Saving Workers' Retirement by OCPA

SAVING

WORKERS’ RETIREMENT: A Comprehensive Plan to Save Oklahoma’s Retirement Systems

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 Real public retirement reform in Oklahoma will result in peace of mind about safe and secure retirement for public employees The Challenge: • Oklahoma’s public employee retirement liabilities are staggering, $11 billion, and exceed the state-appropriated budget by 52 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 (See Appendix 1-1) in order to keep its promises to current and retired government non-hazard duty 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. • Oklahoma must transition into a defined-contribution retirement plan for all new non-hazard duty government employees and teachers. • Oklahoma’s hazard-duty retirement systems must be reformed to be able to provide fair retirement levels at amounts that can be concurrently funded by taxpayers.

Implementing a defined-contribution retirement plan for all new non-hazard duty employees: • 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 nonhazard duty government employees and teachers; • 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 cap unsustainable retirement debt (with no future accumulating liabilities to new employees); 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 If the state’s current retirement systems are not reformed, in the long term it will be very difficult and unlikely for the state to keep its promise to retired, current, and future government employees. Converting non-hazard duty retirement plans to a defined-contribution plan will allow government to secure retirement and keep its promises. In OCPA’s “Saving Worker’s Retirement: First Steps Toward Public Pension Reform In Oklahoma,” we discussed the challenge facing public employee retirement systems. We make this case again in providing a comprehensive plan for Oklahoma’s retirement systems. 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, 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 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 (SEC) 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 statereported 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 show 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

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.

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from fiscal year (FY)-2011 to FY-2013 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. As has been noted by Oklahoma’s State Treasurer Ken Miller and State Auditor and Inspector Gary Jones, the combined funded ratio of the state’s defined benefit plans is a dismal 65 percent. Mr. Jones also noted that even after years of mismanagement, in 11 of 12 recent years the state missed its pension obligations.9 Further, all of the systems have experienced multiple periods of negative cash flow, where cash contributions to the systems do not cover cash payouts of the system. Continuing to operate on negative cash flow is unsustainable and puts retirees and taxpayers in the treacherous position of relying solely on investment gains to make ends meet within the system. In 2012, the Governmental Accounting Standards Board (GASB) passed new rules requiring government pension plans to use more realistic investment returns when calculating unfunded liabilities. This will impact all state-defined retirement systems and more accurately reflect their liabilities in FY-2014. When this happens, liabilities for every system will increase again. To be sure, new 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, 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, the Oklahoma Public Employees Retirement System (OPERS) [as well as the other state retirement systems listed in Appendix 1-1] 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. 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. For example, Table 1 on page 6 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. At the beginning of January 2013, Oklahoma state Rep. Randy McDaniel, one of Oklahoma’s champions of pension reform, 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

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 Randy Ellis, “Commission urges Oklahoma Governor and lawmakers to improve pension funding,” The Oklahoman, NewsOK.com, November 13, 2013, http://newsok.com/commission-urges-oklahoma-governor-and-lawmakers-to-improve-pension-funding/article/3904365. 10 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. 8

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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 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 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

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 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 public pension funds 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,

Saving Workers’ Retirement • December 2013

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 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:12 “In 1985, a total of 89 of the Fortune 100 companies offered their new hires a traditional definedbenefit 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.” 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 definedbenefit 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 em-

ployees 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 are a real eventuality. The state cannot afford to infinitely make contributions exceeding $1 billion for government employee retirement and still meet the funding needs of core services. The current unfunded liability of the state retirement systems alone exceeds individual lawmaker appropriations to every state agency.13 This means that state retirement liabilities, debt, exceeds by 52 percent all lawmaker direct appropriations. Oklahoma’s retirement liabilities are more than 1 ½ times the entire state appropriated budget! To understand how dire the situation is for our state retirement systems, and their unsustainable cost, one need only review an independent funding study of the plans (Appendix 1, page 3). Currently, employer contributions as a percent of covered payroll are at astronomical and unsustainable amounts. For OPERS 15.7 percent, for OTRS 17.2 percent, for OPPRS 30.1 percent, for OFFRS 62.1 percent, for OLERS 62.5 percent, and for UJJRS 22.2 percent (See Appendix 1-1). 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 pension systems.

