They can be police officers, they can be school employees and state employees, and what we do is we we make sure that they have a retirement benefit at the time that they’re ready to stop actively working. I think calpers over the last four years has been making very difficult decisions about the appropriate funding of these pension plans for the few charitable trusts i’m dan leduc – and this is after the fact – and that was marcy frost. She leads the california public employees retirement system. Calpers is the nation’s largest public pension system with a global investment portfolio of around 420 billion dollars, that’s a figure larger than the gdp of countries like norway or singapore, and the difficult decisions marcy mentions affect the retirement benefits for nearly 2 million public employees, retirees and Their families it’s a challenge facing many states across the country as they look at the best ways to fund their public pension systems and that’s. Something greg menace works on at pew. Helping states develop solutions to close the funding gap between what state pension plans owe to their public employees and the money that’s being put aside to pay that bill. A few analysis in 2018 found that funding gap in the states, totaled 1.24 trillion dollars, that’s with a t and that’s the data point for our episode. It’S a number experts see growing with the impact of the coronavirus pandemic. Amid those daunting numbers, states like pennsylvania and california have discovered innovative ways to ensure pension systems keep their promises to retirees.
I think most people are familiar with 401k plans and over 60 million americans save through retirement, primarily through those kind of plans in the public sector. It’S different, where most of the state and local workers participate in what are called defined, benefit pension plans by and large, this distinction, where, in the public sector, benefits are paid for through a fixed payment in retirement and the money is managed by the state and today There’S about four trillion dollars of public assets invested in stocks, bonds and alternative investments. Um is the main difference between how most people save for retirement. All of us have to be concerned about our retirement. All of us need to plan ahead. Why should all of us care about the public employee pension system, a well funded pension system in the public sector, can literally cost billion billions of dollars less every year from the state or local budget as compared to one that’s severely underfunded. The short answer is that in a well funded system, the state or local government is setting aside money each and every year, while people are working to pay for their benefits when they retire and as it turns out by doing that, it ends up that compounded investment Earnings end up paying for the majority of the benefit, in contrast, a severely underfunded system where the money hasn’t been set aside. While people are in their working years, they lose out on all kinds of compounded investment earnings and, as a result, the majority of the cost comes out of the stake or state or local budget.
Just to provide some examples. We look at pension plans in states like tennessee and south dakota and wisconsin, all of which are close to being fully funded. It sounds like if states are planning their investments properly in a smart way. The earnings made by those investments can pay for the costs to maintain the fund, what happens with states that aren’t fully funded? If you look at states like kentucky illinois, new jersey, all of which have less than 50 percent of the assets set aside – that budgetary cost is closer to 15 percent of of revenue on average. So that means in those states somewhere between one and ten and one and five tax dollars, is going to pensions that adds up to about a 10 billion dollars of additional costs across those three states alone. And so i think this is important from the public’s perspective. Not only because of the impact it can have on state and local budgets and in turn, the resources that are available for public services, but also because having a well funded system, helps to prevent reductions in workforce or cuts and benefits that you need to attract a Skilled public workforce to be very specific, that means there’s less money to buy police cars or paved roads or any other public service that taxpayer dollars fund right i mean and that’s that’s a big deal. I mean we government is always looking to contain costs, whether it’s health care or other issues.
This is this is a big ticket item for a lot of states, that’s, absolutely right and – and, as i mentioned before, i think for a larger state and city. The difference between having a well funded system and an underfunded system comes out to billions of dollars every year, so everything from investments in education and infrastructure to health care ends up being strained in the budget each and every year. It almost sounds, like innovation is sort of old school ideas of like just you know, figuring out what the bills are going to be and make sure you got the money to pay for them. You know, i think that that’s right and there are two ways in particular where i think innovation plays a role you know first off it has to do with how plans and pension systems plan for uncertainty and in some of the states that i just mentioned. Tennessee wisconsin and south dakota, they have very clear predefined rules about how to adjust costs if there’s a downturn or if investments underperform. This includes building a margin of safety into assumptions, essentially setting aside a rainy day fund within the pension system and then also adjustments to worker benefits that are clearly understood by everybody. And so from that perspective, i think innovation goes back to looking at the policies and practices that these states have been following for decades. Of course, a lot of the places getting attention now are the places that are troubled.
