| November 1, 2010

How to Defuse Oklahoma's Pension Bomb

Last month in these pages (“The Coming Explosion of Oklahoma’s Pension Bomb”), I outlined the significant problems in Oklahoma’s two largest pension systems, the Oklahoma Teachers Retirement System (OTRS) and the Oklahoma Public Employees Retirement System (OPERS). I also said there are ways not only to eliminate the debt but also to reduce current state employment costs.

OCPA has developed a plan that will:

  • Pay off the debt over time without a need for an infusion of new money;
  • Free up more than $300 million immediately for state services; and
  • Promise every current member of OTRS and OPERS their full retirement plus a guaranteed 2 percent cost of living adjustment every year.

How is this possible? First, and this is the most important point, all new teachers, support personnel, and government employees will begin their employment in a defined-contribution plan instead of the defined-benefit plan that OTRS and OPERS currently use. This move will immediately begin the process of reducing liabilities to the systems, as no new members (and the accompanying liabilities) enter the old system. Without taking this essential step, nothing else will correct the funding issue.

The unions and old-guard politicians understand that they lose control when their members and voters aren’t beholden to them for retirement funds. They will resist this change even in the face of a fiscal meltdown.

Why would new teachers, support personnel, and government employees want to enter a defined-contribution system? How about more money in their paychecks immediately, complete ownership of their accounts, and a defined-contribution plan more generous than almost anywhere in private industry?

The average state worker, for example, pays 3.5 percent of his wages to OPERS, and his employing agency makes a 14.5 percent contribution. Teachers and education-support personnel on average pay 7 percent of their salary (some school districts pay it for them), and the employer pays 9 percent. (In addition, as I pointed out last month, OTRS also receives “dedicated” revenues from various taxes and from lottery proceeds.)

OCPA is proposing a defined-contribution plan that requires no matching payment by the employee.

Under the OCPA plan, the contribution made by the state to the new employees would start with 4 percent directly to a defined-contribution plan in the first year, with the amount increasing by 1 percent each year for five years after the first year of employment until the employee is receiving in his or her account a full 9 percent of payroll in employer contributions. Employees can also opt to make voluntary contributions to this account to enhance their retirement savings.

This account would be fully owned by the employee from day one, unlike the OTRS and OPERS defined-benefit plans in which the employees do not gain retirement benefits until they have been contributing to the systems for eight years in OPERS and five years in OTRS. Prior to that, if the employee leaves service all he receives is his contributions to the system and not the employer contributions or the earnings on any contributions. This lack of portability and ownership really punishes those who may have to leave service for pregnancy, family issues, or just to make a career change. Additionally, it means they do not have access to the funds for things like family medical emergencies, nor does any portion of their retirement benefits become part of their estate should they die.

Additionally, the OCPA plan would offer those who are currently in OPERS and OTRS the opportunity to “cash out” of the plan by providing a full payment of the present value of the benefits accrued to date. This would allow those who prefer to have portability and ownership of their retirement account to transfer those funds in a tax-free exchange to a defined-contribution plan. In this exchange there is an advantage to OTRS, OPERS, and ultimately to the taxpayers because lump-sum transfers will allow the state to hold the amount of debt constant and issue bonds if necessary to fund them.

The OCPA plan goes even one step further in making the defined-contribution plan attractive to potential and current employees. OCPA would suggest that the defined-contribution plan participant should have the option to leave his or her funds in the investment pool of the defined-benefit plan instead of making their own investment choices. This is a win-win for both parties. The employee gains the benefit of the professional investment management and the clout of the size of the investment pool of OTRS and OPERS, while the two systems benefit from the monies remaining in their pool and keeping their economies of scale in place as the defined-benefit plan shuts down over the life of those still in that plan. We would also encourage legislators to consider guaranteeing a rate of return near the plans’ assumed return to further incentivize the number of participants exercising the option to convert.

There may also be an opportunity to access federal funding for some of those funds that are converted. Federal regulations regarding pension liabilities typically result in states’ being “stuck” with the unfunded liabilities that accrue to retirees because of rules regarding the lag time between federally funded employees’ liabilities and the payment of those liabilities. However, by converting these liabilities to bond indebtedness the state now should be able to bill the federal government for its share of those liabilities.

We would also encourage OTRS and OPERS to merge administration and investment funds when the defined-benefit plans are closed to new employees. The investment funds would experience some additional economies of scale and the removal of bureaucratic redundancies would provide direct savings.

The conversion to the defined-contribution plan also would allow Oklahoma to stop pouring tax dollars directly into OTRS. This change would free up nearly $260 million in dedicated funding and another $40 million in reduced benefit costs in the first year of plan inception. OCPA believes this funding source should be eliminated immediately and the savings used as a funding source for eliminating the individual income tax.

Over time, the OCPA plan would also result in a significant decrease in operational costs for every school and government agency, with a corresponding reduction in employee benefit costs. This amount would grow every year as more and more employees joined the defined-contribution system. For example, if in 2009 this plan had been in place long enough to replace all employees in the defined-benefit plan with defined-contribution members, state agencies would have realized more than $150 million in operational savings. The schools would have realized more than $200 million in operational savings. (These calculations are based on 2009 covered payroll from 2009 actuarial reports for OTRS and OPERS, assuming benefit loads of 18 percent for OPERS and 14 percent for OTRS.)

During the years it takes to bring these defined-benefit plans to an end, OCPA proposes directing these savings to OTRS and OPERS. The hidden effect of this fiscally conservative approach will be a large gift to our grandchildren sometime in the future—instead of the mountain of debt the current plan guarantees them.

What about that mountain of pension debt that remains even after the voluntary conversions? How does changing to a defined-contribution system remove this burden from the shoulders of Oklahoma taxpayers?

The short answer is: it doesn’t remove it immediately. As we will show in our forthcoming Oklahoma Policy Blueprint, OCPA proposes to “cash-flow out” the debt. We estimate it will take well over 30 years using conservative projections—even longer if the pension systems’ assumptions are realized—before the benefit payments to retirees exceed the available cash flow with which to pay them.

The good news is that if one uses the rates of return of the two major pension funds, the present value of a dollar will be only approximately 15 cents by the time this occurs. During the approximately 30 more years after this “negative” cash flow point that it will take to bring the system to closure, there will be a steadily declining amount of benefit payments.

Oklahomans have a choice to make for the future of this state. Do we want to leave our grandchildren a fiscally solvent state with no pension debt and a low tax rate? Or do we choose to ignore all the warning signals and leave our problems (and higher taxes) to the coming generations?

Steve Anderson (MBA, University of Central Oklahoma) is an OCPA research fellow and a Certified Public Accountant with more than 20 years of experience in private practice. He spent two years as a budget analyst in the Oklahoma Office of State Finance, and was formerly a state-certified teacher with 17 teaching certifications.

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