Missouri Public Pension Issues
Retirement security is an important issue in this state. LAGERS understands this importance, and strives to ensure this security every day. This page discusses the issues surrounding Missouri’s public pension plans.
What is a Defined Benefit Pension Plan?
Defined benefit plans have a long track record of success in the public sector and continue to be the plan of choice for state and local government workers.
A defined benefit retirement plan is a traditional pension that provides a retiree with a pre-determined benefit after meeting certain criteria. The main purpose of a defined benefit plan is to provide income during the retiree’s remaining years. Benefits are paid on a monthly basis and extend until the retiree’s death. Benefit amounts are often based on a retiree’s average working salary and the length of the retiree’s employment.
A defined benefit plan is “pre-funded.” This means that a retiree’s benefit is paid for before he or she reaches retirement. There are three sources of income to the plan, employer contributions, employee contributions, and the return of the plan’s investments. Contributions to the plan begin when a worker is hired and continue until the worker leaves employment. It is common in the public sector for both the employer and the employee to contribute to the plan. The returns that are generated from the plan’s investment portfolio provide the majority of the funding. In LAGERS, investment returns account for about 65% of the plan’s funding.
It is very important that the required contributions are made to the plan each year. Failing to collect the full contributions puts the plan at risk of higher future required contributions, a higher unfunded liability, and may affect the plan’s ability to make benefit payments.
LAGERS administers a defined benefit plan available to all of Missouri’s political subdivisions, except school districts. LAGERS is a voluntary system that adds about 15 new political subdivisions to its membership each year. There are approximately 3,000 political subdivisions in Missouri, 670 of which are currently participating in LAGERS.
RSMo 70.730 and 70.735 requires that all of LAGERS participating political subdivisions fund 100% of their required contributions. Because each subdivision is required to make their full contribution each month, every employer is working toward and will eventually be 100% funded.
Pensions Are an Investment in Our Communities
A pension plan is a tool for public employers to improve services provided to their communities. They provide a mechanism to attract and retain a skilled workforce to provide the best possible service to the citizens.
The Unfunded Liability Nobody is Talking About
There are real consequences for taxpayers when individual savers fail to adequately prepare for retirement. We hear a great deal about pension liabilities, but individuals can also have personal unfunded liabilities. Read more to find out why the unfunded liabilities in 401 (k) type plans may be America's next big retirement crisis.
Investing the Funds: An Overview
Defined benefit plans tend to invest pragmatically, looking to the long-term and engaging in prudent investment practices.
LAGERS is accomplishing this by collecting contributions from employers and employees and then investing those funds in a diversified portfolio. Returns from these investments compound over time and provide the majority of funding for the plan.
Asset allocation decisions are made by LAGERS’ trustees who have a fiduciary obligation to ensure the participants’ funds are invested prudently. The trustees rely on recommendations from professionals to help aid in making their decisions. Public pension plans, depending on their size, often have an internal investment team consisting of a chief investment officer and an investment team that hire outside firms to manage portions of the portfolio to help aid in producing the best possible results for plan participants.
Defined benefit pension plans tend to earn higher returns on their investments than individuals earn in their private accounts. This is for a few reasons. One is that pension plans have an infinite time horizon on which to base their asset allocation. An individual typically adjusts their asset allocation based on their current stage of life. For instance, someone nearing retirement may decrease their portfolio’s risk by adjusting their allocation to mainly consist of fixed income assets (i.e. bonds) which would produce a lower return. A 25 year-old that just started their career can take on more risk by having a portfolio mainly of equity assets (i.e. stocks) and produce a higher return. Since the pension plan is investing for the average individual and not just one person, it can create an asset allocation to optimize the return for a given level of risk. Therefore, continuing its course of seeking the best returns for its participants into perpetuity.
The level of risk for a pension plan is mitigated by its ability to consolidate its assets into one large pool, giving pensions the ability to negotiate lower fees and invest in assets that are not accessible to most individual investors. This allows the plan to diversify its asset base and create an additional amount of return for an overall lower amount of risk. The average individual usually has no ability to negotiate with the firms setting the expense for their investments. Most investments also have a minimum investment size which can deter individual investors from getting the best diversified portfolio.
Another reason pension plans’ returns tend to be higher than individuals’ is because the pension fund hires professional investment managers to manage the portfolio’s stock selection and asset allocation. Typical working class Americans generally have little knowledge of the investment landscape and may have no interest in learning more. LAGERS works with investment professionals which gives participants one less worry and allows them to focus on serving their communities.
