Commentary

David Coates: The consequences of doing nothing

Editor’s note: This commentary is by David Coates, a retired managing partner at KPMG — Vermont and a member of the Vermont Business Roundtable. He was a member of the 2010 state Commission on the Design and Funding of Retirement and Retiree Health Benefits Plans for State Employees and Teachers. He is on the board of directors of Green Mountain Power. He lives in Colchester.

There is both good news and bad news in the latest report from the state’s actuary. First the good news — the retiree health care benefits unfunded liability for state workers and teachers was reduced by $274 million from 2015 ($2.1 billion) to 2016 ($1.8 billion). This reduction reflects better claims experience than expected and, in fairness, many positive changes for both pensions and retiree health care benefits made by the treasurer.

Once again, the bad news is the unfunded liability for state workers and teachers pensions, which increased by $90 million from 2015 ($1.7 billion) to 2016 ($1.8 billion). In total, the combined unfunded liabilities as of June 30, 2016, is $3.6 billion, or $5,800 for every resident of Vermont. For comparison purposes, the total net tax-supported debt for the state as June 30, 2016, is $637 million or slightly over $1,000 per every Vermont resident.

In other words, these unfunded liabilities are the largest debt in our state and they have been rising despite making payments on the pensions as required by the state’s actuary. Again for comparison purposes, these unfunded liabilities were $2.7 billion in 2010 or $4,300 for every resident of Vermont.

A more detailed look at each of these unfunded liabilities can shed further light on these challenges.

Pensions

As mentioned earlier, despite paying the annual required contribution, the unfunded liability continues to rise by $90 million in 2016 and $197 million in 2015. There are several reasons for this, but the primary one seems to be the assumptions used by the state.

For instance, currently the projected rate used for the earnings and discount rates is 7.95 percent down from 2014 of 8.22 percent … a good thing, but still much higher than can ever be achieved. By contrast, private sector rates for investment earnings are closer to 6-7 percent and discount rates around 4 percent. CalPers, the California Public Employees Retirement System and the largest in the country, recently reduced rates from 7.5 percent to 7 percent. If Vermont did the same, it could add close to $1 billion (including retiree health care benefits) in unfunded liabilities. This would add a significant amount to the annual required contribution, thus requiring more general fund resources putting more pressure on our limited state revenues.

As noted, annual payments to support these benefits will continue to increase even more than the actuary projects, which will continue to put pressure on the general fund and crowd out other important state programs.

 

For example, in 2014, the actuary projected the annual required contribution payment for pensions in 2017 would be $102 million and in 2016, projected this same payment to be $118 million. That $16 million increase exposes how little confidence our state budget committees should have in these projections because at least two critical assumptions are overstated. Remember,higher assumptions for earnings and discount rates result in a smaller liability, and lower assumptions result in a larger liability. Going forward, the assumptions must be made to reflect the real world and provide Vermonters a true sense of the actual cost of these benefits.

Retiree Health Care Benefits

Despite the reduction in these unfunded liabilities from 2015 to 2016, both the short- and long-term outlooks for the state are alarming. There is no possible way the state can correct the present course for these benefits; the annual required contribution is impossible to fund without identifying another source of annual revenue.

Annually, the state underfunds this benefit by approximately $50 million. The underfunding will continue and the liability will rise. The reduction this year was good news, but it pales in comparison to the total debt of $1.8 billion. The assumptions used to compute this liability are questionable as well. My question to the Legislature is this: Why do you provide these benefits if you can’t pay for them?

Incremental changes to date only scratch the surface. Structural change is the only solution at this point and it will take much more than the treasurer. She just can’t do it alone.

The consequences of doing nothing

As noted above, annual payments to support these benefits will continue to increase even more than the actuary projects, which will continue to put pressure on the general fund and crowd out other important state programs. If the state is unable to pay the annual required contribution, at least for the pensions, it will undoubtedly impact the state’s bond rating. And the consequences of a lower bond rating would likely be millions of additional financing costs for the state and other governmental units, including our municipalities.

The state’s financial reports will also be impacted because, as of June 30, 2018, the unfunded liability for the retiree health care benefits will be required to be recorded. The pension unfunded liability of $1.8 billion is currently included, but not the $1.8 billion liability for the retiree health care benefits. If this liability had been recorded as of June 30,2016, it would have resulted in reducing the state’s net asset position (net worth)of a positive $1.2 billion to a negative position of $600 million.

In my opinion, this would reflect poorly on the state and cause the rating agencies to take another look at our rating. Especially, if the state does not have a plan to address the situation. As I said earlier, this outlook is alarming.

In my next commentary, I will provide some context for actions that could alleviate this situation and bring some balance and fairness to our state and all Vermonters.


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  • Ron Ferrara

    “CalPers, the California Public Employees Retirement System and the largest in the country, recently reduced rates from 7.5 percent to 7 percent.” That is both good and bad news.

