Underfunded pensions dwarf deficit

Hartford - It's one of the simpler guidelines in politics: Be careful what you promise; someone might ask you to pay up.

As the state of Connecticut prepares to face a gaping deficit in its budget for the next two fiscal years, lawmakers and Gov.-elect Dan Malloy also will be forced to reckon with an equally challenging and even bigger problem: the long-term cost of the pensions and health care the state has promised its retirees.

The challenge is one inherited from past legislators and governors, who despite occasional periods of reform and investment have repeatedly failed to set aside money for pension accounts - accounts that will owe tens of billions of dollars to retired workers over the next 30 years.

The reason isn't just the collapse in stock market investments, said State Treasurer Denise Nappier, whose office manages the investment of pension funds. That collapse only exacerbated an underlying, older problem, she said: The state for years has failed to set aside the funds it will one day be compelled to pay.

"I think the biggest issue is the fact that the state has not exercised discipline in funding its obligations," Nappier said in an interview last week.

The situation is drawing notice. Connecticut was ranked fifth-worst in its pension funding levels in a recent survey of the states, and its future cost projections are eye-popping, even by the standards of a state growing used to multi-billion-dollar deficits.

Connecticut's unfunded future liabilities - the total cost of benefits the state is obligated to pay to workers and retirees over the next 30 years, but for which no funds have been set aside - now totals some $50.4 billion, according to nonpartisan analysts for the legislature and the executive branch.

Those liabilities include pensions the state will pay to retired workers, judges and schoolteachers, as well as the cost of providing health care to retirees, all guaranteed to workers in repeated agreements between past governors and state employee unions.

If lawmakers hope to catch a break in the form of concessions from the unions, they will have to drive a hard bargain. Eighteen months after agreeing to a concession package to help Gov. M. Jodi Rell and legislative Democrats wriggle out of the last deficit, union officials say the next cut should not come out of the hides of state workers or retirees.

The bill for all this will not come due all at once - retirements happen gradually, over decades, not just years - and pension funds rarely if ever hold 100 percent of the amount they will eventually pay out. Nonpartisan groups like the Pew Center on the States give their highest marks to states that set aside 80 percent or more of the total expected obligation.

But legislators and policy experts at a number of nonpartisan organizations list Connecticut among those states with the biggest imbalance between benefits it has pledged and funds it has set aside to pay for them.

"I wouldn't characterize it as a bomb, but there is definitely a huge liability that seems to be increasing, especially in the last few years, partly because of lower investment returns," said Michael J. Cicchetti, a veteran of the governor's budget office under Rell and predecessor John G. Rowland. "These are dollars the state owes and will have to pay at some point."

The costs of pensions and retiree health care keep growing, even as the assets that will support those benefits fail to keep pace. Something, it seems, is going to have to change.

Funding less and less

As it has fallen behind the pace of the growth of its liabilities, Connecticut has joined a national trend.

A recent study by the Pew Center on the States noted that, nationwide, states were running a surplus of $56 billion in pension plans in 2000.

But liabilities have steadily risen since then, even as the value of the assets that will back future pension claims has fallen, hit by two stock market recessions. Moreover, the states have decided not to make the payments they would need to make to account for future obligations.

The Pew study totaled the amount of outstanding obligations for which states have no corresponding assets at $1 trillion nationwide, and listed Connecticut among the states that have generated "serious concerns" about the funding of their pension systems.

Much of the recent gubernatorial campaign was focused on the current budget deficit - the $3.4 billion shortfall in revenues that will challenge Malloy and legislative leaders as they try to find ways to keep the lights on.

But the underfunding of the State Employees Retirement System is approaching a "danger zone," said Nappier.

The state has too readily skimped, or skipped, on its payments into the retirement system, she said. The system's current assets, after the devastating recession, three years of deferred payments and an early retirement program that swelled the rolls of beneficiaries, are enough to support only 46 percent of what it owes.

In June 2008, the figure was 52 percent, according to the legislature's nonpartisan Office of Fiscal Analysis.

The Office of Policy and Management, which serves as the budget office for the executive branch, estimates the total liabilities of the state employee pension system at $11.7 billion, with just 44 percent of that amount funded as of June 30, the end of fiscal 2010. By contrast, in 2000, the system was projected to owe $4.3 billion in future pension payments and had enough assets to pay out 63 percent of that amount.

The state's retirement system for teachers is in better shape, primarily because of the decision by Nappier and the legislature in 2008 to issue a $2 billion bond to fund those pensions.

The bond, she noted, included language requiring the state to make payments into the teachers' retirement system at the full amount recommended by actuaries for the entire time the bonds are outstanding - a move designed to prevent lawmakers from chronically avoiding paying into the system, as they had in previous years.

Lack of financial discipline

"We do have a problem," said Nappier, a Democrat who was re-elected in November to her fourth term as treasurer. "And it didn't happen because of the economic downturn."

The unfunded ratio of the pension system has been increasing, Nappier said, in part because the total cost of liabilities - all those pension payments to all those retired workers, all that health care for all those people who are living longer and longer - is soaring.

But the problem is also that the Democratic legislature and the past two Republican governors have lacked the discipline to make sufficient annual payments into the funds that Nappier then invests, she said.

"No investment program, no matter how successful, can make up for monies not put into the fund," Nappier said.

For states trying to maintain health and pension systems, "diligence" is crucial, said Ronald K. Snell, an expert on pensions at the National Coalition of State Legislatures.

"The current crisis of under-funding is in part a legacy of underfunding in the past, and in part a result of the stock market crash," he said. "The important thing to do is to make sure that going forward, costs are controlled, and contributions are made as they ought to be made so the problem doesn't get any worse."

