In lieu of actual mandate relief, Governor Cuomo wants to make a seemingly irresistible offer to local governments. A proposal included with his 2013-14 Executive Budget would give counties, municipalities and school districts the option to (a) immediately reduce pension contribution rates by up to 43 percent, and (b) “lock in” a “stable” pension contribution rate for a 25-year period.

This would be accomplished by significantly under-funding the pension system in the short term, based on the expectation that Cuomo’s Tier 6pension plan will ultimately yield more than enough savings to make up the difference later in the 25-year period. (See Part G on page 14 of this memo for a detailed explanation.)

There are three basic problems with the idea.

1. Even under ideal, fair-weather economic and financial market conditions for as far as the eye can see, it’s likely to be a losing bet for employers — saving them less in the short term than it would cost them in the long term.
2. It weakens and increases the financial vulnerability of the pension funds in the short term, and in the long term is a big financial gamble for both their beneficiaries and their ultimate underwriters, New York’s taxpayers.
3. It may violate the state Constitution’s Article V, Section 7, prohibition on impairment of retirement benefits.

Cuomo’s plan cannot be implemented without the approval and cooperation of both state Comptroller Thomas DiNapoli, who is sole trustee of the New York State and Local Retirement System (NYSLRS), and the Board of Trustees of the separately administered New York State Teachers’ Retirement System (NYSTRS). They have no doubt assigned their respective in-house actuaries to examine the proposal, but it’s hard to see how they could find it consistent with their fiduciary responsibilities. After all, the comptroller has already pushed the envelope by successfully proposing for a law that essentially gives local employers the option of borrowing a portion of their pension increase from the pension fund, to be repaid over 10 years at a low interest rate. And Cuomo himself vetoed a bill, passed by both houses at the very end of the 2011 session, that would have allowed school districts to bond out a portion of their pension increases.

Background

Pension and disability benefits are financed out of large investment pools, which have been built up, replenished and backfilled as necessary mainly by annual taxpayer-funded employer contributions, which are calculated as a percentage rate of salaries for covered employees. Depending on hiring date, some public employees also contribute a smaller, fixed percentage of their salaries to the pension funds. The vast majority of workers hired prior to last year contribute no more than 3 percent; those with 10 or more years of service contribute nothing.

Pension investment returns have been especially volatile in the past decade, so the contribution rate for New York’s statewide funds have fluctuated from a low of just above zero in 2000 to the projected 2013-14 levels of 20.9 percent for ERS employees, 28.9 percent for PFRS, and up to 16.5 percent of salary for NYSTRS members.

Cuomo’s proposal is to set the would establish a “stable” contribution rate of 12 percent for ERS, 18.5 percent for PFRS and 12.5 percent for NYSTRS employees.  These rates are nearly twice the projected “normal” rates for Tier 6 employees — i.e., the employer share of the cost of these cheaper pension benefits in a theoretical, steady-state universe of annual asset returns in line with the NYSLRS liability discount rate of 7.5 percent and the NYSTRS liability discount rate of 8 percent.

There’s a reason why this seemingly simple “solution” has never been advanced previously in New York: it imprudently compounds the moral hazards and financial risks already inherent in the defined-benefit pension system. One of the slides displayed in Tuesday’s presentation by Cuomo’s budget director, Robert Megna, actually gives away part of the game:

Note: under the scenario illustrated above, the lines cross in 2020.   Based on the data points in this chart, a county or city taking the deal will realize cumulative savings equivalent to 20 percent of annual payroll in the next five years — while giving away savings of 40 percent of payroll over the next 10 years.

Politicians in general are notorious for their short-term time horizons and need little encouragement to steal money from the future to meet current needs. When it comes to pensions, which rely so heavily on risky and volatile stock investments, the future is especially murky. In fact, as I noted here, simulations conducted as part of NYSLRS’ last actuarial update suggest there is only a 35 percent likelihood the fund will earn as much as 7.5 percent a year in the long term. A median, 50-50 bet would be just under 7 percent — the discount rate just adopted by New York City’s pension funds, which are not part of the governor’s proposal.

So what if asset returns continue to come in below targets? Cuomo’s proposal allows for two initial “evaluation periods,” starting at five and 10 years after the law takes effect. At each of those points, the comptroller and the NYSTRS trustees could nudge their rates upward by no more than two percentage points. In no case could the rate be lower than the base or more than four points higher than the base amounts. And if that’s still not enough, they would have “discretionary authority to increase or decrease the length of the baseline stable pension contribution term to ensure adequate system funding,” the governor’s bill memo explains. In other words, that 25-year period could be stretched out to 35 or 40 years.

The other, opposite fat tail risk is that the markets experience another boom on the 1990s scale, and the pension funds find themselves awash in tens of billions of dollars in excess contributions within the next 15 years or so. Experience suggests that future governors and legislators will not keep their hands off a huge and growing pile of arguably “surplus” cash. They will find a way to both reduce pension contributions and sweeten pensions, just was was done in New York in 2000, contributing to our current problems.

Cuomo administration officials are suggesting this pension scheme is no more objectionable than exchanging an adjustable rate mortgage for a fixed-rate mortgage. In this instance, however. the term of the “mortgage” and the amount owed could increase significantly if the pension fund fails to meet its rate of return assumption.

DiNapoli had an appropriately cautious reaction:

My office just learned of the Governor’s financing proposal for the state pension fund[!], and we are examining it from the perspective of our fiduciary responsibility. New York has one of the strongest pension funds in the country because it has been managed with fiscal discipline over the years. Too many other states have failed to adequately fund their pensions and taxpayers ended up paying the price.

NYSTRS had no immediate comment. Its next scheduled board meeting is Jan. 30.

The legal question

The last time a big change in pension calculation assumptions was considered in Albany came in 1990, when then-Governor Mario Cuomo and the Legislature passed a law directing the comptroller to switch from the relatively conservative “aggregate cost” method to the “projected unit credit” or PUC method, which would have permitted lower employer contributions.

Three years later, ruling on a lawsuit brought by the president of the state’s largest employee union, the Court of Appeals struck down the PUC change. The case is mainly remembered as having hinged on the court’s finding that the change had been improperly forced on the comptroller at the time, Edward V. Regan, who had been “divested of his autonomous judgment” on whether the switch to PUC was prudent. But the decision also contained strong hints that the funding change would have been overturned even if Regan had gone along with it.

The Legislature has some “unquestioned” legal authority over the pension fund, the Court said. However, its opinion added:

Where the State [i.e., the Legislature] maintains such authority in regard to the actual trustee of the funds, and specifically prescribes procedures for contributing to the benefits, concomitant with that authority is the State’s duty to act in a manner consistent with the goal of the “protection” of these funds as required by article V, § 7 of New York’s Constitution. The State must show, like any other trustee or fiduciary, that it has not breached that duty. [emphasis added]

While the PUC method is widely used by other public funds, the court suggested that it might have been rejected on the merits, quite aside from the comptroller’s unwillingness to endorse it.

It’s not far-fetched to suggest that even if DiNapoli and the NYSTRS trustees sign on to Cuomo’s plan, either a group of unions or individual members of the retirement systems could sue to block the law on the grounds that the change would make their pension funds somewhat less secure.