Proposed Reforms Would Be Another Step in the Right Direction for Michigan Pensions
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Commentary

Proposed Reforms Would Be Another Step in the Right Direction for Michigan Pensions

Legislative package would continue Michigan’s efforts to make its pension plans financially sustainable for the long-term while keeping the promises the state has made to employees and retirees.

Michigan legislators have introduced a new package of bills that will make the third wave of recent adjustments to the state’s public school retirement system (known as MPSERS) alongside similar changes to the state’s other pension plans covering state police, judges, and state employees.

The first four bills in the package—House Bills 4530 through 4533—direct the pension plans to adopt the most recent tables on life expectancy, pay off any future unfunded liabilities on a shorter timeline, ensure that contributions made to the plan meet what’s actuarially required, and adopt more conservative actuarial assumptions. The last bill in the package (House Bill 4534) creates a Michigan Legislative Auditor position.

Changes in House Bills 4530 through 4533

  1. Require each retirement system to use up-to-date mortality tables.

Setting proper mortality assumptions plays an important role in pension funding. The most recent study from the Society of Actuaries shows that public employees, on average, have lower mortality rates and longer life expectancies than private-sector pension plan members. These longer lifespans mean more pension payments to retirees that weren’t accounted for, adding to the normal costs of the plan. In turn, the pension plan becomes more expensive, which necessitates higher contributions into the plan for it to stay properly funded.

Adopting the most recent mortality tables would keep the plan’s normal cost (the cost of prefunding retirement benefits for current employees) up to date, making the actuarially determined contribution rate more accurate, and thus not putting the burden on employers and taxpayers down the road to cover the costs of unfunded retirement benefits for today’s current employees.

  1. Require each system to use layered level-dollar amortization to pay off any new debt within a new, fixed 10-year period.

A closed amortization schedule means that the plan has a particular year that the unfunded actuarial liability (UAL) will be paid off. After each year’s payment to the UAL, the schedule moves one year closer to its end date. Layered amortization comes into play when the plan experiences additional actuarial losses while paying off the current UAL. In this case, the plan will not combine these new losses with the old UAL. Instead, it will create a separate 10-year closed amortization schedule for this new debt to be paid off, therefore not affecting its payment or schedule on the old debt. Level-dollar amortization means the plan expects to pay the same dollar amount each year of the schedule, rather than being tied to a salary growth assumption where plans pay less in the early years of the schedule due to assumed increases in plan payroll.

A key reason that many public plans across the country have yet to recover from the economic downturn from over a decade ago is due to adopting the exact opposite of this Michigan proposal. Those plans adopted an amortization schedule that was too lengthy, left the amortization schedule open, and paid down that schedule using the level-percent of payroll method. For example, a plan with a 30-year open amortization schedule paying the debt down as a level percentage of plan payroll (meaning the plan pays less today under the expectation that payroll will increase at a certain percentage each year to help pay for the UAL cost) is most likely making pension contributions that do not fully cover accrued interest on that UAL. This leads to negative amortization (pension debt growing faster than amortization payments). Worse, with open amortization, the plan can re-amortize that growing UAL again and again, never being required to fully pay it off.

With this reform package, Michigan would be adopting amortization policies that would save the state money in the long-term by paying off any new pension debts sooner and ensuring that the debt will, in fact, be paid in full within a set number of years. The level-dollar policy would also prevent future budget difficulties and underpayments towards the debt that could arise from payroll experience that doesn’t match expectations.

  1. Require the payment of any difference in the actuarially determined contributions and actual retirement contribution to be paid off within one year by the state instead of the current five years.

A 2015 National Association of State Retirement Administrators (NASRA) publication pointed out that the states with the largest pension underfunding crises had consistently failed to pay the actuarial required contributions into their plans. On the flip side, the states that had consistently paid 95 percent or more of their required contributions were less likely to face insolvency in their pension plans.

Tightening up the period that full contributions need to be made ensures that when projected required contributions fall short of what’s needed, that money gets into the plan assets quicker allowing it to be invested right away.

  1. Cap the assumed rate of return and discount rate at 6 percent.

The assumed rate of return and discount rate are often confused for one another due to being set at the same percentage for most pension plans across the country—but they have quite different functions.

The assumed rate of return estimates what the plan expects to return on its investments and is used to calculate the required contributions needed to fund the plan. The higher the assumed rate of return is, the lower actual contributions into the plan will be, but a higher assumed rate of return means a higher level of risk for plan solvency since there may be years where the plan does not meet the assumed rate of return.

The discount rate is used to determine the present value of already-promised pension benefits, determining how much is needed today to pay for the plan members’ benefits in the future. The higher the discount rate, the lower the present value of earned pension benefits will be. The lower the present value of earned pension benefits is considered to be, the less the plan sponsor and employees will need to pay in contribution rates for those earned benefits.

Put another way, a high discount rate and a high assumed rate of return lower the needed contributions into the plan, putting it at risk when those rates aren’t met. Lowering these rates to 6 percent creates a much more realistic investment return target, lowering risk and improving the system’s long-term outlook—and thus their ability to fulfill promises made to public workers—at the cost of increased contributions needed for the system today.

Changes in House Bill 4534

HB 4534 creates the position of a retirement system auditor, who will be appointed by and serve at the pleasure of the legislative council. This auditor would become responsible for oversight of the state’s retirement plans. Responsibilities would include evaluating the plans’ overall security by reviewing, calculating, and certifying the annual required employer contributions, as well as continuously evaluating any aspect of a retirement system to determine the retirement system’s actuarial soundness. Having another layer of accountability through the additional oversight of state pensions has long been supported by Reason’s Pension Integrity Project.

Conclusion

House Bills 4530 through 4534 would continue Michigan’s efforts to make its pension plans financially sustainable for the long-term while keeping the promises the state has made to employees and retirees. They would add short-term costs that would drive long-term cost stability by reducing risk exposure relative to the status quo. This bill package builds upon the major reforms implemented the past two years that have improved the sustainability of MPSERS, offering a model that other states should follow to keep their pension plans solvent and avoid kicking the can down the road.

Ryan Frost

Ryan Frost is a policy analyst with the Pension Integrity Project at Reason Foundation.