At a certain age, everyone begins to wonder, “Have I saved enough for retirement?” For most people, the answer is that they have not and will not. Governments have not saved enough for retirement, either, whether in the form of Social Security and Medicare for all seniors or pensions and health benefits for government employees. North Carolina is better prepared than most states for future retirees. Two new papers consider the changes that have been made to get state government to this point and changes that could still be made to meet obligations to retirees and taxpayers.
In 2017, the General Assembly eliminated retiree health coverage for new state employees who start on or after Jan. 1, 2021. This will eventually eliminate the entire $31 billion unfunded liability that now exists. It may sound drastic, but the vesting period for those benefits was already at 20 years, and the changes in health care over the next 20 to 30 years promise to be at least as revolutionary as those over the past 20 years. Daniel DiSalvo, in a new paper for the Manhattan Institute, considers North Carolina a model for other states in the South. Poor management of the plan a decade ago prompted its transfer to the Department of the State Treasurer in 2011. Since taking office in 2017, State Treasurer Dale Folwell has sought ways to reduce health insurance costs for current employees and retirees while ensuring past reforms are not dismantled.
Unlike the State Health Plan, which did not systematically set aside money to pay for future retirees, pension plans like the Teachers and State Employees Retirement System are entirely designed to cover future costs. When its first began, its expected return on investments was roughly the same as the interest rate on 10-year Treasury bonds, which are considered risk-free investments. This was entirely appropriate because pension payments to retirees are guaranteed.
As inflation drove interest rates higher in the 1970s, the Teachers and State Employees Retirement System’s assumed rate of return also climbed. In the 1980s, however, the assumed return of its investments did not drop with interest rates, and by 1992 the assumed return was higher than the yield on 10-year treasury bonds. For the next 20 years, pension managers were in a Red Queen’s race, running faster just to stay in place. With the General Assembly’s blessing, they repeatedly added riskier investments to the portfolio just to keep up with an assumed rate of return that was becoming increasingly difficult to meet. The portfolio’s risk has about 10% volatility, but the risk/return formula indicates it would need to increase to 13% to meet target returns of 7%. The current risk-free rate is more like 2.75%. If the Teachers and State Employees Retirement System valued its liabilities using 2.75 percent as the discount rate, the system would have been just 55% funded in 2018.
The Great Recession of 2007-09 put the exclamation point on the challenge as the Teachers and State Employees Retirement System moved from overfunded to underfunded. In 2001, the pension plan had $4.4 billion more than needed to pay for the promises made to eligible retirees. By 2019, it was $10 billion short of the $83 billion it needed.
In a new paper by the John Locke Foundation and the Reason Foundation, we examine the history of this decline in solvency, recent policy reforms to meet the challenge, and forecast performance. We also suggest two ways to ensure the retirement system’s continued sustainability for future retirees.
First, the state should continue to cut the discount rate for pension assets. A standard rule of finance is to match assets and liabilities. Because the Teachers and State Employees Retirement System guarantees payment to retirees, it should have a less risky portfolio, which would generate lower returns.
Second, the Teachers and State Employees Retirement System should offer more alternatives for new hires. As we state in the report, “The best time to make prudent changes to reduce risk is right now, before major problems materialize.” Possible alternatives include a risk-managed tier with a lower discount rate or other conservative assumptions, a cash balance plan that divides high returns between plan members and the state, a defined-contribution plan like private-sector employees often have, or a hybrid plan like the Thrift Savings Plan that federal employees have. Whatever is created for new employees should also be offered as an option for current employees. Any of these would protect state employees and taxpayers from additional harm in the next recession.
For decades, legislators and pension plan managers accepted overly optimistic assumptions about the ability to pay for promises for pensions and retiree health care. In the past decade, they have made significant strides to cover those promises. With luck, legislators will support Folwell’s continued efforts to reduce health care costs and protect future the finances of retirees and taxpayers.
Joseph Coletti is senior fellow, examining fiscal and tax policy, for the John Locke Foundation.