Recently, Massachusetts’ retirees and policy leaders alike have expressed increasing apprehension regarding the state pension system’s long-term ability to provide promised benefits to public workers. In response to the growing concern, Gov. Charlie Baker’s office released a three-year funding plan that seeks to improve the solvency of the system.
The Massachusetts’ Public Employee Retirement Administration Commission (PERAC) oversees both the State Retirement System, which serves general state employees, and the Teachers Retirement System which provides retirement benefits to K-12 teachers. Together, these systems manage the retirement promises for over 300,000 active and retired members. Combined, they have a funded ratio of 56.3 percent, well below the 100 percent funded ratio target recommended by the American Academy of Actuaries’ Pension Practice Council and the Government Finance Officers Association. PERAC has amassed nearly $44 billion in pension debt.
In 2019, PERAC made roughly 75 percent of the actuarially-required employer contribution to the system, meaning the state’s payments did not meet the suggested levels set by their own actuaries. However, under Gov. Baker’s proposed plan, employer contributions would rise by more than 30 percent over the next three-years. This amounts to a jump from $2.84 billion in 2020 to $3.11 billion in 2021.
If implemented, Gov. Baker’s plan would wisely correct a dangerous trend of chronic underfunding and help ensure the state’s ability to provide promised benefits.
Massachusetts’ system, like most public pension plans, uses a combination of member and employer contributions and investment returns to finance workers’ retirement benefits. Pension plan managers depend heavily on investment returns to help grow the system’s fund to adequate levels. If the actual rate of investment returns fall short of what the plan managers assumed, a funding shortfall is created. This shortfall increases exponentially over time and erodes the plan’s ability to meet the promises made to retirees.
Fortunately, PERAC’s plan managers have noted the trend towards lower investment returns. PERAC has consistently adopted more conservative investment return assumptions. Over the last decade, plan managers lowered the rate of expected investment returns from 8.25 percent in 2012 to 7.25 percent in 2019. These adjustments have helped align the system’s assumptions with the reality that fund managers will likely not be able to depend on market returns at the levels they did in previous years.
Given today’s diminishing stock market forecasts, PERAC may need to reduce these expectations even further, as their current investment return assumptions still may not be conservative enough. Over the past 19 years (2000-2018), for example, PERAC’s average rate of annual return was approximately 6.2 percent. This falls short of the plan’s current assumed rate of return of 7.25 percent.
Overall the pension plan’s current rate is unaligned with the emerging “new normal” of a lower-yield investment environment that is the consensus among major investment managers. Additionally, the J.P. Morgan Asset Management Company expects an aggressive 60 percent equity/40 percent bond portfolio to earn somewhere between 5.4 percent and 6.0 percent in the next 10 to 15 years. This view is further supported by similar analyses by industry peers such as McKinsey, Vanguard and Charles Schwab.
Thus Gov. Baker is right to push for public pension contribution increases in his budget. Elected officials in Massachusetts, however, need to also understand that this move should be just the start of pension reforms.
The governor’s proposal would simply require the state to pay 100 percent of what it already should have been paying into the pension plans. Baker’s proposal does not address structural issues within the pension system’s design that has contributed to billions of dollars in underfunding. Absent additional reforms to solve these issues, there’s a real risk that higher contributions would not solve the underlying solvency challenges. Higher contributions should be coupled with targeted reforms that comprehensively address sources of the government’s pension struggles.
With the near-term investment forecast looking increasingly bleak (even before recent events related to the coronavirus pandemic), Massachusetts should be contributing much more than is needed to only pay the current bill if there’s going to be any hope of eliminating unfunded liabilities in the long run. If it doesn’t, pension debt will likely continue to grow.
Legislators should certainly embrace the governor’s current policy agenda as a starting point for pension reform and commit to working with Gov. Baker on additional steps needed to ensure Massachusetts’ taxpayers and pensioners are protected for decades to come.