Policy Report ­­– January 2014

New Jersey Pension Study

Richard C. Dreyfuss Steven Malanga Policy Report 14-101

NJ-Pension Study.indd 1

1/16/14 12:17 AM

LETTER FROM THE PRESIDENT:

The wake of the recent federal court decision declaring, in the Detroit Bankruptcy Case, that public sector pension commitments are not sacrosanct, should be cause for increased concern about the realities of similar commitments across the nation. While New Jersey is not unique nor, fortunately, the worst state when it comes to its funding status, after years of neglect along with reckless maneuvers, we are at a crucial stage regarding the sustainability of current commitments. ETHICS, or more specifically the lack of, has played a key role in getting us to the current situation. Everything from double and triple dipping, to outright dishonest acts and malfeasance have all taken their toll over the past few decades. With the enduring fallout from the nation’s worst recession on record the Common Sense Institute of New Jersey opted to take a hard look at where the state is in meeting its funding obligations and what options there are going forward. While the situation is certainly not hopeless it does bear serious concerns in light of the commitment by the Christie Administration to step up the state’s annual contributions to the retirement funds to $5 billion (from this year’s $1.67 billion) annually beginning in five years. The need of finding an additional $3+ billion in revenue to meet those obligations within the existing $33 billion budget will be a daunting task to say the very least. As the new realities set in we must all realize the stakes involved and anticipate where the expected tradeoffs will occur. And looking ahead it’s only reasonable (i.e., common sense) to expect that real sacrifices will have to be made. So, in an effort to initiate that difficult dialog this report is released with the goal of setting the stage for the process to begin in earnest. The onset of the New Year provides a perfect opportunity and it is our sincere desire that the discussion will involve a bipartisan commitment of give and take with the goal of arriving at a series of permanent solutions. And at the top of the list will be to establish a single Ethics Standard to apply from the Governor’s office all the way down to our local school, fire, sewer and municipal district level. And every elected official and public employee should be held to it. And, equally important, when this is done the lessons learned must be applied to all future commitments based on what the taxpayers can bear. What was once common practice is no longer practical in our new global economy. Just watch what happens in Detroit.

Jerry Cantrell, President

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NJ Pension Study: Executive Summary The state of New Jersey has been funding pensions for state workers dating back nearly a century. For decades the state’s pension system operated on the notion that it would use “a scientific (actuarial) basis” for financing benefits to ensure the fiscal stability of pensions. But starting in the early 1990s elected officials began manipulating the system to achieve short-term budget relief, starting with the Pension Reevaluation Act of 1992. Over the space of two decades state legislators passed a series of politically motivated bills which changed the basic methods and assumptions by which the assets and liabilities in the system’s seven pension funds are valued. Those changes understated the future obligations of the pension system and led to lower recommended contributions by the state than were necessary to keep the pension system adequately funded. This was often done explicitly to achieve budget savings. At the same time, elected officials continued increasing benefits for workers with little regard for the impact on the stability of the pension system. Between 1999 and 2003 alone the legislature enacted 13 separate pension enhancements to various plans. By 2003 the condition of the state’s pension funds had deteriorated to the point where the cost of adequately funding them represented too great a burden on the state’s budget, and Trenton simply stopped making meaningful contributions into the pension system. That, combined with the financial turmoil that the United States experienced in subsequent years sent the system’s unfunded liabilities soaring, so that various independent analyses judged New Jersey as having one of the nation’s worstfunded pension systems. In 2010 and 2011 state legislators enacted a series of bipartisan reforms to deal with the system’s growing liabilities. In many respects these were significant reforms which should be applauded. Legislation also committed the state to properly funding its pension system every year. However, with the state experiencing severe budget distress thanks to the fiscal downturn that started in 2008, state government also gave itself seven years to gradually get to the point where New Jersey would have to make full annual contributions into its pension system. Since 2011 the state has kept to its commitment to gradually increase funding into the pension system, but every year it is still falling short of contributing the actuarially recommended contribution to reduce the system’s severe debts. At the same time, a volatile stock market has provided the pension system with inconsistent investment returns. Recent independent evaluations of the state’s system continue to judge it as one the least wellfunded in the nation. This study examines the condition of the state’s pension system especially with regard to Trenton’s own legislated goal of achieving full annual required contributions from the state budget by fiscal 2018. The study finds that the condition of the pension funds has improved only marginally since pension reform and that the continued underfunding of the system means that the cost to future state budgets is growing significantly with interest added to any unpaid deficit. By the state’s own accounting, in fiscal 2014 New Jersey state and local government should be contributing nearly $5.9 billion to state pension systems in contrast to the expected contribution of $3.3 billion. The state’s

