A Pension Deficit Disorder

March 01, 2007

by Steve Anderson

Thanks to a 70-year credit card binge by Oklahoma politicians, the state now has more than $10,000,000,000.00 in unfunded liabilities in its pension plans - and you the taxpayers will bear the burden. The current solutions being proposed - infusing the systems with cash or diverting certain tax revenues to them - are not solutions at all. We need real political leaders who will state the obvious: We must abandon our archaic defined-benefit system and move into the 21st century.

Nearly everyone has known someone - usually a young person - who has let his or her credit card charges get out of control. Often the person will make the minimum payments until he realizes he isn't reducing the amount owed and in fact may be going deeper into debt. By the time he comes to see a financial professional he often is past the point of no return. Bankruptcy is the only viable option.

Typically we think of these individuals as being fiscally irresponsible. Their behavior raises the cost of doing business for the rest of the consumer base. What Oklahomans may not realize is that our elected officials have been acting this way for nearly 70 years.

The framers of Oklahoma's constitution wisely included a ban on most forms of state debt so that politicians could not bankrupt the state with giveaways. However, our elected officials have found a big, big loophole. So it is that we now have a multibillion-dollar unfunded liability accumulating in the state's retirement funds.

A March 24, 2006 report from the Oklahoma Pension Oversight Commission (OPOC) entitled "Crisis in the Oklahoma State Pension Systems" included this bit of cheerful news for Oklahomans: "Oklahoma's pension systems are in a state of serious financial crisis. For many years, warnings have been issued, only to be ignored. In the meantime, the problem has grown worse and the financial problems have only accelerated. A crisis state has been reached."

The report went on to point out that "Oklahoma has more than $10 billion in current unfunded liabilities in its pensions" [emphasis in the original] and "four times more money than is currently provided is needed to just keep the fund level from dropping below the current level."

The bulk of this debt is in the Oklahoma Teachers Retirement System (OTRS), which has $7.673 billion in unfunded liabilities, but all of the state's retirement systems (with the exception of the judicial retirement system) contribute to the debt.

Guess who's on the hook for the politicians' irresponsibility? Published opinions from the attorney general (see, for example, No. 96-21 and No. 05-040) indicate this debt is an absolute obligation of the state. This means the ultimate responsibility for paying off this $10 billion debt rests with the Oklahoma taxpayers.

However, even before Oklahomans directly feel the effect on their pocketbooks there will be a hidden cost. As OPOC correctly pointed out, "State government faces negative impact from the funding crisis much sooner than the general public. Left unchecked, the State's credit rating could be downgraded. The unfunded status of the State's pension systems has become a more and more prominently mentioned concern of the rating agencies in their rating reports. A downgrade in the State's bond rating would lead to higher borrowing costs and would siphon off funds that could otherwise be used to fund essential state services."

Just how real are these unfunded liabilities? They are very real. They represent amounts owed to retired or currently employed teachers, state employees, firefighters, and law enforcement officers in the form of promised retirement benefits that are nonnegotiable. As OPOC pointed out, "If the problem is left unaddressed, the systems will eventually require a cash infusion from the State of staggering proportions to meet current payment obligations. This could result in the need for the State to raise taxes or dramatically reduce funding to vital State programs."

Incredibly, the amount of the total debt is most likely understated since the assumptions used in the calculations to arrive at the estimate of future payments typically lag the realities of the real world. For example, the assumptions use an estimated life expectancy that cannot predict breakthroughs in modern science that may extend life past the estimated benefit payout life currently used. Additionally, since benefit improvements for each system's retirees are voted on by the legislature, the systems can only estimate what they believe may happen with future benefit increases.

How Did We Get Here?

How did we get into this mess? The simple answer is that the state embraces a type of retirement plan that has shown a tendency to become fiscally insolvent. Defined-benefit plans such as the state uses in each of its systems have inherent flaws that are almost unavoidable. In a defined-benefit plan the employer guarantees a certain benefit payment to an employee for his or her lifetime, come hell or high water. The collapse of Bethlehem Steel, the continuing crisis at General Motors, and dozens of other examples have spotlighted the inherent problems with defined-benefit plans.

Unfortunately, the flaws of defined-benefit plans are even more pronounced in the public sector. For years a perverse incentive existed where Oklahoma politicians could use the plan to buy votes but hide their actions from all but the most knowledgeable financial wizards. For many years this debt was kept "off the books" thanks to flaws in governmental accounting rules which allowed politicians to cover their tracks. However, recent rule changes enacted by the Governmental Accounting Standards Board (GASB) have required government entities to reveal these debts to the public in their annual financial statements.

