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January 23, 2013


Governor Cuomo’s pension gimmick

E.J. McMahon

In lieu of actual mandate relief, Governor Cuomo wants to make a seemingly irresistible offer to local governments. A proposal included with his 2013-14 Executive Budget would give counties, municipalities and school districts the option to (a) immediately reduce pension contribution rates by up to 43 percent, and (b) “lock in” a “stable” pension contribution rate for a 25-year period.

This would be accomplished by significantly under-funding the pension system in the short term, based on the expectation that Cuomo’s Tier 6 pension plan will ultimately yield more than enough savings to make up the difference later in the 25-year period. (See Part G on page 14 of this memo for a detailed explanation.)

There are three basic problems with the idea.

  1. Even under ideal, fair-weather economic and financial market conditions for as far as the eye can see, it’s likely to be a losing bet for employers — saving them less in the short term than it would cost them in the long term.
  2. It weakens and increases the financial vulnerability of the pension funds in the short term, and in the long term is a big financial gamble for both their beneficiaries and their ultimate underwriters, New York’s taxpayers.
  3. It may violate the state Constitution’s Article V, Section 7, prohibition on impairment of retirement benefits.

Cuomo’s plan cannot be implemented without the approval and cooperation of both state Comptroller Thomas DiNapoli, who is sole trustee of the New York State and Local Retirement System (NYSLRS), and the Board of Trustees of the separately administered New York State Teachers’ Retirement System (NYSTRS). They have no doubt assigned their respective in-house actuaries to examine the proposal, but it’s hard to see how they could find it consistent with their fiduciary responsibilities. After all, the comptroller has already pushed the envelope by successfully proposing for a law that essentially gives local employers the option of borrowing a portion of their pension increase from the pension fund, to be repaid over 10 years at a low interest rate. And Cuomo himself vetoed a bill, passed by both houses at the very end of the 2011 session, that would have allowed school districts to bond out a portion of their pension increases.

Background

Pension and disability benefits are financed out of large investment pools, which have been built up, replenished and backfilled as necessary mainly by annual taxpayer-funded employer contributions, which are calculated as a percentage rate of salaries for covered employees. Depending on hiring date, some public employees also contribute a smaller, fixed percentage of their salaries to the pension funds. The vast majority of workers hired prior to last year contribute no more than 3 percent; those with 10 or more years of service contribute nothing.

Pension investment returns have been especially volatile in the past decade, so the contribution rate for New York’s statewide funds have fluctuated from a low of just above zero in 2000 to the projected 2013-14 levels of 20.9 percent for ERS employees, 28.9 percent for PFRS, and up to 16.5 percent of salary for NYSTRS members.

Cuomo’s proposal is to set the would establish a “stable” contribution rate of 12 percent for ERS, 18.5 percent for PFRS and 12.5 percent for NYSTRS employees.  These rates are nearly twice the projected “normal” rates for Tier 6 employees — i.e., the employer share of the cost of these cheaper pension benefits in a theoretical, steady-state universe of annual asset returns in line with the NYSLRS liability discount rate of 7.5 percent and the NYSTRS liability discount rate of 8 percent.

There’s a reason why this seemingly simple “solution” has never been advanced previously in New York: it imprudently compounds the moral hazards and financial risks already inherent in the defined-benefit pension system. One of the slides displayed in Tuesday’s presentation by Cuomo’s budget director, Robert Megna, actually gives away part of the game:

Note: under the scenario illustrated above, the lines cross in 2020.   Based on the data points in this chart, a county or city taking the deal will realize cumulative savings equivalent to 20 percent of annual payroll in the next five years — while giving away savings of 40 percent of payroll over the next 10 years.

Politicians in general are notorious for their short-term time horizons and need little encouragement to steal money from the future to meet current needs. When it comes to pensions, which rely so heavily on risky and volatile stock investments, the future is especially murky. In fact, as I noted here, simulations conducted as part of NYSLRS’ last actuarial update suggest there is only a 35 percent likelihood the fund will earn as much as 7.5 percent a year in the long term. A median, 50-50 bet would be just under 7 percent — the discount rate just adopted by New York City’s pension funds, which are not part of the governor’s proposal.

