Pension Funding Policies are Putting Colorado’s Credit Rating at Risk

Commentary

Pension Funding Policies are Putting Colorado’s Credit Rating at Risk

A recent statement from Standard and Poor’s (S&P) Global Ratings punctuates the critical nature of Colorado’s ongoing discussions on pension reform. According to the report, S&P just adjusted its outlook on Colorado’s credit rating from stable to negative, citing Colorado’s pension woes as the primary driver of a possible downgrade from their current AA rating. The news comes at a time when discussions on possible reform for Colorado’s Public Employees’ Retirement Association (PERA) are already underway—and the potential hit to the state’s credit rating further emphasizes the critical need for lasting and meaningful change.

Colorado’s PERA suffers from an unfunded liability that has consistently grown over the past 15 years. In 2016, the plan reported a deficit of $33.8 billion and a funded ratio of just 56.1%. The solvency metrics look even worse when reported under GASB accounting standards, which show a total PERA unfunded liability of $50.8 billion and a funded ratio of 46.1%. As a result, Colorado currently sits among the ten worst funded states when looking at combined state pension systems. In fact, three of the subdivisions of PERA are expected to run out of cash between 2036 and 2041 (based on GASB accounting) unless some serious changes are made to the status quo.

Several factors have contributed to Colorado’s growing unfunded liability, but the S&P report singled out one problem in particular: “[Colorado] continues to annually fund less than its ADC (actuarially determined contribution) and the gap needed to fully fund the retirement systems grows further.” What the S&P is referring to is Colorado’s practice of fixing contribution rates in statute rather than paying what actuaries determine is necessary—the ADC—to fund the cost of providing pension benefits.

Each year, actuaries calculate the minimum employer contribution amount necessary to prevent the fund from falling further into debt. These figures are reported to PERA which publishes them in an actuarial valuation. Unfortunately, Colorado’s policy is to ignore the ADC and set contribution rates via a formula determined by the legislature in the abstract based on what they can afford, after taking various political concerns into account.

For example, PERA’s School Division (the largest within the system) received an employer contribution of 19.25% of its payroll despite the fact that the ADC required 22.3% in 2016. As a result of this policy, the state has come short of its minimum required employer contributions every year since 2003, each year adding to its unfunded liability. All years combined, Colorado has fallen behind by $4.6 billion since 1996 due to its failure to meet the ADC amount.

The possibility of a credit rating downgrade likely comes as no surprise to Colorado policymakers and pension fund managers. Fully aware of the state’s pension challenges, PERA’s board recommended a package of reforms in September, which would increase the contribution levels for both employers and employees. Governor Hickenlooper suggested an increase in employee (but not employer) contributions shortly after. Since both proposals increase the overall annual contribution levels for the fund, they are both likely to reduce the chances of a credit rating downgrade. They both fall short, however, in comprehensively fixing the policies that led to the chronic underpayment of required contributions.

There is sufficient evidence that determining the state’s contribution by statute rather than the amount prescribed by the ADC leads to insufficient payments. Increasing the contribution rate within the statute will provide a temporary solution to Colorado’s growing unfunded liability, but is likely to result in similar underpayments in the long-term. If policymakers were to instead use the ADC to determine the state’s annual contributions, there would no longer be years in which payments fall short of the required amount. The ADC would allow contributions to reflect the trends in the market, rather than policymakers making slight (and often too late) adjustments every couple of years.

The change in S&P’s outlook for Colorado’s credit rating highlights the flaws in past policies for pension contributions. Fortunately, local policymakers appear willing to at least consider meaningful reforms to avoid the negative effects of a downgraded credit rating.

Considering the source of the current pension struggles, it would be prudent for Colorado to focus on enacting reform that, at a minimum, addresses the policy that is used to calculate the amount paid in contributions each year going forward.


Note: For more details, a recent Pension Integrity Project analysis of PERA’s solvency challenges and a conceptual framework for reform is available here.

Zachary Christensen is a policy analyst for Reason Foundation's Pension Integrity Project.