Saving Workers’ Retirement First Steps Toward Public Pension Reform in Oklahoma by OCPA

SAVING

WORKERSâ&#x20AC;&#x2122; RETIREMENT: First Steps Toward Public Pension Reform in Oklahoma

This publication was prepared by the Oklahoma Council of Public Affairs. www.ocpathink.org 1

About OCPA The Oklahoma Council of Public Affairs (OCPA) is an independent, nonprofit public policy organization— a think tank—which formulates and promotes public policy research and analysis consistent with the principles of free enterprise and limited government.

OCPA is committed to delivering the highest quality and most reliable research on policy issues. OCPA guarantees that all original factual data are true and correct and that information attributed to other sources is accurately represented. OCPA encourages rigorous critique of its research. If the accuracy of any material fact or reference to an independent source is questioned and brought to OCPA’s attention with supporting evidence, OCPA will respond in writing. If an error exists, it will be noted in an errata sheet that will accompany all subsequent distribution of the publication, which constitutes the complete and final remedy under this guarantee.

Executive Summary Oklahoma’s public employee retirement systems’ need for reform and real structural change no longer can be ignored. The Challenge: • Oklahoma’s public employee retirement liabilities are staggering, $11.5 billion, and exceed the state appropriated budget by 69 percent. • Oklahoma’s public retirement employee liabilities grew again during the past year. • Across the United States of America and the world, defined-benefit retirement plans are in trouble due to an imbalance in promises and resources, a lack of realistic expectations, susceptibility to political misdirection, and inherent cost challenges. • Over the long-term, Oklahoma needs real public employee retirement reform of all six of its active state defined-benefit plans in order to keep its promises to current and retired government employees and to allow for adequate funding of core services. The Solution: • Real public retirement reform in Oklahoma will result in peace of mind about safe and secure retirement for public employees. • Reform of public retirement plans can be done in stages. • Reform of the Oklahoma Public Employees Retirement System (OPERS) is the best place for structural reforms to public retirement plans to begin. • Oklahoma needs a defined-contribution retirement plan for all new employees eligible for the OPERS.

Implementing a defined-contribution retirement plan for all new employees eligible for the OPERS: • will help government keep its promises to current and retired government employees and allow for adequate funding of core services; • can be accomplished and will fairly compensate state employees; • will help employees have control over their own retirement; • will ensure that pensions are available and sustainable; • will result in a fair system from government that both public employees and taxpayers can trust; • will allow the state to fully pay off its OPERS retirement debt (with no future accumulating liabilities) in 32 years; and • will give employees an asset that can be managed and transferred to employees’ families and allocated for other needs deemed important to employees.

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The Challenge Imagine public servants who have worked for a majority of their lives in service to a government entity. Their dedication was based on their desire to serve their fellow citizens and their commitment to work, in exchange for compensation including guaranteed retirement payment plans. Now imagine that these employees have retired, with the vast majority of their retirement dependent upon their guaranteed retirement payment plans. But due to government officials who control the retirement system and the inherent structural flaws of a guaranteed retirement payout,

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the employees’ retirement payment plans are in danger. These employees’ guaranteed retirement payment plans are threatened because benefits were promised without careful consideration of cost and were based on a faulty overreliance on investment returns that routinely fail due to numerous factors. This discouraging story is becoming more and more common. Across the United States of America, both public1 and private2 guaranteed retirement programs suffer from threatening and growing liabilities and have

Taxpayers are Facing a looming public employee retirement deficit that demands immediate attention from their elected representatives. significant exposure to be unable to meet their promises to the employees who depend upon the retirement. According to Forbes magazine, the Northern Mariana Islands (a U.S. commonwealth in the Pacific Ocean) Retirement Fund filed for bankruptcy protection in 2012 and will fail in 2014.3 In 2010, the U.S. Securities and Exchange Commission charged the state of New Jersey with securities fraud for failing to tell bond investors it was underfunding its retirement funds.4 The SEC also recently charged the state of Illinois for failure to properly disclose pension liabilities and funding

challenges to bond investors.5 The story of Prichard, Alabama, is a warning for all of us. According to multiple reports, the public retirement system of Alabama became so overwhelmed that for periods of time it ceased paying the benefits it owed retirees.6 No matter the source of the research regarding public retirement liabilities and future challenges, it is clear that the way retirement is provided for public employees must be reformed. Analysis from the Pew Center is the most conservative estimate of public retirement liabilities, because it reports what states report as liabilities. Organizations like the American Enterprise Institute have noted that state-reported liabilities are based on large assumed rates of return, which do not reflect the reality of market conditions over the last decade. Despite its reputation as a conservative stronghold, Oklahoma has not escaped the reckoning. The data shows that Oklahoma is not immune to problems associated with defined-benefit retirement systems. Just two years ago, Oklahoma public retirement liabilities nearly equaled total Oklahoma state spending. Recognizing this problem, lawmakers made several changes to Oklahoma public retirement systems, the most impactful of which was a commonsense measure requiring that benefits be concurrently funded.7 These changes

