Public pension costs in New York are mushrooming—just when taxpayers can least afford it. Over the next five years, tax-funded annual contributions to the New York State Teachers’ Retirement System (NYSTRS) will more than quadruple, while contributions to the New York State and Local Retirement System (NYSLRS) will more than double, according to estimates presented in this report. New York City’s budgeted pension costs, which already have increased tenfold in the past decade, will rise by at least 20 percent more in the next three years, according to the city’s financial plan projections.
NYSTRS and NYSLRS are “fully funded” by government actuarial standards, but we estimate they have combined funding shortfalls of $120 billion when their liabilities are measured using private-sector accounting rules. Based on a similar alternative standard, New York City’s pension funds had unfunded liabilities of $76 billion as of mid-2008—before their net asset values plunged in the wake of the financial crisis.
The run-up in pension costs threatens to divert scarce resources from essential public services during a time of extreme fiscal and economic stress for every level of government. New York needs to enact fundamental pension reform to permanently eliminate the risks and unpredictability inherent in the traditional pension system.
In November 2003, the Manhattan Institute for Policy Research issued a report de-scribing New York State’s public pension system as “a ticking fiscal time bomb.”
The bomb is now exploding—and New Yorkers will be coping with the fallout for years to come.
New York’s state and local taxpayers support three public pension funds encom-passing eight different retirement systems—five covering different groups of New York City employees, and three covering employees of the state, local governments, school districts and public authorities outside the city. Between 2007 and 2009, these funds lost a collective total of more than $109 billion, or 29 percent of their combined assets. Two of the three funds ended their 2010 fiscal years with asset values below fiscal 2000 levels; the third has barely grown in the past decade.
Meanwhile, the number of pension fund retirees and other beneficiaries has risen 20 percent and total pension benefit payments have doubled in the past 10 years. Tax-payers will now have to make up for the resulting pension fund shortfalls.
This report forecasts pension funding trends for the New York State and Local Re-tirement Systems (NYSLRS) and the New York State Teachers Retirement System (NYSTRS), which cover nearly every public employee outside New York City. It also summarizes official reports of funded status and projected costs over the next three years for the New York City Retirement Systems. Assuming the pension systems all hit their rate-of-return targets:
Taxpayer contributions to NYSTRS could more than quadruple, rising from about $900 million as of 2010-11 to about $4.5 billion by 2015-16. The projected increase is equivalent to 18 percent of current school property tax levies.
State and local employer contributions to NYSLRS will more than double over the next five years, adding nearly $4 billion to annual taxpayer costs even if most opt to convert a portion of their higher pension bills into IOUs that won’t be paid off until the 2020s.
New York City’s budgeted pension contributions, which already have in-creased by more than 500 percent ($5.8 billion) in the last decade, are projected to increase at least 20 percent more, or $1.4 billion, in the next three years.
Pension costs would be even higher if New York’s state and local retirement funds were not calculating pension contributions based on permissive government ac-counting standards, which allow them to understate their true liabilities.
While New York’s two state pension systems officially are deemed “fully funded,” we estimate that NYSLRS is $71 billion short of what it will need to fund its pension obligations, and that NYSTRS has a funding shortfall of $49 billion, based on valua-tion standards applied to corporate pension funds.
New York City’s pension systems are not as flush as NYSLRS and NYSTRS, which is the main reason why the city spends more for pension contributions than all of the state’s other public employers combined. The official “funded ratios” for the five city retirement systems ranged from 56 percent to 80 percent as of June 30, 2008. This would indicate they were $42 billion below fully funded status before the financial market meltdown wiped out more than 20 percent of their net assets. However, the city actuary also has computed alternative measures of funded status based on the kind of more conservative assumptions used in the private sector. These measures show the city’s pension system was underfunded by $76 billion in 2008.
The shortfalls in the city systems undoubtedly have grown much larger in the last two years, but the full dimensions of the problem won’t be known until the pension plans issue their financial reports for fiscal 2010.
