[I]n July 1995, Vermont’s state auditor wrote a letter to the speaker of the House, copying the Senate leader and the governor. The auditor, Ed Flanagan, could not have been more clear about the likely consequences of a proposal to shortchange the teachers' pension fund by some $7 million.
“It is not fiscally prudent for us to promise today what others will have to pay for tomorrow,” Flanagan wrote to Mike Obuchowski, the former House leader. “This type of generational inequity is both unfair and fiscally unsound.”
The auditor said Gov. Howard Dean’s administration was misguided in its claim that retirement funds were “very healthy,” adding that the governor was violating statute by ignoring the recommendations of retirement fund boards.
“By underfunding the retirement system today, we only delay an inevitable reckoning,” Flanagan wrote. “It amounts to a kind of camouflaged deficit spending, because the state must eventually cure the funding deficiency.”
The Dean administration underfunded anyhow, and the Legislature signed off on it. And the state continued to shortchange the pension system for the next decade.
A generation later, Flanagan and others who urged fiscal prudence have been vindicated. The state needs about $3.38 billion to cover future teachers’ pension liabilities, but after years of underfunding and underperforming investments, only about 55% of that is in its pension fund, leaving an unfunded liability of $1.513 billion, according to the state’s actuaries.
To pay that off, Vermont policymakers have committed $120 million this year and an average of $150 million over the next 20 years. And that’s just to catch up on the old payments and debt service. That doesn't included the normal ongoing cost of the pensions, which is about $7 million this year (members also pay in 5% to 6% of their paychecks).
Although Vermont’s economy is humming right now, about 40% of the $54 million in expected surplus state revenue this year is going to be consumed by the pension liability. When that’s combined with other debts and reserve funding, there’s little money left for new social programs or infrastructure -- the same type of programs and projects enabled by underfunding in the ’90s.
Sen. Jane Kitchel, D-Caledonia, chair of the Senate Appropriations Committee, has been preparing fellow lawmakers and advocates for disappointment as this year’s budget process unfolds.
“When people are coming in saying, ‘Why don't you do more for this particular service area?’ Or ‘This program hasn't had a benefit increase in years,’ the expectation is there's more money,” Kitchel said. “But if you take 40% right off, then and then you've got to deal with all those ups ... there's nothing left.”
Kitchel was on the other side of the budget conversation in the 1990s, as the secretary of human services. She said that the Dean administration was telling legislators not to worry about the underfunding, because investment returns were so strong.
“When you have so many competing priorities, and you're sitting around, and if someone is saying that their conclusion is that the underfunding isn't going to be a problem, then that's kind of an attractive option to take,” she said.
Obuchowski, the former speaker, said the political calculation was straightforward. “There was a sense that there were bigger needs than paying an annuity. I think it was that simple, that people saw the needs of common ordinary people and made the judgement that we can short this a little bit now and pay for it later,” he said.
Dean had promised to abide by a 1991 pact forged between Speaker Ralph Wright and Gov. Richard Snelling to retire the state’s deficit, which had soared under Gov. Madeleine Kunin. “There was a lot of pressure at that time — pressure to spend — and there wasn't any revenue to go after,” Obuchowski said.
The tension between pension obligations and current needs — health care, education, food and housing — always exists, Obuchowski added. He said there was spirited debate in the Legislature over whether to accept Dean’s recommendation to underfund on pensions and spend elsewhere. “Does everybody bear some responsibility for this? Yes. Is there a lesson here? Yes,” he said. "There’s really nobody with clean hands."
Vermont's unfunded teachers' pension liability, explained
Graphic by Felippe Rodrigues
Flanagan, who died in 2017, wasn’t the only state official telling legislators to look long term and follow the advice of actuaries, whose job is to assess risk in the state’s finances. Former Gov. Jim Douglas, who was treasurer from 1995 to 2003, was part of the chorus warning against underfunding,
“I felt as a fiduciary, as a trustee of the systems, I needed to advocate for full funding and did, but you know, didn't always succeed,” Douglas said. “I think there was a greater sense of optimism, and that was well founded in terms of the actual returns on our investments. Then the recession of 2000 offered a dose of reality to a degree. And then obviously, the Great Recession, of ’07 and ’09, was a heavy dose of reality.”