served to eliminate nearly a third of Oklahoma public retirement liabilities. Unfortunately, Oklahoma pension liabilities still grew from FY-2011 to FY2012 and the funded ratio declined,8 despite over $1 billion in contributions annually by government to the retirement systems. Here too taxpayers are facing a looming public employee retirement deficit that demands immediate attention from their elected representatives.

last year—and that is after receiving roughly $270 million in member and taxpayer contributions. This loss of -0.05 percent means that OPERS’ unfunded actuarial accrued liability increased over the last year.

Concerning OPERS, OCPA research fellow Matt A. Mayer’s analysis (written in October 2012) reveals:9

The most troubling trend for Oklahoma taxpayers is the enormous increase in funds they have to pay into OPERS to support the system, especially as compared to the number of employees in the system. The number of active employee contributors actually decreased slightly from 44,292 employees in 2002 to 40,551 employees in 2011. From 2002 to 2011, the total employee contributions increased by just 30.6 percent. At the same time, the total taxpayer contributions increased by a stunning 81.1 percent, which costs taxpayers more than a quarter of a billion dollars per year!

Because of reform legislation passed in 2011, the funded status of the Oklahoma Public Employees Retirement System pension plan increased from 66 percent to 80.7 percent. These figures come from the OPERS Comprehensive Annual Financial Report (CAFR) for the fiscal year ended June 30, 2011. That means that for every $1 in liabilities, OPERS possesses $0.807 in assets. The 2011 CAFR notes that the market value of OPERS’ assets on July 1, 2011, was $6.841 billion. Though we won’t know the final figures until the 2012 CAFR is released, OPERS discloses on its website that the market value of its assets on June 30, 2012, stood at $6.805 billion. If that figure is accurate, that means OPERS lost $36 million in assets over the

With OPERS just barely above the 80 percent threshold most pension experts believe is necessary, the market-value loss likely pushed the funded status below 80 percent.

This large discrepancy between employee and taxpayer contributions exists because employees only have to contribute 3.5 percent of their pay to the pension plan while taxpayers have to contribute 16.5 percent of each employee’s pay to the pension plan. For private-sector Oklahomans,

1 Pew Center on the States, The Widening Gap Update (Washington, D.C.: Pew Charitable Trust, 2012), http://www.pewstates.org/research/reports/thewidening-gap-update-85899398241. 2 Emily Brandon, “The 10 Biggest Failed Pension Plans,” Money, U.S. News and World Report, August 23, 2010, http://money.usnews.com/money/blogs/ planning-to-retire/2010/08/23/the-10-biggest-failed-pension-plans. 3 Edward Siedle, “PBGC Should Investigate Causes of Pension Failures,” Investing, Forbes, February 15, 2013, http://www.forbes.com/sites/ edwardsiedle/2013/02/15/pbgc-should-investigate-causes-of-pension-failures/. 4 Jennie L. Phipps, “Could Your Public Pension Fail?,” Retirement Blog, Bankrate.com, August 23, 2010, http://www.bankrate.c om/financing/retirement/couldyour-public-pension-fail/. 5 Rob Wile, “Illinois Settles with SEC for Misleading Muni Investors—State Had Failed to Properly Disclose Underfunded Pension,” Finance, Business Insider, March 11, 2013, http://www.businessinsider.com/sec-sues-illinois-2013-3. 6 Michael Cooper and Mary Williams Walsh, “Alabama Town’s Failed Pension Is a Warning,” U.S. News, CNBC, December 23, 2010, http://www.cnbc.com/ id/40791768. 7 Patrick B. McGuigan, “Oklahoma’s Pension Reforms Are ‘A Big Deal,’” Center for Economic Freedom, Oklahoma Council of Public Affairs, August 4, 2011, http://www.ocpathink.org/articles/1482. 8 Oklahoma State Pension Commission, Summary of Actuarial Reports (Cambridge, Mass.: NEPC, 2013), http://www.state.ok.us/~ok-pension/reports/ actuarial/2013%2002%2020%20Actuarial%20Summary.pdf. 9 Matt A. Mayer, “It’s Time for Government Pension Reform in Oklahoma,” Center for Economic Freedom, Oklahoma Council of Public Affairs, October 4, 2012, http://www.ocpathink.org/articles/2035.

