Colorado lawmakers in 2018 set out to fix a $32 billion problem confronting the state’s public-pension program, and by all accounts, they appear to have succeeded.
In its latest financial statements, the Public Employees’ Retirement Association showed dramatic improvement, finally reversing a years-long slide. The rating agency questioning the state’s unfunded pension debts has withdrawn its threat to downgrade Colorado’s credit worthiness. And PERA’s insolvency risk — which was recently as high as 40 percent — has now dropped to 3 percent or less for school districts and the state.
But what if it wasn’t a $32 billion problem after all?
That’s the question policymakers in Colorado — and across the country — are now facing, as outside financial advisers and rating agencies take a closer look at pension-funding practices in the wake of the Great Recession. And it’s a question that Colorado got wrong eight years ago, when lawmakers passed the reform package known as Senate Bill 1.
A number of factors contributed to the earlier effort’s unraveling, but the most significant was that lawmakers, under PERA’s guidance, underestimated a key component — the sheer size of the debt they were seeking to address.
This year’s reforms are based on more-conservative financial ground — and they have built-in safeguards to protect the pension’s finances from future unknowns. A stellar stock-market run in 2017 got the effort off to a good start: The unfunded liability is now down to $29 billion in PERA’s latest financial reports. But the same fundamental question remains.
Is the pension program’s unfunded debt the $29 billion that PERA’s actuaries now say it is, or is it closer to the $54 billion figure that more-conservative accounting methods suggest?
And if it’s something in between, are there sufficient safeguards in place to protect the retirement funds of more than 580,000 Coloradans?
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Why PERA’s assumptions matter
Pension finances are complicated. But the key thing to understand is most of the numbers are essentially an educated guess about the future.
So when PERA says it has a $29 billion unfunded liability, that doesn’t mean it literally owes retirees $29 billion that it doesn’t have. It means that over time — based on how much people are expected to earn, when they’re expected to retire and how long they’re expected to live — PERA will probably need $29 billion more than it has today to pay for its current and future retirees’ benefits.
And because most of these benefits will be paid out decades from now, PERA just needs to contribute enough that its money will become $29 billion as its investments grow.
If retirees live longer than PERA expects, that number is going to grow. If the stock market outperforms expectations, that number is going to shrink.
So, when PERA repeatedly adopted more-conservative assumptions in the wake of the Great Recession, either the pension plan needed more money to pay off the debt or it needed to cut the benefits it had promised to retirees. But lawmakers did neither until this year — and PERA, in the meantime, dug itself a deeper hole.
Among the most significant of these assumptions is the expected rate of return. Today, PERA assumes that its investment portfolio will grow by 7.25 percent each year. That’s down from 8.5 percent a decade ago and lower than the average public pension, which banks on a 7.5 percent return, according to Boston College’s Center for Retirement Research, which tracks public pensions. But it’s still higher than many financial analysts believe is prudent.
So if PERA’s actual returns are 6.75 percent, the debt grows by $5 billion. And if it’s below 5 percent — using a blended discount rate that it’s required to report for accounting purposes — the debt grows to $54 billion.
So what’s the right number? Schools of thought vary
Debating the rate of return has proved a fraught exercise across the country, according to public-pension experts — in part because there are two debates happening at once.
One is a disagreement over the stock market: whether pensions are being overly optimistic about what the future holds.
At one extreme, BlackRock Investment Institute projects just 5.2 percent returns for a typical investment portfolio split 60/40 between stocks and bonds. For larger institutional investors, such as PERA, it assumes a 5.6 percent return. Milliman, one of the top pension consulting firms in the country, is at 6.71 percent, concluding in a recent study that it expects to see pensions across the country continue to reduce their rates of return in coming years to catch up to Milliman’s forecasts.
Still, over the long term, PERA’s investments have hit their targets more often than not. PERA has averaged 9.5 percent returns over the past five years and over the past 35. But when you stop the snapshot at a decade — which includes a disastrous 26 percent loss in 2008 — the average plummets to 6 percent.
In an interview, PERA board president Tim O’Brien said he’s comfortable with the 7.25 percent assumption; he views it as conservative.
But, he added, “The dilemma that I have with even trying to respond to something like that (a push to lower the rate of return) is the money that goes into the trust fund is contributions plus return on investments. So, if you don’t think the return on investment is there, you need more contributions. And I don’t think the legislature wants to talk about that.”
