Pension Debt: The Still Unsolved Problem Threatening Lincoln

Policy Study

Pension Debt: The Still Unsolved Problem Threatening Lincoln

The Lincoln Police and Fire Pension Fund (PFPF) defined benefit pension plan has just under 600 active members and nearly 400 retirees. The city reported earlier in 2016 that it has promised an estimated $286.4 million in retirement benefits to this group of public safety employees and retirees, but exactly how many benefits have really been promised and what is saved to pay for them is up for some debate. In June 2016, Lincoln passed an ordinance that — in part — changed how PFPF values all promised pension benefits in a way that lowered the recognized value of benefits promised to an amount around $250 million. The actual amount of normal retirement benefits didn’t change, just the accounting method used to add up all estimated future pension checks and then translate those streams of future payments into a single amount reported in today’s dollars.

Unfortunately, the change adopted by Lincoln — specifically, increasing the “discount rate” used to value liabilities from 6.4% to 7.5% — was a step in the wrong direction for pension solvency. Using accounting methods more widely accepted amongst financial economists and closer to those used by private sector defined benefit plans, Lincoln taxpayers may actually be on the hook for closer to $345 million in promised pension benefits.

This conclusion is based on analysis of PFPF that we have recently co-published in a new policy study with Nebraska’s Platte Institute. The study outlines the problems facing Lincoln, provides a quantitative forecast for what unfunded liabilities will look like in the coming years if there are no changes to the pension plans, and details a series of solutions that can address these challenges.

Read the full report here.

The discrepancy in how much Lincoln’s pension debt really amounts to is reflective of a fundamental challenge facing Lincoln PFPF: whether the actuarial accounting practices used by the city and PFPF board accurately reflect the value of the promised pension benefits. This is a problem for Lincoln today, and it has been a major part of why unfunded liabilities have grown for PFPF in the first place.

Until 2008, PFPF reported that it had more assets on hand than the value of all promised benefits – i.e., it was “over-funded.” In fact, from the late 1990s through the late 2000s, Lincoln PFPF reported funding ratios of between 100% and 130%. Since, the financial crisis, however, the public safety pension fund has seen its funding ratio consistently hover around 80% — assuming we count assets set aside for Lincoln’s 13th Checks. Another change Lincoln made in June 2016 was to merge an asset pool set aside to pay out so-called “13th Checks” — a sort of cost-of-living adjustment (COLA) — with the pool of assets for normal retirement benefits.

Since the early 1990s, PFPF paid out 13th Checks, but didn’t pre-fund the benefit with normal cost, instead paying for the COLAs by siphoning off a certain amount of investment returns in years where the market was strong. Merging the asset pool for COLAs and normal retirement benefits — and subsequently adopting a proposal to guarantee the COLA — means that PFPF will report a larger amount of assets in future years, but in practice, the combined money has always been a part of PFPF.

Focusing just on the assets PFPF has recognized as available to pay normal benefits, the funded ratio at the end of 2015 was just 62%. Absent reform, the funding ratio will probably dip further in coming years.

The financial crisis effectively exposed serious, systemic problems with the funding polices for PFPF:

  • Problem 1: Prior to 2008, Lincoln consistently paid less than the actuarially recommended amount into the system annually, and was able to do so because favorably timed investment returns helped paper over the shortchanging contributions.
  • Problem 2: Prior to 2008, the city chose to adjust its asset allocation to increase the percentage of high-yield, high-risk investments because doing so allowed the plan to make up for falling yields in lower-risk assets like bonds and keep a 7.5% assumed rate of return. As market conditions changed and the returns for low-risk investments fell over the past few decades, the city could have kept it allocation of assets fixed and simply lowered the assumed return. But, in order to avoid the additional contributions this would have required, Lincoln added investment risk. This only exacerbated the losses in the financial crisis when they happened.
  • Problem 3: Prior to 2008, the discount rate for PFPF didn’t change, even as “risk free” rates of return plummeted for decades, ultimately leaving liabilities undervalued. If Lincoln had pegged the discount rate it used for PFPF to the rate of change in 30-year treasuries starting in 2001, then by 2008 instead of reporting a 100% funded plan, Lincoln would have reported PFPF as only 82% funded with $39 million in unfunded liabilities.

Our conclusion based on analysis of these problems is that Lincoln moved in the right direction when it reduced its assumed return rate down to 6.4% to better reflect market conditions. But by reversing this decision and increasing the assumed return back to 7.5% (after the 13th Check asset pool merger), Lincoln failed to address the underlying problem facing PFPF and further exacerbated the problems inherent in the existing system. Despite efforts to address pension issues over the past decade in one form or another, PFPF unfunded liabilities are still likely to continue growing and harm Lincoln finances.

See the full report for our actuarial forecasting of PFPF, as well as details on the policy solutions we recommend Lincoln consider to solve its problems.

Anthony Randazzo

Anthony Randazzo is director of economic research for Reason Foundation, a nonprofit think tank advancing free minds and free markets. His research portfolio is regularly evolving, and he maintains a wide interest in economic policy at both a domestic and international level.