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the average employer contribution to their 401(k) is 4 percent. Why are taxpayers putting in more than four times that amount into government pension plans? Earlier this year, the Governmental Accounting Standards Board passed new rules requiring government pension plans to use more realistic investment returns when calculating unfunded liabilities. OPERS assumes a 7.5 percent investment return rate every year to arrive at the 80.7 percent unfunded actuarial accrued liabilities figure. Such an unrealistic forecast misrepresents the health of OPERS’ finances. OPERS’ CAFR notes that in Fiscal Year 2011, OPERS achieved a 21.2 percent rate of return. Even with that large rate of return, the annualized rate of return for OPERS over the last five years was just 5.4 percent, or 2.1 percent less per year on average than the 7.5 percent forecast. Because of the expectation of compounding the rates of return each year, this 2.1 percent reduction compounds as well, pushing OPERS further in the hole as time goes on. The 40-year trend looks even worse without that 7.5 percent rate of return forecast. Allow me to explain. Let us make the following assumptions: • Active Member Salary Base Annual Increase: 2 percent (even though from 2010 to 2011 the actual increase was 1 percent) • Member Contribution Percentage: 3.5 percent (as current law requires) • Taxpayer Contribution Percentage: 16.5 percent (as current law requires) • Annual Payout to Retirees Increase: 5 percent (even though from 2010 to 2011 the actual increase was 7.5 percent)

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• Annual Rate of Return: 7.5 percent (as currently forecast) If we make those assumptions— some of which are generous—then the published market value of $6.805 billion in 2012 will increase until 2046, when it then begins a steady decline. If, however, we keep the first four assumptions above but change the rate of return to 4 percent, which is what private-sector pensions must use, then OPERS’ market value increases to $7.536 billion in 2022, but then drops in value each year until going into a negative balance in 2042 (i.e., in 30 years). Bumping the rate of return to 5.5 percent only stems the bleeding by five years, as the market value goes negative in 2047. If you believe it will be very difficult to maintain an annual rate of return of 7.5 percent, the only way to keep OPERS viable is to increase the member contribution rate and/or the taxpayer contribution rate. You also could reduce the pension payout, but that would only nibble on the margins of the problem. Without real reform, taxpayers remain at risk of having to bail out OPERS with even higher taxpayer contributions. New Governmental Accounting Standards Board (GASB) standards, which will require public retirement plans to more fairly present the value of assets and liabilities, also further highlight the need for reform. Concerning the impact of such rule changes on OPERS, OCPA research fellows J. Scott Moody and Wendy P. Warcholik’s analysis (written in November 2012) reveals:10 As we’ve pointed out numerous times in these pages, Oklahoma’s pension crisis is far worse than the official estimates. The official estimates are guided

by the dictates of the GASB. Finally, after years of debate, GASB is taking the first timid steps toward better transparency, which will improve the integrity of Oklahoma’s pension accounting system. While there are many details to these changes, there are two in particular that will have the most impact on Oklahoma’s pension systems. The first change shifts the actuarial smoothing of investment returns in favor of current market valuation of assets. Currently, OPERS uses a five-year smoothing of investment returns. While this provides a degree of stability in the pension calculations, smoothing is completely unrealistic since assets could never be sold on the market based on their five-year average price. The second change begins to separate the investment return on assets and the discounted value of pension benefits owed. Currently, pension systems use the long-term investment return on assets, usually around 7 to 8 percent, as the discount rate on pension benefits owed. More specifically, OPERS uses a rate of 7.5 percent. However, using the same rate for the investment return and discount value wrongly confuses the vastly different risk profiles of assets and liabilities. On the asset side, pension systems are heavily invested in stocks, which yield a very high investment return at the cost of a having a high-risk profile—in other words, returns can vary dramatically from one year to another. On the liability side, pension payouts are very predictable and, in most states, are guaranteed by the taxing authority of the state. … The new rules will still allow pension plans to tie their investment returns rate to the discount rate as long as assets are projected to sufficiently

cover benefit payments. For any years where benefits exceed assets, they will be treated as general obligation debt and discounted by the municipal bond rate, generally around 3 to 4 percent. Alicia Munnell and her colleagues at the Center for Retirement Research at Boston College recently estimated the impact of the GASB rule changes on 126 pension systems. Table 1 shows the results for OPERS. Despite the very modest changes in the GASB rules, OPERS, on a percentage basis, would see a sizable change in its funded ratio, which represents the percentage of assets to liabilities. Oklahoma state Rep. Randy McDaniel, one of Oklahoma’s champions of pension reform, recently made the case for further pension reform:11 The new year brings a renewed sense of opportunity. Resolutions are abundant. As legislative resolutions are made for the coming session, the impetus for more pension reform is building. The need is clear. The new actuary reports are completed. The unfunded liability of Oklahoma’s public pension system increased by a billion dollars last year. Moreover, several structural deficiencies still exist, especially regarding the firefighter retirement plan. Pension obligations are one of the most challenging fiscal issues confronting every state government. For decades, decision-makers authorized more benefits without providing the necessary funding. As a result, most state governments