The “funded ratio” of the teacher’s retirement fund -- the value of assets compared with the value of liabilities -- steadily increased during the Dean administration, hitting a peak of 90.7% in 2005. Then it started falling. When the recession hit in 2008, it dropped from 80.9% to 65.4% in a single year. A decade later, it’s at 55.2%.
“Poor decisions were made,” said Beth Pearce, the current treasurer, who entered office in 2011. “If you don't invest your dollars, you lose the ability to to take advantage of compound interest. And when you do that, the taxpayer suffers.” (Kitchel made the same point, recalling a lesson on compound interest from the movie "Mary Poppins.")
Pearce said actuaries have estimated that at least $25 million of what the state is paying for unfunded pensions each year is because of chronic underfunding by “multiple administrations and multiple legislatures” from 1989 to 2007. But she stressed that’s the minimum figure, and it could be far higher. VTDigger’s own analysis shows that underfunding since 1979 (the furthest back we could find data for) has cost about $430 million if you factor in real inflation and assume annual returns of 5.5%.
The state hires an actuary every year to make a recommendation for how much it should pay into teacher and state employee pensions (which is also underfunded to a lesser degree). Because the pension fund needs to cover obligations that will be paid out decades from now, the recommendation is based on long-term projections of pension costs and financial returns, as well as human factors like how long retired teachers will live on average, when they will retire, and how many beneficiaries will also collect.
While Dean was not the first governor to ignore the advice of actuaries and fiduciaries in state government -- the practice goes back at least to the late 1970s -- his 11-plus years at the helm saw unprecedented underfunding, both in scale and duration.
Teachers’ pensions were underfunded each of his years in office, from August 1991 to January 2003. In 1996, his budget allocated $11.5 million to the unfunded liability —just 38.4% of the recommended $29.9 million. On average, payments to the retirement system were only 70% of what actuaries recommended during Dean’s tenure.
The cost of underfunding over the decades
Graphic by Felippe Rodrigues
Dean said in an interview that he has no regrets about his decisions regarding pension funding. He said it was one of many tough decisions during a time of fiscal austerity, and it was preferable to some of the other options.
“I just wasn't going to take health care away from poor people. And I wasn't going to raise people's property taxes by shifting it all out of the education department,” he said. “So I chose not to fully fund the pension.”
Dean, a Democrat known for fiscal conservatism, said that while he accepted responsibility for his part in the current situation, underfunding wasn’t the only factor. He pointed to poor investment returns over the past decade as a major reason for the funding gap.
“Well there were an awful lot of people who did much better than we did in terms of how their investments performed and ours is ... kind of at the bottom of the heap,” he said. “I mean, there were large funds that increased their value by twice the percentage that ours did. So I mean, one might make the argument over the last 15 or 20 years since I was governor, that ... there were a lot of reasons for this.”
Dean argued that if Vermont’s retirement fund investment managers — a board vice-chaired by the treasurer — had hit the projected returns over the past two decades, the pension funds would be in far better shape.
Dean’s practice of underfunding continued into Douglas’ tenure following his election in 2002. In his first four years in office, the pension funds were paid into at 70% of the actuary’s recommendation, going as low as 50% in 2006. But starting in 2007, payments either met or exceeded the actuarial recommendation, and that has continued until now.
Douglas, a Republican, remembered during his time as treasurer unsuccessfully lobbying Jeb Spaulding, the Senate Appropriations chair, to fully fund pensions. Then Spaulding became treasurer and tried to convince Douglas, as governor, to fully fund. “And I'd say, well, gosh, let's go to the tape here,” Douglas said of those conversations with Spaulding, adding: “Where you stand depends where you sit.” (Spaulding declined to be interviewed).
