Birmingham, Alabama, Mayor Randall Woodfin recently issued a stern warning to city officials and the general public, bringing attention to the city’s $378 million in unfunded pension debt. In doing so, the mayor exemplified a willingness to lead on challenging issues. He noted that meaningful public pension reforms are difficult but doable
“Please understand, if we do not take definitive action now, the city will face widespread financial problems. The city’s credit rating will likely be lowered, creating an even greater challenge in fully funding the pension,” Mayor Woodfin wrote to Birmingham employees. “Beyond that, it would have an immediate impact on efforts to fund projects like street and sidewalk repairs, the purchase of equipment and even the size of our workforce.”
The public workers of Birmingham have earned every penny of their retirement benefits and deserve retirement security that has been promised to them. Likewise, taxpayers deserve an equitable solution that ensures the future solvency of the pension plan and protects the city’s overall fiscal health. But before pension problems can be solved, local officials must first adopt a realistic view of pension fund liabilities and the full scope of the problem.
A standard measure of pension health called the funded ratio compares a pension plan’s assets to the value of the benefits a plan has promised to pay out (the accrued liability). Ideally, the city of Birmingham Retirement and Relief System’s invested plan assets would earn enough to match the long-term assumed rate of return needed to provide all the benefits that have already been promised to future retirees.
However, the city currently has a funded ratio of 73.42 percent. This is well below the 100 percent funded ratio target recommended by the American Academy of Actuaries’ Pension Practice Council, Government Finance Officers Association, and Segal Consulting (the actuarial firm currently overseeing the valuation of the fund). Although some have cited 80 percent as an acceptable targeted funded ratio, this assertion is at odds with industry best practices and falls short of keeping the retirement promises made to public workers.
The funded ratio, however, is just a simple snapshot of the pension system’s health. The current pension debt didn’t materialize overnight. As the mayor noted, Birmingham has been consistently contributing less than the required amount to keep the system solvent. The actuarially required contribution (ARC)—the amount of money the system needs to pay each year to meet future obligations—and the actual contributions made have been diverging for at least decade.
According to the latest 2017 actuarial valuation report (pg.26), the city of Birmingham Retirement and Relief System has made only partial payments of the required amount in recent years. In 2009, the actual contribution made was 74.89 percent of ARC. In 2017, the actual contribution had fallen to 45.95 percent of ARC. This ongoing decline is a direct threat to the fiscal sustainability of the plan.
Mayor Woodfin’s messaging indicates that the priority will be to close the growing gap in the annual required contributions through additional funding, but there are still other problems that, if left unaccounted, will further increase the city pension’s budgetary pressures.
Most notably, the assumed rate of return used by Birmingham’s pension may be overly optimistic. Currently, the plan has an assumed rate of return of 7.50 percent, which is at odds with the emerging “new normal” consensus among major investment managers. The J.P. Morgan Asset Management Company expects an aggressive 60 percent equity 40 percent bond portfolio to earn somewhere between 5.5 percent and 6.0 percent in the next 10 to 15 years. This viewpoint is further corroborated by similar analyses by industry peers such as McKinsey, Vanguard and Charles Schwab. However, instead of lowering expectations on future returns, the city’s pension fund is employing a riskier investment mix in order to achieve the higher targeted investment outcomes, which could make the fund even more vulnerable to economic fluctuations.
Currently, only 15 percent of the city’s pension assets are held in low-risk bonds—ironically, this amount roughly matches what the plan invests in higher risk hedge funds. Furthermore, foreign and domestic equities compose over 65 percent of pension fund investments. According to a recent study by Willis Towers Watson, global pension fund investment allocations average 46 percent equities and 27 percent bonds. The same study found American pension fund investment allocations average 50 percent equities and 21 percent bonds.
This seems to suggest Birmingham’s pensions investments are taking on aggressive risk by global and domestic standards. This should be particularly concerning for all members of the pension system because if the plan’s realized investment returns fall short of the expected assumed rate of return, pension fund liabilities would unexpectedly grow, worsening the pension debt issue.
Pension fund managers in Birmingham cannot continue to ignore the city’s pension issues. Mayor Randall Woodfin is right to raise awareness of this issue. The city owes public sector retirees and city residents a fiscally responsible solution to numerous problems plaguing the pension system. It is possible for the city to uphold its obligations to current retirees while implementing meaningful changes to ensure a better outlook for taxpayers and future city workers alike.