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.ok.gov/triton/modules/ newsroom/newsroom_article.php?id=223&article_id=11742. 12

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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 definedcontribution plans. This reform is saving Michigan taxpayers billions of dollars. 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. In addition, Louisiana has moved to reduce growth in taxpayer liabil-

ity by limiting taxpayer guarantees to contributions made on behalf of employees. Pending judicial approval, the Louisiana reform sets up a “cash balance” plan for all new employees. 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. Oklahoma has actual experience with conversions from defined-benefit plans to defined-contribution plans. The Oklahoma Department of Wildlife converted its retirement plan for new employees to a defined-contribution plan for all new employees, and the agency reports the change has been a huge success. 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 some plan’s current funded ratios are near or exceed 80 percent. This is false hope, as retirement systems must reach a funded ratio of 100 percent or more, 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 Due to the similarity of public em-

ployees eligible for OPERS and privatesector 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 definedbenefit plans, the private sector is closing defined-benefit plans and moving most employees to defined-contribution plan’s 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. Moving new non-hazard duty government employees and teachers 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 retirement liabilities. Defined-contribution plans also have the added benefit of the incentive such plans provide for employees to actively save and prepare for retirement. Defined-benefit plans often fail to incentivize employees to contribute toward their retirement and result in little preparation for retirement. Defined-contribution plans

Matt Ayer, “It’s Time for Government Pension Reform.” Girard Miller, “Pension Puffery,” Public Money, Governing, January 5, 2012, http://www.governing.com/columns/public-money/col-Pension-Puffery. html#ht4. 14 15

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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 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. OCPA recommends that lawmakers implement the following for all new non-hazard duty government employees and teachers: Establish a defined-contribution (DC) plan, effective July 1, 2014, for all new state (OPERS-eligible) employees: • 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).

Establish a defined-contribution (DC) plan, effective July 1, 2016, for all new teachers and judges: • 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 teacher’s “401(k)” beginning when the employee is hired]. • The plan would take the difference of the new DC plan contribution and the old defined-benefit (DB) plan contribution and inject it into the system, using it to pay down the debt over time. • To preserve the funding stream for OTRS (Oklahoma Teachers Retirement System) and eliminate transition costs, current OTRS teachers could not convert to the new DC plan. • To preserve the funding stream for OTRS and judges, 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 employment, the employer would still have to contribute to the current DB systems as if the employee were still employed (until that position is filled by a new employee). Based on an independent actuarial study of these recommendations (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 all the systems over time based on the recent asset return of the system. This is accomplished by the dedication of the savings to pay off the unfunded liability, and capping liabilities. While the actuarial study analyzes the effects of converting hazard duty systems to a defined contribution plan, OCPA does not recommend making such a change

for the hazard duty systems. Also, based on a recent state compensation survey, the average privatesector defined contribution is approximately 5.7 percent. 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.16 Transitioning to a defined-contribution plan for all new hires of non-hazard duty employees and teachers 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 long-term 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) often shorter than the vesting period required for the state defined-benefit plans. This means that many employees leave state employment and get no retirement contributions from the state if they do not meet the vesting period. Defined-contribution plans also become assets of the employee that are easily transferred and retained by the family upon death. The state’s 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 a participant. Defined-contribution