In all, 19 states made changes to their pension plans in 2010, Snell said, including Rhode Island and New Jersey, which reduced benefits, and Vermont, which cut benefits and boosted employee contributions to the pension system.

More states should be expected to follow suit in 2011, Snell said, in what could be a "major year" for adjustments in both pension and retiree health care funding.

More red ink

Connecticut's State Employee Bargaining Agent Coalition (SEBAC), which negotiated the current 20-year contract that covers state workers' health and retirement benefits through 2017, agreed to benefit plan changes as recently as 2009.

That year, the union coalition struck a deal with the Rell administration under which employees hired after July 1, 2009, must pay for 10 years into a fund that will support health costs for retired workers.

(Before a 2008 rule-change by the Government Accounting Standards Board, states were not required to account for or publish the future cost of non-pension benefits, such as health insurance for retired state workers. That change added a huge new dash of red ink to the state's books: $26.6 billion in unfunded future health benefits for retired employees, and an additional $2.9 billion for teachers.)

But the SEBAC deal also added significantly to the underfunding of the pension system: The employees union agreed to let the Rell administration defer payments into the funds into the future, increasing the shortfall, in order to help balance the budget. The state withheld pension contributions of $50 million in fiscal 2009, $164.5 million in 2010, and it will withhold another $100 million in 2011.

The challenge for legislatures and governors, Snell said, will be deciding the amount that a state can realistically afford to pony up each year to back a pension system, and whether the decided-upon amount will fund the systems they already have or require changes in benefits. And then, even in rough years like the one currently looming in Hartford, they'll have to find the "diligence and discipline" to make the payments.

"The question going forward is to make sure that the structure is sustainable, and that's a question of how much money you want to put into it" annually, Snell said.

Some have been pushing for change, including Republican gubernatorial candidate Tom Foley, who spoke during the campaign about switching the state from a traditional pension system to the 401(k) and IRA plans that dominate the private sector.

Such a drastic move is uncommon among states, but many have considered or adopted "hybrid" plans that combine a smaller guaranteed benefit with a defined contribution add-on. Such plans were adopted in Michigan and Utah in 2010, according to the NCSL.

Some change is coming, said Cicchetti, the deputy secretary at the Office of Policy and Management who chaired the state's Post-Employment Benefits Commission, which Rell formed to advise her on possible reforms of the pension and health benefits systems.

"I think that future policymakers are going to be faced with making some changes in how we fund retiree benefits for state employees, or they're going to continue to see a larger and larger percentage of the state budget going to retiree benefits and retiree health," Cicchetti said in an interview.

If lawmakers "do nothing," the annual cost of benefits could hit 19 percent of the state's budget by 2032, Cicchetti said.

"Not only have the gross amounts increased, but the percentage of the state budget will continue to grow, which means there's less and less dollars for other programs that the state funds," he said.

Nappier sits on the "asset side, not the liability side" of pension decisions, she said, but she did say the state needs to adjust the plans to ensure that costs for pensions and health care are realistic and not "exorbitant."

"We do need to get a better handle on our liabilities and become more disciplined in funding them," Nappier said. "We need to be more prudent about the kinds of the design of the plan itself. The fact is that in some cases they have been runaway benefits."

But for many pension recipients, the benefits are reasonable - "The guy who's well into six figures, and he's been there 30 years, that's not the average worker," Nappier said - and the primary problem has been the government's unwillingness to pay up the cash it has promised.

"I don't think the culprit is just the defined benefit," she added. "There are pros and cons to both… We have not properly managed this fund over the years, and now it's come home to roost."

A test for Malloy

Then there are the workers themselves.

The unions that represent roughly 50,000 state workers zealously guard the benefits - pay, retirement, health and time - that they have negotiated with the state over years.

Many also bridle at the public suggestion, from legislators and the news media, that the workers are taking home lavish pay and otherworldly benefits at the expense of fellow citizens just struggling to make it.

"We were the only ones who helped the budget out the last two years," said Patrice Peterson, the president of CSEA/SEIU Local 2001, referring to the 2009 package of union concessions, which yielded an estimated $700 million in budget savings over three fiscal years.

"It would be really nice to get some acknowledgment that we've already given, and there are a lot of other places in Connecticut to be looking," she said.

Labor leaders are preparing for a tough session and a "task master" in the person of Malloy, said Sharon Palmer, the president of AFT Connecticut, the teachers' union.

They're also preparing for a fight with conservatives or others who they feel might make public employees the target in the search for budget cuts, whether seeking to cut the work force, pay scales, benefits or all of the above.

"I don't think the research bears out" the assumption that state workers are overpaid compared to the private sector, said Palmer.

SEBAC has distributed a study by researchers from the University of Wisconsin-Milwaukee that found public sector employees were more frequently paid less than their private sector counterparts if additional qualifications, especially education and specialization, were taken into account.

While candidates like Foley have talked about shifting old-school pension systems toward a 401(k) model, Palmer said she considers it "scary... for the future of the country," and warned that the long-term implication of such a system could wind up being more expensive for taxpayers, if recipients cannot live on smaller benefit packages and resort to social programs instead.

"I know it's the trend out there; we happen to think that it's not a good trend," Palmer said. "In the labor movement, we're trying to raise everyone up, whether they're in the union or not."

Malloy has been frank but noncommittal. He refused to join Foley in pledging not to raise any taxes or fees, and has pledged to spare the state's "safety net" from damage, but he has also boasted of his reputation as a cost-cutter and streamliner during his 14 years as mayor of Stamford.

One area to test the new governor's budgeting abilities will present itself immediately: According to projections from OPM, the state's required annual contribution to the employee pension system in each of the next two years will surpass $1 billion.

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