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share of that burden alone would represent 12 percent of the total state budget, if New Jersey were fully funding its pension system. This has grown from just 5 percent of the budget in 2006. Even more troubling is that using more conservative and traditional funding assumptions and methods including reducing the long-term annual asset return rate of 7.9 percent, this report estimates that the state and local government would actually have to contribute as much as $8.75 billion in fiscal 2014 to ensure that the pension system was progressing toward a proper level of funding based upon standards used by accountants and Moody’s. Because the state cannot afford to contribute fully to the pension system, and funding levels continue to lag behind, contribution levels are likely to grow even steeper in coming years. By 2018, when the state commits to making its annual required pension contributions every year, the financial burden on state and local budgets could well be impossible to meet. A recent credit report by the ratings agency Moody’s estimates the cost to the state budget of pension contributions at that time could be as high as $4.8 billion annually. With these challenges in mind, this report recommends further action be taken as soon as possible to address the shortfalls in the pension system. In its conclusion, the report presents a series of options to be considered.

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SECTION ONE: BACKGROUND TO THE CRISIS The state of New Jersey first began using public money to finance government employee pensions nearly a century ago, when the legislature established the Teachers’ Pension and Annuity Fund and noted in the legislation creating the fund that its management would be governed on a sound, “scientific (actuarial) basis.” Over the next seven decades the state added a host of other retirement programs, including funds for police and fire personnel, prison officers, judges, and general state workers. The state continued contributing to these programs on a regular basis, so that the state’s pension system reflected, by 1995, a high level of funding with only modest unfunded liabilities of $2.9 billion. i However, as fiscal pressures began to weigh on the state budget in the economic downturn of the early 1990s, Trenton initiated a series of maneuvers to diminish the impact of financing pensions on the state budget. Thus began a nearly two decades long period in which state politicians used questionable accounting and actuarial practices to minimize the debts of the pension system, ignored their obligation to fully contribute proper amounts to state worker pensions, and increased benefits to workers even as the system’s debts were piling up. The result was a pension system that even today, according to a June 27, 2013 study by the ratings agency Moody’s, remains one of the five worstfunded state pension systems in the country despite reforms the state put in place two years ago.

New Jersey’s 3 largest state pension funds have among the highest ratios of unfunded liabilities to state revenues of any pensions in America, according to a recent Moody’s report.

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The state pension system includes the Public Employees Retirement System, the Teachers’ Pension and Annuity Fund, the Police and Fireman’s Retirement System, the State Police Retirement System, the Judicial Retirement System, the Consolidated Police and Fire Retirement System, and the Prison Officers Pension Fund. For the purposes of this study we focus on the three largest systems: The Teachers’ Pension and Annuity Fund, The Public Employees Retirement System, and The Police and Fire Retirement System Accounting and funding traditional defined benefit pensions is a complex process that can be difficult for the average citizen to understand, so it has not always been readily apparent to taxpayers or government employees how actions in Trenton put the system at risk. In 1992, for instance, as the state faced budget pressures from a continuing economic downturn, the legislature passed the innocuous sounding Pension Reevaluation Act, signed into law by Gov. Florio, increased the projected rate of return that it would achieve on its assets from 7 percent annually to 8.75 percent, making the system’s future seem far rosier. Using this new formulation, the state estimated far higher future assets in the pension fund and began cutting contributions in the present, in anticipation of those future dollars. New Jersey thus decreased by a net $1.5 billion in budget years 1992 and 1993. Two years later the state added new twists to its pension financing to further diminish state contributions. Legislators passed a bill signed into law by Gov. Whitman which allowed the state’s pension funds to switch to a method of allocating retirement costs for workers as they neared retirement age, commonly described as ‘backloading,’ as compared to the system that the state previously used, which allocated those costs evenly throughout a worker’s career. Although the state’s new method, known as the projected unit credit (PUC), was legally acceptable, few other pension plans used it because it defers costs and increased risks of underfunding. The state of Illinois is one government whose pension funds, like those in New Jersey, have used this method of pension financing. Illinois was cited in March of 2013 by Securities and Exchange Commission’s for misleading investors about the health of its pension system. As the SEC noted about Illinois’ pension financing under PUC: “The PUC method results in less funding for active employees, accumulates assets more slowly, produces more volatile measures of contribution rates, and results in rising rather than level contribution rates. The impact of the 1994 pension financing changes on the state’s budget and annual funding of the pension system were substantial. This action reduced the state’s contributions into the pension system by a combined $1.4 billion in fiscal 1994 and 1995. Thanks to heady stock market gains in the mid-1990s, assets in the state’s pension funds continued to increase despite these declines in government contributions. In 1997, seeking to further lower the state’s costs, the legislature passed the misleadingly titled Pension Security Plan, signed into law by Gov. Whitman, which allowed the state to issue $2.75 billion in pension obligation bonds under the theory that the pension system could earn more by investing that money than it would have to pay in interest costs on the borrowing. To further minimize the cost to the budget the state borrowed the money by issuing deferred interest bonds which required no interest payments for 10 years but which, 5