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. 16

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“...a defined-contribution plan is the only risk-free retirement plan that keeps promises to employees and protects both employees and taxpayers...” 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 nonhazard employees to a full definedcontribution retirement plan for all new employees is necessary. Converting public retirement systems to a defined-contribution plan is the only way to permanently end the accumulation of liabilities to future employees. Placing all new employees in a definedcontribution plan is the only risk-free retirement plan that keeps promises to employees and protects both employees and taxpayers from the risk of politically mismanaged future promises. Other options still require government to make a promise, a guarantee incurring debt, with just a lesser amount of risk, but risk is involved. The chief challenge facing the hazard duty state retirement systems is the allowance of an exorbitant benefit option, the current over-rich deferred

retirement option plans (DROPs). These plans allow for participants to have an enrichment that no state employees, teachers, and few private citizens receive. According to the Oklahoma Firefighters Pension and Retirement System (OFFPRS), a DROP works as according to the following:17 After election to participate…, a member’s normal retirement benefit is calculated as of the effective date of the [DROP] election. The System defers the payment of the pension benefit to the member until the member actually terminates employment. The member shall terminate employment after five (5) years of the effective date of the … election. The deferred pension benefit is deposited into the electing member’s [DROP] account. The member remains employed as an active firefighter but is no longer required to pay contributions to the system. The employer’s contributions will continue to the system and member’s [DROP] account is credited with one-half (1/2) of the employer’s contribution...

Conclusion

The [DROP] account will earn interest at a rate of two (2) percentage points below the annual rate of return to the System’s investment portfolio, but no less than the actuarial assumed interest rate which is currently seven and one-half (7.5%). The interest is simple interest and will be credited on the ending June 30 balance. This means that participants not only get a healthy guaranteed retirement, but also get what amounts to a cash savings account with guaranteed interest of at least the assumed rate of return for the system! Even more egregious, some are allowed this option retroactively, thus allowing a participant to game the system and make the election based on knowledge of market returns! Such a benefit is obviously unsustainable, as evidenced by the fact that, for example with OFFPRS, the total value of DROP accounts equals 26 percent when compared to the actuarial value of OFFPRS assets. This benefit must be removed for all new hazard duty employees.

Moving all new non-hazard duty employees and teachers to a defined-contribution plan will be a success, just as experienced by the transition of the Oklahoma Wildlife Department’s retirement plan to a defined-contribution plan. Moving all new non-hazard duty employees and teachers 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.

http://www.ok.gov/fprs/Plan_B_Information/

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Appendix 1-1 Funding Study for State of Oklahoma Public Employees Retirement System Teachersâ&#x20AC;&#x2122; Retirement System of Oklahoma Oklahoma Police Pension and Retirement System Oklahoma Firefighters Pension and Retirement System Oklahoma Law Enforcement Pension and Retirement System State of Oklahoma Uniform Retirement System for Justices and Judges

June 2013 Presented by: Pension Applications

Innovation Inspired by Experience

PensionApplications.com

Funding Study Introduction

Pension Applications was engaged to provide an analysis of the following defined-benefit pension plans (“Plans”): • State of Oklahoma Public Employees Retirement System (“OPERS”) • Teachers’ Retirement System of Oklahoma (“Teachers”) • Oklahoma Police Pension and Retirement System (“Police”) • Oklahoma Firefighters Pension and Retirement System (“Fire”) • Oklahoma Law Enforcement Pension and Retirement System (“Law”) • State of Oklahoma Uniform Retirement System for Justices and Judges (“Judges”) The focus of the analysis in this report is on the funded status of the Plans, amortization of the unfunded liability under certain scenarios, and a brief discussion of plan attributes. The 2012 Actuarial Valuations are the basis for the projections contained in this report. The report will not provide any conclusions or recommendations; the information herein is to be utilized by those tasked with making decisions regarding the aspects covered.

Retirement Plan Design Philosophy

For many years, defined-benefit plans were the plan of choice for both private and public employers. Indeed, defined benefit plans have provided countless retirees the ability to retire comfortably without fear of outliving their income due to the pooling nature of mortality risk or losing their investments since the employer assumes this risk. In the last decade, defined benefit plans have struggled as the cost levels and volatility have caused many employers to cease offering these vehicles. The private sector has seen massive numbers of plan freezes and terminations. Defined benefit plans are still quite popular in the public sector but are struggling with the issues mentioned. The primary options that have been proposed to deal with the defined-benefit problems are: • Continue the course with the defined-benefit plan as investment markets will provide enough returns to help fully fund the plan. • Place all employees or newly hired employees into a different type of plan that may ultimately cost less or be less volatile. It is not clear whether either of these approaches will