Table 1 Funded Ratios for Oklahoma Public Employees Retirement System Fiscal Years 2006 to 2011

Public Employees Retirement System Fiscal Year

Current Funded Ratio

New Funded Ratio

Percent Difference

2006

71.4%

—

2007

72.6%

—

2008

73.0%

—

2009

66.8%

—

2010

66.0%

60.0%

-9.1%

2011 (a)

80.7%

74.7%

-7.4%

(a) Assumes change in new funded ratio for 2011 is equivalent to estimated change in 2010. See endnote 5 for source. Sources: Oklahoma Public Employees Retirement System; Center for Retirement Research at Boston College; Oklahoma Council of Public Affairs were struggling to meet their pension funding requirements prior to the economic downturn. [W]orthy goals of financial sustainability and intergenerational fairness necessitate legislative action. Illinois provides an example of the economic consequences of inaction. The state is on track to spend more on its government pensions than on education by 2016. “Under current actuarial assumptions,” Illinois Gov. Pat Quinn said, “required state pension contributions will rise to [more than] $6 billion in the next few years if no comprehensive

pension reform is enacted, which will continue to result in significant cuts to education.” Illinois’ massive unfunded pension liability has led to credit downgrades and tax increases. Poor credit leads to higher borrowing costs. . . . These byproducts of a poorly funded pension system are avoidable. This session, I will author legislation intended to strengthen the state retirement system. The coalition for more pension reform is becoming larger, enhancing the probability of success. Many positive developments are transpiring throughout Oklahoma. Support for

J. Scott Moody and Wendy P. Warcholik, “Oklahoma’s Pension Problems Are Worse than You Think,” Center for Economic Freedom, Oklahoma Council of Public Affairs, November 5, 2012, http://www.ocpathink.org/articles/2071. 11 Randy McDaniel, “Oklahoma Lawmaker: Need Exists for Further Pension Reform,” NewsOK. The Oklahoman, January 6, 2013, http://newsok.com/oklahomalawmaker-need-exists-for-further-pension-reform/article/3743568. 10

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greater financial responsibility is strong, while the opportunities for economic prosperity continue to grow. If government retirement programs are not structurally reformed, they will fulfill Frederic Bastiat’s classic 1848 warning, “Government is the great fiction through which everybody endeavors to live at the expense of everybody else.” A crucial point to understand, highlighted by Bastiat 165 years ago, is that any government service necessarily comes at the expense of private production via taxation, either directly or indirectly through debt. Whatever value public employment provides, it depends entirely on a healthy private sector. Without a productive private economy, there is no tax base to fund public services. The deficit in the OPERS pension fund represents a serious impediment to the ongoing health of Oklahoma’s private economy, upon which the pensioners ultimately depend. For the sake of their own financial security, public employees need reforms that put their retirement programs on a more sustainable course. On the free market, labor’s value, and therefore wages, is ultimately determined by consumers. In fact, all the factors of production—land, labor, and capital—derive their value from the consumer goods and services they produce. Compensation for labor is based on each worker’s marginal productivity. In other words, a worker is paid according to his or her marginal contribution to the firm’s production of goods and services. This compensation can be paid either in direct wages, or in other benefits such as health insurance and retirement plans. Just like other factors of production, such as capital and land, labor must pass the profitand-loss test to prove its value. When a firm incurs losses, this is the market’s signal that resources, including labor, are being used in a wasteful way (i.e., in a way that does not accord with

Saving Workers’ Retirement • June 2013

On the free market, labor’s value, and therefore wages, is ultimately determined by consumers. consumer preferences). A profit, on the other hand, communicates a productive use of labor. Notably, there is no profit-and-loss test when it comes to government expenditures. The resources used to pay public employees are obtained by coercive taxation, and the services rendered by public institutions are often monopolized, eliminating consumer choice. Absent voluntary payment and competition, there is no profit or loss, and therefore no rational method by which to determine the “proper” level of public employee compensation. At the very least, it would seem reasonable that public employee compensation should not exceed that of its source, namely private employees. That is simply not the case when it comes to retirement benefits and all forms of compensation and employment security. Over the last few decades, private employers have had to come to terms (pushed by the always present profitand-loss test) with the unsustainable nature of defined-benefit pension programs, turning instead to definedcontribution plans. According to economist Peter Orszag: “In 1985, a total of 89 of the Fortune 100 companies offered their new hires a traditional defined-benefit pension plan, and just 10 of them offered only a defined-contribution plan. Today, only 13 of the Fortune 100 companies offer a traditional defined-benefit plan, and 70 offer only a defined-contribution plan.” 12