Defined-benefit plans are typically funded by contributions from both the employee and the employer, but in the case of OTRS taxpayers have been the victims of politicians' profligacy from day one. When OTRS was formed in the 1940s, legislators chose to grant benefits to teachers who had not yet contributed towards their retirement. Since that time, legislators have done things like borrow money from OTRS for pet projects and grant benefit increases without providing money to fund them - knowing full well that the bill for these acts would not come due during their tenure. (With respect to OTRS, more than one state legislator has been known to quip, "Thank God for term limits.")

In effect, politicians have used a "credit card" to buy votes from the members of the school-employee labor unions. With minor variations, the situation is similar in each of the other state retirement systems' accumulation of unfunded debt.

A recent example was seen during the fiscal "crisis" from 1999 to 2002 when Oklahoma legislators were strapped for cash with which to appease the Oklahoma Education Association (OEA), Oklahoma Retired Educators Association (OREA), and the Oklahoma Public Employees Association (OPEA). Legislators used their "credit card" to run up charges of nearly $2 billion by giving ad hoc benefit improvements to the members of those groups.

In an effort that was similar in effect to putting a Band Aid on a gaping ax wound, legislators passed a law directing four percent (it will increase to five percent in 2008) of Oklahoma's individual income tax, corporate income tax, sales tax, and use tax receipts to go to the OTRS. This means millions of dollars a year (in fiscal year 2006 it was more than $202 million) are diverted from important tasks like locking up prisoners and fixing roads and bridges.

A similar diversion is used by the Oklahoma Law Enforcement Retirement System (OLERS), Oklahoma Police Pension and Retirement Plan (OPPRS), and the Oklahoma Firefighters Pension and Retirement System (OFPRS) to finance benefits. Part of the cost of insurance purchased by hardworking Oklahomans is a state tax charged to the insurance companies called the insurance premium tax. Oklahomans may think these tax receipts are spent regulating the insurance industry and/or helping the poor afford insurance, but in 2006 more than $145 million was re-directed to the aforementioned retirement systems.

OPOC's Non-Solutions

"The current health of the State public pension systems is poor," the OPOC report concluded. "This report is a call to action for Oklahoma policymakers similar to the warning of a heart attack. The patient can choose to eat healthier, exercise, and stop smoking and continue to live a long, healthy, productive life. Or the patient can be stubborn and refuse to change his ways, thus choosing a path that leads to an early grave. The choice is up to Oklahoma's policymakers."

OPOC correctly diagnosed that the patient is dying. Unfortunately, OPOC's four-part prescription amounts to no more than hooking the patient up to a respirator.

First, OPOC suggests that policymakers "increase State revenues to pension systems." But by OPOC's own admission it is not feasible to infuse the amount of cash needed to fix the current debt. One has to ask: What in the history of any of the pension funds, most especially OTRS, leads OPOC to conclude that OTRS won't just incur more unfunded liabilities even if it can pay off the current ones?

Second, OPOC suggests that policymakers "eliminate or ameliorate the effects of transferable tax credits on the insurance premium tax base." In other words, a back-door tax increase. And at the end of the day you have the same problem as in recommendation number one - you have not done one thing to change the situation that created this mess.

Third, OPOC suggests dedicating a portion of excess revenue collections to the pension systems. Again, we have the same fundamental flaw as in recommendations one and two above.

Fourth, OPOC suggests that policymakers "pursue other financing mechanisms, such as pension obligation bonds [POBs], to infuse additional money into the systems." On the face of it this idea has some appeal. But OPOC fails to point out the risk to the state - millions of dollars per year - if the market were to take a prolonged dip during the first years of the POBs. More money would be added to our debt payout, and at the end of the day we still haven't done one thing to address the underlying cause of the problem.

How Then Do We Solve the Problem?

How do we get out of this mess? The answer is simple but the execution is complex.

We must remove the ability of the legislature to fund benefits without providing funding. No doubt the framers of Oklahoma's Constitution would have included a provision to limit unfunded liabilities if they had known they would exist. Without a constitutional control, the best hope for Oklahoma taxpayers is for a change in the type of plan used.

Most private businesses use some version of a defined-contribution plan in which the employer guarantees the level of contribution to the plan. The employee is usually empowered to make investment choices but is not guaranteed any more than the amount in the plan at retirement. The very nature of the plan almost guarantees fiscal solvency for the provider. In previous issues of Perspective, Naomi Lopez Bauman has written about defined-contribution plans in great detail.

The bottom line: It is improper to burden 3.5 million Oklahomans with billions of dollars in debt just so a tiny fraction of the population can cling to an archaic benefit system. It's time for some true leadership on this issue.

OCPA research fellow Steve Anderson (MBA, University of Central Oklahoma) is a Certified Public Accountant with more than 20 years experience in private practice. He previously spent two years as an analyst in the Oklahoma Office of State Finance, where he specialized in Medicaid and pension issues.

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