So what if asset returns continue to come in below targets? Cuomo’s proposal allows for two initial “evaluation periods,” starting at five and 10 years after the law takes effect. At each of those points, the comptroller and the NYSTRS trustees could nudge their rates upward by no more than two percentage points. In no case could the rate be lower than the base or more than four points higher than the base amounts. And if that’s still not enough, they would have “discretionary authority to increase or decrease the length of the baseline stable pension contribution term to ensure adequate system funding,” the governor’s bill memo explains. In other words, that 25-year period could be stretched out to 35 or 40 years.

The other, opposite fat tail risk is that the markets experience another boom on the 1990s scale, and the pension funds find themselves awash in tens of billions of dollars in excess contributions within the next 15 years or so. Experience suggests that future governors and legislators will not keep their hands off a huge and growing pile of arguably “surplus” cash. They will find a way to both reduce pension contributions and sweeten pensions, just was was done in New York in 2000, contributing to our current problems.

Cuomo administration officials are suggesting this pension scheme is no more objectionable than exchanging an adjustable rate mortgage for a fixed-rate mortgage. In this instance, however. the term of the “mortgage” and the amount owed could increase significantly if the pension fund fails to meet its rate of return assumption.

DiNapoli had an appropriately cautious reaction:

My office just learned of the Governor’s financing proposal for the state pension fund [!], and we are examining it from the perspective of our fiduciary responsibility. New York has one of the strongest pension funds in the country because it has been managed with fiscal discipline over the years. Too many other states have failed to adequately fund their pensions and taxpayers ended up paying the price.

NYSTRS had no immediate comment. Its next scheduled board meeting is Jan. 30.

The legal question

The last time a big change in pension calculation assumptions was considered in Albany came in 1990, when then-Governor Mario Cuomo and the Legislature passed a law directing the comptroller to switch from the relatively conservative “aggregate cost” method to the “projected unit credit” or PUC method, which would have permitted lower employer contributions.

Three years later, ruling on a lawsuit brought by the president of the state’s largest employee union, the Court of Appeals struck down the PUC change. The case is mainly remembered as having hinged on the court’s finding that the change had been improperly forced on the comptroller at the time, Edward V. Regan, who had been “divested of his autonomous judgment” on whether the switch to PUC was prudent. But the decision also contained strong hints that the funding change would have been overturned even if Regan had gone along with it.

The Legislature has some “unquestioned” legal authority over the pension fund, the Court said. However, its opinion added:

Where the State [i.e., the Legislature] maintains such authority in regard to the actual trustee of the funds, and specifically prescribes procedures for contributing to the benefits, concomitant with that authority is the State’s duty to act in a manner consistent with the goal of the “protection” of these funds as required by article V, § 7 of New York’s Constitution. The State must show, like any other trustee or fiduciary, that it has not breached that duty. [emphasis added]

While the PUC method is widely used by other public funds, the court suggested that it might have been rejected on the merits, quite aside from the comptroller’s unwillingness to endorse it.

It’s not far-fetched to suggest that even if DiNapoli and the NYSTRS trustees sign on to Cuomo’s plan, either a group of unions or individual members of the retirement systems could sue to block the law on the grounds that the change would make their pension funds somewhat less secure.

Filed under: Public Pensions, Uncategorized

9 Comments »

  1. If the governor is proposing that the localities’ contributions will be a constant percentage, with any shortfall made up by the State (such that the overall integrity of the system remains the same as it would be under the \old\ system) then the tradeoff from local governments’ perspectives is surely worth it. It is primarily the enormous upside yearly variability that is so impossible to deal with. And if the system is lucky enough to experience a \fat tail,\ the risks are not necessarily worse that the bonus will be squandered under this proposal. Further, if in fact the governor is truly committing the state to continue funding an actuarially sound system (without presumably watering down the assumptions beyond the existing ones) then the overall risk to the system should not increase.

    Comment by Xif — January 23, 2013 @ 6:33 pm

  2. To first commenter:

    Unless I missed something, which perhaps you can find in the memo, he’s not offering to have the state make up any shortfall. The state would not be involved. If I’m wrong, I stand corrected.

    ejm

    Comment by mcmahon — January 23, 2013 @ 8:07 pm

  3. The wild swings over the years in employer contribution rates to the various pension systems, from lows of less than 1 present to highs in the 20’s, must have had a negative effect on overall investment income and does not seem fiscally prudent. In fact, I think one could characterize the years with low ECRs as underfunding pensions. (Additionally, it must be difficult for state agency, municipal, and school district budget planners to work such swings in the ECR.)