as a result, made the borrowing more expensive in total to pay back. Over the life of the bonds, the state will pay back more than $10 billion in interest and principal on the original $2.7 billion borrowing. ii The legislation allowed the state to take a ‘holiday’ from any contributions when the pension fund had more than 100 percent of the assets needed to pay its accrued liabilities. Thanks in part to the money from the pension borrowing, which made the pension system seem well-funded, the state reduced or completely eliminated its own contributions to from fiscal 1997 through fiscal 2003. The state, for instance, contributed no money at all to the Public Employees Retirement System and the State Police Retirement System in these years. Meanwhile, it contributed just twice, in 1997 and 1999, to the Teachers’ Pension and Annuity Fund. One argument against governments’ borrowing money for their pension systems is that the cash from these borrowings tends to make systems appear better-funded than they are, which then prompts a demand by employees for higher benefits. That’s what happened in New Jersey. In 2001, a statewide election year, the legislature increased pension benefits for state employees by 9.09 percent. That was one of only more than a dozen enhancements provided to state employees between 1999 and 2003 which cumulatively, according to Gov. Cody’s 2005 Benefits Task Force iii study, increased the unfunded liability of the pension system by $6.8 billion. The impact of these fiscal ploys began to wear on the pension system especially after the technology stock bubble burst in 2000 and market returns skidded precipitously. The system’s rate of return slumped to negative 10.4 percent in 2001 and minus 9 percent in 2002, before rising to a stillmeager 3.3 percent in 2003. The combination of these lower returns, benefits enhancements and declining government contributions resulted in an unfunded liability of $12 billion, according to Gov. Richard Codey’s 2005 report on benefits, iv which recommended a host of changes to the state’s pension systems. Average Annual Investment Returns NJ Pension Funds

20.0%

17.1%

14.1%

15.0%

13.4% 8.7%

10.0%

18.0%

9.8%

3.3%

5.0%

2.5%

0.0% -5.0%

'01

-10.0% -15.0% -20.0%

-10.4%

'02

'03

'04

'05

'06

'07

'08 -2.7%

'09

'10

'11

'12

-9.0% -15.4%

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Source: NJ Investment Council Annual Reports Had the state legislature reformed the system in 2005, New Jersey would have had a much easier time bringing its pension costs under control. Instead, when Jon Corzine took office in 2006 he initiated further study of the system and proposed several changes, including bolstering the system with money from a leasing of the New Jersey Turnpike, that proved unpopular. Ultimately the state achieved only minor reforms, including changing the so-called ‘multiplier’ by which a retiree’s pension is calculated. This was not nearly sufficient to stem the buildup of liabilities, especially since the state’s chronic budget problems continued, and Trenton solved them largely by shortchanging pensions. From fiscal 2006 to fiscal 2011, the state contributed just $2.339 billion to its pension funds though its actuaries calculated that the state should have put $13.1 billion into the system to adequately fund it during that period. v In 2006, for instance, the state put just slightly more than one-tenth of the recommended contribution into all its pension funds collectively. In 2009 it put just one-twentieth the actuaries’ recommended amount into the system, and in fiscal 2010 and 2011 New Jersey put nothing from its coffers into the system.

