The Pension Benefits, Design, and Funding Task Force created by the Vermont General Assembly is expected to release its findings in December. The task force’s report should influence next year’s legislative debate over how to reform the state’s severely underfunded pension systems and other post-employment benefits (OPEB) program that covers retiree health benefits. With $4.6 billion in net public pension and OPEB liabilities reported at the end of the fiscal year 2020, Vermont urgently needs retiree benefit reform.
Truth in Accounting recently ranked Vermont 43rd of the 50 states based on its measure of “Taxpayer Surplus or Burden” with a per capita burden of $24,000. “Vermont’s overall financial condition worsened by 25 percent during the onset of the pandemic mostly because pension plan liabilities increased faster than investment income,” the report said.
Vermont’s two statewide public pension systems—the Vermont State Teachers’ Retirement System (VSTRS) and the Vermont State Employees’ Retirement System (VSERS)—had relatively low funded ratios (assets as a percentage of liabilities) throughout the 2010s. Rising stock prices in late 2020 and early 2021 offered only modest relief for the plans. The VSTRS funded ratio, based on the market value of assets (MVA), improved from 49.2% to 58.5% funded today. VSERS’ funded ratio rose from 63.3% to 73.9%.
But the results could have been better. VSTRS’ 2020-2021 fiscal year investment return of 26.64% and VSERS’ return of 25.71% were below the median 27% fiscal year return reported by state pension systems nationwide. The Vermont pension system returns also ran far behind the 40.74% return on the Standard and Poor’s 500 index for the 12 that months ended June 30, 2021.
Vermont’s actuarial gains from strong investment returns were offset by actuarial losses caused by inflation. Unlike many systems in other states that cap automatic cost of living increases at 3% annually, VSTRS and VSERS both have a 5% cost-of-living adjustment cap. Most retirees in the two systems are eligible to receive adjustments equal to the annual increase in the Consumer Price Index (CPI) up to this cap, although teachers hired after 1990 receive cost-of-living adjustments (COLAs) equal to half of the CPI increase. With CPI rising 4.6% for the 12 months ending June 30, 2021, most retirees will be receiving a COLA double the rate of inflation assumed by VSTRS and VSERS actuaries.
Finally, although the systems’ MVA improved markedly, state pension contributions are based on the actuarial value of assets (AVA), which does not fully incorporate large investment gains or losses the year they are achieved. Instead, only 20% of the gain above each system’s assumed rate of return is recognized in any given year. Based on the actuarial value of assets, VSTRS and VSERS saw minimal funded ratio improvements, of just 1.6% and 1.2% respectively.
Because Vermont does not prefund its other post-employment benefits, investment gains were not available this year to reduce the state’s net OPEB liability. Had Vermont Senator Bernie Sanders’s plan to lower the Medicare eligibility age to 60 been included in the Build Back Better program, the state would have seen some OPEB liability relief courtesy of the federal government. But the odds of significant Medicare expansion passing Congress in the next few years now appear to be increasingly remote.
As the task force has observed, the lack of OPEB prefunding obliges the state to discount future expected retiree healthcare benefit costs at a relatively low discount rate, which means higher calculated costs. While Vermont uses a 7% discount rate for pension liabilities, Government Accounting Standards Board rules require the use of a high-quality municipal bond rate for OPEB liabilities when they are not prefunded. Last year, this rate was only 2.21%.
If Vermont adopts and follows a prefunding strategy, it could also discount future OPEB costs at 7%, reducing balance sheet liabilities by an estimated $1.68 billion. The disadvantage of prefunding from a budgetary standpoint is that the state will have to dedicate funds to building up its OPEB reserves each year. This means that one-time funds like federal support under the American Rescue Plan Act (ARPA) will not be sufficient. Vermont could use ARPA money for the first two or three annual OPEB prefunding payments, but the state would have to rely on own-source revenues thereafter. An alternative use of ARPA funds would be to provide initial funding for retiree healthcare savings accounts, and then offer these accounts to some classes of employees as a substitute for their defined retiree healthcare benefit.
The task force’s website shows that members have collected a large volume of information and are having an informed discussion. This year, Vermont has benefited from increased tax revenue as well as federal ARPA support exceeding that of most states on a per capita basis. Hopefully, the combination of information flow and revenue flow will give Vermont the opportunity to address its retirement system funding challenges in a sustainable manner.
Stay in Touch with Our Pension Experts
Reason Foundation’s Pension Integrity Project has helped policymakers in states like Arizona, Colorado, Michigan, and Montana implement substantive pension reforms. Our monthly newsletter highlights the latest actuarial analysis and policy insights from our team.