Investing the Funds: Active vs. Passive Portfolio Management
Defined benefit pension plans typically utilize active portfolio management when investing participant funds. Active management means that the pension plan is using an investment strategy that seeks to earn a return in excess of normal market returns. This is opposed to passive management, where an investor seeks to earn only the market return by investing in an index fund. For example, an investor may invest in an index fund designed to simply mirror the returns of the S&P 500 Index versus an active management strategy which seeks to earn a return greater than the S&P 500 Index.
Pension fund trustees and investment staff have a fiduciary obligation to seek the best possible risk-adjusted outcomes for participants. This includes devising an investment strategy that first identifies the amount of risk the fund is willing to accept, and then looking to earn the highest possible returns for that given amount of risk.
A recent study by CEM Benchmarking, a leading global benchmarking firm, concluded that pension funds are better off by using active portfolio management. CEM’s researchers looked at a global sample of over 6,600 defined benefit plans spanning 1992-2013. The study concluded, “Gross of investment costs, the value added by pension funds over their policy return averaged 58 basis points. The key question though is whether it was worth it. Does the result justify the added costs and risk of active management? The answer here is again, yes, as net of investment costs the value added is 16 basis points.” You can also see a similar result in the below graph based on LAGERS experience. It shows that active management has created an additional $1.87 billion over passive management.
Public Pensions Are Sustainable
Not only can public pensions survive in Missouri, but they can thrive! Research shows that Americans want secure retirement benefits, poverty rates among the elderly are lower with pensions, and local communities benefit from experienced public servants.
A recent report published by the Center for State and Local Government Excellence (SLGE) outlined success strategies for sustainable public pension plans. The report looked at five US public pension plans that have a history of fiscal solvency and identified traits these plans share that explain their amazing track records. The authors of the report identified the employers’ commitment to funding, recent lowering of the annual investment return assumption, adjustment of contributions, and benefit adjustments as the common characteristics that have made the plans in the report well-funded success stories.
LAGERS could have easily been included as the sixth plan in SLGE’s report because we share the same sustainability characteristics of the other five plans. In fact, LAGERS funded ratio is even higher than the average ratio of the five plans in the study!
Commitment to Funding
What is the #1 secret to a well-funded pension plan? Commitment to making the full contribution necessary to fund the benefits promised to the members.
Think about your mortgage. What would happen if you failed make your monthly payment or decided to only pay a fraction of the actual amount due each month? It doesn’t take an advanced degree in mathematics to figure that one out. The same applies to pensions. Pension benefits are designed to be funded over decades of time by contributions from employers and employees as well as the investment return generated from those contributions. If the funding of the benefits is not a pension plan’s #1 priority, it will eventually run into problems.
This is not an issue for LAGERS or its members. Each month, participating employers contribute the full amount that is due, which is required by Missouri State Law. Our member employers are extremely dedicated to funding their employees’ benefits, but if an employer falls behind, LAGERS Board of Trustees has the authority to work with the State Treasurer’s office to obtain the necessary funds.
Recent Lowering of the Annual Investment Return Assumption
LAGERS investment return assumption was lowered from 7.5% to 7.25% in 2010. This decision was based on historical returns as well an asset liability study projecting returns 30 years into the future. All of the plans featured in SGLE’s report had conservative assumptions of 7.5% or lower.
The annual investment return assumption is referring to the return that pension plans assume they will make on their investments. Investment income matters, as investment earnings account for a majority of pension funding. A shortfall in long-term expected investment earnings must be made up by higher contributions or reduced benefits.
Funding a pension benefit requires the use of projections, known as actuarial assumptions, about future events. One actuarial assumption is the investment experience. This must be a realistic figure to ensure that members and employers are not being undercharged or overcharged. If the assumption is too low, member and employer contributions must increase, if the assumption is too high, shortfalls in the investment performance would have to be made up by higher contributions or reduced benefits.
Remember, the #1 priority is commitment to funding. While it is true that slight upward pressure was applied to LAGERS employers’ contribution rates in 2010 as a result of the change in the assumption, it reaffirmed our commitment to funding.
Adjustment of Contributions and/or Benefit Levels
LAGERS’ participating employer contribution rates are adjusted each year to ensure funding is on track. Each employer may change the contributions required by employees and its benefit levels, either up or down, to meet the needs of its workforce and budget. The flexibility available within the LAGERS plan design is great for participating employers and a major factor in why the system is doing so well.
The five pension plans featured in the Center’s report are shining examples of public retirement plan excellence because of their commitment to funding, conservative investment assumptions, and the ability to adjust plan provisions. All of these traits are present in LAGERS’ plan structure and have contributed to the fiscal success of our system.
LAGERS Uses an Appropriate Discount Rate
A discount rate is the interest rate pension plans use to calculate the current value of future retirement benefits. This tells you how much money is needed today to be able to pay future benefits, which in turn is one factor in determining the contribution rates required from employers and employees.
