Taxpayers Bear the Risk of a Very Rich Oregon Public Employees Retirement System
By Randall Pozdena
The Oregon Public Employees Retirement System (PERS) fund is, once again, in the news because of its weak financial condition. The Oregon Supreme Court recently rejected cost containment changes to PERS plans. Also, asset returns have been weaker than hoped. The Oregonian reported last December 1 that PERS’ unfunded actuarial liability (UAL) was likely to be $20.5 billion by the January 1, 2016—an amount equal to 27 percent of Oregon household income.
The PERS experience illustrates the hazard of legislating defined-benefit (DB) pension plans for public employees. If, as courts have ruled, such legislation creates a contract, the state and other public employers have little ability to manage unanticipated plan risks. The problem is aggravated because DB plans tempt politicians to make overly lavish promises today because risks are only manifest in the future. The complexity of defined-benefit plan actuarial mathematics helps obscure the risks of bad plans.
The origin of the PERS funding problems is 1975 legislation that promised a guarantee against low fund asset returns—specifically, returns below those assumed by the plan itself. In addition, between 1975 and 1999, the PERS board went further, crediting most excess returns to beneficiaries. Set-asides for the inevitable decline in returns grew to be woefully inadequate.
I learned of this crucial feature from the fund’s actuary in 1993—my second year of service on the Oregon Investment Council (OIC). The heads-we-win, tails-employers-lose arrangement was unique among state plans and there was little appreciation of the risks it posed. In fact, however, the crediting process is tantamount to a very risky derivatives strategy—called selling “naked put options”—with employers and taxpayers de facto bearing the risk.
Since the burden of this practice was not known, the OIC requested one of its consultants to make this measurement. An attorney for the unions later characterized this as “pushing buttons [Pozdena and the OIC] had no business pushing.” The dire implications for fund solvency were presented at a PERS board retreat after a year of extraordinarily large asset returns in 1999. The board was urged to not credit that year’s excess return, but did so anyway.
The “winners” in this risky game were Oregon public employees in the plan for the longest time (“Tier 1”). According to PERS data, 2006 Tier 1 retirees with 30 years of experience enjoy average retirement income equal to 100 percent of their final average salary (FAS)—a 100 percent replacement rate. The average replacement rate for all 30-year retirees between 1990 and 2014 is 81 percent. In contrast, a 30-year private DB retiree in our census region enjoyed a replacement rate of just 51 percent in 2010. Moreover, in 2015, only 19 percent of private workers have access to a DB plan, and 54 percent have access to a defined contribution (DC) plan.
I have calculated that, to enjoy a 50 percent replacement rate after 30 years using a DC plan, workers have to invest 18 percent of their income yearly. To achieve 81 percent or 100 percent, like some PERS beneficiaries, they would have to put aside 30 percent or 40 percent of each year’s salary, respectively.
There is an axiom in finance that “risk does not go away; it can only be put on someone else.” There are only three ways to manage risk in this case. One is to achieve better asset returns. But the OIC and the Treasury have limited ability to do so without incurring further risk to plan solvency. The second way is to reform, after the fact, historical crediting excesses. This option is foreclosed by Oregon Supreme Court rulings. The court considers legislated pension plans to be de facto contracts with inviolate features. The state can, and has, created less risk-prone plans for future employees, but this cannot extinguish existing risk. The third way to shift risk is through increased taxation of private incomes and/or termination of public employees and loss of their services. Taxing private incomes is tantamount to making the private sector bear its own plus PERS risks. It also poses macroeconomic risks. Professor Alexander Volokh of Emory Law School has suggested outsourcing or privatization of public services as a means of lowering pension costs that limits economic and service losses.
Randall Pozdena, Ph.D. and CFA, is a consulting economist and former professor and research vice president of the Federal Reserve Bank of San Francisco. He is also a former member and chair of the Oregon Investment Council and a Cascade Policy Institute Academic Advisor.
A version of this commentary was originally published in The Oregonian on December 10, 2015 as “Why PERS is under water yet again.”