Reforms Needed for North Carolina’s Ailing Pension System

Headlines across the nation have been sounding the alarm about state government pensions. Even very conservative estimates place the total amount of unfunded state pension liabilities to be approaching a trillion dollars nationally. For the last several years, however, North Carolinians have been assured that North Carolina’s pension system is among the strongest in the nation. But these days that would be akin to saying you are in the nicest suite in the Titanic. Everything is relative.

While North Carolina’s pension system for retired teachers and state employees is not as far underwater as those of say California or Illinois, there is still cause for concern.

• As of 2010, the state’s primary pension plan had accumulated $2.8 billion in unfunded liabilities.
• Annual taxpayer support for the pension plan is estimated to total more than $800 million this year, and grow past the $1 billion mark in the next five years.
• The average state pension payout to North Carolina state retirees is 66 percent higher than the national average retirement income for former private sector workers.
• Only about 20 percent of private sector workers have access to the same type of retirement plan that North Carolina government workers enjoy.
• Tens of thousands of additional retirees will begin to draw pension benefits in the next decade, and they will be living longer.

In numerous measurable ways, North Carolina’s pension benefits are more generous than those offered in the private sector and most other states. Financial and demographic trends point toward rapidly increasing obligations in the near- and long-term future. Sensible reforms that bring North Carolina’s pension benefits more on par with those of other states and the private sector are needed to avoid a massive taxpayer bailout of the pension fund.

Introduction

North Carolina’s primary state employee pension system is the Teachers’ and State Employees’ Retirement System (TSERS). Most full-time state employees, including teachers, are automatically enrolled in TSERS when they are hired.  The pension plan includes roughly 427,000 active members and 164,000 retirees.[1]

TSERS is funded from contributions from current employees, the state (i.e. taxpayer dollars, receipts from state programs) and investment income from the pension fund. Currently, state employees contribute 6 percent of their salary into the pension fund, while the state contribution varies according to an annual rate set by state budget writers.[2] Budget writers are guided by actuarial recommendations as to how much the state should contribute to ensure the pension fund is fully funded – but it is up to their discretion as to what rate to set every year. For the FY 2012-13, the state contribution to TSERS is set at 8.33 percent of state payroll – which equates to about $811 million[3] for General Fund supported positions.

Eligibility and Benefits for Retirees

North Carolina’s state pension plan is a “defined-benefit” plan – meaning that retirees are promised a set amount of benefits upon retirement. In the case of TSERS, that benefit comes in the form of a monthly payment for the rest of their life.

The payment due to retirees is calculated using a set multiplier (1.82 percent) times the average of the four highest paid consecutive years during the employees career with the state; then multiplied by the number years of service. For example, someone whose four highest paid consecutive years of service averaged $50,000 would multiply that by 1.82% (50,000 x .0182 = 910) and multiply that by years service, say 32, and get the annual payment (910 x 32 = $29,120) of $29,120. That payment can be adjusted in future years if state budget writers insert a cost-of-living adjustment (COLA) in the budget.

To be eligible for this full benefit payment, state employees have to meet certain age and/or service requirements, which include:

• 30 years of service at any age
• Age 65 with five years of service (or ten years of service for employees hired after August 1, 2011)
• Age 60 with 25 years service

State employees can also become eligible for partial pension benefits upon retirement. To be eligible for partial benefits, employees need to meet one of the following requirements:

• Age 50 with 20 years of service
• Age 60 with five years of service (or 10 years of service for employees hired on or after August 1, 2011)

Partial retirement benefits are calculated in the same manner as full benefits, except they are reduced by a percentage determined by the retirees’ age and years of service.[4]

Pension Plan Obligations Quickly Becoming Unsustainable

In spite of North Carolina’s pension fund being rated among the best in the country,[5] problems persist and will continue to grow if left unchecked.

Unfunded Liabilities

Due in large part to significant drops in value of the pension’s investment fund; the TSERS fund fell below the fully-funded ratio by the end of 2008.[6] At that point, the funding ratio had dropped from 106.5 percent from just three years prior. By the end of 2010 (the most recent data available) that ratio had fallen to 95.4 percent. The 11 percentage-point drop in the funding ratio marked a $5.8 billion swing in the liability of the pension fund in just five years. At the end of 2005 the fund had $3 billion in extra assets above and beyond calculated pension obligations. By 2010 that surplus had disappeared, and instead grew to a $2.8 billion unfunded liability of promised pension benefits for state retirees.

Growing unfunded liabilities mean an increasing burden on taxpayers to bail out the pension fund. Projections from the state treasurer’s office show by FY 2017-18 contributions need to grow to 11.04 percent of payroll to get the pension fund back to fully funded status, even assuming no payroll growth during that time (a highly unlikely scenario).[7] Such a hike would represent an increase of the annual state contribution to $1.08 billion – an alarming 33 percent growth in 5 years.