Unsurprisingly, government bureaucracies have lagged the market in taking similar steps to reform retirement benefits. Defined-benefit plans can be seen to a large extent as an artificial consequence of government intervention in the first place. During World War II, the government imposed wage and price controls on the private market in an attempt to tamp down inflationary pressures due to the vast wartime spending. With the government limiting direct wages, companies increasingly turned to indirect compensation—namely, health insurance and defined-benefit pensions. What has led to such a discrepancy between public and private retirement programs? To a great degree, the disparity is simply embedded in the logic of government action. Politicians are inclined to treat government employees favorably (and make promises betting on the future) since they are a reliable voting base. However, politicians would prefer to grant those favors in ways that won’t raise the ire of private taxpayers. Because large increases in direct wages to public employees are potentially more obvious and provocative, politicians instead extend generous retirement benefits that tend to pass under most citizens’ radar. Another political advantage of retirement benefits over direct wage hikes is that the cost is put off for future politicians and taxpayers to worry about. Public choice theory teaches us that politicians have uniquely short time horizons; all they are incentivized

to care about is getting through the next election. Any consequences that extend beyond that point do not demand their attention. This phenomenon is demonstrated over and over again as legislatures continually paper over problems with temporary solutions that do little more than kick the can down the road. Private businesses, on the other hand, don’t have the luxury of kicking the can down the road. In the private sector, that is a formula for bankruptcy. Longer retiree life expectancies and underwhelming market returns have led many firms to abandon defined-

benefit plans for far more sustainable defined-contribution programs. It is long past time for public pension programs to follow suit. Public employees’ joining the call for reform is a welcome development. The current situation is simply unsustainable. Whatever shortfall exists now will only worsen with time if left as is. Better a controlled restructure now that keeps its promises to current employees and retirees than great pain and broken promises later. We are witnessing in Greece and other European countries the fate that awaits us if we wait too long to act. If the public burden on the private economy

grows too large, draconian cuts and total economic breakdown is a real eventuality. The state cannot afford to infinitely contribute 16.5 percent or more of salary for state employee retirement and still meet the funding needs of core services. The current unfunded liability of OPERS ($1.6 billion) alone exceeds individual lawmaker appropriations to every state agency except the Board of Education.13 In the interest of the Oklahoma taxpayers, our overall economic vitality, and everyone’s retirement security, we must act decisively to bring true and lasting reform to the OPERS pension system.

The Solution Many states are taking bold steps and implementing structural reforms. OCPA research fellow Matt A. Mayer notes:14 [In 2011] Rhode Island Democrats were bucking the labor unions and pushing through reform legislation that adopted a hybrid pension system. The hybrid system provides employees with a small definedbenefit annuity—one that won’t require a taxpayer bailout—and a defined-contribution component that provides them the portability and inheritability of a 401(k) account. The reform is estimated to save Rhode Island taxpayers roughly $3 billion. Back in 1997, Michigan, led by Republican Gov. John Engler, ended defined-benefit plans for new

state workers. Today, 49 percent of Michigan state workers are in defined-contribution plans. This reform is saving Michigan taxpayers billions of dollars.

to contributions made on behalf of employees. Pending judicial approval, the Louisiana reform sets up a “cash balance” plan for all new employees.

Even left-of-center voters in California are taking bolder steps than policymakers in Oklahoma. In San Diego and San Jose, voters overwhelmingly passed pension reform ballot measures. In San Diego, future government workers will be placed in a 401(k)-type definedcontribution plan. In San Jose, the new plans reduce the benefits of workers and require a higher employee contribution rate.

The reality is that the private sector has moved away from pensions, making them largely a creature of government, because guaranteed large annual payouts for pensioners’ lives make predicting actual liabilities highly speculative and costly.