The the last number i saw was something like one: almost 1.3 trillion dollars in in a shortfall between sort of what’s going to be owed, workers and what’s sort of available that’s like a mind, boggling number um. Is it possible to catch up? No, i i think it definitely is um, certainly it’s the case where the underfunded systems that have fallen behind on contributions and now have less of the assets on hand. It’S going to it’s a problem that’s been decades in the making and it’s going to take decades to address that, and – and i think pennsylvania is a great example of a state that came out of the first decade of the 2000s, with severe financial strain on their Pension system, but over the course of almost a decade, has incrementally taken steps towards reform to make their system more stable, while preserving a path to retirement security for their public workforce. Let’S talk a little more about pennsylvania. How do they figure out the problem and how did they start figuring out the fixes sure? So i think the case study in pennsylvania actually goes back to around the year 2000, when the system was actually reporting having more than 100 of the assets to pay for future benefits. And in fact, around that time, the average state pension system was just about fully funded pennsylvania, passed a law to increase worker benefits when the system was flush by as much as 25 and then over the first 10 years of the 2000s made less than 50 of The annual required contributions that the actuaries were recommending, um that ranked pennsylvania 49th out of 50 states with only new jersey behind them in that core measure of fiscal discipline, and in addition to that, of course, the 2000s were not a bull run in the stock market.
We saw the dot com downturn in 2001 and two uh, as well as the financial market crisis in 2009.. So, as the result, they went from being over funded to having less than 50 percent of the assets on hand to pay for benefits. Well, walk us through the stages of reform that pennsylvania went through first off beginning in 2012, the state endeavored on a plan to dramatically increase con annual contributions. Um phasing it into a five billion dollar increase each and every year out of the budget from one to six billion dollars. Then, in 2017 they passed what i think we consider a landmark reform that strengthened that commitment to pension financing in the category of innovation implemented a well designed hybrid plan, one with a smaller pension benefit combined with a 401k style savings account a result that i think, Would help the state manage risk better in the future, but also provides a more equitable source of retirement savings across the workforce, including those that may change jobs and the last piece as part of that reform was the requirement to more carefully examine two things: number one. Reducing investment fees and the state has now completed a study and is expected to save three billion dollars on that front, but second, to explore the use of pension stress testing, and this, i think, is an area where we’ve definitely seen more. Recent innovation that stress test requirement was passed just this november in pennsylvania, but actually it’s the kind of analysis that the state used in 2017 to assess the risk of the system and come up with an estimate of savings between five and 30 billion dollars.
For that reform, let’s stop for a minute now and let’s make sure people understand what a stress test is. I mean i i’m old enough to have been to the cardiologist recently. I know what i have to do there. How does that apply here? Stress testing is a simulation technique that public pension plans can use to evaluate how they’re going to weather an economic downturn by running what, if scenarios, and on the one hand, i think the science of this is very technical and can be fascinating, but it’s really the Art of the exercise and establishing a stress test report that can be understood by government plan sponsors and decision makers. There are now 12 states that have a mandatory requirement in law to regularly publish a stress test report that is designed specifically to educate policy makers on the budget impacts under different economic circumstances. Obviously, the pandemic has been playing um, a big role in state budgets. We’Ve seen revenues cut over the last six months for a lot of states, what’s that going to mean for addressing the public pension system well well. First off, i think it’s important to first acknowledge the critical role state and local governments are playing in managing the national public health emergency from a budget and pension perspective. The way that we’ve been thinking about it is it’s important to have a plan both for next year, managing a very difficult budget year with a lot of uncertainty around the pandemic, but also connecting that to a longer term strategy.
That will require some resetting expectations and we’ve been thinking about this overall as a five year planning process uh, both through the downturn from kova 19, as well as the expected recovery. The more i talk to you. This is important. Interesting stuff. I mean billions of dollars. Public services uh that could or could not be funded, be based on these decisions, the future retirement security of literally millions of americans and the fact that things can change so dramatically. You mentioned you know, just in within a decade, you can go from being fully funded to 50 funded because decisions change that fast it’s, really a critical issue both for the performance of state and local governments and, at the same time, it’s part of a conversation about Retirement security for all americans, which is another significant challenge that the country’s having a big conversation is occurring in the nation’s biggest state. California, here’s marcy frost, who you heard at the beginning of this episode. So calpers is the california public employees retirement system and it is a system that takes care of both retirement and health care for about two million public sector workers in the state of california. So those public sector workers can be firefighters, they can be police officers, they can be school employees and state employees, and what we do is we we make sure that they have a retirement benefit at the time that they’re ready to stop actively working and our portfolio Sits at roughly 425 to 430 billion dollars and that’s uh again, that’s 75 funded.
