Why closing Michigan pension system didn’t stop debt

Jonathan Oosting
Detroit News Lansing Bureau

Lansing — A renewed effort by Republican lawmakers to reform Michigan’s teacher pension system has prompted a fight over whether a similar change two decades ago really worked.

The state employee pension system has compiled nearly $6 billion in debt or “unfunded liabilities” in the 20 years after legislators ended state employee pensions for new hires in 1997. The state employee system was fully funded in 1996 when then-Gov. John Engler and the Republican-led Legislature finalized a groundbreaking move to shift new hires into 401(k)-style retirement savings plans.

Critics call the added debt a cautionary tale for GOP lawmakers who are considering closing the teacher pension system to new workers on the promise of paying down or avoiding additional liabilities.

The 1996 reform was a “perfect laboratory experiment for what happens when you shift people from defined-benefit to defined-contribution systems,” said Todd Tennis, a lobbyist for the Coalition for a Secure Retirement, which opposes moving new teachers into 401(k)-style plans.

“When you reduce people coming in, you have to pay more per person that you have there, and if you don’t, then you create debt,” Tennis said, adding that “you need to invest a lot of money in the early years after you close it or else you’re going to build up debt.”

Reform advocates counter that today’s $5.8 billion deficit would be much larger if the reforms hadn’t been adopted. When the state stopped adding new workers, it prevented the extra debt they would have created in an unsustainable pension system, they said.

“If they hadn’t done that, there would be billions more in unfunded liabilities,” said Anthony Randazzo of the Reason Foundation, a libertarian think tank that is advising Michigan legislators on addressing the teacher system’s $29.1 billion liability.

“There would have been tens of thousands of state employees hired into a pension system that over the last 20 years has had its investments underperform and has seen the state consistently fail to make the appropriate contributions to their benefits.”

New state employees no longer receive a set pension from the state but instead can contribute a portion of their paychecks into a retirement savings account and choose from a variety of investment options. The state contributes up to a 7 percent match .

Pension system 64% funded

The 1996 pension reforms, coupled with incentives for early retirement, were promoted as a way to give state employees portable retirement accounts while helping the state avoid a potential “train wreck” of future debt.

In fiscal year 2015, the most recent data available from actuaries, the state employee pension system had gone from fully funded to 64.2 percent funded with liabilities of $5.82 billion.

The teacher pension system, which was fully funded two decades ago, is now 60 percent funded. Traditional Michigan public schools have fewer teachers today than experts predicted, Tennis said, in part because charter schools have siphoned off students and teachers, who do not pay into the system. The state’s population has also declined over 20 years.

Legislative leaders warn the projected $29 billion debt could doom school districts across the state, but a newer hybrid pension plan that became the standard offering in 2010 is fully funded today.

The Engler administration also wanted to close the teacher pension system to new hires in 1996 but did not have the votes, former state Treasurer Doug Roberts said. Engler pushed action in the lame-duck session since Democrats were set to retake the House in 1997. Roberts said state employee pension reform prevented even larger unfunded liabilities from accruing.

Many circumstances may explain why pension debt grew anyway, experts said. They include the stock market dive during the Great Recession that pummeled pension investments and longer-than-anticipated life spans that resulted in unexpected retirement costs.

The state also “severely mismanaged the implementation process” after the 1996 reforms, according to a recent report by Randazzo. Legislators “systematically failed” to make recommended contributions to the state employee pension system between 2002 and 2013, he said.

The same could happen again if the state closes its teacher pension system to new hires, Randazzo acknowledged.

Snyder resisting change

Officials predicted initial cost increases when they closed the state employee pensions systems to new hires, Robert said.

“But that’s a cost you’re going to have to end up paying some day anyway,” the former treasurer said. “So pay it now, get it over with and at least some point in time things will be able to fall. You can’t run from it.”

As of September 2015, 75,644 active state employees and retirees remained part of the closed pension system, down from more than 100,000 in 1997. Membership will keep shrinking due to deaths.

Potential upfront and long-term costs derailed an effort late last year to close the teacher pension system to new hires. Gov. Rick Snyder’s administration balked at the projected price tag and argued the newer hybrid pension plan is working well.

Senate Majority Leader Arlan Meekhof has said his caucus is looking at newer numbers suggesting smaller costs for teacher pension reforms, but he hasn’t made those figures public.

Snyder recently cracked the door to negotiations, telling reporters that moving new school hires to 401(k)-style plans “might be somewhat less” expensive than previously thought. But Meekhof suspended budget talks with the governor late Thursday because of a continued impasse on pension reforms.

The latest estimates from the state Office of Retirement Services indicates that closing the hybrid pension system to new hires and using “best practices” to accelerate payments on pension debt would cost school districts and the state $683 million in 2018 and a total $20.6 billion over 30 years.

Part of the reason is that 401(k)-style plans simply cost more. School districts currently contribute about 4 percent of staff payroll salary into the hybrid system but would contribute up to 7 percent under the pending legislation.

It could mean about $16 million in additional costs for 2018 and up to $813 million a year by 2048, according to a recent analysis by the Anderson Economic Group commissioned by Macomb County superintendents.

While the state is helping districts pay down unfunded liabilities, any increases in “normal costs” would directly increase costs for local schools, said Jason Horwitz, a senior consultant with the Anderson Economic Group.

“The current liability doesn’t go anywhere if you close the system,” Horwitz said. “Of course, you’re reducing the risk for future unfunded liabilities that could arise from new employees.”

Legislation introduced last year would have also forced the teacher pension system to reduce its assumed rate of return on investments. It is a key income generator for pension systems that critics say has been overinflated for years, masking the true scale of debt.

Reducing the rate or return could put school districts and the state on a more realistic path to pay down the pension debt, but it would also immediately increase the projected debt and required payments, costing $539 million in 2019 and $853 million by 2038, when the debt would be retired, according to the Office of Retirement Services.

Potential costs disputed

Accelerating payments when closing the system, a best practice to pay down debt recommended by ORS, could cost the state $663 million in 2018 but help it avoid $1.3 billion in additional costs by fiscal year 2038.

“Eventually after enough time passes you save money, but it costs you up front, and not just for one year. It’s for a very long time,” said Mitch Bean, former director of the House Fiscal Agency who served as chief economist when the state employee pension system was closed to new hires.

While leaders have not introduced legislation this session, teacher pension reforms proposed last year would not have saved the state any money “in my lifetime,” Bean said.

“We’ve already got a looming budget problem, and this adds to that,” he said, pointing to new laws devoting general fund money to roads and expanding the Homestead Property Tax Credit.

Randazzo said the ORS estimates are “potentially misleading” because the state should be lowering the rate of return on investments and accelerating payments anyway.

The only required price of the teacher pension reform, he said, is the “normal cost” associated with employers making higher contributions for a 401(k)-style plan, which ORS estimates would cost $20 million in the first year but up to $836 million by 2047.

Sponsoring Sen. Phil Pavlov, R-Port Huron, has disputed ORS projections and said last week legislators are still trying to “wrap our arms around” the true costs of closing the teacher pension system.

“By no means are we underestimating the cost, because it will be significant,” Pavlov said, “but much more significant is the projection of how big the crater is going to get on the debt side of this.”

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