A Look at Innovative Ways Public Pensions Approach Funding

Some methods increase flexibility for individual employers.

In a new report from the National Institute on Retirement Security (NIRS), “Beyond the ARC [Annual Required Contributions]: Innovative Funding Strategies From the Public Sector,” the organization looks at various ways public pension plans fund themselves.

The NIRS notes that the markets rebounded better this year after the COVID-19 pandemic hit than they did during the 2008 Great Recession. “However, there are concerns that cash-strapped governments will cut back on funding required contributions to public pension plans,” the institute says in the report.

The collection of funding actions that the report summarizes run the gamut—from implementing a wholesale funding strategy for a large statewide plan to more targeted reforms that simply increase participating employers’ control of how costs are paid over time. These innovative strategies extend well beyond the oft-cited annual required contributions or actuarially determined employer contribution (ADEC).

The first strategy is to develop separate funding methods for legacy costs and ongoing plans. The Indiana Public Retirement System (INPRS), for example, had continued to fund its legacy system on a pay-as-you-go basis, which the NIRS says is a low bar for funding purposes. The legacy system—the Teachers’ Retirement Fund (TRF)—was combined with the Public Employees’ Retirement Fund (PERF) in 2011 to create the INPRS.

“In short,” the report says, “the broader system is growing out of the consequences that stemmed from being late to move toward prefunding. Today, there are more people in the prefunded TRF tier than the pay-go tier. In summary, the financing plan essentially partitioned off the legacy tier, retained lower expectations for the pay-go tier, exceeded those expectations in a significant and systematic way, and bought time to correct a historic mistake.”

Kentucky used a fixed allocation of unfunded liabilities to mitigate risks. The proposal for the Kentucky Employees Retirement Systems (KERS) Non-Hazardous (NH) plan funding changes has not yet become law, but, the NIRS report says, “given that the proposal is insightful about diagnosing a key problem faced by the retirement system, it seemed appropriate to include this approach for its potential utility within our community.”

The KERS NH plan had been underfunded for many years. In 2013, the state legislature committed to begin funding it on an actuarially sound basis, resulting in employers reducing plan payroll by 33% between 2010 and 2020.

As of June 30, 2019, the KERS NH plan was only 13% funded.

To break the vicious cycle of rising rates leading actuarial calculations to be off-track, the Kentucky legislature proposed determining each employer’s share of unfunded liabilities as of that date, as a fixed dollar amount, and required employers to pay off those obligations over 27 years. “Essentially, unfunded liabilities are partitioned off and funded separately from the traditional percent of pay funding strategy that would still be utilized for new accruals,” the report says. “With this change, an employer’s share of unfunded liabilities is no longer driven by its share of the plan payroll.”

Yet another approach is enabling organizations to gain control over their retirement system with employer side accounts. “These efforts generally allow employers to prepay pension contributions into side accounts to reduce [the employer’s] future costs,” the institute wrote. “Those contributions are then managed for the employer, and various methods are used to determine how future costs will be reduced by these credits.”

The Oregon legislature authorized the use of side accounts in 2002 for its Public Employees Retirement System (PERS). The excess contributions may be used to reduce  contributions—the plan may amortize these funds over six, 10, 16 or 20 years.

The California Public Employees Retirement System (CalPERS) approach is to offer employers flexibility in managing pension costs, through a prepayment option. “Employers can submit pre-payments to CalPERS, with those funds being deposited into a Section 115 trust that is administered by CalPERS,” the NIRS wrote. Employers can choose between a lower-risk and a moderate-risk portfolio. “The prepaid contributions are not automatically amortized and used to reduce employer costs equally across future years,” the report says. “Instead, employers have flexibility regarding when to use these funds to reduce their pension contributions.”

New York State employers have the option to establish retirement contribution reserve funds to help stabilize their pension costs over time, and employers are permitted to establish and fund the fund accounts themselves.

Pennsylvania is allowing its employers to prepay unfunded liabilities. They may make a one-time lump-sum payment of 75% to 100% of their respective unfunded accrued liability in exchange for reducing their future pension costs.

Then there are pension obligation bonds. “When pension bonds are issued, this typically results in a large sum of money invested in the markets at once,” the NIRS wrote. “This moves a pension fund away from its typical practice of dollar-cost averaging.”

Maine adopted a packet of broad reforms, including funding changes. Under the changes, the state will calculate the unfunded liability using the same assumptions it does for the ongoing funding of the plan. This means the plan will not recognize any gain or loss by the employer’s decision, similar to the practice used by multiemployer plans, according to the NIRS.