So if we’re fully funded uh, that number would be much higher at the state level. What are the pressures on people like you um to try to make sure your fund is adequately funded right? I mean you there’s an obligation that the state has made to state employees to get them a safe retirement. It helps you recruit good people and helps you keep good people so uh. What are the pressures that you have to navigate to try to increase your numbers, the biggest uh pressure that we have as a as a pension plan is really the portfolio and the expected growth on that portfolio year after year is seven percent, and that is seven Percent, after all, fees are paid that’s, seven percent uh after you have adjusted for for risk. That is certainly a pressure for the investment office for calpers generally, the calpers board and every essentially every stakeholder who operates around us. I think the second pressure is one that we’ve identified in our top three risks to the system, which is the employer, the 3000 participating employers and calpers their ongoing ability to pay the contributions both on the unfunded liability side, as well as the normal cost of the Plan, how do you innovate to make sure that the funding is going to be there for the people who need it? I think part of innovation is courage. You know having courage to make the tough decisions that really no one wants to have to make yeah.
When i you know, when i think about what’s been innovative at calpers, i i can really just reflect back on the last four years since i’ve i’ve been here and one of the things we noticed right away. Is that the the rate in which we invest and that we assume that we’re going to make seven and a half percent on the money that’s being provided by the members and the public employers? When we looked at the the markets it was, you know we did not see that as being feasible, so we knew that we had to work with our stakeholders work with our legislators to help them to understand the problem. We were trying to solve that if we were not able to get seven and a half percent earnings on the money. What that means is that our public employers would have to, by contributions, make up the difference between what we were able to earn and what uh you know what we were expected to earn when we don’t hit the expected rate of return for the most part, the Public employers are paying for that. Those costs there is a dollar amount associated to it, and then it gets uh financed. If you will, over a 30 year period of time, it’s almost like a home mortgage where you’re financing a certain debt, you purchased a home for 300 000. You finance that over you know, 30 years and you’re paying 2 000 a month.
That same principle applies to the unfunded liability. What we found in that financing of 30 years is that we had negative amortization, meaning that the contributions were not coming in in a way that could even pay the interest associated with it. Remember, they’re, paying us seven percent on that unfunded liability, because if that money was actually in the trust fund, the expectation is that it would be earning seven percent. So we have to make that up and we’re making that up through interest applied to that debt and uh. We decided that uh that 30 year amortization was just not a financial policy that our actuaries could support. Or frankly, you know the calpers uh organization itself could support. It certainly wasn’t a fun message to have to send out to the members and to our employers and all of our stakeholder groups, but it ended up effectively being the right decision to make and california also adopted its version of stress testing that greg mennis explained earlier. California, or at least calpers has been, you know, stress testing. If you look for you know quite quite some time, and essentially what that means is that we have these. You know assumptions that we use in funding the system, but you need to stress test. Your assumptions. Stress test: what happens if the markets don’t return? You seven percent. We load all of the valuation data in for that particular employer, and we put it back in their hands.
They can run scenarios about what would happen so really stressing the assumptions that are used to fund the system under multiple scenarios, i think, is both about transparency and it’s, about building trust in the system and making sure that the decision makers around you, you know understand That you’re thinking beyond the best case scenario, what you’ve just described, shows just the incredible complexity and number of factors involved, and a lot of it sounds innovative because it seems like basic smart way to do stuff. It’S sharing information um, getting the people who are going to get pensions involved too, because they’re contributing to that. How hard was it for you to get some of those reforms in place, um and and get things closer to on track? The outcome everyone wants is a healthy, sustainable pension plan because, even though city managers, even those individuals in the municipalities, are you know, within the state departments themselves, they will receive a pension from calpers as well. So there is this uh common goal about making calpers as healthy as possible. I think what was lacking a bit was some transparency about the challenges and some transparency about how we were operating the portfolio or how we were operating the business. What is the one thing you wished? Maybe that just the general public and taxpayers of california better understood about the importance of getting this right. You know, as people age you don’t want them running out of money.
You also want them to have you know income, because i think it’s, almost 90 percent of our retirees, 26 billion dollars being spent in the state of california, so this portfolio, that’s earning seven percent or earned 4.7 last year – is really this economic engine of you know Paying these benefits at 60 cents on every dollar that then gets returned back to the communities in california, where it’s spent, and so i think i think sometimes that is lost well marcy, frost, thanks. So much you’ve you’ve put in a lot of work. In the last four years there we have it’s, been a it’s, been a real team effort, our work isn’t done. We have challenges ahead of us, but we’ve made good progress thanks so much for the time today. Yeah, thank you so we’re wrapping up our season on states of innovation, whether it’s making sure public pensions are funded or communities are prepared for flooding or ensuring treatment is available to meet the opioid epidemic or any of the other topics. We’Ve covered this season, you can learn more at pewtrust.org. After the fact all these innovations are based on facts and research which provide a common ground for policymakers to come together and find solutions to problems at a time when many may lament gridlock in government they’re. Examples that show progress is possible and that things can be made better. We’Ll continue that theme. The next time you hear from us. The nation’s civil legal system has been undergoing big changes over the last few decades, and those changes have only been exacerbated by the pandemic.