achieve employers’ goals, and they are not without their own problems. In the first case, attempts to achieve greater returns can put the plans further at risk of losing assets, causing required contributions to escalate further, possibly jeopardizing basic services to taxpayers in the case of public entity sponsors. Indeed, the pension investment landscape is now focused more on risk control (keeping the assets that are here today) than shooting for unreasonably high returns. In the second case, reviewing the characteristics of different plan types and the goals of the plan sponsor is most appropriate. Many sponsors have changed to defined-contribution or hybrid plans such as cash balance plans in hopes to save money. However, while the benefit accrual patterns of these plans may be different than a defined-benefit plan, the only way to reduce costs is to reduce the level of benefits provided or eliminate other components such as the lifetime income guarantee. The type of plan selected does not inherently make benefits less costly. Investment risk is transferred to the employee in a defined-contribution plan. A cash balance plan is a definedbenefit plan that mimics a defined-contribution plan – investment risk usually stays with the employer, though there are designs that can share this risk with employees. Traditional defined-benefit plans are also evolving designs to share investment risk(1). (1) Pensions & Investments, April 29, 2013, Adjustable pension plan design begins to gain converts.

Analysis of Current Plans

The following table presents key metrics reflecting the funded status of the Plans as reflected in the most recent actuarial valuations except as noted. The amortization years required to pay off the unfunded liability are based on the assumptions contained in the valuations and contributions as determined for each plan’s funding policy and the results of the 2012 actuarial valuations. The actual number of years to pay off the unfunded will be determined experience deviations from the assumptions or contributions less than the determined under the funding policies. Investment returns in excess of the assumptions and contributions in excess of the funding policies will serve to reduce the number of years to pay off the liability; conversely, investment returns less than the assumptions and contributions below the funding policies will serve to increase the number of years required to pay off the liability.

It is importation to distinguish between two types of amortization payments in the plans, level dollar and level percentage of payroll. A level dollar amortization is similar to a mortgage payment in that it does not change from year to year. A level percentage amortization starts smaller than the level dollar amount but increases over time based on the assumed payroll growth. If actual payroll growth matches the

assumed growth, then the payment, though increasing in dollar amount, will remain a constant percentage of payroll. However, if actual payroll grows slower than anticipated, the payment will grow as a dollar amount and as a percentage of payroll. The assumed payroll growth and actual growth over the last five years are shown in the table.

(1) Amortizations are paid as either a level dollar amount or level percentage of payrool. (2) Calculated as a part of this analysis.

Sensitivity to Asset Returns

The actual number of years required to pay off the unfunded liability will be determined by experience of the plan, with asset returns being the largest factor. In the table below, we estimate the number of years required to pay off

the unfunded liability based on several asset return scenarios. For purposes of this analysis, we have kept the contributions at the same percentage of pay as in the 2012 actuarial valuations â&#x20AC;&#x201C; in reality, the contributions will increase or decrease based on plan experience.

Sensitivity to Plan Changes and Terminal Funding

The following changes to the pension plan were considered: • Assume new employees go into for a defined contribution (DC) plan with contribution of 7% • Assume total contributions for the employees remaining in defined benefit plans (DB) to be same % of pay as in 2012 valuation • Assume an additional employer contribution is made annually to pension plan equal to 2012 % 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 DB plans at the point in time when assets are sufficient to do so • The assumed plan changes will not add any new additional liabilities to the existing plans. We utilized the population and all assumptions from the

July 1, 2012 actuarial valuations except as noted in the Assumptions section of this report. 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 actuarial valuation rate 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 the rate used in the actuarial valuation, it will take longer 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:

Assumptions

Future experience assumed to follow the July 1, 2012 actuarial valuations assumptions except as noted below: • Payroll increase for employees remaining in DB plans: -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®

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