What are the Underfunding Implications for Public Agencies
The California Public Employees' Retirement System ("CalPERS"), renowned as the largest pension fund in the US, has recently disclosed an investment return of 5.8%, falling short of its 6.8% benchmark by 1%. This performance follows a historically poor prior year return of -7.4%. Unfortunately, these figures carry significant additional financial repercussions for public agencies over the next two decades and beyond.
The Immediate Impact of Investment Losses on Public Agencies
These investment setbacks have triggered a decline in the overall estimated funding level of CalPERS, which currently stands at 72% of the required amount to cover retiree benefits. This shortfall, known as the unfunded actuarial liability (UAL), places the responsibility of reimbursement squarely on public agencies. This burden is further compounded by an annual interest rate of 6.8%, imposing significant strain on resources allocated for essential services, local projects, and various budgetary needs.
The Dilemma of Underfunded Pension Plans
For agencies that have defined benefit programs with CalPERS, unfunded liability, or UAL, is very expensive. Ideally, pension plans should be fully funded at 100%, because (i) agencies are legally obligated to fulfill 100% of pension benefits promised to retirees and pensioners, and (ii) UAL interest expense IS avoidable. To the extent plans are not 100% funded, agencies must carry the commensurate financial burden of 20-year debt at an interest rate of 6.8% – easily the most expensive debt of any public agency. In fact, a simple calculation of the total UAL interest expense paid over the past 10 years will shock most agencies. These are monies that are being squandered due to the lack of proactive management and fiscal belt tightening – similar to carrying credit card debt.
The Paradox of Low Funded Levels and the Quest for Solutions
At first glance, it seems counterintuitive to not maintain pension plans at 100% funded levels. After all, who would willingly accept a hefty 6.8% interest penalty on a 20-year debt that continues to revolve? Yet, despite this seemingly straightforward equation, many agencies continue to struggle with underfunded plans (i.e., unfunded liability or UAL). The persistence of this perplexing situation raises questions about contributing factors and the financial complexities at play.
Exploring Nine Factors Amplifying Underfunding of Pension Plans
1. Complexity Beyond the Surface
The intricate nature of pension economics poses a significant hurdle to maintaining fully funded pension plans. Concepts involving actuarial assumptions, market dynamics, ramping structures, superfunding and future projections can be daunting for those unversed in pension intricacies. Short terms of service for council and board members can exacerbate this challenge.
2. Time Constraints and Staff Burden
The workload faced by administrative staff can also play a crucial role. Juggling multiple responsibilities, agencies might struggle to allocate adequate time and resources to comprehensively address pension management and funding concerns. Overwhelming workloads, including day-to-day operations and administrative duties, can inadvertently sideline critical pension fund management matters.
3. Fears of Overfunding
Surprisingly, the prospect of overfunding, while seemingly positive, can actually deter agencies from pursuing higher funding levels. The concern over exceeding the 100% threshold – referred to as "superfunding" – can create hesitancy. Agencies might worry about diverting excess funds from other vital areas, inadvertently impacting their overall budgetary allocations.
4. Optimism in Investment Returns
A hopeful outlook on investment returns can also diminish the urgency to address underfunded plans. Relying on the assumption that the CalPERS will eventually deliver consistent positive returns, some agencies delay taking immediate action to close the funding gap. However, this optimism doesn't negate the pressing need to proactively manage pension obligations – because any funding gap is very expensive.
5. Dependency on External Solutions
A prevailing dependence on CalPERS to provide solutions can inadvertently contribute to the underfunding dilemma. While CalPERS plays a pivotal role, it's essential for agencies to actively collaborate and strategize, rather than solely relying on external entities to navigate this financial landscape.
6. Political Pressures and Priorities
Political considerations can sway decision-making regarding pension funding. Short-term political priorities might lead to underfunding in order to allocate resources to other visible initiatives, potentially neglecting long-term financial obligations.
7. Budget Constraints
Resource limitations and budgetary restrictions can hinder agencies from contributing more funds towards pension plans. Competing financial commitments might limit the ability to allocate sufficient resources for pension funding.
8. Inertia and Complacency
Organizations may slip into a pattern of inertia, assuming that existing contribution levels are sufficient. Complacency about the potential consequences of underfunding can hinder proactive steps towards resolution.
9. Lack of Expertise
A shortage of skilled personnel well-versed in pension management and financial planning can hinder an agency's ability to make informed decisions about funding strategies.
Guiding Public Agencies on a Path Forward
It is clear that current pension management practices are in need of transformation. Going forward, the critical objective is to uphold stringent pension funding practices while confronting the multitude of factors contributing to the persistent underfunding issue, as elaborated above. This undertaking mandates proactive forecasting of revenue, pension obligations, Other Post-Employment Benefits (OPEB), and labor costs. Such forward-looking assessments empower decision-makers to assess risks, make well-informed trade-offs, and adeptly navigate the intricate landscape of pension management. However, a crucial requirement at the core of these efforts is the formulation and implementation of a comprehensive Pension Management Plan.
Leveraging decades of experience in intricate pension affairs, Weist Law is at the forefront of developing and facilitating custom-designed comprehensive Pension Management Plans (PMPs). These PMPs stand as essential tools for proactively managing pension plans and associated costs. Powerful, well-crafted PMPs empower management to achieve and sustain a financially strong and sustainable pension plan funded status. This approach maximizes economic efficiency and instills confidence in navigating uncertainties.
Although many actuaries suggest a funded status of around 90%, the difference between 90% and the full 100% carries significant financial implications, including a substantial 6.8% interest rate. This highlights the need for agencies to employ a variety of effective strategies to proactively manage these liabilities. These strategies must be seamlessly integrated into both the PMP and Pension Policy, while also strategically incorporating an IRS-designated 115 Trust framework. Serving as vital guiding documents, PMPs and Pension Policies direct current and future staff, boards, and councils, fostering incremental changes that yield exponential savings, enhance budget predictability, and ensure long-term sustainability. These efforts are fortified by proactive annual management practices.
Weist Law's long track record of working with numerous cities, counties and special districts has led to the development several unique pension cost mitigation strategies, all designed to reduce long-term pension costs and to achieve and maintain a healthy funded status. These strategies are incorporated in each PMP so that each year pension cost saving opportunities do not get overlooked. Once a well-structured PMP and Pension Policy are firmly established, the path to disciplined, ongoing, proactive management becomes clear and well-defined.
If you are interested in learning more about Pension Management Plans and Pension Policies and cost mitigation strategies, we invite you to click here to sign up for a free consultation.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact a designated Weist Law representative. This material may be considered advertising under certain rules of professional conduct.