Phase Two: State Pension Reform? Not Quite

 

Over the last several weeks, South Carolina’s pension system has drawn even more attention from lawmakers, prompting them to propose bills that would significantly change the state’s retirement landscape. Some bills would completely overhaul the system, while others would simply modify it. And with more public employees retiring each day, the proposals aren’t going away any time soon. In fact, it’s likely that the pension debate will only amplify as the state feels increasing pressure to pay down its unfunded liabilities.

That being considered, it is important to reexamine the system as it currently exists before unpacking any major proposals. Understanding how it works, and more importantly, how it doesn’t, is necessary to understanding why it needs to be changed.

The current retirement system

The vast majority of South Carolina’s public employees are enrolled in the South Carolina Retirement System (SCRS or the “system”). The SCRS is a defined benefit retirement plan that covers state agencies, public and charter school districts, public universities, local governments and even a few non-government entities. The plan currently covers an estimated 500,000 members. In addition to the SCRS, there are also other retirement plans for police officers, judges, and even members of the General Assembly.  While each plan is administered by the Public Employee Benefit Authority (PEBA), a body that is mostly accountable to legislative leadership, actual investment decisions are made by a separate body: the Retirement System Investment Commission (RSIC).

The SCRS offers a generous plan for its members. The “defined benefit” element of the plan means that members are guaranteed a set amount when they retire. This is in contrast to the state’s Optional Retirement Program (ORP), a simple “defined contribution” 401(K)-style plan, which does not guarantee a set dollar amount for the retiree. The state offers both options to its public employees, but most elect into the SCRS because workers can calculate exactly how much money they will receive in retirement.

The other important distinction between the two plans is that the SCRS has put the state billions of dollars into debt. Because members in the SCRS are guaranteed a predetermined amount by law, the state must ensure that funds are available as each member retires. This requires serious financial discipline and forward planning, two areas where the state has continually demonstrated its shortcomings.

For instance, lawmakers have consistently overestimated the rate of return that the SCRS will earn each year. A defined benefit pension plan is funded from three sources: The employee contribution, the employer (taxpayer) contribution, and the interest earned when those contributed funds are invested. The estimated rate of return is the starting point for the SCRS, and the employer/employee contribution amounts are based on that figure. If the assumed rate of return is unrealistically high and the investments underperform, the pension fund will run a deficit. This is where the SCRS unfunded liability originates. The artificially high rate of return could have been addressed last year when lawmakers passed their “pension reform” bill, but instead they opted to only marginally adjust the rate from 7.5% to 7.25%. For reference, the SCRS only realized an average return of roughly 5% from 2006 through 2016. That’s one of the reasons why the state’s unfunded pension liability estimate ranges anywhere from $19 billion to $57 billion.

Many other states are running into similar problems, and are following the lead of the private sector in shifting away from unsustainable defined benefit plans and toward defined contribution and hybrid plans – including 16 states where an alternative plan is now mandatory for new employees.

Lawmakers framed last year’s pension “reform” law as the first phase in a two-part series of reforms: the first modifying financial and governance aspects of the current system, and the second restructuring it entirely for future employees. Now it appears lawmakers are preparing for phase two – restructuring the retirement system. Several weeks ago, House leadership introduced H.5000 and referred it to the House Ways and Means Committee. Here is a breakdown of how that bill would change the pension system.

The Optional Shared-Risk Defined Benefit Plan (SRDB)

The bill creates two new retirement plans for public employees. The first is the Optional Shared-Risk Defined Benefit Plan (SRDB). As its name implies, this is a slightly more moderate defined benefit plan that would guarantee set benefits for its members, and it would only be available for new employees hired after June 30, 2019. Members would need to be at least 60 years old and earn 30 years of credited experience to receive benefits (these standards are similar to those required for state employees currently in the SCRS).