Years shortchanging pension system

Required pension payments as percent taxes Required payments Actual payments $4,000 14.0% $3,595 $3,389 Dollars in millions $3,500 12.0% $3,061 $3,000

$2,519

$2,500 $2,000 $1,500

$1,451

$2,231

8.0% 6.0%

$1,023

$1,000 $500

$1,779

$2,090

10.0%

$1,046

$1,027 $484

$164

$106

$-

$-

2009

2010

2011

4.0% 2.0%

$-

0.0% 2006

2007

2008

2012

2013

Source: State Budget Crisis Task Force Report on NJ As a result, the condition of Jersey’s pension funds grew from troubling to critical. By 2011, thanks to the high cost of benefits, continued underfunding by the state and the severe downturn in financial markets in 2008, the state’s unfunded liabilities had grown from $12 billion in the 2005 report to an estimated $50 billion. To accentuate the state’s troubling management of the pension 7

system, moreover, in 2010 New Jersey became the first state ever charged by the Securities and Exchange Commission with fraud, when the SEC accused the state of misleading investors about the condition its pension funds from 2001 to 2007. Among the charges leveled by the SEC was that the state failed to disclose the true cost of funding some of the benefits enhancements it provided to employees and failed to warn investors that a previous five-year plan the state had adopted to begin digging its way of out pension debt had been abandoned by Trenton. "The State of New Jersey didn't give its municipal investors a fair shake, withholding and misrepresenting pertinent information about its financial situation," the SEC said. By this time, New Jersey’s pension system was judged by independent evaluations to be among the worst-funded in the nation. In a 2010 conference paper, finance expert Joshua Rauh of the Kellogg School of Management at Northwestern University calculated the year that public employee state pension funds could start running out of money absent significant reforms. Jersey’s pension funds, he estimated, could become insolvent as early as 2019. Only three other state pension systems—in Oklahoma, Louisiana and Illinois--faced a greater risk of insolvency. vi Critically, Rauh used a generous projected rate of investment return of 8 percent annually to make his calculations, but he warned that it was likely that pension systems would achieve lower returns in the difficult investing environment after the financial crash of 2008. In his presentation Rauh also noted that when pension funds achieve such a high level of underfunding as represented by plans like New Jersey and Illinois, bailing them out can become expensive.

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SECTION TWO: REFORM Facing a growing threat to its long-term fiscal stability thanks to its pension liabilities, the state initiated a series of reforms in 2010 and 2011. New Jersey passed legislation requiring the state to make the annual recommended contributions (ARC) to the pension system as calculated by the state’s actuaries, though the legislation phased in that requirement by calling for the state to pay one-seventh of the ARC in the fiscal year beginning July 1, 2011, and an additional one-seventh for the next six years until the state is making full contributions out of its budget to the pension system in the fiscal year beginning July 1, 2017. The state also raised the retirement age for new workers, dropped the percentage of final salary that workers receive as pensions, required workers who are members of the state’s various pension funds to increase their annual contribution to the own retirement, and suspended annual Cost of Living Adjustments (COLA) for retirees. The actions taken by the Governor and the state legislature in 2010 and 2011 were significant reforms, undertaken in a difficult political environment. By comparison, several other states and cities with deep pension problems had done far less. The suspension of COLAs, in particular, was a significant savings because of how quickly the cost from annual increases can build up in a pension system. At the same time, however, it is important to understand that because the state was operating from a starting point that included tackling such large liabilities, the pension system remained under stress after the reform, as various independent pension experts warned that it might back in 2011. Rauh, the Kellogg School finance expert, told the press that the size of the state’s problem was something that, “is not the kind of problem you can solve overnight." Public finance expert Eileen Norcross of the Mercatus Center at George Mason University, who has studied the state’s pension system, observed: "While I think the bill is a good sign of acknowledging a very big problem . . . I don't think it's going to be enough to save the system from the size of the liability they are looking at.” Their predictions have proved prescient. Two factors in particular are important in what has happened to the system. Although the state reduced its projected rate of investment return as part of the reform effort, New Jersey is still projecting that the funds will earn an average of 7.9 percent annually in returns, a relatively high rate at a time when other funds around the country and the world were cutting their investment targets. Moody’s adjusted the state’s pension liabilities using a high-grade long-term taxable bond index rate (5.67% for their recent 2011 fiscal reports on the states), resulting in New Jersey’s pension liabilities remaining substantially among the worst in the nation. In addition, the state’s ongoing budget crisis meant that New Jersey could not afford to make a full contribution to the pension system. As a result, for seven years starting in 2011, the state will continue making only partial payments into the system, even as state and local employees continue working and accruing new pension credits. This means that the pension system’s liabilities will continue growing, producing the need for even higher contributions in future years when the full 9

impact of the reform legislation requires the state to fully fund the pension system out of its budget on an annual basis. In other words, the challenges to the system remain large and have continued to grow despite the reform legislation.

