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Budget Basics: Employee Retirement Benefits — the Problem Is Large

A series that details the fundamentals of New Jersey's budget, as well as its current budget woes

richard f. keevey
Richard F. Keevey

This is the seventh in a 10-part series outlining New Jersey’s fiscal fundamentals. The goal is to demystify some of the state’s financial challenges, and put them in context of the broader issues New Jersey faces. This series is also intended as a way to underscore the importance of state government in a year that will see a new governor and a new Legislature chosen by voters. Follow this link to see the other stories in this series.

Background

Most state employees are enrolled in state-sponsored defined-benefit pension systems. Unlike defined contributions plans —like 401(k)s — in these systems employees and employers make annual contributions and the employees are promised a specific pension amount based on years of service and salary level. The employee contribution is specified as a percentage of their salary, the employer contributions are annually determined by actuaries based on the earnings of pension investments and the characteristics of the workforce.

The state sponsors seven different defined-benefit pension systems for public employees. As a result of (1) lower than required annual appropriations by the state for an extended period of time, (2) lower than expected investment earnings, and (3) benefit enhancements enacted in 2001, the financial condition of the pension funds have significantly deteriorated — and absent action by the state will soon be depleted.

Information indicating the state has a net pension liability of $115 billion (based on accepted GASB 67/68 disclosure standards) is alarming enough, but misses the point. The state’s October 2017 bond prospectus indicates that if current trends continue, one of the major systems (teachers pension) will be depleted of all assets within 12 years and another major system (judges) in five years.

In addition, the unfunded future liability for retiree health benefits is $69.3 billion — or a total of $184.3 billion. This is more than five times the state’s total bonded debt of $35 billion.

Each year the state’s independent actuary determines how much money the state should appropriate to fund properly the systems — assuming certain investment returns, a level of contribution by employees, and the projection of future costs. But for many years the state failed to appropriate the required amount — in some years the appropriation was zero.

The state also contributes to the retirement program — a 401(k)-type system — for professors and other employees at the state colleges and universities( 8 percent of base pay), and the state pays for their group life insurance and long-term disability — in fiscal year 2017, $170 million was appropriated.

One could write extensively about this history and enumerate the bad actors, but that is not the goal of this article. Rather, one needs to understand the dimensions of the current problem, and what actions could be taken to address the underfunding.

Key Points to Be Recognized

Four points need to be recognized to understand fully the issue of employee benefits and its effect on current and future budgets:

1) As noted, the state also pays all or a major portion of health benefits for retirees. But, unlike pensions, no dollars have been set aside for future commitments; rather future payments are on a “pay-a-you-go” basis.’ The unfunded liability of future health benefits is $69.3 billion.

The state previously pre-funded future health benefits, but this was discontinued in 1995. In 2002, all existing funds — totaling $450 million — were taken from the fund and used to balance the budget.

2) The state pays the school districts’ share of pension contributions and post-retirement health benefit for all K-12 teachers. The current payments for both are $3.1 billion. In addition, the state pays the school-district share for Social Security — $758 million in the current year.

Almost $4 billion of state payments are made each year on behalf of local school districts. Absent these appropriations, property taxes would increase.

3) The state also administers the pension funds for municipalities. But except for a small amount of state support of approximately $110 million, local municipalities provide funds from local budgets. Furthermore, unlike the state systems the local systems are better funded — at 77 percent — and for the past eight years the full required contributions were made. Curiously, the state “requires” the municipalities and counties to fund their system, while failing to fund its own systems. Further, the local systems would now be 100 percent funded if the Legislature and governor had not directed the local governments to underfund their systems during a five-year period to minimize property-tax growth.

4) Dating back to 2005, there have been numerous changes to the pension and health-benefits systems to reduce costs, long-term liabilities, and benefits for employee. For example, the age for full benefits was increased to 65 — early retirements to age 62 (with penalty); the funding calculation factor was reduced by 9 percent; and cost-of living increases (COLAs) curtailed (until the systems reaches an 80 percent funding level) for all current and future retirees.

Further, employee contributions have been significantly increased from 1.5 percent of salary to a current high of 7.5 percent — based on graduated income. Also, the base for current employee contributions for health benefits was changed. Instead of paying 1.5 percent of salary, the employee now pays a percentage up to 35 percent (based on salary) of the cost of the policy — similar to private industry. Without these expanded employee contributions, the unfunded liability would be materially higher.

In addition to retiree costs -- the state also funds health benefits ($1.3 billion) and the employer’s share of Social Security ($526 million) for the current work force. So, in total, in fiscal 2018 the state will spend over $7 billion (21 percent of the budget) for current and retired employees for pension contributions, health benefits, and social security.