The need for reform
The record-breaking investment returns of the 1980s and ‘90s lulled New York’s elected leaders into a false sense of complacency. State and local payrolls were ex-panded and retirement benefits were enhanced under the assumption that pension costs would remain near historic lows. The downturn of 2000-03 and its impact on pension costs should have come as a wake-up call to state officials. Instead, they responded with pension funding gimmicks and minimal “reforms.”
In the short run, assuming the state Constitution is interpreted as allowing no change in benefits for current workers, there is no financially responsible way to avoid the coming increases in pensions costs. However, state and local officials in New York can seek to contain the damage by reducing headcount where appropri-ate, and by exploring ways of saving money on employee compensation, including wage increases and health insurance benefits. A statewide public-sector salary freeze—which the Legislature has the power to impose, according to a legal analysis commissioned by the Empire Center1 —could help minimize the extent to which ris-ing pension costs force service cutbacks, layoffs or tax hikes. But these will just be bandages covering a more fundamental problem.
The lesson is clear: the traditional pension system exposes taxpayers to intolerable levels of financial risk and volatility. New York’s existing defined-benefit (DB) public pension plans need to be closed to new members, once and for all. They should be replaced either by defined-contribution (DC) plans modeled on the 401(k) accounts that most private workers rely for their own retirement, or by “hybrid” plans, combining elements of DB and DC plans, that cap benefits and require employees to share in some of the financial risks of retirement planning.
This is not just a matter of financial necessity but of basic fairness to current and future taxpayers—the vast majority of whom will never receive anything approaching the costly, guaranteed benefits available to public employees.
1. PENSION FUNDING TRENDS
New York’s 1.3 million state and local government employees belong to defined-benefit (DB) pension plans, which guarantee a stream of post-retirement income based on peak average salaries and career duration. Pension (and disability) benefits are financed by large investment pools, which in turn are replenished by tax-funded employer contributions. Some public employees, depending on their hiring date and “tier” membership, also contribute a small share of their own salaries to pension funds (see Appendix).
While employee contributions (where required) are fixed or capped, contributions by employers fluctuate, based on actuarial assumptions. The rate of return on pension fund assets is the key determinant of pension costs to taxpayers. Since the mid-1980s, when pension funds began allocating more of their assets to stock investments, those rate of return assumptions have ranged from 7.5 percent to 8.75 percent; for most of the last 10 years, New York’s public pension plans have assumed their investments would yield an average annual return of 8 percent.
During the historic bull market of the 1980s and ‘90s, investment gains easily ex-ceeded expectations, averaging in the double digits. The result, as shown in Figure 1: tax-funded employer contributions tumbled in the three state pension plans covering employees outside New York City. By 2000, employer contribution rates for members of these plans essentially had dropped to zero.2
Government workers shared in the market windfall. The state Legislature repeatedly increased pension benefits for targeted groups of employees during the 1990s. Those enhancements were topped off in 2000 by the state Legislature’s approval of cost-of-living adjustments in all public pensions, automatic partial indexing to inflation of future pension payments, and the permanent elimination of employee contributions for Tier 3 and 4 retirement system members who had been on the payroll for at least 10 years.3 Lawmakers essentially sold these changes to the public as a free lunch, assuming the stock market boom would continue indefinitely.
In fact, as elected officials should have recognized, the minimal employer contribu-tion rates of 1990s were a historical anomaly. “Normal” contribution rates—assuming a hypothetical steady state of asset returns meeting investment targets—would have ranged from 11 to 12 percent for most non-uniformed state and local employees, including teachers, to nearly 20 percent for most police and firefighters in NYSLRS.
The decade that followed the enactment of the major pension sweeteners was characterized by extremely volatile—and ultimately stagnant—investment returns. Asset values dropped sharply between 2000 and 2002, recovered over the next five years, and then dropped sharply after 2007.