    No personal financial advisor would recommend to a client that they save for retirement by investing $40 a month for several years, then over time increase the amount to $2,000 a month , and then decrease the amount to $200 month, and so on.

    While I don’t know if the Governor’s plan is sufficiently prudent to be the best choice for addressing the need for ’smoothing out’ the ECR, at least it has some people examining the concept. It would be a shame if some fiscally-responsible approach was not implemented.

    Comment by Bob — January 24, 2013 @ 7:41 am

  4. This may be one of the few times I agree with Mr. McMahon. There is no good reason for a local government to accept this proposal. It is kicking the can down the road, and probably not very far. The can will be much bigger next time you try to kick it.

    What the Governor should propose is a minimum contribution rate every year. Then when the stock market is riding high, money is still going in. This would also help even out the wild swings, as governments would always be budgeting for some amount, and the few years that the pension fund is over funded would average out for the tough years

    Comment by Scott — January 24, 2013 @ 1:50 pm

  5. excellent job above. Although the school districts are being hammered by the pension costs, none of us wish for gimmick solutions which violates accounting and pension regulations.

    Comment by andrew giaquinto — January 24, 2013 @ 2:51 pm

  6. As always, the devil will be in the details: if the proposal does not provide for a state-funded mechanism to make the system whole, if necessary, and if the only adjustments are the periodic 2% (I’m assuming that’s percentage points), then either the plan is fiscally imprudent on its face or it simply kicks the reckoning can down the road. On the other hand, a reasonable and responsible approach would be to couple the constant contribution from localities with a hard commitment by the state to make up the difference — it is the state that sets virtually all the rules of the game (both pension and collective bargaining) and consequently should have at least a portion of the responsibility for the consequences of those rules. With such a shared approach, localities would not be “let-off-the-hook” for their role, however limited, in driving the systems costs, but it would bring some much-needed fairness, not to mention stability, to an almost out of control situation.

    Comment by xif — January 25, 2013 @ 11:46 am

  7. Is anyone asking what this could mean for today’s students. Does the author of the article understand the impact to students of allowing the pension contributions to increase to 16.5%? Should not municipalities have the opportunity to level off the ups and downs of pension contributions? I am a novice at this, but there seems to be one simple answer here. Firstly, it is clear that the contribution amount is high given historical data. If we work with that premise and if the actuaries agree and if we have the safety net of the evaluation periods, we can insure system solvency by setting the rate this high. Here is what the tax payer needs to have this “gimmick” make fiscal sense. Districts need an opt-out option…one in which they could “balance” their payments over time (factoring in the system’s growth). OK–enough of my poorly structured economics lesson. As a school board member concerned about today’s students (mine have since graduated from K-12 public school), we need to strongly consider this option. If we don’t, students will suffer.

    Comment by DS — January 27, 2013 @ 8:37 pm

  8. We are fortunate to have people like EJ McMahon and the Empire Center to give us an objective analysis of the fiscal proposals and policies of the State government. Most of us do not have time to do the research. Isn’t the question, we know you can not borrow from the pension fund, so can you contribute an IOU under the banner of smoothing? What would be the impact on this new proposal and the required contributions if the stock market dropped by 25%? Under current rules, contributions would rise sharply. The only real solution is to change to a pure defined contribution pension if we are going to keep the 2% tax cap. SUNY professionals have done very well under that DC system they elected.

    Comment by Chris Kendall — February 2, 2013 @ 4:20 pm

  9. As it happens, it turns out that EJM is correct that there is no commitment in the Governor’s proposal to fully fund the system were shortfalls to occur. But why would entities such as the Empire Center not press for such a plan? And if the future turns out to be brighter than expected and a surplus develops, then surely one could come up with a reasonable plan to utilize that surplus in a responsible fashion, whether it entails making the state whole for its “excess” payments during the short years and/or lowering the stabilized contribution rate appropriately and/or returning the bonus to the taxpayers in some fashion and/or something else entirely. Instead of just being critical, it certainly could be more helpful were responsible policy advocates and watchdogs to develop and get behind some reasonable alternatives to both the currently dysfunctional system and the flawed proposal from the governor. What we have now is not sustainable.

    Comment by xif — February 5, 2013 @ 12:39 am

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