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Fiscal Pulse Global Economics

Mary Webb (416) 866-4202 mary.webb@scotiabank.com

Emily Jackson (416) 863-7463 emilyj.jackson@scotiabank.com

State Pensions — Working Towards a Gradual Turnaround

With State governments’ array of enacted measures since the recession to trim back their unfunded pension liabilities and recent buoyant U.S. equity markets, a slow turnaround is anticipated for the States’ aggregate unfunded pension liability burden through mid-decade. Data on State pensions, unfortunately, are lagged and recognition of the aggregate turnaround will be delayed. This past spring, PEW released State pension data for fiscal 2012 (FY12) indicating that unfunded State pension obligations were still expanding two years ago. From a $452 billion aggregate gap in FY08 to $757 billion in FY10 and $915 billion in FY12, liability by State in FY12 varied widely (top chart).1 PEW estimates that adding in the unfunded pension commitments of local governments, with more than 2½ times the employees (bottom chart), would raise the aggregate FY12 pension liability over $1 trillion.

The size of unfunded retirement liabilities relative to the jurisdiction’s fiscal capacity has frequently posed a convincing argument for benefit reforms, though the ability of State and local governments to adjust their pensions varies widely, in part due to the strength of legislative and contract restrictions. In addition to scaled-back benefits for defined benefit (DB) plans, structural benefit shortfalls have convinced some States to shift to defined contribution (DC) plans or offer supplementary DC options to employees. Other alternatives include hybrid plans (with a mandatory defined contribution and a defined benefit component) and cash balance plans (typically guaranteeing a 4%-5% return compared with the historical 8% assumption of many defined benefit plans). Importantly, these alternatives allow benefits for short-tenure employees as well as lessening the government sponsor’s investment and mortality risks.

The U.S. Governmental Accounting Standards Board recent proposal requiring State and local governments to report their Other Post-Employment Benefit (OPEB) obligations on their balance sheets rather than in a footnote mirrors the Board’s similar disclosure standard for pension liabilities in 2012. It is expected to add over $0.5 trillion to local and State liabilities, with some uncertainty regarding the liability increase given the unknown path of interest rates over the next half decade and the appropriate discount rate. The increased visibility of retirement liabilities and the pressure of other longer-term liabilities such as Medicaid, will remain factors encouraging fiscal prudence. Greater cash compliance with Actuarial Required Contribution rates for pension and OPEB benefits (top chart) is expected among some States, but raising these payments to cover future benefits is difficult when current State program needs are pressing. For some municipalities, affordability is a major issue, with annual pension funding contributions as high as 20% of revenues.

Illustrating the lack of sustainability in some retiree benefit arrangements is Detroit, making history in July 2013 as the largest U.S. municipality to file for bankruptcy. The renegotiated retirement benefit package, linked to the City’s extensive art collection in the

August 25, 2014

0

5

10

15

20

25

<65 65-74 75-84 85-94 95+

% Funded % of ARC* paid

Financial Health of State Pension Funds

# of states, 2012

*Actuarial required contribution. Source: The Pew Charitable Trusts.

1 For 46 States, fiscal 2012 year-end is June 30, 2012. All dollar data in US dollars.

13.7

13.9

14.1

14.3

14.5

14.7

5.0

5.1

5.2

5.3

5.4

5.5

06 08 10 12 14

millions, sa

U.S. Government Employment

Source: U.S. Bureau of Labor Statistics.

millions, sa

State, LHS

Local governments, RHS

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Fiscal Pulse Global Economics

August 25, 2014

“grand bargain”, was approved in late July 2014 by current employees and retirees. As Detroit returns to Court to defend its plan to exit bankruptcy, its pension arrangements are estimated to save the City about $30 million annually. The plan is opposed by some creditors, however, as too generous because it gives retirees, as unsecured creditors, preferential treatment. Yet the proposed reforms include a hybrid pension plan going forward with higher employee contributions. Benefit cutbacks for retirees are significant, such as a 90% reduction in health care benefits.

Mirroring the States’ difficult pension reforms are increased member contributions, higher insurance premiums and reduced benefits among U.S. federal plans. Of note, in the Bipartisan Budget Act of 2013, are steep insurance premium increases for single-employer DB pension plans to help the Pension Benefit Guaranty Corporation address its significant red ink. The flat rate portion of the premium per plan participant will climb through 2016 with subsequent indexation, but the steeper increases are focused on the variable rate portion of the premium which is levied per $1000 of unfunded vested benefits, offering a substantial incentive for pension repair.

U.S. State pension reforms also are aligned with the reforms implemented by other sub-sovereign governments around the world. In the mid- to late-1990s, all but two Australian States and Territories shifted new employees to DC pension plans. In Canada, Saskatchewan made a similar choice in the late 70s, and a “shared risk” (also known as Target Benefit) option has been adopted in New Brunswick. The latter is currently proposed by Ottawa as an option for Canada’s federal enterprises and federally regulated corporations.