Despite the recent stock market recovery, the net assets of the New York City pen-sion funds and the New York State Teachers’ Retirement System (NYSTRS) as of 2010 were still below 2000 levels, while the net assets of the New York State and Local Retirement System (NYSLRS) were up just 4 percent on the decade.* Meanwhile, total benefit payments doubled between 2000 and 2010. The year-by-year trends for the period are shown in Figure 2.
* NYSLERS includes both the State and Local Employee Retirement System and the Police and Fire Retirement System.
The combination of falling asset prices and rising benefit outlays meant the pension funds were developing huge shortfalls. Meanwhile, employee contributions into the state pension funds actually decreased during this period, as a growing number of Tier 3 and 4 members reached the 10-year seniority mark.4 Taxpayers were left to pick up the slack, as shown in Figure 3. In 2000, tax-funded employer contributions to New York’s pension funds totaled just under $1 billion. By 2010, they had risen to a combined $17.3 billion for the state and New York City systems.
But this was just the beginning of the pension explosion.
2. THE WRONG KIND OF “BOOM”
How hard will taxpayers be hit by New York’s coming pension explosion? To an-swer that question, we have projected employer contribution rates for NYSLRS and NYSTRS for each of the next five years. These projections are based on assumptions about future events, particularly the performance of fund assets, but also growth in employee headcount and salaries.
These projections represent our best effort to replicate the funds’ contribution rate calculations under the Aggregate Funding Method used by the pension system actuaries. Because the funds do not make public their expected streams of future cash flows, we must make assumptions about the path of changes in certain figures that form a part of those calculations, particularly the present value of the salaries that currently active employees are expected to earn. However, we believe that these projections represent a good estimate based on publicly available data, and can provide state and local governments with useful guidance about the path of pension costs in future years.
We projected contributions in three scenarios: “Base,” in which the pension systems hit their current investment targets (7.5 percent for NYSLRS, 8.0 percent for NYSTRS); “High Returns,” defined as 11 percent per year; and “Low Returns,” de-fined as 5 percent per year. We also estimated tax-funded contributions to NYSLRS over the next five years assuming that local employers opt to join the state in cap-ping pension contributions and amortizing excess amounts for a 10-year period.
Pension “mitigation”: Cap and owe
Under a new law backed by Comptroller Thomas DiNapoli and approved as part of the 2011-12 state budget,5 the state government’s fiscal 2010-11 pension contribution rates will be capped at “graded rates” of 9.5 percent for the ERS members and 17.5 percent for PFRS members, instead of the billed rates of 11.9 percent and 18.2 percent, respectively.
Starting in fiscal 2011-12, the contribution rates used to calculate the state’s pension bill will be allowed to increase by only one percentage point a year, starting at this year’s capped level. Billed contributions above that amount in any given year can be spread, or amortized, over 10 years, payable to the pension fund at a rate pegged to interest on taxable bonds, generally in the neighborhood of 5 percent. As part of the deal, the minimum contribution level is permanently fixed at 4 percent. Local governments have been given the option of joining this “rate mitigation program,” and many are already choosing to do so.
Delayed payments will be counted as liabilities on employer balance sheets, and as receivable “assets” of the pension fund. The comptroller has strongly taken issue with any suggestion that this program is tantamount to borrowing from the pension fund. Semantics aside, however, there is no denying that the cap on pension payments simply transfers liabilities into the future—well into the 2020s, at a minimum. Assuming all local government employers amortize a portion of what they will owe the pension fund, and assuming the funds’ asset returns hit their 7.5 percent target, we estimate a total of $11 billion in state and local pension payments will be deferred over the next five years—stretching these costs into the middle of the next decade.
It is possible that stronger-than-expected market performance will bail out state and local governments and blunt the coming spike in contribution rates. Indeed, projections created by the comptroller’s office in support of the original amortization proposal in 2009 assumed that investment returns would match those from 1989 to 2008, not averaged but on a year-to-year basis. If the stock market boom of the 1990s is repeated, the deferred amortization payments will be repaid in relatively short order. But it is equally possible that investment returns will fall below the 7.5 percent target over the next decade, and that the path of contribution rates will be worse than projected in the “Base” scenario projected in Table 1. State and local governments will need to prepare for this possibility rather than simply hoping for strong returns.
