In a July 3 Denver Post article, “PERA paints a rosy future”, Colorado Senate President Brandon Shaffer is quoted as saying, “We fixed our state pension system.” Nothing could be further from thef truth. Recent research reveals that Colorado’s Public Employee Retirement Association (PERA) is the most underfunded pension plan in the nation, even after the reforms enacted in 2010 in Senate Bill 1.
PERA discounts the liabilities in the pension plan at 8 percent, the rate of return it assumes on investments. Most financial experts argue that pension plans should use a rate of discount that reflects the market risk inherent in those liabilities. For example, a recent study by finance professors Robert Novy-Marx and Joshua D. Rauh, “The Revenue Demands of Public Employee Pension Promises,” uses actual Treasury yields to calculate the present value of liabilities in state and local pension pans.
They then calculate the contributions that state and local governments would have to make to pay off these liabilities over a 30-year period.
To pay off liabilities in the pension plan over a 30-year period, annual contributions to PERA would have to more than quadruple from the current 11.3 percent of payroll to 53.9 percent of payroll.
There is no other pension plan in the country that imposes such a financial burden on future taxpayers. Every household in Colorado would have to pay $1,739 more in taxes annually, just to meet pension obligations.
It should be emphasized that these estimates reflect the reduction in cost-of-living adjustments enacted in Senate Bill 1, and recently upheld in Denver District Court.
If more than half of every salary dollar must be earmarked to pay off liabilities in the pension system, this would not leave much revenue for government services. Fully funding the PERA pension plan would require more layoffs of teachers, firefighters, police and other public sector workers. In recent years 10 states have replaced their defined benefit plan with a defined contribution plan. In a “soft freeze” the defined benefit plan is closed to new employees who are then required to enroll in a defined contribution plan, or a hybrid plan combining defined contributions and defined benefits. In their analysis, Novy-Marx and Rauh estimate that in most states a “soft freeze” has moderate revenue saving effects. However, in seven states, including Colorado, a soft freeze increases the fiscal burden of the pension plan on the state. That is because in these states the government must bear the cost of the defined contribution plan plus the entire Social Security contribution.
In states such as Colorado only a hard freeze will generate revenue savings in the pension plan. In a hard freeze all employees, including current employees, are required to enroll in a defined contribution plan; all future benefits in the defined benefit plan are terminated. The benefits already earned by current employees and retirees in the defined benefit plan are fully funded, and Social Security benefits are extended to all employees.
In Colorado such a hard freeze would reduce the required increase in PERA contributions from 42.5 to 32.6 percent of payroll.
Even with this reform, significant increases in taxes or reductions in government services would be required to fully fund the pension plan, but the financial burden would be much less than that required by the current defined benefit plan.
Most private employers have in fact implemented either a soft freeze or hard freeze to constrain the cost of their private pension plans. Novy-Marx and Rauh maintain that there is a high probability that defined benefit plans with significant unfunded liabilities, such as PERA, will default on their obligations. The risk of bankruptcy is what has led Utah and other states to enact a soft freeze, replacing their defined benefit pension plans with defined contribution plans.
It would be more difficult and costly for Colorado to enact such a reform because of the magnitude of unfunded liabilities that have already been incurred in PERA; but that is all the more reason to enact reforms now, rather than wait for the funding crisis in PERA to bankrupt the state.
Barry W. Poulson Ph.D. is Senior Fellow in Fiscal Policy at the Independence Institute in Golden.