However, the SRDB would also feature several key differences from current plans. First, PEBA would have the authority to set the assumed rate of return for the SRDB without requiring the approval of lawmakers, although a cap is established at 6%. This rate is still too high, however. Experts suggest that a rate closer to 2-3% is more realistic, and a wiser approach might be tying the assumed rate to a historical average instead of setting an arbitrary rate with an arbitrary cap. Furthermore, if actual pension investment earnings fall below 6%, the employer and employee equally share the cost. In other words, if an employee’s investments do not meet the returns predicted by the state, half of the needed money to cover their retirement plan would literally come out of the employee’s paycheck. Similarly, if actual earnings exceed 6% in a given year, the employer and employee would share the gain.

Finally, the bill requires that the plan be 100% funded at its inception, although the specifics for how that would be accomplished are not included. If the funded ratio falls beneath 95% for two consecutive years, or 90% for one year, the plan closes to new members, and those members would be automatically enrolled in the second plan: The Defined Contribution Primary Retirement Plan.

The Defined Contribution Primary Retirement Plan (DCPRP)

The DCPRP is a revised version of the existing 401K plan and would be open to both new employees and current state employees that want to leave the current SCRS plan. All state employees currently enrolled in the state’s 401K plan (the Optional Retirement Program – ORP) would be automatically enrolled in the DCPRP, although current retirement contracts of employees that are transferred into this plan from another plan would not be affected.

In many ways, the new DCPRP would operate similarly to the current ORP. The default employee contribution rate would be 9% (the same for SCRS members), with the option to lower it to 7% in the future. Employers would contribute a minimum of 3% and match up to 2% of voluntary employee contributions. A formula is also implemented requiring that employers contribute a certain dollar amount to PEBA until the unfunded liability for the SCRS is paid off, although given that the state’s unfunded liabilities range in the billions, it is unlikely this funding source alone will be sufficient. The plan also details the selection process that PEBA must follow when picking the financial institutions they will contract with. These are the private investment companies that will actually manage each employee’s retirement investment.

Not the reform lawmakers promised

The most glaring question left unanswered by this bill is if new state employees could still enroll in the old SCRS plan. Unfortunately, the bill does not address this specifically. Instead, it states that each new public employee hired after June 30, 2019 is “automatically enrolled in the DCPRP with a nine percent payroll contribution rate”. The absence of language specifically closing the old plan to new employees could be seen as a possible loophole.

Even if new hires cannot join the old plan, the newly created defined benefit plan would essentially be a continuation of the old plan, just with slight modifications. The employer (taxpayers) would still share the burden of shouldering the costs if actual returns fall short of expected returns – something that happens almost every year. Additionally, the bill does not explain how the plan would be funded at its inception – an important omission given that the current pension plan is still deeply in debt. This lack of funding clarity was also present in last year’s pension law, which is totally void of a funding mechanism. It’s difficult to have confidence in the long-term success of the SRDB plan when it is unclear how it would be paid for.

On the other hand, under a 401(K) style plan like the new DCPRP (and the existing ORP), taxpayers aren’t forced to pick up the additional cost of the plan if projected earnings fall short. However, the proposed DCPRP plan is still far from perfect. For instance, lawmakers set forth too many instructions for PEBA in how it must select its financial vendors. Outlining general guidelines for PEBA to follow is not necessarily bad policy, but that level of specificity is restrictive and counterproductive. Not to mention, PEBA is regularly involved in the financial sector and should be considered more qualified to make these decisions than legislators.

Overall, this bill cannot be considered true reform to an unsustainable state pension plan. However, it is not the only bill being proposed. S.1040 takes a concise and deliberate approach to reforming the state pension system, unlike the House solution. This bill would enroll each new public employee hired after July 1, 2019 into a defined contribution plan established by PEBA. In contrast with H.5000, this bill clearly articulates that the old plan is shut off to new employees and would give PEBA full authority to decide how the plan would be operated. However, H.5000 is sponsored by House leadership and therefore has a greater chance to pass into law – although its likelihood of passing this year is uncertain this close to the end of session. As always, we will continue to track each bill as it moves through the legislative process and provide updates as they occur.

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