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SECTION THREE: ANALYSIS AND RECOMMENDATIONS The actuarial reports of the following three major pension plans are further analyzed in this section. 1)

The Teachers’ Pension and Annuity Fund (TPAF) vii

2)

The Public Employees Retirement System (PERS) viii

3)

The Police and Fire Retirement System (PFRS) ix

These three plans total over 471,000 active members or approximately 99% all active members participating within the NJ pension system. Under the auspices of the NJ Treasurer, each plan has its own board. x Within PERS and PFRS separate accounting is maintained between state and local employees participating in these plans. A demographic summary of each plan is provided below based on the July 1, 2012 actuarial valuations (the most recent available).

Active Members

TPAF* 150,200

PERS* 280,158 84,910 State 195,248 Local

PFRS* 40,819 7,187 State 33,632 Local

Average Salary

$69,833

Retired Members and Beneficiaries#

89,700

$44,723 $58,025 State $38,938 Local 153,625

$92,145 $75,462 State $95,710 Local 39,767

Average Age of Active Members

44

Average age of New Retirees

61.6

51** 49** 52** 63** 60.9 63.7 12

18 Average Remaining Years of Active Employment *Includes both contributing and non-contributing members

Total 471,177

283,092

41 40 41 52.4##** 52.6## 52.2## 11

#Includes deferred vested 11

##Special Retirements (25 Years of Service) ** Author’s estimate These demographic statistics are significant given a basic principle of proper pension funding is that pensions should be fully-funded or “paid-up”, in the aggregate, by the time the average employee retires. A corollary to this is any current funding deficits should be eliminated over this same duration. In contrast, the funding practice in NJ resulting from the 2010 and 2011 reforms is to amortize any current and future deficits over a 30 year period. This is done together with a practice known as “open amortization” in which each year begins a new 30 year period. This is analogous to a homeowner resetting a 30 year mortgage to a new 30 year period on an annual basis. The specific reform provisions affecting the management of the substantial and growing unfunded liability are curious and worthy of comment. First, the 30 year open amortization policy will continue to be in effect and in fact will be reset annually to a new 30 year duration until the fiscal year beginning July 1, 2020. Next, at that point and in subsequent years this amortization period will be closed (fixed) and annually reduced by 1 year meaning the July 1, 2021 amortization period will be 29 years and the July 1, 2022 period will be 28 years. Finally, this annual progression will continue until July 1, 2030 when a 20 year amortization period will be in effect. This revised funding policy is far from that necessary and appropriate to make the plans sustainable. It is significant that little, if any, meaningful progress in addressing the unfunded liability will likely take place until 2020 when it will become a deferred problem to be addressed by policymakers at that time. It is of little relevance that these recent reforms represent incremental improvement over years where no contributions were made. With respect to these plans, based upon the author’s research, at no time have the underlying demographics determined the amortization periods. Such is the practice recommended according to actuarial and accounting standards. Of note, the Government Accounting Standards Boards (GASB) recently updated their standards in Statements #67 & #68 requiring shorter amortization periods than were previously in effect. Moreover, such a methodology is also generally consistent with that utilized by credit rating agencies such as Moody’s in evaluating credit risk. Apart from the significant size of these pension systems, an important statistic relevant to proper amortization periods is the average age of the active members and the corresponding average expected years remaining until retirement. This ranges from about 18 years for TPAF to approximately 12 years for PERS and about 11 years for PFRS. Therefore, based upon these current averages, even a 20 year amortization period effective in 2030, will likely still fail to achieve a demographically-driven funding standard.

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It is also useful to examine the respective financial status of the various plans as of 7/1/2012. TPAF $26.038B