In addition, Louisiana has moved to reduce growth in taxpayer liability by limiting taxpayer guarantees

Oklahoma’s public retirement plans will be a challenge to solve. If efforts are made every year, progress will be seen. Some may be tempted to retain the status quo because OPERS’ current funded ratio is 80.2 percent. This is false hope, as retirement systems must reach a funded ratio of 100 percent or more,

Peter Orszag, “Defined Contributions Define Health-Care Future,” Bloomberg Businessweek, December 9, 2011, http://www.businessweek.com/news/201112-09/defined-contributions-define-health-care-future-peter-orszag.html. 13 House Fiscal Division, FY-13 Oklahoma Budget Overview (Oklahoma City: Oklahoma House of Representatives, 2012), http://www.okhouse.gov/ Documents/2012%20FY-13%20Budget%20Overview%20End%20of%20Session.pdf. 14 Mayer, “It’s Time for Government Pension Reform.” 12

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due to the necessity for high return years to compensate for negative return years (often recessions) with defined-benefit plans. The safest and most prudent funded ratio for retirees who rely on the retirement and the taxpayers required to fund the system is 100 percent or more.15

payment as long as the retiree is living, with a limited option of a reduced payment to a spouse upon death—and an employee’s defined-benefit plan generally is not transferable otherwise.

This is accomplished by the dedication of the savings (9.5 percent) to pay off the unfunded liability, which equals 8.72 percent according to OPERS most recent actuarial valuation report.16

OCPA recommends that lawmakers implement the following for OPERS:

Due to the similarity of public employees eligible for OPERS and private-sector employees, and the current funded status of OPERS, the system is the best place to start implementing significant structural reforms. Because of the inherent problems of defined-benefit plans, the private sector is closing defined-benefit plans and moving most employees to defined-contribution plans where certainty of costs and contributions benefit both the employee and the employer. Due to OPERS’ current SoonerSave infrastructure, OPERS already has a structure to implement a full defined-contribution plan for all new OPERS eligible employees. OPERS temporarily is in the easiest position to transfer to a defined-contribution plan for all employees because it has a sufficient enough dedicated revenue stream to allow for a transition without increasing costs.

Establish a defined-contribution (DC) plan, effective July 1, 2013, for all new state (OPERS-eligible) employees:

Also, based on a recent state compensation survey, the average private-sector defined contribution is approximately 5.7 percent.17 So a plan such as this not only provides both public employees and taxpayers certainty for retirement costs but also still provides a competitive benefit.

Moving new OPERS employees to a defined-contribution plan while also providing a sufficient dedicated revenue stream to pay down existing unfunded liabilities is what is necessary to stop the accumulation of liabilities for promises to new employees and to set a dedicated path for paying down all OPERS liabilities. Definedcontribution plans also have the added benefit of the incentive such plans provide for employees to actively save and prepare for retirement. Definedbenefit plans often fail to incentivize employees to contribute toward their retirement and result in little preparation for retirement. Definedcontribution plans also result in an accumulated asset that employees can transfer to other family members upon death or other needs. Defined-benefit plans generally are a promise of a fixed

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• The plan would pay 4 percent of annual salary immediately, increasing to 7 percent of annual salary beginning in the fourth year of service with the state [the state would contribute 4 percent of salary to the employee’s “401(k)” beginning when the employee is hired]. • The plan would take the difference (16.5 percent minus 7 percent) of the new DC plan contribution and the old defined-benefit (DB) plan contribution (16.5 percent) and inject it into the system, using it to pay down the debt over time. • To preserve the funding stream for OPERS and eliminate transition costs, current OPERS employees could not convert to the new DC plan. • To preserve the funding stream for OPERS, all employers would be required to maintain overall contributions to the system as of their contribution levels for fiscal year ending June 30, 2012 (FY-2012). Even when a current employee leaves a state agency, the agency would still have to contribute to the current DB system as if the employee were still employed (until that position is filled by a new employee). Based on an independent actuarial study of this recommendation (see Appendix 1-1), such a plan would have no transition costs, would not increase liability of the system, and would allow the state to fully pay off the liability of OPERS in approximately 32 years based on the recent asset return of the system.

Transitioning to a defined-contribution plan for all new hires eligible for OPERS will have several positive effects. It will ensure that Oklahoma can keep its promises to current employees and retirees by putting a plan in place to ensure their promised benefits are funded and that a retirement plan for new employees can be adequately funded and realistic in its promises. Defined-contribution plans also provide a significant advantage to the employee. Since the contribution is a fixed and guaranteed number based on an individual’s salary, given the federal requirements for current payment of defined-contribution plans, no longterm liability can be accumulated. Also, defined-contribution plans are mobile, just like the current workforce. Many state employees are employed by the state for a time period (six years or less) shorter than the vesting period required for OPERS’ defined-benefit plan. This means that many employees leave state employment and get no retirement contributions from the state if they do not meet the approximately seven-year vesting period. Defined-contribution plans also become assets of the employee that are easily transferred and retained by the family upon death. OPERS and most other defined-benefit plans only guarantee a long-term monthly payment, and do not provide the employee with an asset the employee owns. Generally upon death, the defined benefit is significantly reduced for the surviving spouse and cannot be