The assumed rate of return is the return that a pension fund plans to receive on its investments and is determined by usingThe trick with choosing a discount rate is to pick a figure that is realistic so that contributions may remain level for decades, helping to ensure the taxpayers of today are charged as appropriately as the taxpayers of tomorrow. a set of assumptions to project future investment returns. The discount rate and assumed rate of return are one in the same which helps to ensure level contribution rates as well as making sure there is enough investment income to cover future liability shortfalls. The investment income matters, as investment earnings account for a majority of pension funding. A shortfall in long-term expected investment earnings must be made up by higher contributions or reduced benefits.
The most important thing to understand about a discount rate and assumed rate of return is that ultimately, the pension fund’s actual return on investment matters much more than the discount rate and the assumed rate of return.
Here is an example. Let’s say a pension fund assumes a low discount rate of 4%. Initially, the contributions required from employers and employees would be high because the fund expects only a 4% return on investments. But over time, the fund’s investment returns exceed a 4% return, and so, the contributions required will decrease because more money than expected is being poured into the fund from investment return.
Now let’s assume a pension fund has a high discount rate of 9%. Initial contributions would be low because the plan is expecting a high return on investments. But, over time, if the pension fund’s investments do not return 9%, contributions would have to increase in order to pay for the benefits.
The trick with choosing a discount rate is to pick a figure that is realistic so that contributions may remain level for decades, helping to ensure the taxpayers of today are charged as appropriately as the taxpayers of tomorrow. In other words, the end result should create generational fairness.
LAGERS uses a conservative discount rate of 7.25%. This is based on an asset liability study that incorporates capital market assumptions and liability projections for the future. As of 2015, LAGERS’ 20 year return is 8.70% and its return since inception is 8.92%. LAGERS is very comfortable with its assumptions and the contribution rates charged to employers and members and performance and experience is evaluated every five years to ensure the appropriate figures are being used to maintain a financially stable pension fund.
New Pension Accounting Requirements
If you haven’t already, you may begin to hear about new accounting standards required of public pension plans. These standards may make some plans look worse off financially – even if they’re not. The important thing to remember is the only thing that is changing is the reporting and measurement of pension costs, not how much a pension costs. As these new standards take effect, here are four important facts to remember:
Neither actual pension costs nor obligations have changed, only the way in which they are measured and reported.
The Governmental Accounting Standards Board (GASB) is the entity that sets such standards. Historically, GASB standards have always held a close link between accounting and funding measures. As the new standards are implemented, accounting and funding measures will become disconnected. The new standards attempt to show pension obligations as if they were all due today, when much of the obligation won’t come due until many years in the future.
The only thing that is changing is the reporting and measurement of pension costs, not how much a pension costs.Some LAGERS employers may appear to be more under-funded as a result of these new standards, even though they’re not.
One reason for this is that LAGERS-participating employers will now have to publish future pension obligations on their balance sheets. For some employers, this will show up as a liability. Pension liabilities have always been fully reported and transparent, but placing them on the balance sheets will make them more visible than before.
In addition, GASB now says that some employers may have to use a different discount rate to determine pension liabilities in today’s dollars. In the past, pensions have calculated liabilities using the long-term expected rate of return on pension plan investments. While most LAGERS employers will not be in this position, a few may have to discount at least a portion of liabilities using the municipal bond rate. Since the municipal bond rate is lower than the long-term expected rate of return, this could make some participating employer pensions appear more underfunded than before.
Benefits for employees and retirees are still as secure as they have ever been.
LAGERS has a 50 year history of sound, structured, stable funding procedures. These new standards will not affect any of that. Retirees will continue to be paid on-time, each month and members can expect their earned benefits to be fully paid for without interruption.
LAGERS employers will not have to pay more for their benefits.
LAGERS participating employers diligently pay their full bill each and every month. This will continue, as normal, with no changes whatsoever in this process. LAGERS will be providing new reports for employers to comply with the GASB standards in the Fall of each year and employers will work with their auditors to comply, but the month-to-month funding mechanisms will remain in place.
Defined Benefit Plans vs. Defined Contribution Plans
Who is responsible for investment decisions?
The investment return of the system provides approximately 65% of LAGERS’ funding. The rest of the funding comes from employer and employee contributions. LAGERS Board of Trustees is responsible for ensuring the system’s portfolio is invested to produce the best results for LAGERS members.
Who bears the investment risk?
If employee contributions are required by the employer, LAGERS member employees are always guaranteed to receive back everything they contribute plus interest. Since such a large portion of LAGERS funding comes from investment return, this does have an impact on employer contribution rates. When LAGERS portfolio produces a return above what is assumed, the excess is credited back to employers. When the portfolio does not produce an excess return, upward pressure is applied to employer contribution rates to make up for the lack of funding.