PERS $25.176B $8.390B State $16.786B Local

PFRS $21.126B $1.829B State $19.296B Local

Total $72.340B

Actuarial Value of Assets

$31.079B

$28.886B * $9.512B State* $19.374B Local*

$23.575B* $2.074B State* $21.501BLocal*

$83.540B

Accrued Liability

$51.405B

$45.393B $19.384B State $26.009B Local

$31.732B $4.027B State $27.705B Local

$128.530B

Unfunded liability using MVA

$25.367B

$20.217B $10.994B State $9.223B Local

$10.606B $2.198B State $8.409B Local

$56.190B

Unfunded liability using AVA

$20.326B

$16.509B* $9.872B State* $6.635B Local*

$8.157B $1.953B State $6.204B Local

$44.990B

Funded Ratio using MVA

50.65%

55.5% 43.3% State 64.5% Local

66.6% 45.4% State 69.6% Local

56.3%

Funded Ratio using AVA

60.46%

63.6% 49.1% State 74.5% Local

74.3% 51.5% State 77.6% Local

65.0%

Market Value of Assets

*Used for GASB disclosure

Since each plan is separately valued, the underlying basis of these liabilities and the corresponding unfunded liabilities (funding deficits) is fully predicated on the assets earning an annual long-term assumed rate-of-return specified by the State Treasurer as part of the reform statute. This long-term rate provided by the State Treasurer for the 2012 valuations was 7.90%. This mandate prompted Milliman, the retained actuary for TPAF, to note:

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In compliance with New Jersey statute, this actuarial valuation is based on an investment return assumption of 7.90%. The investment return assumption is specified by the State Treasurer. Based on our most recent analysis, this assumption is outside our reasonable range. If the investment return was lowered, the actuarial accrued liability and statutory contributions would increase and the funded ratio would decrease. Determining results at an alternative investment return assumption is outside the scope of our assignment. Such an observation is significant for several reasons. First, the selection of the asset return rate is the most significant of all the actuarial assumptions. This input together with other assumptions such as future pay increases and longevity are used to develop the plan’s liability and annual recommended contributions. To overstate expected investment returns as noted by Millman effectively understates pension contributions both now and in the future placing taxpayers at risk. Second, Milliman raises an important point that nowhere in this or the other two reports are short- and long-term forecasts provided using current and alternative assumptions quantifying the impact of changing one or more of these assumptions. Such illustrations are commonly referred to as a sensitivity analysis. This is of great importance to current and future taxpayers attempting to understand the estimated future required contributions, the projected unfunded liabilities together with the overall risks inherent within these plans. Such information should be requested by policymakers on an annual basis and provided to the public. These plans develop their financial statements based on a rolling five-year asset value which is significantly higher by 15% or over $11B compared to the market value of assets. This creates the illusion of higher asset levels and masks the extent of the true unfunded liability. It is useful to underscore the 2010 and 2011 reforms explicitly written into NJ statute that underfunding would continue through the fiscal year ending June 30, 2018 ensuring this would be a problem for future policymakers. Specifically, the statue limits the state taxpayer’s contribution to these plans by increasing the allowable contribution over a seven year period overriding the annual recommended contribution developed by the actuaries. This creates the appearance of overall balanced budgets when pension plans are, in fact, underfunded by statue. Such actions mask the true cost of government. Further complicating matters, in subsequent years should the State Treasurer decide to lower the 7.9% assumed annual interest rate to a figure deemed more reasonable by the consulting actuary, the resulting impact would be to increase current and projected employer contributions providing additional burdens on state and local budgets. In addition, should the plan choose to adopt a pension asset valuation approach based upon the market value of assets --a standard utilized by GASB and Moody’s—the state and local governments would have to further increase their contributions. Adopting both a lower assumed interest rate together with the market value of assets would have a compound effect at a time when NJ is currently contributing insufficient amounts to these plans absent these changes.

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Generally, at the local level within PERS and PFRS, contributions have conformed to the actuarially recommended contributions. However, such actions have been mitigated by overall poor financial practices illustrated in the following examples within PERS: 1) The 2009 statute permitted the State Treasurer to allow Local employers to contribute 50 percent of their required 2009 employer contribution in favor of a 15 year payment schedule beginning in the fiscal year ending June 30, 2012. xi 2) Several Local employers offered unauthorized early retirement incentives which were not reflected in the official actuarial reports until July 1, 2011. xii 3) Certain Local employers issued refinancing bonds to cover their cost of early retirement incentives. xiii These actions individually and collectively serve to increase already unsustainable liabilities for current and future taxpayers. Below is a recap of the systemic underfunding by plan from the respective 2012 actuarial reports. Figures for 2013 and 2014 are estimates based upon the actuaries’ current understanding of state budget resolutions. Local and state figures for PERS and PFRS have been combined. TPAF By Year

Annual Required Contribution (ARC)

Employer Contribution

Annual Percentage Contributed

2009

$1,601,478,508

$95,863,972

5.99%

2010

$1,796,358,016

$33,199,655

1.44%

2011

$2,123,175,950

$30,655,332

1.85%

2012

$2,269,823,968

$317,927,358

14.01%

2013

$2,331,811,395

$645,811,044

27.70%

2014

$2,459,169,641

$1,020,804,486

41.51%

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PERS & PFRS (State Portion) By Year