In any event, even employers choosing to amortize will experience a doubling of ERS contributions and a near doubling in total PFRS contributions over the next five years. If asset returns are high enough to drive down rates quickly after a few years, those employers will continue paying higher rates for a longer period. School dis-tricts paying into the NYSTRS, which has no amortization option, will see their con-tributions quadruple even under our rosiest scenario for asset returns over the next five years.
The impact of the projected base rates on total contribution amounts is depicted in Figure 4. The $3.6 billion rise in teacher pension contributions (from about $900 mil-lion in 2010-11 to $4.5 billion in 2015-16) equates to 18 percent of 2010-11 school tax levies, or an average increase of nearly 3.5 percent a year. This is well above the annual property tax growth that would be allowed under a 2 percent tax cap proposed by Governor-elect Andrew Cuomo.
The Big Apple’s bomb
Virtually all New York City employees (and some employees of the city Transit Au-thority) belong to one of five different municipal pension systems. The systems have different funding and contribution levels while pooling their assets in a common city pension trust fund.
The financing of these pension plans is arcane and complex compared to those of NYSLRS and NYSTRS. Crucial pension fund financial data for the 2009 and 2010 fiscal years has not yet been published, and the city Office of Management and Budget (OMB) uses an opaque process to generate the city’s official pension cost estimates.
The city’s pension contribution averaged about $1.4 billion during the late 1990s and dipped as low as $615 million in 2000. By 2010, the contribution had risen to an all-time high of $6.6 billion—and it’s still climbing. OMB’s official financial plan estimates of pension obligations are depicted in Figure 5.
These figures, which show the pension contribution growing from $7 billion in 2011 to $8.4 billion in fiscal 2014, reflect changes made by OMB in its November budget modifications in anticipation of a forthcoming revision of actuarial assumptions. Given the steep losses sustained by city pension funds in 2007-2009 (as shown in Figure 2 on page 4) and the underfunded status of the pension plans even before the downturn, the pension contribution is likely to grow significantly after fiscal 2014.
Measuring pension fund assets and liabilities
Parties obligated to pay an amount at some future date need to know the size of that obligation in today’s dollars, which will tell them how much money to set aside. That sum can be smaller than the principal amount due because it can earn interest until the due date. If, for example, you owe $10,000 in ten years, and your savings account offers an interest rate of 3 percent, you would need to set aside only $7,441 today. In this example, you have assessed your future obligations using a 3 percent “discount rate”—the rate at which the principal due is discounted over a given period of time to produce the loan’s net present value.
The discount rate applied to future obligations is a crucial determinant of a pension system’s necessary funding levels: the lower the rate, the larger the contributions required to maintain “fully funded” status, meaning the assets are sufficient to cover all promised pension benefits.
Private pension plans must discount liabilities based on what’s known as a “market” rate—typically, the interest paid on bonds issued by financially solid corporations. This is often much lower than the plans’ projected returns, but it reflects what the money would be earning if invested in lower-risk assets, matching the low risk tolerance of future retirees who are counting on their promised pensions.
Public funds, however, are allowed to discount their long-term liabilities based on the targeted annual rate of return on their assets—i.e., what they hope to earn from investments in a basket of assets dominated by stocks, which offer a chance of higher returns in exchange for higher risk of losses.
Until recently, all of New York’s public pension funds had pegged their target rates at 8 percent, like most other public systems around the country. In 2010, Comptroller DiNapoli, acting as sole trustee of the New York State & Local Employee Retirement System, adopted new actuarial guidelines reducing the target rate for state pension funds to 7.5 percent, along with other changes in actuarial assumptions concerning career duration, salaries and life expectancy. These are all factored into the system’s employer contribution rates going forward. The New York State Teachers’ Retirement System (overseen by a separate board of trustees) and the New York City pension funds will also be considering changes to their rate of return assumptions in 2011.