What protections do employers have from rising contribution rates?
LAGERS does provide protections to employers from extreme rate increases. First, LAGERS statutes limit the annual increase in an employer rate to 1% unless the employer chooses to make a benefit enhancement. Also, annual investment gains and losses credited to employers are smoothed over a five year period to help protect against volatility in the rates.
What about plan fees and administrative costs?
Fees that are charged to defined contribution plan participants ultimately decrease the participant’s retirement benefit because they are often paid directly from plan assets. LAGERS is a non-profit entity and does not charge fees to employee members. Therefore, there is no decrease in retirement benefits because of fees. The administrative costs to run the system are paid from the investment returns of the LAGERS portfolio.
Switching from a Defined Benefit Plan to a Defined Contribution Plan
Pension reform has been a popular topic in recent years and some of that discussion has focused on eliminating defined benefit pensions and transitioning public workers into a 401(k)-type defined contribution plan. While it is always good to look into ways to be more efficient and improve the financial condition of pension systems, switching government workers from a defined benefit pension plan to a defined contribution plan will ultimately hurt the retirement security of workers and be more costly to governments.
A recent study by the National Institute on Retirement Security (NIRS) examined states that have transitioned from defined benefit pensions to defined contribution plans. The study found that these states experienced increased retirement plan costs and increased plan underfunding.
West Virginia, one of the states studied in the report, switched to a 401(k)-like plan in 1991 only to switch back to a“The transition from DB to DC plans will require future retirees to negotiate their way through a minefield of challenging decisions that may reduce retirement income.” —Boston College Centerfor Retirement Research defined benefit pension 2005. Why? The state found that the costs were lower for the DB plan and employees were not saving like they should in the 401(k)-type plan. In fact, there were 1,767 West Virginian teachers over the age of 60 in 2005. Only 105 of them had account balances over $100,000 for retirement. Hardly enough to allow them to retire and maintain their standard of living.
Another study by the Boston College Center for Retirement Research found that defined contribution plan features are linked to retiree poverty.
“The transition from DB to DC plans will require future retirees to negotiate their way through a minefield of challenging decisions that may reduce retirement income,” the authors of the study wrote.
The research found that defined contribution plan features like pre-retirement lump sum withdrawals and limited options for steady monthly income increased the risk of retirees from these plans becoming financially insolvent. For example, one out of five defined contribution plan participants in the study reported that they had received a lump sum distribution from their plan prior to age 55, compared to only one out of ten of those with a defined benefit plan.
“Workers in future cohorts that rely on non-annuitized DC plans as their sole source of retirement income are likely to be demonstrably worse off [than those studied in this report],” the authors wrote.
Not only does the move from DB to DC hurt workers, it also costs more. Employers who have made this move cite cost as their #1 reason for moving to a DC plan. This is often because they are not providing the same level of benefit. Another recent NIRS study found that DB plans have a 48% cost advantage over DC plans to offer an equivalent benefit.
Funded Percentage, Unfunded Accrued Liability, and Employer Contributions
Every pension plan’s goal is to be 100% funded. That is when a plan’s assets are equal to its liabilities. A pension plan that is not 100% funded is not necessarily in danger so long as it has a sound funding policy and receives its full contributions each year. An 80% funded percentage is generally accepted as the benchmark for a healthy pension plan.
LAGERS is currently 94.4% funded. The funded percentage of a pension plan is its assets divided by its liabilities. A plan’s assets are the sum of the contributions it has collected plus the returns from the plan’s investments. Liabilities, officially called, “Actuarial Accrued Liabilities” are the present value dollars of plan promises to pay benefits in the future allocated to employee service that has already been earned. A liability has been established (“accrued”) because the employee has earned service, but the resulting monthly cash benefit may not be payable until years in the future. Accrued liability dollars are the result of complex mathematical calculations, which are made by the plan’s actuary. An actuary is a person who is trained in statistical analysis of life expectancy, market expectations, inflation, and other data important to pension plans.
When a plan is not 100% funded, that means that its actuarial accrued liabilities exceed its assets. When this happens, an unfunded accrued liability is created, which is the difference between the accrued liabilities and the assets on hand.
The existence of an unfunded accrued liability is not necessarily a problem. The amount of this liability is amortized over future years by the plan’s actuary and paid for by contributions and investment return over time.
The amount an employer must pay to fund its pension plan is often called the annual required contribution, or ARC. The ARC has two components, the first of which is called the normal cost. This is the cost for retirement benefits for current year. The second component is the supplemental cost, sometimes called prior service cost, or the unfunded accrued liability cost. This is the portion of the ARC that is used to cover the amortized unfunded accrued liability payment.
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