O’Brien’s concern is one that Nari Rhee has observed across the country. The director of the Retirement Security Program at the University of California, Rhee says most public pensions have responsibly adopted lower returns in recent years, and adjusted contributions and benefit structures to match. But some haven’t. Instead, they’ve lowered the rate of return, exploding the systems’ debt on paper, without paying for the difference.
“You have states that are saying, ‘We’re willing to be more conservative and we’re willing to fund it,’” Rhee said. “And then you have other situations where legislatures are ratcheting down the discount rate, really to make the plan look more politically vulnerable.
“If you (reduce the rate) without funding the plan, you’re really just undermining the plan.”
Complicating matters, she said, are new accounting standards and inconsistent advisories from rating agencies — which now use the $54 billion figure for PERA’s liabilities — that have muddled the debate.
“There’s this conflation of what’s a reasonable expected rate of return vs. how do you sort of abstractly value this liability,” she said. “I’m a little unclear at this point what the bond rating agencies want the states to do.”
Olivia Mitchell, executive director of the Pension Research Council at the University of Pennsylvania, says the focus on stock-market returns is a distraction from the real problem: Public pensions shouldn’t be basing their benefit-funding policies off investment returns in the first place.
“Ideally, you would want to use a risk-free rate,” she said. “These people are counting on the pensions. They’re not counting on the lottery, which may be there or may not.”
Public pensions have long been treated differently by federal law than their private counterparts, which are required to fund their pensions at a much lower rate of return — the interest rate a person can get on a high-quality corporate bond, which today averages under 4 percent. The different rules have long been accepted practice because, unlike a private company, the state of Colorado isn’t ever going out of business. And if it falls behind, it can always raise taxes to pay off what it owes.
Mitchell says that premise is flawed — and rating agencies are starting to think the same thing. She says recent bankruptcies in Detroit and Puerto Rico are proof that a state could go bankrupt under the weight of its pension and other debts. It just hasn’t happened yet. And Colorado’s tax-limiting state constitution presents major hurdles to fixing the problem with a tax hike.
Just as troubling as the doomsday scenario of a bankruptcy is what chronic underfunding is already doing to public services.
“The reality is that taxpayers today — and employers and workers — are paying for services rendered 30 years ago, because the pensions weren’t fully funded when the promises were made,” Mitchell said. “It really threatens the delivery of services now and in the future if you’re using all your money to pay for police, firefighters and judges that served 20-30 years ago.”
Reforms made PERA, but economic and political risks remain
Even if the assumptions are off, lawmakers avoided the most-detrimental mistakes made in 2010. The government will begin paying down the debt immediately, rather than phasing higher contributions in over time. And there’s a fail-safe: The legislation has a trigger mechanism that would automatically cut benefits and hike contributions if the fund veers too far off financial track.
According to the latest risk analysis study provided to the legislature, PERA can now endure returns as low as 4.41 percent annually without running out of money to pay benefits.
There are also new political pitfalls. The reforms include a $225 million annual payment by the state, which some worry will make a tempting target for cuts the next time there’s a recession.
PERA also remains a fixture on the campaign trail.
In a recent joint interview on “The Aaron Harber Show,” Democratic state treasurer candidate Dave Young, a Greeley lawmaker, defended the pension board’s management and current rate of return, while his opponent, Republican businessman Brian Watson, said serious changes are needed to strengthen the system.
Watson also took aim at the $225 million, saying, “Where could that money go? I’ve got a good idea — why don’t we keep it in the people’s pocket so they can afford their rent and their mortgages and to send their kids to school. That would be a good place to start.”
Young voted against the reform bill, saying it was rewritten too late on the last day of the session for proper vetting. But he said he nevertheless supported the $225 million payments from the state general fund. “We’ve got to solve the problem here,” he told Harber.
Meanwhile, the economic tea leaves offer conflicting visions of the future. Key economic indicators continue to beat expectations. Also, it has been a decade since the market crashed, and many economists — including the state’s own budget forecasters — see warning signs that could mean the country is due for a recession.
If there’s one enduring lesson from PERA’s past two decades, which saw the pension drop from 100 percent funded to 58 percent, it’s that things can change quickly. And lately, they’ve mostly changed for the worse.
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