State Pension Board Faces a Tough Call

Trustees must decide how much to expect from investments

By Michael Dresser and Alison Knezevich, The Baltimore Sun

5:17 PM EDT, July 16, 2012

Maryland’s $37 billion state pension system may lower its expectations of what it can earn on investments — a decision with potentially significant consequences for retirees and Maryland taxpayers.

Trustees of the system — which covers more than 370,000 current and retired public school teachers, police and state employees — are expected to vote Tuesday on whether to reduce its assumed annual rate of return of 7.75 percent.

Whether to cut the rate is an issue that has challenged similar plans around the country in the aftermath of the 2008 stock market meltdown and the recession that followed.

Any reduction would force the O’Malley administration to make some tough choices about whether to allocate extra money from the state budget to fund pensions. Without enough money, the plan eventually could have to reduce benefits for retirees.

The decision will be made by the State Retirement and Pension System’s 14-member board of trustees, a group made up of state Treasurer Nancy K. Kopp, state Comptroller Peter Franchot, gubernatorial appointees and elected employee representatives. The board is not a part of the administration, but governors typically exert some influence on the system’s direction through their appointments.

The governor’s office referred questions about the pension system to Kopp.

Last week, the board of the Baltimore County Employees Retirement System slashed its relatively rosy projection of a 7.875 percent annual return to a relatively austere 7.25 percent. The change is expected to require an increase of about $15 million in the county’s contribution to its system in next year’s budget.

The move was seen as a significant change for a system that wasn’t in crisis. “By and large, we haven’t seen the shifts of that size,” said David Draine, senior researcher at the Pew Center on the States.

Kopp, who chairs the state pension board, said she sees no need to go as low as Baltimore County. None of the plan’s investment advisers and actuaries have recommended that low a rate, she said. What’s more likely, she said, is a decision to drop the rate to 7.5 percent, to make no change or to find a middle ground. If the board does change the rate, it could do so in one step or in stages, she said.

Lowering the rate to 7.5 percent, along with a package of other changed forecasts, could cost the state $32 million a year. That could make it harder for the governor and General Assembly leaders to achieve their goal of eliminating the state’s long-term revenue shortfall in next year’s budget.

George Liebmann, director of the Calvert Institute for Policy Research, a free-market think tank, said many public retirement systems’ assumed earnings rates are much too high. “If you don’t [lower them], you’re just living in a fool’s paradise because there’s no way over the long term that the state’s going to earn that,” he said.

One reason conservative advocates favor a lower assumption is that it could force hard choices they consider overdue — such as reduced public employee benefits or a move away from a defined-benefit system to a defined-contribution system similar to 401(k) plans that prevail in private companies. In such plans, the employer and employee typically kick in a specified amount to a fund that invests the money, but there is no guaranteed minimum payout.

Public employee unions, which remain powerful in Maryland despite the erosion of their clout in other states, oppose such moves. Jeff Pittman, spokesman for the Maryland chapter of the American Federation of State, County and Municipal Employees, noted that after some dismal returns, the state plan’s performance rebounded to 14 percent in 2010 and 20 percent in 2011.

Pittman said that under a defined-contribution plan, the employee loses the economic security of a guaranteed minimum pension check.

“Why would you want to scrap something that has worked so well, so long for so many?” he said.

If changing the target has its risks, so does leaving it where it is. Over the past decade, public pension plans have regularly fallen short of their investment targets — even with a stock market rebound over the last two years.

The problem is national in scope. The Pew Center for the States recently estimated the gap between public pension plans’ obligations and reserves at $1.38 billion in 2010.

Maryland’s system has underperformed its peers in recent years. For the 10 years leading up to Dec. 31, the median investment return for public pension plans was an anemic 5.7 percent, according to the National Association of State Retirement Administrators. Maryland posted a 4.7 percent gain for that period.

For most of that period, Maryland has continued to assume it would earn an average of 7.75 percent a year, leading to a chronic underfunding of the system. As of the 2010 budget year, Pew said, Maryland was funded at 64 percent of its obligations, putting it among the two-thirds of states that did not achieve the widely recommended threshold of 80 percent funding.

Draine said the underfunding does not pose a threat to retirees’ pension checks in the short term or even 10 years down the road. But unless addressed in a timely way, he said, the state could face some hard choices — including benefit cuts and higher taxes —years from now.

The consequences of chronic underfunding became especially stark in Rhode Island, where funding levels fell to under 50 percent. Last year, Gov. Lincoln Chaffee and legislative leaders pushed through a drastic reform that included benefit cuts, a freeze on cost-of-living raises until funding reaches 80 percent and a rise in the retirement age.

As part of that reform, Rhode Island also slashed its projected rate of return from 8.25 percent to 7.5 percent.

Maryland’s 7.75 percent benchmark now ranks in the middle of the pack for public pension plans. According to a state retirement administrators group, many plans are still at 8 percent. Baltimore City’s plan cut its projection for current employees from 8 percent to 7.75 percent in December — a move that increased the city’s contribution by $9 million.

In the aftermath of the 2008 bust and the recession, some of the nation’s largest pension plans have moderated their expectations. Draine said 18 plans in 14 states reduced assumptions in 2010 and 2011. In March, California’s CalPERS, the nation’s largest pension system, cut its rate from 7.75 percent to 7.5, rejecting a recommendation from its actuary that it go as low as 7.25 percent. The one-quarter percentage point cut was expected to cost that state more than $300 million.

Some private pension plans have been even more aggressive in lowering expectations. Early this year, General Motors’ pension plan cut its expected rate of return from 8 percent to 6.2 percent, partly because of its decision to shift money into less risky fixed-income investments.

Liebmann, a former Republican candidate for the U.S. Senate, has argued that public pension plans should lower their expectations to an annual rate of about 6 percent to more closely match the private sector.

Kopp said corporate and public pension plans are different entities that follow a different set of rules. Government plans, she said, operate on a much longer timeline.

“This is the fund of a state,” Kopp said. “We are not going to merge or be acquired by another state, and we are not going out of business.”

Last year, Gov. Martin O’Malley and the General Assembly took steps to close the gap, including increasing the required contributions by employees, lowering payouts for future hires and cutting cost-of-living increases for more than 125,000 retirees. They also allocated $300 million more annually as the state’s contribution.

Kopp said last year’s changes aren’t expected to produce dramatic results in one year, but will put the state on a path to a relatively healthy 80 percent funding by 2021 and to eventually reach full funding.

Draine said Maryland’s trustees need to consult with their actuary and make the best possible estimate of what rate of return they can expect.

“The longer they wait, the harder the choices and the more pain that will have to be shared,” he said.

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