City pension plans – Future options – Part 3 of 4

Submitted by Dave Lott
April 30, 2014 7:22 a.m.

In Part 1 of this three-part series, the fundamental elements and structure of the City’s pension plans and its financial performance were reviewed. Part 2 reviews the various options that could be considered by the Pension Boards and the City Commission as they move forward in their discussions of potential pension reform for the City’s plans.

As noted in the earlier articles of this series, the primary financial risk associated with a Defined Benefit pension plan such as the two plans (Police/Fire and General Employee) currently in place is borne solely by the City. While the employee’s contribution amount is at a fixed percentage of their salary, the funding amount required of the City is based largely on future events over which it has little to no control. It is critical to understand that the assets (investments held by the plan and participant contributions) and liabilities (benefit and participant plan withdrawals) of a pension plan are not static as they are all influenced by future activities.

The financial position of the plan is impacted by investment returns and the rate at which payments to the plan by the participants are made. Plan participants that leave earlier than expected, retirees that live longer than actuarially expected (good for the retiree, not good for the plan), and lower than projected investment returns are all major factors outside the control of the City. Any change in plan benefits can also significantly affect the liability side of the Plan.

When it is stated that a pension plan is 100% funded, it only means that should the pension plan be terminated at that point in time, the balance in the plan would be expected to cover that percentage of payments due to the eligible participants for the duration of the plan. But even that is not certain as the actuary tables can only project life expectancy and there is no crystal ball I know of that will accurately project investment earning rates. A healthy and fiscally secure pension plan is one that is adequately funded, competitive to attract and retain a qualified work force, flexible, and has a proper level of risk management and oversight.

The general rule of thumb is that a retiree will need about 80% of their ending income to maintain their current lifestyle in retirement. Their retirement income will come from the “three-legged stool” of retirement income sources: Social Security, pension plan, and the individual’s savings and investments (IRAs, stock/bond portfolios, etc.) accounts. Increasingly, many workers are assuming their pension will be their primary retirement revenue source as fears about the long-term viability of Social Security increase and personal savings and investment levels remain at their lowest level in 50 years.

Over the last 30 years in the private sector and the last 15 years in the public sector, there has been a concerted effort to migrate Defined Benefit pension plans to Defined Contribution plans such as a 401(k) and/or IRA or operate hybrid plan plans. Based on the latest statistics I was able to find, the private sector mix of employees in Defined Benefit versus Defined Contribution pension plans is 18% to 82%; whereas in the public sector, the inverse is true with a ratio of 78% to 22%. Under a Defined Contribution plan, the employee makes contributions to the plan and those contributions are generally matched by the employer to some level, but the investment options selection is made entirely by the employee from a range of investment portfolios with varying levels of risk and expectations of earnings.

The employee owns and manages the plan. The primary advantages of Defined Contribution plans to the employee are their stronger growth potential, portability when changing jobs, shorter vesting period, and the level of control provided to the employee in making their investment decisions. The advantage to the employer is a lower overall funding expense, lower plan administrative costs and no future liability for retirement payments. The main disadvantages cited for the employee is the educational effort needed to make informed investment option decisions, as well as the uncertainty as to the exact amount of the retirement payment they will receive.

A number of states and municipalities have modified their retirement compensation plans under what has generally been called “pension reform”. The primary impetus of their action was the increasing level of contribution being required to fully fund the plan resulting in either tax increases or cutting other services in the budget. There are a number of variations possible for pension plan reform. Each of these options is discussed in greater detail below:

• Total switch from Defined Benefit to Defined Contribution plan – this is the most aggressive change that could take place. A modified strategy is to allow current employees to join the Defined Benefit plan when they are eligible, but make only a Defined Contribution plan available to new employees. While this provides a lower cost solution to the City in the longer term, there would be additional transition and operating costs incurred that will likely increase the City’s net spend over the short term. Since there would no longer be new (and presumably younger) workers entering the old plan, an actuary would have to calculate expected plans costs and determine the amount of the expected shortfall that will require additional funding contributions. The City would then have to develop a plan to cover the expected funding of the shortfall; an amount that could be substantial.

• Move the current City plans to another pension plan provider such as the Florida Retirement System (FRS). FRS is highly regarded as one of the top statewide pension plans in the U.S. FRS currently offers both a Defined Benefit and a Defined Contribution plan for participants; although there have been discussions to eliminate the Defined Benefit plan for new participants. The main disadvantages would be the dismantling of the current plans with the resulting loss of local input and control. There would also be costs for transitioning over to FRS. The primary advantage would be to have professional, full-time management of the pension plan. Of course, an evaluation of the FRS’ plan performance compared to the City’s plans would have to be made as well. An option would be to retain the current Defined Benefit plan for current employees and require new employees to elect a pension plan through FRS. This option would impose some additional administrative burden on the City’s Human Resources personnel as they would have to be involved with two plans. Most likely, the City would need to fund additional contributions to the current plans as explained in the option above. Additionally, as membership in the City plans wound down and approached their termination point, it might be difficult to get people willing to serve on the pension boards. Regardless, at some point, the plan would have to be converted as the small number of participants and their pool of invested funds could never justify the expenses of the pension plan’s legal and investment advisors.