Projections indicate that this amount will increase to approximately 32 percent or higher of the total state budget if all commitments were fully funded.

The Problem Revisited

When the legislature and governor and employees reached an agreement in 2011 to address the retirement-funding problems, it was assumed the problem was solved. Sizable givebacks were made by current and retired employees, including the curtailment of the COLA and a host of other changes (as noted). In return, the state agreed to fund annually an increasing amount over seven years — such that full funding would be achieved.

Unfortunately, the full “annual required contribution” (ARC) was made for only two years as other budgetary pressures and revenue shortfalls limited payments — the state failed to uphold its part of the bargain and fell back to its old practice of underfunding the pension systems.

A recent analysis by J.P. Morgan (May 2016) indicates the cost of meeting all future obligations accrued to date in New Jersey would approach 38 percent of the budget. They suggest one of three solutions would be necessary: sizable (26 percent) increase in taxes; significant (24 percent) reductions in program spending; or a quintupling of contributions by workers. And this would not be a one-time event; it would be kept in place for 30 years.

Is There a Solution?

Most public employees would argue that it is the responsibility of the state to fund properly the pension and health-benefit systems. When employees were hired, these benefits were promised and were part of the hiring agreement. Further, when the systems were underfunded and projected to be in financial trouble, public-employee unions agreed to reduced benefits, and substantial increases in contributions. They were promised the state would make the required payments.

As noted, the state did not fund the agreement. The unions and some legislators have recommended increases in the top income tax rate for millionaires. The estimated effect would be an increase of approximately $600 million — well short of what is required to address the shortfalls with related impacts.

Further, Gov. Chris Christie established the NJ Pension and Health Benefit Study Commission on August 1, 2014 to examine the existing pension and health benefit systems and develop solutions. The reports are extensive and provide detailed information about projected costs and past bad decisions.

In short, the major recommendations are: 1) freeze existing pension plans such so that only benefits earned to date would be retained; 2) initiate a new “cash balance plan” — similar to a 401(k) —for new employees and for those current employees whose existing plans were frozen; 3) align health plans (in other words “reduce” ) to private-sector levels; 4)apply these same changes to local government employees and school teachers; and 5) lock in pension funding with a constitutional amendment. No changes were proposed for existing retirees.

In the fiscal 2018, the Lottery was transferred into the pension system. It is projected that the assets of the Lottery will generate $37 billion in funding over 30 years and provides an immediate increase in the funded ratio.

However, as part of this transfer, approximately $1 billion was reduced from the proposed fiscal year 2018 pension budget. In effect the total fiscal 2018 contribution to the pension system is the same as proposed in the original budget — $2.5 billion. It’s simply being funded in a different manner. The stated benefit is that the pension system now has a predictable flow of monies. But, in fact, in the long run it will only have an impact if the state makes the full required contribution — specifically, to increase appropriations by an additional $2.5 billion — for a total of $5 billion, plus the Lottery proceeds. Current state revenues would suggest this is unlikely. Moody’s Rating Agency indicates that the transfer “does not alter the burden on the state’s credit profile.”

No further actions were taken to address the $69.3 billion of unfunded liabilities associated with retired health benefits.

Final Observation

Problems faced by New Jersey are replicated in many states, but New Jersey’s underfunding problem is at the top of the list. Some states are taking similar actions. For example, Pennsylvania is gradually shifting a portion of pension risks to future employees. Tennessee implemented a hybrid plan for new employees, while Oklahoma moved to a defined-contribution plan for new employees. As noted above, New Jersey has already taken some of these actions and still has a major problem,

The large gap between resources and increasing costs for retirement systems is the largest single fiscal issue facing the state — and has been the root cause for reductions in the state’s bond rating.

Unless significantly more annual monies are paid into the pension systems — or changes such as those proposed by the New Jersey Health Benefit Study Commission are implemented — the pension systems will soon be depleted of all assets. At such time the state will face a constitutional crisis and will have to answer the question, is it required to make annual payment to retirees even if no funds remain in the system — or do retirees receive smaller or no pensions?

The NJ Supreme Court has not specifically opined on this issue, but in several related opinions, including “Burgos v. State” (2015), the wording in the text and in related footnotes suggest that the state has a duty to make the state pension system sound. If ultimately ruled in that manner, the state would face a huge annual and recurring appropriation (at least $10 billion) to meet such requirements. It is critical that the pension issue be addressed in a timely manner.

Richard F. Keevey is the former budget director and comptroller for New Jersey, appointed by two governors from each political party. He was also the CFO for the U.S. Department of Housing and Urban Development and the deputy undersecretary of defense. He is currently a senior policy fellow at the School of Planning and Policy at Rutgers University and a lecturer at the Woodrow Wilson School, Princeton University.

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