Late last week, the redoubtable Andrew Biggs of the American Enterprise Institute published a state-by-state comparison of full-career public pension retirement benefits, in that organization’s monthly Economic Perspectives.  While news of PERA’s long-term fiscal problems won’t be a surprise to anyone reading this blog, it may come as a surprise to learn that Colorado ranks among the most generous states when it comes to that measure.

In nominal dollars, Colorado ranks fourth in the country, at just over $60,000 for an employee who spends his entire career in the state civil service.  The $60,420 per annum figure ranks just behind California and Alaska, and considerably behind Nevada’s $64,000.  When adjusted for the states’ relative cost of living, as calculated by the Council for Community and Economic Research, Colorado jumps well past both California and Alaska, into 2nd place.

Biggs also noted that the present value of these benefits can create “pension millionaires,” whose benefits exceed $1 million in today’s money.  When Colorado’s benefit is compounded at the maximum 2.0% COLA, and then discounted using a 3.5% risk-free discount rate, the total comes in at $1.25 million in 2014 dollars, assuming the beneficiary retires at 60 and lives to 82.5 years of age.

As Biggs points out, the need to stay for an entire career in order to collect benefits, at the same time that they forego Social Security benefits for those years, is a serious disincentive to retaining qualified and motivated public employees.  Those who leave – or arrive – in the middle of their career get shortchanged the most, since vesting and benefits are not proportional to the years served.

The problem here isn’t that workers are greedy, or that these benefits themselves are unsustainable.  It’s that the results are unfair to the majority of workers, who find their own benefits shortchanged in order to fund the retirements of full-career public servants.  A conversion to a defined contribution plan, where workers are always fully vested in their own contributions would help to solve this problem, and be much fairer to the majority of workers who do not spend their entire careers with the government.

My introductory at-bat in the Independence Institute’s lineup at the Greeley Tribune:

The assumption of a 7.5 percent return masks considerable risk and volatility. Although catastrophic market years such as 2008 have historically been rare, smaller routine losses are to be expected. Those losses can force an already-underfunded system to eat its seed corn by paying benefits out of assets that should be earning returns.

As a result, considerable risk exists that in the future, the state will still need to cut benefits to those who are already retired, to raise taxes, to cut services, or all three.

There is a way out.

I suggest three reforms that would help solve the problem.  We’re no longer in a budget crisis.  The Democrats’ passion for spending every last dime that comes in on new programs that will cry poor in the next recession may fix that.  In the meantime, though, now would be a good time to fix this.

Today at PERA’s testimony in front of the Colorado legislature’s Joint Budget Committee, the subject of the revisions of GASB’s public pension accounting rules came up.  While PERA produced the usual song and dance about discount rates, one portion of the discussion was illuminating.

It turns out that each district that participates in PERA will have to show a pro-rated portion of that fund’s liability on its own balance sheet.  PERA makes a couple of comments about this; first, that this is an unusual liability that can’t be brought forward, and second, that there’s nothing that the district can do to reduce it.  The first comment is the usual stuff that public pensions always use to justify their higher discount rate.  The second requires a little explanation.

You need to remember that the unfunded liability is PERA’s, and it’s only being distributed for accounting reasons to the various districts.  The PERA funds are managed by PERA on behalf of the individual members, not on behalf of the districts.  The districts have an annual required contribution based on the salaries of the individual PERA members working there, but that’s it.  Their contributions go into the appropriate PERA fund, and become the property of PERA.  There’s no “JeffCo School Account” at PERA, or “Mesa County Employees” account.

Which means that there’s also no way for the individual district to discharge it own portion of PERA’s unfunded liability, even if PERA were permitted to take additional contributions from employers, which it’s not.

Suppose the School Fund has an unfunded liability of $10 billion.  Suppose 5%, or $500 million of that, is attributable to JeffCo School.  And suppose JeffCo, in a Herculean effort, raises $500 million in taxes to pay it off, and ensure that they never have to worry about their portion of PERA’s unfunded liability again.  JeffCo School cuts a check to PERA for $500 million.  And that money goes into the Big Barrel called, “PERA School Fund,” reducing its unfunded liability by 5%, to $9.5 billion.  And the next year, JeffCo’s Schools gets a Thank You Note, along with a notice from PERA that they are responsible for 5% of PERA’s School Fund unfunded liability, or $475 million.  That’s what PERA means when it says that this is a unique liability for districts – they can’t really do anything about it on their own, but there it sits, on their balance sheets, screwing up their ratios.

Wait, ratios?

Yes, ratios.  It turns out that the Colorado Department of Education does a Fiscal Health Analysis on the various school districts, and a key part of that analysis is certain ratios, three of which (Asset Sufficiency, Operating Reserve, and Change in Fund Balance) depend on the districts’ General Fund Balance.   CDE hasn’t disclosed yet how they’ll deal with this change, but if it were up to me, I’d more or less ignore it in that analysis.  The liability really belongs to PERA, not to the district, and since the legislature will ultimately fix (or not) the problem, it’s almost impossible to know how it relates to any district’s current demographics, employment, or finances.

Last Thursday, Colorado PERA Executive Director Greg Smith gave his annual SMART Act testimony to the Joint Finance Committee of the Colorado General Assembly.  Since 2012, all departments of the Colorado state government have been required to testify during the interim concerning their operations, their efficiency, and the degree to which they are fulfilling their mission.

PERA recently changed its assumed long-term rate of return from 8% to 7.5%.  In light of that change, its amortization period – the time when PERA will have no unfunded liability, assuming a constant rate of return – has grown from 30 years, probably to something near 40 years.

During the Q&A session, State Rep. Lori Saine (R-Dacono) asked Smith about using a Monte Carlo simulation to test PERA’s long-term soundness.  As described in more detail here, averaging a given return over a period of time isn’t the same thing as getting that rate of return every year.  PERA’s portfolio might well average 7.5% over 40 years, and still go bust because its returns in the next few years are below average, leaving to try to make up the difference from a lower balance.  Rep. Saine was asking if PERA did or could run a simulated 40-year set of returns, and see how often the fund went bust and how often it stayed solvent at the end of that 40-year window.

Mr. Smith replied that yes, they do Monte Carlo simulations, and then proceeded to describe not those, but instead a sensitivity analysis available in the Comprehensive Annual Financial Report (CAFR).  The sensitivity analysis is something else altogether.  It looks as what happens to PERA if the returns over 40 years are 6.5%, 7.5%, 8%, up to 9.5%, but it still assumes a constant rate of return.  This is a completely different analysis, one that admits the possibility of lower-than-expected long-term returns, but ignores the danger in a few years of very low short-term returns, or even a couple of years of severe losses.

Monte Carlo simulations model the year-to-year variability in return that is an inherent function of risk.  As a result, even funds that appear to be well-funded, or that appear to have a long-term path to being fully-funded, can show low likelihoods of staying solvent through their amortization periods.  Doing such an analysis helps to prevent unpleasant surprises, and is to be preferred to a simple sensitivity analysis such as the type PERA performs and publishes.

Regardless of one’s preference, the two shouldn’t be confused for each other.

You can hear the entire exchange here: