🔒Pension split aims to avoid major future tax hikes

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Gov. Dannel P. Malloy's recent proposal to lengthen the payoff date of Connecticut's $25.7 billion unfunded pension obligation comes with an unknown pricetag, but also acknowledges the increasing risk of annual retirement contributions swamping the state budget in the not-so-distant future.

Malloy and his budget director, Office of Policy and Management Secretary Benjamin Barnes, said in an interview this month with the Hartford Business Journal that pension-plan changes are needed, and the sooner they come, the lesser the overall impact will be on future state budgets.

If no changes are made, Barnes warned businesses and other significant taxpayers will likely conclude that the state will need to raise taxes further to meet higher pension obligations in the years ahead, which he likened to heading for a fiscal cliff.

“Who's going to want to be in that car?” Barnes asked.

Thanks to a series of reforms negotiated in 2011 and 2012, Malloy was able to significantly reduce the state's unfunded liability for retiree health benefits. He has also made the full required annual contribution to the pension system over the past several years.

But Connecticut's unfunded liability for retiree pension payments has shot up since 2000, thanks to early retirement incentives, overly optimistic assumptions about stock market returns, and lower-than-required contributions in several years.

The employee and teacher retirement plans were 42 percent and 59 percent funded as of last year.

Even if those funds average annual returns of 8 percent until 2032, and the state's actuaries make correct assumptions about retirement rates and other factors, annual costs will rise from around $1.8 billion today to $6 billion in 2032, adding a significant burden to the state budget.

It's possible to hit or beat those investment assumptions. From 1983 to 2000, the teacher's and employee's funds averaged returns of 13 percent and 11 percent, respectively.

But what if the market underperforms like it has over the past 10 years, averaging just 5.5 percent returns? It will create a much worse reality for the state, according to a recent report by The Center for Retirement Research at Boston College, which was commissioned by the administration.

“If, instead of realizing the assumed returns, the systems' investment experience is similar to the past decade, total annual costs for the two systems could balloon to $13 billion in order to be fully funded by 2032,” the report said.

The current annual state budget is about $20 billion.

Even if the result ends up somewhere in the middle of those two scenarios, Malloy said it will create a serious financial challenge.

“There's no way we're ever going to make the size payments that would be required if we don't step up to the plate right now,” Malloy said. “It's the 800-pound gorilla in the room. Always has been.”

Split lengthens pay-off horizon

Malloy has proposed a structural change no other state has tried: Splitting off approximately 30,000 of the most expensive retirement-system members, known as Tier I beneficiaries, and paying their annual benefits through an appropriation in each state budget.

After splitting off the Tier I members, the state would continue to prefund its obligations to the remaining less expensive plan beneficiaries on an actuarial basis. If the entire plan's assets are applied to those remaining members, the plan will immediately be 95 percent funded, reducing required state contributions, Barnes said.

The combination of payments to the split-off members and the remaining members would be about $2 billion per year, Barnes said.

Under Malloy's proposal, the debt to the Tier 1 pension recipients, which the governor insisted remains “an absolute obligation,” could be paid off over a longer period, though exactly how long is not clear.

Malloy committed in 2012 to fully fund the pension system by 2032. But state government and pension officials have known for some time that the deadline carried a risk of sharply increasing annual costs in the later years. In addition to investment risk, the plan is amortized to include back-loaded payments, which is another thing the administration wants to change.

But the governor said the state has no choice but to act now and pay for its past failures to fund the plan, which wasn't pre-funded until the 1970s.

Malloy's plan has drawn doubts from several state officials, including Treasurer Denise Nappier and State Comptroller Kevin Lembo. Nappier argued any plan alterations could violate bond covenants related to $2 billion in debt the state took on in 2008 to help fund its teacher's pension fund.

Meanwhile, Comptroller Kevin Lembo last week unveiled an alternative pension-funding proposal that includes extending the current amortization period, lowering investment-return assumptions, and changing the methodology for amortizing gains and losses based on variations between actual and assumed experience.

Lembo also proposed regular independent comprehensive audits of the plans' actuarial valuations to determine the reasonableness of the actuarial methods and assumptions being used.

He did not support Malloy's plan to split off Tier 1 retirees on a pay-as-you-go basis, arguing it raises to many legal, financial and other questions.

Barnes said the administration will work to convince key stakeholders that its plan is the best way forward. The state also plans to hire lawyers and actuaries to better vet the proposal.

“We should have a plan implemented over the coming months,” Barnes said.

The administration must also convince unions to accept some of the changes. While wage negotiations are happening now with nearly all state-employee unions, the union coalition SEBAC isn't required to agree to open pension negotiations until 2022.

‘No’ to 401(k) conversion

The number of defined-benefit pensions has fallen sharply in the private sector, as companies look to cut costs and liabilities.

What about converting Connecticut state workers to 401 (k) plans?

It would make only a marginal difference in annual required contributions because so much of that money goes to the unfunded liability, Barnes argued. Plus he said pensions help the state attract “long-term, committed employees.”

He said the state's newest pension system “Tier III,” for employees hired in fiscal year 2012 or later, has helped lower costs. The administration pushed for the creation of Tier III in 2011.

“Tier III and social security is a safety net retirement,” Barnes said. “It is not a second-house-in-Vermont kind of retirement.”

Putting those employees into a defined-contribution plan might actually be more expensive, Barnes said.

Pensions for those Tier III workers cost the state approximately 3 percent of payroll, which is right around the national average for 401(k) plans.

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