 2020 would be addressed automatically by reducing the COLA cap to the statutory minimum of 0.5% for one year.
If losses are greater than that, plan advisers recommended that the COLA policy be revised so that the cap could automatically drop as low as 0%, resulting in no adjustment in a given year. Such a change would require legislative approval and allow the fund to absorb losses associated with a negative 11.6% return on investments. Initial feedback on strengthening the variable COLA proved positive, with at least one trustee representing retired members voicing support.
The board also discussed two other actions at the March meeting, both of which have since been tabled. They were to allow a small unfunded liability for a short period of time and to suspend the state contribution to a supplemental employee account and change benefits going forward for some workers.
At the June 3 meeting, the state investment officer reported that current return expectations are closer to 0.5%. As a result, no additional changes are expected to be necessary at this time for the plan to maintain full funding; the plan now expects to be able to grant a small COLA in the next fiscal year. However, the actuaries cautioned that circumstances could change quickly and the plan should be ready to consider additional corrective actions if needed. In addition, staff is recommending that the variable COLA be strengthened starting in 2021.
Cost-sharing policies such as South Dakota’s effectively keep employer costs stable, but they have an impact on workers and retirees. Still, career employees receive full or close to full income replacement through the core defined benefit combined with Social Security. The plan also includes provisions that ensure that workers who leave midcareer are on a path toward retirement security with protections against inflation, as well as an option to claim a portion of employer contributions if they leave before retirement.
Because the COLA is determined automatically based on plan funded status and inflation, the short-term benefit reduction would be in place only until the plan’s financial health improves. Changes to the benefit would apply to both today’s retirees and career workers once they retire—and both would have advance notice on the variable COLA. With the steps already taken and the attention paid to funding issues now, South Dakota serves as a strong example of how states can act to maintain fiscal sustainability while providing promised retirement security to their workers.
David Draine is a senior officer and Aleena Oberthur is a manager with The Pew Charitable Trusts’ public sector retirement systems project.
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