    CalPERS will spread this reduction over three years (2017-2020), during which time it also expects a concomitant increase of (at least) 30% in its unfunded accrued pension liabilities.

    http://www.calpers.ca.gov/page/newsroom/calpers-news/2016/calpers-lower-discount-rate

    CalPERS knows that even these reduced expected returns (introduced to shore up Governor Brown’s pension reforms), are unrealistic and insufficient to avoid (perhaps) a $1 trillion debt.

    http://www.eastbaytimes.com/2017/02/02/borenstein-gov-browns-pension-reform-effort-has-failed

  • James Rude

    If Vermont did initially set its discount rate to something closer to what invested returns actually are, then the public would be shocked at how much public pension cost the taxpayer to fund such programs annually. This is the main reason why public pensions have gotten into deep water because by keeping the assumption of invested returns artificially high, they have been able to present a false picture as to how public pensions operate. It is not just the overly optimistic discount rate that has gotten public pensions in trouble but also the benefit structure itself. Most private pension plans base their benefits on someone working to full service, usually 25+ years and targeting an income replacement of around 60% including any Social Security if the company was an SS participant. Income replacement in private pensions is usually based on an employee’s base salary only thus eliminating an employee’s ability to spike final years earning for a higher benefit

  • James Rude

    In many ways, it is ironic that private companies have moved away from traditional defined benefit pensions because of the costs imposed by government regulations, while public pensions still flourish because of a different set of relaxed accounting rules.

  • As we speak, our legislators are cloistered in Montpelier reviewing a host of new bills and regulations. Any guesses on pending actions to address this critical issue? My guess – none. Please correct me if I am wrong. Doing nothing is not an option. Phil Scott took a brave stand in attempt to lead the horse to water on school spending a few weeks ago. Here is another opportunity for our new governor to demand our legislators address the important issues facing our state rather than turn a blind eye to appease a vocal base of contributors – kicking the can down the road for another year. I look forward to David’s next commentary recommending actions.

  • Re: The consequences of doing nothing

    I thank Mr. Coates for reiterating this issue. And I caution readers to beware the likely push-back that has been typical in the remarks of Vermont’s financial management team, including the State Auditor, who typically down-plays the significance of debt in our budget considerations. After all, government and education employment makes up the lion’s share of Vermont’s current job growth.

    • Paul Richards

      “After all, government and education employment makes up the lion’s share of Vermont’s current job growth” This is a shell game set up by the public sector unions. The fox is watching the chicken coop, still. $1.8 BILLION in promises made by people who knew they could not deliver. As they depart it’s left up to someone else, another generation. The taxpayers are fools to allow this to continue.
      There is a fix for it but it’s not going to be easy; stop the practice of providing these discriminatory pension plans and return public sector unions back to illegal status. Too many people are feeding at the trough in this corrupt system. Start taking real actions to dismantle it before we end up like Detroit.

  • You have described the problem well David. Looking forward to your suggested solutions.

  • Neil Johnson

    We should provide all pay and accounting for any employee of state or school to reflect the entire amount. From here on out, you are paid your retirement, health care, taxes….all in the year you earn them. All accounted for on one bill. That way everyone knows where they stand and what is being done.

    At that point we’ll have rapid and needed changes. The accounting is messed up!

    • Kathy Callaghan

      Interesting concept, but it would result in the employee paying out more in taxes on those benefits than they would when they retire and are in lower tax brackets. Whatever I have to pay out in taxes, I can’t put away for retirement.

    • Arthur Hamlin

      That’s like saying you should pay your entire 30 year mortgage in one year, or don’t own a house.

  • Jack Ewell

    This narrative exposes failures of multiple administrations to act at times that might have presented greater options for dealing responsibly with this financial obligation which legislators effectively hide from the public. It also exposes the failure and myth associated with local control of education. Local school boards and communities do not plan for nor even discuss these obligations as part of the total compensation for teachers in the budget process with the public. Legislators and advocates of “local control” speak passionately about its importance and then point fingers at each other when the taxpayer is caught in the vice grip of its failure. Our political leaders do a great disservice to taxpayers by continuing this myth, especially with extraordinary financial consequences to taxpayers and those expecting to benefit from this uncontrolled obligation.

  • John McClaughry

    Thank you David Coates for your years of focusing public attention on this serious problem, which is getting worse despite a few modest steps by the present Treasurer. Instead of drafting her to find revenue for Lake cleanup, the legislature ought to ask her to explain how Vermont will ever get out from under the multibillion dollar unfunded retirement obligation overhang.

  • Arthur Hamlin

    According to the Treasurer’s website, the average net return of the State Employees Pension Fund over the last 7 years is 8.7 percent, exceeding the 7.95 percent that Coates’ says can never be achieved!

  • I’ve just looked through the auditor’s report (David Driscoll of Buck Consulting) for 2016 (http://bit.ly/VTRFAudit) and one fact that renders Coates’ commentary a bit suspect is found in the table on page 26, which lays out the anticipated total contribution the state will need to make over the next 23 years to extinguish the unfunded liabillity. The amount increases steadily by 4MM ($4 milllion) for a few years, then 5MM for a few, etc., until it’s all paid off on 6/30/2038. So on a year by year basis we are talking about a very small differential from year to year vs the overall state budget.

    A lot of assumptions are available for framing discussions about the state teachers pension fund. The one Coates focuses on, the anticipated rate of return on the 1.7B ($1.6 billion) in current assets, is only one. Schedule B of the report lists 14. There’s no crisis here. It is well managed.