• Increasing employees contribution level – As noted in the first article of this series, currently City Police/Fire employees contribute 7.7% of their salary and General Employees contribute 6.75%. Any increase in contribution amounts would require approval by the unions under their collective bargaining agreements. Such agreement might be difficult to achieve without some other benefit being provided as an offset; but such a modification has been successfully accomplished in other municipalities.

• Changing investment strategy – The pension boards control the investment strategy of their respective plan and the City has no authority to force such a change. A general investment rule is the higher the potential rate of return, the higher the risk that the investment portfolio fails to meet its performance goals. The pension boards appear to have predominantly used their professional investment advisors to build their investment portfolios. Like any investment firm’s selections, some decisions have outperformed the market and some have underperformed. The Boards must continually measure the performance of their investment advisors in comparison to the fees they are being paid. Again, the City has no capability to impact such a decision.

• Modifying benefits for new, and possibly existing, retirees – Again, any change in the current plan would require the agreement of a majority of the participants; although benefit factors (i.e. the multiplier, tightening compensation definition) for new participants could be made but would still require union approval for modifications to the collective bargaining agreement. Since the Police/Fire plan operates under Chapter 175/185 of Florida Statutes (and receives a 6.5% contribution from the State lowering the City’s required contribution), there are limitations as to the benefit changes that can be made. The City’s pension legal advisors can help better define these options.
• Moving to more conservative actuarial assumptions (i.e. rate of return) – A lowering of the projected rate of return from its present level of 8.0% is a step that a number of plans have done in recent years. However, such a move is a double edged sword in that lowering the return rate will increase the unfunded liability percentage in the near term forcing the City to immediately increase its contribution to restore the pension plan’s funding level to a financially stable level. Again, the actuary would have to run the numbers to see what the exact financial impact would be.

• Purchase of service credits – Both plans currently allow an employee to purchase service credits. This practice should be reviewed to determine if it should continue; and if so, ensure that the cost of the credits is based on an actuarial valuation. Elimination of this option would require the approval of the City’s unions.

• Anti-Spiking – Spiking is the practice of an employee increasing their overall compensation level used in the calculation of their pension amount in the years just before retirement by incurring overtime and lump sum payments of vacation, sick and personal time. The Florida legislature passed a bill that requires pension plans to limit or exclude some of these compensation elements from the pension payment calculation. For participants that are union members, the exclusion is effective after the renegotiation of their collective bargaining agreement. Relative to the City’s plans, since the UBC renegotiated their contract in 2012, this anti-spiking change has already gone into effect. With the renegotiation of the Fire/Rescue collective bargaining agreement retroactive to October 1, 2013 this change will also take effect as soon as the appropriate ordinance can be approved by the Commission.

• Increasing vesting time period / retirement age – These changes would also require modification of collective bargaining agreements for union employees regardless if it was being made applicable to only new employees or to current employees. The normal retirement age for Social Security is 67 for those born after 1960 and people are living longer so it might be appropriate to reset the normal retirement for new participants. While increasing the vesting period should provide the advantage of encouraging a more stable workforce, the City would need to ensure that its overall compensation plan remains competitive in the market.

As expected, efforts to modify pension plans have generally been met with resistance by the worker’s unions and industry representative groups. One only needs to look in our own backyard as the Florida legislature has made efforts over the last two years under the overall plan for pension reform that to close off the current Defined Benefit plan to new workers and only offer them participation in the State’s Investment (Defined Contribution) Plan. This action is supplemented by the FL Supreme Court upholding, after a lengthy court battle, the Legislature’s right to require State employees participating in the Florida Retirement System plan to contribute 3% of their salary to their pension plan. The State’s teacher’s union has been fighting both efforts amid claims that teachers “shouldn’t have to worry about retiring into poverty.”

As noted in Part 2 of this series, the Governmental Accounting Standards Board (GASB) has adopted some new accounting standards dealing with the handling of pension plans that will be effective with the 2014-15 pension plan financial year and impact the City’s upcoming budget process. One of those changes that will affect the City, since the current pension plans are underfunded, is that the City will be required to use a combination of the historical rate of return and a lower rate tied to a high-quality municipal index rate. The overall effect of this rate that will be lower than the 8% projected rate is that the plans’ long-term liabilities will appear significantly more than they currently do resulting in a higher unfunded percentage. Under the new GASB standard, the City will be required to report its unfunded pension liability on the face on the financial statement and not as a footnote to the financial statement as had been specified in the past.

While considered more financially prudent, other changes could make it more difficult for citizens to determine the exact financial condition of the pension plans. It will be optional for plans to obtain an actuarially determined Annual Required Contribution (ARC) and to show that information along with the actual employer contribution in its financial report.

In the final part of this series, we will examine the questions and issues that are likely to be faced by the City Commission, City Attorney, City Manager and its legal and actuarial advisors as well as the employees and pension board members.

Editor’s Note: Dave Lott has been a management consultant specializing in consumer banking and payment systems for 30+ years. As a former 11 year resident of the City, Dave has served on numerous City advisory committees. Dave served as Interim City Manager. He currently resides in Atlanta, Georgia.