The rapidly expanding pension obligations will crowd out other spending priorities in the state budget, and put greater pressure on lawmakers to raise taxes to make up the difference.

Aging Workforce Puts Greater Pressure on Pension System

The average age of a North Carolina state employee in 1987 was 36. By 2008 that number had climbed to about 45.[8]

There are more than 67,000 active members of the pension system between the ages of 55 and 64.[9]  Some of those may already be retired and receiving benefits, but most likely are not. This number represents a sizeable influx of retirees over the next decade that will put a considerable strain on the pension system’s ability to pay out all of the benefits promised to state retirees.

Lastly, people are living longer, which means state retirees have more years to collect benefits. For instance, in 1973 when North Carolina’s pension system changed one of its eligibility requirements to allow for an employee to become eligible for full benefits after 30 years of service, regardless of age, a person aged 65 could expect to live another 15.5 years. By 2010, that expectancy had grown to 18.5 years – a 19 percent increase in expected pension payouts.[10]

Generous Benefits Compared to Private Sector

In several ways, the pension benefits offered to state employees in the current system are more generous than those in the private sector. Such generosity may help secure political support from state employee groups, but puts added pressure on taxpayers and helps force the pension fund down an unsustainable path.

• The average annual public pension payout to North Carolina state retirees is $22,000.[11] By comparison, the national average annual income from private sector pensions and annuities is $13,222; a difference of 66 percent.[12]
• Annual pension benefit payments to state retirees in North Carolina’s TSERS program equals approximately 54 percent of the worker’s annual final compensation, for those with 30 years of service.[13] For a comparison of similar pension benefits in the private sector, a study by the Social Security Administration found an average replacement rate of 47 percent for private sector retirees age 65 with 35 years of service.[14] In other words, even at a higher age and with more years of service, private sector defined benefit pension payments were less generous than the payouts for North Carolina state retirees.
• Given the previous two bullet points, it is unsurprising that the method by which the pension benefits for North Carolina state retirees is calculated is likewise more generous than the private sector. The 1.82 percent “multiplier” is higher than the 1.48 percent average for private-sector defined-benefit plans.[15] Further, North Carolina’s use of the highest consecutive four years of compensation as the “average final compensation” is more generous than the most prevalently used number in the private sector, which is the highest consecutive five years of compensation.[16] It is somewhat easier to “spike” that average final compensation when spread out over only four years compared to five.
• The “30 and out” eligibility provision that enables state retirees to receive full pension benefits after 30 years of service regardless of age is a service requirement offered to only 2 percent of workers enrolled in private-sector defined-benefit plans.[17]

State Pension Reform Sweeping the Country

Massive unfunded liabilities for state pension programs have reached crisis levels. The Pew Center on the States reports a $757 billion gap between promised pension benefits and assets currently available to cover those liabilities.[18]

Some analysts, however, credibly argue that this figure drastically understates the true size of the problem.[19]

The alarming state pension crisis has prompted a majority of states to take action to address their massive liabilities.  According to a National Conference of State Legislators report, “41 states enacted significant revisions to at least one state retirement plan in 2010 or 2011.”[20]

North Carolina was included in this list, but enacted only a very minor change. The state increased to 10 years from five the number of years service for retirees age 65 (for full benefits) or age 60 (for reduced benefits) for employees hired on or after August 1, 2011. Although a step in the right direction to curb the growing pension liability, the change is projected save only about $1 million annually going forward in the next several years.[21]

North Carolina needs true pension reform. Below are several pension reforms that North Carolina state lawmakers should  consider in order to secure the long-term viability of state retiree benefits and save taxpayers billions over the next decades.

Convert From a Defined Benefit Plan to a Defined Contribution Plan

North Carolina’s TSERS pension fund is a defined-benefit plan, in which contributions are made by both employees and taxpayers into the fund while the employer is working. Employees are in turn promised an annual benefit when they retire (based on the methodology previously described in this article).

This system has proven to be unsustainable, especially given the generous benefit amounts promised to state workers.

North Carolina should enact a policy whereby new hires are instead enrolled in a 401(k) defined-contribution plan. This type of plan will empower the employees to manage their own retirement accounts, and no longer expose taxpayers to the risk of unfunded pension liabilities.

Currently, four states offer only a defined contribution retirement plan for employees, while six others offer new employees a choice between a defined benefit and defined contribution plan.[22] Moreover, Louisiana just passed legislation moving new hires to a 401(k)-style plan, and Pennsylvania is considering similar legislation.

