How Pension Reform Can Help the City of Omaha

Commentary

How Pension Reform Can Help the City of Omaha

Facing a $700 million unfunded pension liability, in September 2013 Standard & Poor’s Rating Service downgraded the City of Omaha’s bond rating from AAA to AA+ marking the first time in 30 years that Omaha has had anything less than a AAA rating. Standard & Poor’s cited “the city’s high net direct debt and underfunded pension obligations” as part of the reason for the downgrade. In a new study released by the Platte Institute for Economic Research, pension expert Andrew Biggs describes how Omaha’s deteriorating pension system is putting the fiscal stability of the city at risk, and how switching to a defined-contribution system can help.

Annual required contributions to Nebraska’s Cash Balance pension system for state and county employees’ and the City of Omaha’s Police and Firefighters Retirement System have dramatically increased in the last 10 years. These payments are taking up a larger percentage of the city’s budget and making it more difficult for the city to fund other services. For instance, annual required contributions to the state’s cash balance plan increased from $14.2 million in 2003 to $56.7 million in 2013. Required contributions to Omaha’s civilian and uniformed (police and fire) employees’ plans have also increased from about $6 million in 2004 to $15.6 million in 2012 for the civilian plan, and from about $22 million in 2004 to $54 million in 2012 for the uniformed officials plan.

Omaha has not been able to keep up with these increasing annual required contributions (ARC), and as a result, both of the city’s defined-benefit (DB) pension plans are poorly funded. Beginning in 2003 Omaha began underpaying its ARCs. The city went from making 120 percent ARC payments to the uniformed officials plan in the late 1990’s and early 2000’s to just 65 percent in 2013. The city also skimped on payments to civilian plan, making just 46 percent of the ARC in 2012. As a result, both systems funding ratios are now dangerously low-the uniformed officials plan is 45 percent funded and the civilian employee plan is 56 percent funded. The situation is much worse using a fair market valuation approach to calculate Omaha’s pension liabilities, rather than the city’s overly optimistic 8 percent discount rate. Using a fair market valuation approach, Omaha’s unfunded pension liability is $1.45 billion rather than $700 million, and the uniformed officials plan is only 25 percent funded rather than 45 percent funded.

As Andrew Biggs explains in the study, many states and municipalities have started to switch from defined-benefit plans to 401(k) style defined-contribution (DC) plans. For Omaha, switching to DC plans would have several advantages:

  • Reduced Benefit Costs: Typical private sector 401(k) plans cost employers 3 percent of wages. By contrast, Omaha’s Police and Firefighters Retirement System has a normal cost of over 23 percent of payroll. When employee contributions are subtracted from the normal cost (17 percent), Omaha’s system is still more costly than a 401(k) style system. Making the change would significantly reduce the costs to the city’s budget and the risks taxpayers face in paying for a defunct system should the city be required more interest on their debts.
  • Lower Budgetary Risks: Normal costs do not account for the full cost of pensions for employers; there are also the costs of servicing the existing pension debt (amortization costs). Amortization costs equal 39 percent of payroll in Omaha, and the city is not making its full amortization payments. The city’s latest actuarial report shows the city contributed $39 million to pay down the city’s unfunded pension liabilities, short $13 million they needed to make a full payment. A switch to a DC system caps the unfunded liabilities at the amount they are now, making it easier to draw down the debt while keeping amortization costs from rising (unless the city wants to speed up the amortization process to pay the debt down faster to avoid higher interest payments). Since defined-contribution plans don’t generate unfunded liabilities, once the Omaha’s current debt is paid off a switch to a DC system would eliminate ARC payments. The city would still have to make its full employer contribution into the DC plans every year, but eliminating ARC payments would be another significant source of budgetary savings.
  • Improved Ability to Attract and Retain Employees: DB plan benefits do not accrue evenly over a public worker’s career. They are back loaded, favoring employees in the later stages of their careers rather than those in the early to middle stages. As a result, employees that only work half their careers in the public sector receive a disproportionally smaller benefit than career public sector workers. In contrast, DC plan benefits accrue smoothly and regularly over a worker’s entire career. Slow initial accruals will not attract talented young workers who do not plan on spending their entire careers in the public sector. Recognizing that DB plan benefits accrue unevenly, favoring those who stick it out for long careers in government likely creates a perverse incentive for longer serving public workers to work longer for the sake of their pensions rather than working because they enjoy their job. Employees who do not want to have a lifelong career in the public sector would do better – benefit wise – with a DC plan.

In the study Biggs also addresses the “transition cost” myths that pension reform opponents often bring up.

  • Accounting Based Transition Costs: Biggs dispels the myth that GASB requires a switch from level percent of payroll amortization to level dollar once a DB plan is closed. Level dollar amortization increases initial payments (decreasing the amount of payments in the long run), but GASB does not require a switch to amortizing the unfunded liability in this manner. Nothing prevents Omaha from amortizing the same way that they have been doing prior to switching to a DC plan, if they so choose.
  • Investment Based Transition Costs: Perpetuators of this myth argue that closing a DB plan would require investing in more liquid and lower risk (thus lower yielding) assets because of the shorter time frame in which benefits need to be paid out. Since these investments would be lower yielding, it is argued that contributions will need to be increased to fully fund the plan. Biggs counters that there is no evidence to support that public pension plans have ever had to do this, noting that there is evidence of the opposite actually occurring. Indeed, public pension plans take on more risk as the participant population has aged. It could be argued that plan sponsors have sorely underfunded their ARC payments knowing that assumed rates of return were far too high. Further, by keeping a DB pension plan open to newer workers, it is easy to hide the underfunding, where the future workers continue to subsidize current retiree costs. Biggs also argues that if Omaha used more accurate assumed rates of return in their current DB plans, any costs related to a reform to DC plans would be fairly insignificant. Moving to safer assets is not necessarily a cost if you factor in the “cost of risk”. In the event that plans are not liquid, the fact that they are investing in relatively safe assets means that a line of credit could be offered to fund the DB plan if needed, at a low cost to the sponsoring government.

Switching to a DC system for the city of Omaha’s retirement plans would be a great way for the city to get its fiscal house in order and restore its credit rating. Cities and states that have tackled pension reform have usually seen their credit ratings improve. Additionally, switching to a DC system would make Omaha’s pension systems (which have seen a steady decline in their funding) more sustainable in the long term.

For more on common objections to pension reform and how pension reform can be achieved see Reason Foundation’s “Addressing Several Common Objections to Shifting from Defined-Benefit Pensions to Defined-Contribution Pensions” and Reasons pension reform case studies on Rhode Island, Michigan, San Jose.

Victor Nava is a policy analyst at Reason Foundation, where he researches public sector pensions, federal and state economic policy, and crony capitalism.