The Arkansas state public pension system has six different plans, the largest two of which represent 90 percent of the active members and more than 85 percent of total pension funds. There are more than 65,000 retired members associated with these two pensions, namely, the Arkansas Teacher Retirement System and the Arkansas Public Employees Retirement System.
One issue associated with the public pension system is the ability of the pensions to pay promised benefits based on the assets the pensions have accumulated.
A widely used metric for gauging the financial health of a pension is the funding ratio. (A funding ratio of 100 percent means that if the actuarial assumptions turn out to be true, the plan could pay all of the benefits that have been promised, with $0 remaining at the end.) Based on the most recent APERS and ATRS financial reports, the pensions have funding ratios of 78 and 73 percent, respectively.
The actuarial assumptions used to estimate a plan’s financial health include such things as investment returns, payroll growth, eligibility of benefits and longevity of retired members, as well as other economic and noneconomic assumptions.
Naturally, there is uncertainty in any or all of the actuarial assumptions, but attention should be paid to the uncertainty surrounding investment returns because of their importance to the financial health of pension plans. For example, in 2014, the APERS plan showed employer contributions to be $264 million, employee contributions to be $48 million and investment earnings to be $1.2 billion. These amounts represented 80 percent of total contributions.
The APERS plan assumes a 7.75 percent return on investment. But investment returns are potentially very volatile. For example, APERS had a return of -20.9 percent in 2009 and 26 percent in 2011. This volatility creates uncertainty over whether the pensions will have sufficient assets to pay promised benefits in the future.
Even if ATRS and APERS were 100 percent funded, there would still be less than a 50-50 chance that the pensions would have sufficient assets to pay all future promised benefits. In order for both plans to be fully funded, an additional $6 billion is needed right now.
In order for the pensions to increase the likelihood to 90 percent that they have a sufficient amount of assets for future promised benefits, without any additional contributions in the future, the plans would collectively need approximately $30 billion in additional assets right now. While it is possible that the pension plans will not need additional assets to fund promised benefits if the pensions earn higher than expected returns on their assets, it is relatively unlikely that will happen.
One commonly suggested response to the volatility of asset returns is to reallocate the plan portfolio by shifting to less volatile assets. Unfortunately, reallocation is not an automatic fix. It increases the chances of funding future benefits for a longer period, but it also results in lower average returns, contributing to a dramatic increase in the likelihood of not being able to fund longer-term benefits without significant increases in contributions.
When the pension systems are underfunded, the assets are insufficient to pay the benefits that have already been earned by current workers and retirees. In order to make the system appear to be solvent, worker contributions that should be set aside for retirement must be diverted to pay for benefits that have been insufficiently funded. This further compounds the underfunding and shifts the financial burden off to future generations of workers and taxpayers.
It is a question of when, and not if, some sort of pension reform will be undertaken in which employee or employer contributions are increased or benefits are reduced. Increases in employer contributions would likely affect all taxpayers in Arkansas to the extent that additional contributions may require higher taxes in the future.
Many states have enacted a variety of sweeping reforms to address these critical issues. Whether the reforms manifest as increased employee or employer contributions, a reduction in benefits or the adoption of some type of 401(k) type defined contribution, the state’s funding shortfall will likely occur unless pension change is implemented relatively soon.
Erick Elder is a professor of economics in the University of Arkansas at Little Rock College of Business. Email him at EMElder@UALR.edu.