Annual Required Contribution (ARC)

Employer Contribution

Annual Percentage

2009

$987,328,459

$69,423,220

7.0%

2010

$1,027,127,598

$35,236,700

3.4%

2011

$1,248,974,149

$38,708,903

3.1%

2012

$1,393,658,759

$214,699,674

15.4%

2013

$1,480,741,835

$420,127,365

28.4%

2014

$1,634,551,960

$662,006,892

40.5%

PERS & PFRS (Local Portion) By Year

Annual Required Contribution (ARC)

Employer Contribution

Annual Percentage Contributed

2009

$1,436,697,603

$1,275,057,773

88.7%

2010

$1,557,111,612

$1,363,768,481

87.6%

2011

$1,912,841,824

$1,683,031,831

88.0%

2012

$1,739,632,056

$1,587,855,248

91.3%

2013

$1,710,029,897

$1,565,864,973

91.6%

2014

$1,765,666,996

$1,611,646,486

91.3%

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As a broad estimate of the funding gap for 2014, the author believes the following represents the appropriate levels of funding based upon demographically-driven amortization periods using the market value of assets. Failure to contribute the ARC increases the unfunded liability with interest. Of course, as referenced by Milliman, an assumed interest rate lower than the 7.9 percent currently in effect would serve to further increase contributions from the levels summarized in the following table. Pension Plan

Actuarially Recommended Contribution (ARC)

*Recommended Standard using Market Value of Assets and Reduced Amortization Periods

Expected Contribution

TPAF

$2.459B

$3.248B

$1.020B

PERS - State

$1.192B

$1.823B

$.484B

PERS -Local

$.925B

$1.611B

$.835B

Total - PERS

$2.117B

$3.434B

$1.319B

PFRS - State

$.443B

$.450B

$.178B

PFRS - Local

$.841B

$1.619B

$.777B

Total PFRS

$1.284B

$2.069B

$.955B

Total TPAF, $5.860B $8.751B PERS & PFRS *Author’s estimate using projected unit credit cost method

$3.294B

In summary, state and local taxpayers would need to contribute an additional $2.6B and $5.5B to satisfy the basic ARC and optimal funding levels respectively. Of note, the reform provisions also required the creation of a new pension committee with significant powers to review benefit levels, including possible enhancements, once an interim funding target is achieved based upon the following criteria: 17

The Target Funded Ratio (TFR) is defined as the ratio of the Actuarial Value of Assets to the Actuarially Accrued Liability and equals 75% for fiscal year 2012 (June 30, 2010 actuarial valuation) increasing to 80% in equal increments over the following 7 years. However, upon attainment of the Target Funded Ratio (TFR), a new pension committee will be formed to review possible changes to member contributions, retirement benefits including eligibility conditions, and with priority consideration, reactivation of pension adjustment benefits. The committee may modify the basis for the calculation of the adjustment and set the duration and extent of the reactivation. No decision of the committee will be implemented if the system’s funded ratio falls below the TFR in any projected valuation period during the 30 years following implementation. For purposes of Chapter 78, P.L. 2011, the “target funded ratio” is 75.714% and 76.428% for June 30, 2011 and June 30, 2012 respectively. Based upon the most recent actuarial valuations, the plans remain short of this threshold. These “target funded ratios” are effectively interim short-term funding goals. They should be viewed as directionally correct although still significantly short of a desired 100% funding goal. One should also appreciate these ratios are based upon (1) the underlying assumptions including a 7.9% expected annual return on assets and (2) actuarial methods (the projected unit credit cost method and the actuarial value of assets based upon a rolling five year average value). Both of these are “unconservative” approaches serving to artificially inflate funded ratios. Should any interim funding progress be achieved against these short-term targets, it will trigger the establishment of this new oversight group, no doubt replete with political dimensions and risks to taxpayers. The existence of such a committee will maintain the political forces within the pension system and create significant unpredictable headwinds against any reform efforts seeking to reduce the unfunded liabilities. It is likely any funding progress may be redirected towards enhancing future benefits, retroactively increasing benefits or (re)deferring costs deemed to be unaffordable. Conclusion To achieve financial sustainability, NJ first needs annually updated long-term forecasts of employer pension contributions and unfunded liabilities by plan. This should be illustrated under various scenarios. For a plan to achieve comprehensive and sustainable reforms there must be a series of plan design actions which should include but not be limited to increasing employee contributions, modifying normal and early retirement ages and otherwise reducing future benefits. This action needs to be accompanied by the equally important funding reforms beginning with contributing 100 percent of the ARC based upon realistic funding assumptions and methods using demographically-driven amortization periods. Funding reforms and plan design reforms should not be decoupled. The 2010 and 2011 changes addressed some plan design reforms but were mitigated by a (re)deferral and continued underfunding, albeit an improvement over certain failed policies of the past. However, these incremental measures will not prove to be sufficient to alleviate the shortcomings of the past and will prove to be of little solace to future taxpayers. 18