Government workers are in the minority when it comes to access to defined-benefit pension plans. In the private sector, only 20 percent of workers have access to defined-benefit plans.[23] By comparison, 84 percent of state workers have access.

Features of a 401(k) retirement savings plan for new North Carolina state government employees would include:

• Defined contribution plan, employee can manage investment options
• Employee can choose level of contribution
• State contribution to be set at 5 percent of compensation
  • This rate compares favorably to the 3.5 percent median employer contribution of large (500-plus employees) private companies for defined contribution plans.[24]
  • The rate is in line with the most commonly-used employer contribution rate of 5 percent for North Carolina counties and municipalities that offer 401(k) retirement programs.[25]
  • The rate is lower than the roughly calculated 6.77 percent average state contribution rate over the last 30 years in the TSERS system,[26] and significantly lower than the current and projected state contribution rates.[27] The result is significant taxpayer savings.
• Employees become vested in the state contribution share after five years service.

North Carolina already offers state and local government employees an optional, supplemental 401(k) plan. The plan has nearly 225,000 members, and has roughly $5.5 billion in assets.[28] Thus, the management and administrative infrastructure already exists for a 401(k) fund, making the transition much easier.

Rough Estimate of Savings

Over the long-term, cost savings to taxpayers from this transition will be substantial. For state employees on a 401(k) retirement plan, there is no unfunded liability. For instance, a research paper suggests that the state of Michigan’s measure to enroll state employees hired after March 1997 into a 401(k) plan has spared the state from $3.3 billion in unfunded liabilities today.[29]

Looking at the more immediate term, we can roughly estimate ballpark cost savings of placing new state government hires into a defined contribution plan versus a defined benefit pension plan. Using an average annual turnover rate including only retirement and voluntary leaves over the last five years of 10.3 percent,[30]  we assume 427,000 (number of currently active TSERS members) times 10.3 percent to get just under 44,000 TSERS-eligible state positions to be replaced. Of this number, roughly 70 percent are General Fund supported positions, leaving about 30,800 open slots. Even if the state only replaced 90 percent of those positions, that amounts to about 27,700 new hires annually.

From here, we can compare the costs in taxpayer contributions for the new hires’ retirement plans.

We can roughly estimate the total payroll for the new hires by multiplying the 27,700 new hires by the average salary of a state employee with 1-4 years experience of $34,277.[31] Under the current defined benefit system, the state contribution would be 8.33 percent of the total payroll of the new hires. Under the proposed 401(k) plan, the state contribution would be 5 percent. This difference translates into a first-year taxpayer savings of approximately $31.6 million. These savings will rapidly accrue over time as more and more new hires are added every year.

Immediate Changes to the Current Defined Benefit System

Enrolling all new state employees into a defined contribution plan will yield its greatest results over the long-term. North Carolina, however, is facing funding challenges to its pension fund now – challenges that will not go away as the state tries to pay for the accrued benefits promised to state workers enrolled in the defined benefits plan. For the workers enrolled in the defined benefit system, some sensible reforms to the benefits will be necessary to head off the threats it poses to the state’s budget and taxpayers.

The majority of states have enacted such reforms in the last three years, and North Carolina would be well advised to follow their lead. Recommended reforms to the current TSERS pension program include:

• Ending the “30 and out” policy: North Carolina allows state workers to retire with full pension benefits after 30 years, regardless of age. Thus, someone could start working for the state at age 22, and retire at age 52 with full pension payments for life. North Carolina implemented this policy in 1973, when life expectancies were considerably shorter.
  • North Carolina is one of only six states offering a “30 (or fewer years) and out” provision for full pension benefits. According to the National Conference of State Legislators, 24 major state pension plans increased their service requirements for full pension benefits in the last couple of years.[32]
  • To be eligible for partial benefits, raise the minimum age from 50 to 55 (with 20 years service). Only six states offer pension plans with partial benefits beginning at age 50, with fewer than 20 years service.[33]
• Decrease the “multiplier” of 1.82 percent used to calculate pension payment amounts for retirees. As mentioned previously, this rate is significantly higher than the average rate used in the private sector, resulting in much more generous annual pension payments. Since 2009, ten major state-based employee pension systems lowered the multiplier number for calculating retirement payments.[34]
  • The state should also offer a choice of a higher employee contribution rate to workers wishing to keep the 1.82 percent multiplier figure.
• Effort to reduce salary “spiking.” Currently, North Carolina allows state retirees to calculate pension benefits based on an average of the four highest consecutive annual salaries. Instead, the state should adopt the “high five” method of using the five highest consecutive salaries as a basis for pension calculation – the most widely used method of calculation for defined benefit pension plans in the private sector.[35]  At least nine major state pension plans in the last three years have approved measures to reduce salary “spiking.”[36]