While most public pension managers continue to resist the idea, many independent actuaries and financial economists agree that the net present value of risk-free public pension promises should be calculated on the basis of low-risk market interest rates. Using this approach, for example, Andrew Biggs of the American Enterprise Institute has estimated that state pensions across the country are underfunded by $3 trillion, or six times the officially reported under-funding estimates as of 2008.6 This estimate doesn't even take into account the impact of the 2008 market downturn on pension fund asset values.
Indeed, sharp drops in asset values cause pension plans' financial statements to become even more misleading. When a pension plan underperforms its targeted in-vestment returns, it does not recognize the loss immediately; instead, it “smooths" recognition of the loss over a period of years, usually five. This means that most pension plans will not have fully recognized the stock market declines of 2008 and 2009 until 2014. For example, while ERS held assets with a market value of $94 billion as of March 31, 2009, it reported an actuarial asset value of $126 billion on that date—and that $126 billion figure underpins the plan's claim that it is 101 percent funded.
In this report, we also present “market value” funding data for New York’s state and local pension funds, in addition to the more-commonly discussed actuarial funding basis. For the statewide pension funds, we calculated our market value funding calculations by using the most recent available data on market value of assets from the funds’ Comprehensive Annual Financial Reports. In the case of NYSLRS, the data are for March 31, 2009; for NYSTRS, the data are current as of June 30, 2009.7
We also adjusted the estimated pension liabilities to a “market value liability” calculation by using a discount rate based on high-quality corporate bonds, provided by Mercer Consulting as of September 2010. As is the standard practice for public sector pension funds, these funds’ actuarial liabilities are calculated by discounting future payments to a present value using discount rate equal to the funds’ expected rate of return: 7.5 percent for ERS and PFRS, and 8 percent for TRS. Our adjusted discount rate is approximately 5 percent, varying slightly depending on the funds’ mix of active and retired participants. This lower discount rate reflects the typical practice for private-sector pension plans, with a discount rate based on the risk experienced by pension beneficiaries.
For the New York City pension systems, market valuation measures are already in-cluded in official financial reports, so we simply reproduce those along with our estimates for the state funds, based on their latest published financial data, in Table 2. It should be noted that the city’s actuarial and market-based data in the table are for fiscal 2008, and do not reflect the fund’s losses in 2009.
The New York City Fire Pension Fund is financially the weakest of the eight public pension funds in New York State. Measured on an official actuarial basis, the Fire Pension Fund had only 56 percent of the assets needed to meet its liabilities as of June 30, 2008; using a market rate standard, its funded ratio was only 41 percent on the same date. Given the city funds’ investment losses, the fire fund’s condition has undoubtedly deteriorated in the past two years.
As of their reporting dates in 2009 (March 31 for New York State ERS and PFRS, and June 30 for NYSTRS), each of the state systems reported an actuarial funding ratio of slightly more than 100 percent. But recalculating these figures on a market value basis shows a much worse funding situation: TRS was just 60 percent funded, PFRS 58 percent, and ERS 56 percent. The discrepancy has two sources: sharp stock market declines in late 2008 and early 2009 meant that the market value of these plans' assets was far below their actuarial value. And changing to a market value discount rate significantly increases the plans' measured liabilities.
Updated liability estimates
In the year following the last official actuarial reporting date, asset values rebounded somewhat. We estimate the New York State ERS and PFRS were 65 percent and 69 percent funded, respectively, using a market rate standard as of March 31, 2010. The market-rate unfunded liabilities for these two systems came to $71 billion, including $61.8 billion for ERS and $9.5 billion for PFRS, according to our calculations. NYSTRS was approximately 61 percent funded as of June 30, 2010, with a shortfall of $49.2 billion. Thus, the combined shortfall for the two systems came to $120 billion, while the official estimate of the shortfall in the city funds, measured on a market basis, came to $76 billion as of June 30, 2008.