Absent these additional reforms these pension plans will remain unsustainable with the only question being by how much and when insolvency will occur. Properly funding pension plans is not a matter of convenience as this requires a prioritization of expenditures and/or new revenues. Failed strategies such as pension obligation bonds (using borrowed funds to reduce pension deficits) have also played out in New Jersey as well in other states. The reality is these plans must be better funded now which will quickly invite a political debate involving what taxes will be raised and/or which favored program(s) will be trimmed – all in an election year. The reality is proper funding a pension plan has a low political rate-of-return. With the SEC, GASB, Milliman, Moody’s and other entities all expressing various degrees of concerns, one hopes this would create an incentive to adopt comprehensive reforms. Absent this the current net out-migration of residents together with an unfavorable economic climate and mounting pension debt does not bode well as an incentive to live, work and invest in NJ.

NOTES i

http://www.state.nj.us/benefitsreview/final_report.pdf, p. 10 http://www.northjersey.com/news/state/BUDGETBUSTERS0213.html iii http://www.state.nj.us/benefitsreview/final_report.pdf , p. 51 iv http://www.state.nj.us/benefitsreview/final_report.pdf , p. 21 v http://www.statebudgetcrisis.org/wpcms/wp-content/images/2012-10-22-New-Jersey-Report-Final.pdf p.11 vi http://kelloggfinance.wordpress.com/2010/03/22/the-day-of-reckoning-for-state-pension-plans/ vii http://www.nj.gov/treasury/pensions/pdf/financial/2012tpaf.pdf viii http://www.nj.gov/treasury/pensions/pdf/financial/2012pers.pdf ix http://www.nj.gov/treasury/pensions/pdf/financial/2012pfrs.pdf x http://www.nj.gov/treasury/pensions/96boards.shtml xi http://www.nj.gov/treasury/pensions/pdf/financial/2012pers.pdf , p. 4 xii http://www.nj.gov/treasury/pensions/pdf/financial/2012pers.pdf , p. 5 xiii http://www.nj.gov/treasury/pensions/pdf/financial/2012pers.pdf , p. 5 ii

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ABOUT THE AUTHOR Richard C. Dreyfuss is an actuary and business consultant. He worked for The Hershey Company (formerly Hershey Foods Corporation) for 21 years, and held numerous positions there, including director of compensation and benefits, prior to his retirement in 2002. He was also involved in the establishment of the Pennsylvania Health Care Cost Containment Council in 1986 and was its chair in 2001-02. He is currently a Senior Fellow with The Manhattan Institute and The Commonwealth Foundation. He is also an adjunct scholar with The Mackinac Center for Public Policy. Dreyfuss is a pension and health care expert who has written extensively and testified before Congress and state legislatures on strategies to effectively manage long-term employee benefit liabilities. He has authored policy studies analyzing the underlying causes and specific reforms required to achieve comprehensive and sustainable reform. He has written extensively on public pension reform and his work has been referenced by national publications including The Wall Street Journal, The New York Times and Reuters. He has been interviewed on many radio and TV broadcasts including the Fox News Network. Rick holds a B.A. in mathematics and economics from Connecticut College and an M.A. in actuarial science from Northeastern University. Also contributing in critical areas of the study - Steven Malanga. Steven Malanga is City Journal's senior editor, a Manhattan Institute senior fellow, and a RealClearMarkets.com columnist. He is author of the recently published Shakedown: The Continuing Conspiracy Against the American Taxpayer, about the bankrupting of state and local governments by a new political powerhouse led by public-sector unions. He writes about the intersection of urban economies, business communities, and public policy. He was recently cited as one of Governor Chris Christie's intellectual influences (BusinessWeek, August 2010).

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