Douglas also blamed much of the underfunding on the gap between projected returns, which were as high as 8.25% in 2010, and actual returns. The investment returns' target is central to the actuary’s recommendation, so when investments underperform it can dramatically expand the unfunded liability.
In the 10-year period leading up to 2016, Vermont achieved about a 4.5% annual return on both its teachers' and state employees' pension funds, near the bottom of national rankings, according the Pew Charitable Trust. The South Dakota Retirement System has hit the highest returns in the country during that time, at almost 7%. No state met or exceeded its investment return target.
Pearce accused Pew of having an “ideological bent” and said 10-year snapshots can be misleading because of market volatility. “December wasn't a great time for us. January has been a little bit better. So depending on when you look at those numbers, you're going to get different results,” she said. The treasurer’s office boasts a 7.7% annual return for the State Teachers' Retirement System in the seven-year period through June 30, 2017. (Pew said in an email that its work is "fact-based, nonpartisan, and designed to serve the public interest.")
Pearce added that the state has recalibrated investment strategies to reduce risk since the Great Recession. In fiscal 2009, the teachers' pension fund lost $177 million of value in a single year. Only 53% of the state’s pension funds were invested in equities up until last month, when the investment committee switched up the formula, according to Pearce. That means Vermont has not benefited as much as it could have from a booming stock market.
“To me, you don't want to put 80% of your money in stocks, for instance -- you might do that at home, you might take your own bet on that -- but downside risk is important to the taxpayer,” Pearce said. “And for us, we want to be that steady upward trend, and not that big volatile up and down.” The new investment formula allocates 71% to “growth assets,” which includes equities.
And while the pension assets have grown more slowly than expected, the liabilities have ballooned, largely because of rising health care costs. Douglas noted that during his administration, government accounting standards changed, requiring states to include health care in their projected costs.
“So that caused an immediate decline in the funded status and an increase in the the actuarial recommended payment each year,” he said. The state has since set up a separate teachers' health care fund that has quickly caught up with pensions -- accruing almost $1 billion in unfunded liability on its own. But unlike with pensions, there is no statutory obligation to prefund health care, though Pearce has started a push to store away some money.
Douglas said he is skeptical about the state’s 7.5% target for investment returns, which is two points above average returns across the country in the past 10 years, “which means that the actual underfunding might even be greater now,” he said. “You mention the 2038 amortization period. I mean, we've gone after those before and we keep recalculating, and so I hope it's paid off in 20 years. We'll see.”
Pew says the next 20 years will see annual returns of 6.5% from a typical institutional investment portfolio. But it says there’s a 25% chance the yearly returns don’t even top 5%. “Despite the greater risk incurred, public sector plans continue to see real returns underperform against actuarial assumptions,” Pew wrote.
Keeping the target for returns higher is attractive for the same reason as underfunding: it means the state has to put less money in the funds now, because it will be made up by earnings down the road. If actual returns are significantly below expectations, that could have a huge impact on the size of annual payments, or it could require the state to recalculate its repayment plan entirely.
Pearce said she has hired a consultant to look at the 7.5% figure and conduct a risk assessment to determine whether it should be revised. She declined to speculate on how much the pension funding arc would shift if the number were revised down by a point or more, but said her process for setting the target is entirely apolitical.
Whatever materializes in the years to come, the treasurer wants the state to keep making its pension payments. “There are no silver bullets, there’s only fiscal discipline,” she said. “And we need to do the right thing now, so that we don't end up having the same conversation 20 years down the road.”
2022 Election Briefs
- Bernie Sanders endorses David Zuckerman’s bid for lieutenant governor (August 1, 6:14 pm)
- 2nd poll shows Becca Balint well ahead of Molly Gray (August 1, 5:15 pm)
- VTDigger launches printable, multilingual primary voting resources (July 20, 11:24 am)
Missing out on the latest scoop? Sign up for Final Reading for a rundown on the day's news in the Legislature.