By Ian Berg, CPA, Special Districts Consulting Senior Manager
It’s no secret that many pension plans are underfunded by government agencies throughout California. With fewer assets than liabilities, these underfunded pension plans are not projected to have enough money to pay out benefits that have been promised to plan members. The question becomes, what is the best way to address these underfunded pension plans? Many agencies are seeing pension liabilities grow on their balance sheet year after year and are recognizing sizable pension expenses as a result. The reality is that pension costs can’t be stopped, and we can only hope to contain or offset them.
The good news is that fiscally responsible strategies can be implemented to address past and future retirement costs. Generally, pension liability factors are out of the scope of an agency’s control, but with proper action, the time value of money can be turned into an advantage. There is no one-size-fits-all answer, but here are some general guidelines to assist in analyzing and addressing each unique situation.
Review your agency’s Unfunded Accrued Liability (UAL) on an annual basis. If your agency contracts with the California Public Employee Retirement System (CalPERS) you are probably familiar with this term. The UAL is the difference between current plan assets that CalPERS holds on your behalf and the estimated future benefits previously earned by plan members. On average, most agencies are around 70% funded, which means that plan assets are underfunded by around 30%.
Understand interest costs associated with carrying the UAL over time. CalPERS requires minimum payments annually to pay down the UAL over a period of 24 years. Think of this like a minimum payment on a credit card each month. We all know that only paying the minimum payment on a credit card results in higher interest costs. Correspondingly, a higher UAL balance over a longer period of times results in higher interest costs to the agency. Currently, CalPERS charges 6.8% on shortfalls of plan assets.
Determine potential savings by funding the pension plan directly. Every year CalPERS releases an annual valuation for your agency, and it shows a 24-year amortization schedule with associated payments. It also projects interest savings over time using 10 and 15-year periods. Agencies can lock into a “hard fresh start” with CalPERS by moving to a 10-year or 15-year amortization period. Recent valuations have shown that an agency with a $2.8 million UAL could save an estimated $1.1 million in interest costs by moving to a 10-year period. Agencies can also mirror shorter amortization periods without locking into a schedule by making Additional Discretionary Payments (ADPs) for payment differences between the required period and the shorter period. This method is known as a “soft fresh start” with CalPERS because it is voluntary, and ADPs can be discontinued if necessary. Agencies should strategize to fund ADPs with onetime windfalls or with excess cash reserves. Contact your CalPERS actuary to understand available options and potential interest savings.
Establish a UAL funding target. The goal is not necessarily to become 100% funded with assets held in CalPERS. Remember that money sent into CalPERS is locked into the pension plan. Targeting anywhere from 90-95% funded status in the plan is a beneficial strategy. This range eliminates unreasonable interest costs while allowing room for investment performance or pension trust assets to make up the 5-10% difference. Becoming over 100% funded in CalPERS is essentially frozen capital as it is not able to be withdrawn or used for another purpose.
Establish a 115 Pension Trust Fund (115 Trust). Pension trusts are a funding vehicle used to prefund future retirement costs. Once funds are deposited into this irrevocable trust, they may not be withdrawn for any purpose other than funding retirement benefits. Investments in the trust build up over time and could also be used as a rainy-day fund for retirement costs during challenging economic times. Benefits of a Section 115 trust include but are not limited to:
- Voluntary contributions that can be adjusted in amount and frequency as needed by the agency.
- Investment flexibility and risk diversification. Trust assets can be invested in higher-yielding instruments when compared to conventional investment funds such as LAIF or County pools.
- Helps smooth annual budgeting by absorbing future pension cost volatility due to market performance fluctuations or changes in actuarial assumptions.
- Ability to select asset allocation strategy to match your agency’s risk tolerance and investment time horizon.
- Flexibility to access trust assets if used to pay employer pension costs, including normal costs and UAL payments (rainy-day fund for retirement costs).
Of course, all investment vehicles carry the risk of losing principal in a down market – consult your CPA on whether a trust is right for your agency.
Source funding for pension plan payments. Where will the money come from to make ADPs into CalPERS and fund a 115 Pension Trust? There are a few options available.
- Cash reserves (if available) otherwise invested in LAIF or another investment vehicle with lower yield.
- One-time windfalls of cash due to the sale of assets, or unexpected revenue rebates.
- Unexpected excess revenues over expenses.
- Pension obligation bonds (POBs) during periods of low interest rates. If CalPERS is charging 6.8% on shortfalls of plan assets and POBs can be issued at 2-3% then interest savings are possible. However, there is always risk involved because proceeds are placed into pension plan investments. If CalPERS investments perform poorly, it will be difficult to recover. The agency’s financial position could be worse than before issuing the bonds in some scenarios.
Develop an Unfunded Accrued Liability (UAL) Pension Management Policy. Agencies should identify goals, strategies, and various funding options for retirement costs. The policy should address a pension plan funding target, ensure that pension funding decisions protect current and future stakeholders, and create transparency as to how and why the pension plan is being funded.
Review the UAL Pension Management Policy annually. Ensure compliance with the adopted policy and be sure to update annually with changing conditions. A properly designed UAL policy tailored to your agencies unique circumstances will help defray increasing retirement costs and convey a sense of fiduciary duty to your stakeholders.
In short, it is key to review and understand the costs associated with retirement, establish funding goals, and develop policies to address retirement costs over the long-term. You can start developing a fiscally responsible strategy that works for your agency today.