used for other vital financial means or hardships facing an OPERS participant. Defined-contribution plans also help employees more adequately and realistically plan for retirement by encouraging retirement savings on behalf of the employee and rewarding work as opposed to premature retirement. Structural retirement reform of OPERS to a full defined-contribution retirement plan for all new employees is necessary. Converting public retirement systems to a definedcontribution plan is the only way to permanently end the accumulation of liabilities to future employees. Placing all new employees in a defined-contribution plan is the only risk-free retirement plan that ensures promises to employees and protects both employees and taxpayers from the risk of politically mismanaged future promises. Some other options such as cash-balance or hybrid plans still require government to make a promise, a guarantee, with just a lesser amount of risk, but risk is involved. Due to political pressure and a desire by some for the status quo, conversion to a defined-contribution plan for all employees may not be enacted. An optional full defined-contribution plan for new employees received consideration by the legislature during the 2013 legislative session for this reason. Although such a plan would not solve once and for all the accumulation of liabilities for promises to new employees (for the employees that chose the traditional defined-benefit plan), it would set in motion providing employees a choice that they deserve and that would contribute to reducing the debt in a small way.

The current optional full definedcontribution plan for new employees considered by the legislature would provide the following: • The plan would match dollar for dollar up to 7 percent of annual salary immediately [the state would contribute up to 7 percent of salary to the employee’s “401(k)” beginning when the employee is hired]. • Employees would be required to contribute a minimum of 3 percent of annual salary. • The plan would take the difference (16.5 percent minus 7 percent) of the new DC plan contribution and the old DB plan contribution (16.5 percent) and inject it into the system, using it to pay down the debt over time.

current OPERS employees could not convert to the new DC plan. Based on an independent actuarial study of this recommendation (see Appendix 2-1), such a plan would have no transition costs, would not increase liability of the system, and would only marginally allow the state to begin to reduce the number of promises for future liabilities to new employees. This is accomplished by the dedication of the savings (9.5 percent) to pay off the unfunded liability, which equals 8.72 percent according to OPERS most recent actuarial valuation report.18 ---

• To preserve the funding stream for OPERS and eliminate transition costs,

Conclusion Moving all new OPERS employees to a defined-contribution plan while also providing a sufficient dedicated revenue stream to pay down existing unfunded liabilities will help Oklahoma keep its promise to current employees and retirees and would establish a promising and secure future for all Oklahomans.

Girard Miller, “Pension Puffery,” Public Money, Governing, January 5, 2012, http://www.governing.com/columns/public-money/col-Pension-Puffery. html#ht4. 16 Oklahoma Public Employees Retirement System and Cavanaugh Macdonald Consulting, LLC, State of Oklahoma Public Employees Retirement System Actuarial Valuation Report, 2012 (Bellevue, Neb.: Cavanaugh Macdonald Consulting, LLC, 2012), http://www.opers.ok.gov/Websites/opers/images/pdfs/ Report-2012OPERSVal.pdf. 17 State of Oklahoma Office of Personnel Management, Annual Compensation Report, Fiscal Year 2010 (Oklahoma City: Office of Personnel Management, 2010), http://www.ok.gov/opm/documents/FY10Compensation-Accessible.pdf. 18 OPERS, State of Oklahoma Public Employees Retirement System Actuarial Valuation Report. 15

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Appendix 1-1 State of Oklahoma Public Employees Retirement System Funding Study November 2012

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State of Oklahoma Public Employee Retirement System Pension Applications was engaged to provide an analysis of the State of Oklahoma Public Employees Retirement System (OPERS). An outline of the analysis follows: • Freeze OPERS to new participants effective 7/1/2013; • Assume new employees are eligible for a definedcontribution (DC) plan with ultimate contribution of 7%; • Assume contributions for the employees remaining in OPERS to be 16.5% of pay; • Assume an additional contribution is made annually equal 16.5% of pay for employees going into the DC plan less the contribution into the DC plan for these employees; • Purchase annuities for all participants remaining in OPERS at the point in time when assets are sufficient to do so. We utilized the population and all assumptions from the July 1, 2012, OPERS actuarial valuation except as noted in the Assumptions section of this report. The contribution rate of 16.5% of pay for existing employees developed in the July 1, 2012, actuarial value assumes a 7.5% expected return on assets (EROA) and a twelve-year amortization of the unfunded liability (i.e., assets equal liabilities twelve years after the valuation, or July 1, 2024). For purpose of the actuarial valuation, the 7.5% represents not only the assumed return on assets but is the interest rate used as the discount rate to determine the liability, which is the present value of projected benefit payments based on the discount rate. For purposes of this study, liabilities are defined as the cost of purchasing annuities from an insurance company for participants in the plan. This liability is higher than that calculated using 7.5% as a discount rate since insurance companies are currently using a discount rate below 3% to price annuities. Therefore, if assets are assumed to earn 7.5% as used in the actuarial valuation, it will take longer than twelve years to accumulate enough assets to purchase annuities. For purposes of this study, we have used 3.5% as the discount rate of annuities, reflecting an assumed slight increase in interest rates.

The number of years to accumulate enough assets to purchase annuities will be highly dependent on the actual return on assets during the period. Therefore, we have provided the estimated number of years on several compound rates of return: Compound Rate of Return on Assets 0.0% 5.0% 7.5% 10.0%

Estimated Years to Sufficiency 45 32 18 12

A partial list of the projected state and local agency annual contributions is shown below based on the assumptions outlined. Note the estimated payment is the same under all scenarios since the contribution projection is not based on the rate of return on assets.

Year 1 2 3 4 5 ... 10 ... 12 ...

Projected State and Local Agency Annual Contributions (millions) $280,366 283,255 286,509 290,135 294,142 ... 333,584 ... 348,833 ...

ASSUMPTIONS Future experience assumed to follow the July 1, 2012, actuarial valuation assumptions except as noted below: • Payroll increase for employees remaining in OPERS: -3.0% • Annuity Purchase Rate: 3.5%

CERTIFICATION To the best of my knowledge, this report is complete and accurate and the calculations were performed in accordance with generally accepted actuarial principles and practices. The undersigned actuary is a members of the American Academy of Actuaries and other professional actuarial organizations and meets the “General Qualification Standards for Prescribed Statements of Actuarial Opinions” to render the actuarial opinion contained herein.

L. Gregg Johnson, EA, MAAA, MSPA, CFA, AIF®

Appendix 2-1 State of Oklahoma Public Employees Retirement System Funding Study April 2013

Presented by: Pension Applications

Innovation Inspired by Experience PensionApplications.com

State of Oklahoma Public Employee Retirement System Pension Applications was engaged to provide an analysis of the State of Oklahoma Public Employees Retirement System (OPERS). An outline of the analysis follows: • Assume new employees are given a choice for a defined-contribution (DC) plan with contribution of 7% and that 5% of employees elect to enter it; • Assume contributions for the employees remaining in OPERS to be 16.5% of pay; • Assume an additional contribution is made annually equal 16.5% of pay for employees going into the DC plan less the contribution into the DC plan for these employees; • Purchase annuities for all participants remaining in OPERS at the point in time when assets are sufficient to do so; • The assumed plan change will not add any new additional liabilites to the existing plan. We utilized the population and all assumptions from the July 1, 2012, OPERS actuarial valuation except as noted in the Assumptions section of this report. The contribution rate of 16.5% of pay for existing employees developed in the July 1, 2012, actuarial value assumes a 7.5% expected return on assets (EROA) and a twelve-year amortization of the unfunded liability (i.e., assets equal liabilities twelve years after the valuation, or July 1, 2024). For purpose of the actuarial valuation, the 7.5% represents not only the assumed return on assets but is the interest rate used as the discount rate to determine the liability, which is the present value of projected benefit payments based on the discount rate. For purposes of this study, liabilities are defined as the cost of purchasing annuities from an insurance company for participants in the plan. This liability is higher than that calculated using 7.5% as a discount rate since insurance companies are currently using a discount rate below 3% to price annuities. Therefore, if assets are assumed to earn 7.5% as used in the actuarial valuation, it will take longer than twelve years to accumulate enough assets to purchase annuities. For purposes of this study, we have used 3.5% as the discount rate of annuities, reflecting an assumed slight

increase in interest rates. The number of years to accumulate enough assets to purchase annuities will be highly dependent on the actual return on assets during the period. Therefore, we have provided the estimated number of years on several compound rates of return: Compound Rate of Return on Assets 0.0% 5.0% 7.5% 10.0%

Estimated Years to Sufficiency <sufficiency not attained> 47 23 13

A partial list of the projected state and local agency annual contributions are shown below based on the assumptions outlined. Note the estimated payment is the same under all scenarios since the contribution projection is not based on the rate of return on assets.

Year 1 2 3 4 5 ... 10 ... 12 ...

Projected State and Local Agency Annual Contributions (millions) $280,366 272,520 264,932 257,595 250,503 ... 218,495 ... 207,198 ...

L. Gregg Johnson, EA, MAAA, MSPA, CFA, AIF®

Oklahoma Council of Public Affairs 1401 N. Lincoln Blvd. Oklahoma City, OK 73104 Tel: 405.602.1667 Fax: 405.602.1238 ocpathink.org