On Nov. 16, 2017, S&P Global Ratings put Colorado’s credit rating on negative outlook. The finances of the state’s public pensions, the Public Employees Retirement Association (PERA), were in trouble, and were getting worse. Since the taxpayers of the state are responsible for assuming PERA’s obligations, if something weren’t done, the state’s AA credit rating faced an estimated one-third chance of being downgraded.
Nothing concentrates the mind like the probability of an execution in the morning, and virtually nothing gets a legislature to take positive, fiscally responsible action like the threat that the credit markets will turn against it. Pension obligations have bankrupted cities such as Stockton, Calif., and have helped destroy the business environment in Illinois. The same thing could happen here in Colorado.
At the time, according to the most recent Comprehensive Annual Financial Report (CAFR), covering 2016, PERA’s funded ratio was 56.1%, with an unfunded liability of nearly $34 billion. That meant that for each dollar PERA expected to pay out in the future, it had 56 cents in the bank, after accounting for how much that investment would grow over time.
Bad decisions
How did PERA end up in such a perilous condition? It was the result of bad decisions by the state legislature and the PERA board, with respect to financial management and financial reporting. The latter, which helped hide the extent of the problem, made the former possible.
First, PERA consistently overestimated its funded ratio. Encouraged by high returns during the ’90s, PERA used an expected return of 8.75%, which not only overestimated how much money it would have on-hand in the future, because of the way liabilities are calculated, it underestimated those liabilities.
The value of liabilities today is called their “present value,” and it’s calculated by running the interest rate clock backwards. We understand that, for example, at 5% interest, $100 today is worth $140 in seven years. That is called the “future value.” Run the clock in the opposite direction, and the present value of $140 seven years from now, at 5%, is $100. And the higher the interest rate, the lower the present value. By using an 8.75% rate of return, PERA looked as though it was well over 100% funded at the end of 2000. PERA didn’t choose such a high rate of return to deceive anyone, but the effect was to make things look better than they were.
Worse, at the turn of the century, PERA’s board, under pressure from the governor and with the agreement of the legislature, created what would become known as the Service Credit Fire Sale. PERA members’ benefits are based in part of how many years of service they have, and years of service is also part of the formula for determining when a member can retire with full benefits. During the fire sale, PERA sold years of service credit to members far below the value of the increased benefits they could be expected to receive. Although the policy lasted only a few years, it accounts for several billion dollars worth of its unfunded liabilities.
Finally, core benefits and cost-of-living adjustments (COLAs), which were adopted in 1969 as a response to inflation, were simply too generous to be supported. Remember, PERA is mostly a defined-benefit plan, an old-time pension where a specific benefit is guaranteed after retirement. By contrast, most of the country has some combination of Social Security and 401(k) or IRA savings to draw on.
Through this, we should remember that the bulk of PERA’s Board of Trustees is elected by the membership, which means that its first incentive is to preserve benefits, not necessarily tell their members unpleasant truths and stabilize the system.
While all the membership groups are amply represented, the only elected representative of the taxpayer is the state treasurer. As a result, the board over time has resisted efforts at transparency or greater accounting conservatism. Unsurprisingly, a 2019 study showed that elected board membership was associated with lower bond ratings than appointed board membership.
Half measures
Under the pressure of successive shocks — the bursting of the dot-com bubble, the early 2000s recession, and the 2008 real estate bubble — the legislature adopted measures to shore up PERA, most of which involved employers and, to some degree, employees, shoveling more money into it. It helped, but not enough.
Under that threat, the legislature passed Senate Bill 18-200, a major PERA reform bill, that seeks 100% funding for PERA by 2048.
Since court decisions have held that core pension benefits are contractual obligations that must be met by the employer — the taxpayer — the bill took three major measures to alter PERA’s crash-bound trajectory. First, it committed the state to a General Fund line-item contribution of $225 million per year. Second, it committed employers to greater contributions during times when PERA lagged behind its 2048 target for full-funding. And finally, it cut COLAs to existing retirees during those same lagging periods. COLAs are not considered “core benefits” by the courts.
Now, PERA is 62.7% funded, and its unfunded liability has crept downward to $32.5 billion. Even after a recent unpleasant actuarial shock stemming from its retirees living longer — and therefore drawing more benefits — using a constant rate of return of 7.25%, PERA expects to be fully funded by 2048.
As skeptical as we should be of defined benefit plans that are constantly destabilizing the finances of states and cities across the country, and as critical as we should be of boards that resist oversight, PERA looks as though it’s in a better place now than it was five years ago, and that is why it has largely faded from the headlines.
Threats remain
That said, serious threats to PERA’s stability remain. PERA might be forgotten, but I promise it is not gone.
First, returns might fail to materialize. While the long-term trends look more favorable to PERA, we still have to live through the short term to get there. We need to bear in mind that while a long-term 7.5% rate of return might be reasonable, those returns vary greatly from year to year. When you or I have a bad year, we can cut back on our expenses. Not so PERA, which has to make its payments to its retirees. Bad years hurt more than good years help, and right now, when PERA is underfunded, successive bad years can hurt a lot.
We can get a sense of how much they hurt from the annual “Signal Light Report” produced by its actuary, so called because it evaluates PERA’s health in terms of shades of green, yellow and red. Instead of assuming constant returns over the period in question, it uses a Monte Carlo simulation of returns over the next few decades, giving each year a random return based on the historical returns of the holdings in the portfolio, essentially rolling the dice each year.
At the end of 2021, PERA was in the green, indicating that it would likely meet its target of full funding by 2048. After PERA’s -13.4% return in 2022, its school and state retiree divisions — by far the two largest — had slipped to yellow, indicating that they likely wouldn’t be fully funded until 2068, a generation later. Contrast that with PERA’s assertion that it was “on track” for full funding by 2048 based on constant returns on 7.25%.
Another potential vulnerability, related to the first, is PERA’s private equity valuation. In the search for higher returns, PERA, like many public pensions, has gradually increased its investment in private equity and alternative investments. In 2015, those accounted for 10.4% of PERA’s portfolio; at the end of 2022, they had climbed to 15.5%. The paper returns on those are roughly in line with stocks, and tend to be less volatile.
But the valuations of those investments are opaque and they are not traded on the open market. Analysts, being only human, are frequently unwilling to question their own judgment until a reevaluation becomes inevitable.
While a catastrophic write-down is unlikely, PERA might be forced to reduce the values of some of its private equity or alternative holdings.
A recent survey showed that a substantial majority of institutional investors believe that their private equity holdings are overvalued, and private equity data company PitchBook believes that, for the first time in a while, private equity will underperform the equity markets this year.
This worry comes with a caveat: the losses on the balance sheet are paper losses; they don’t become real until PERA tries to sell its stake in the investment, either on the open market or to other institutional investors. It is possible that the value returns before PERA has to take a real loss. That said, valuation is supposed to be based on the amount of money the company will make, and a lower valuation could make it harder for the company to attract new investors or to borrow more money. The losses might not be realized, but that doesn’t mean they’re imaginary, and they would affect PERA’s funded status.
Inflation’s toll
Finally, there is the great economic story of our day — inflation — of which the effects on PERA’s long-term and even medium-term health remain unknown. The immediate short-term effect has been for governments, especially local governments, to raise salaries, which means raising employee and employer contributions into the fund, thus making PERA look better-funded. But those also mean larger payouts down the road, so the direct financial effect might or might not be a wash.
And while most of us would like to be done with inflation, it’s far from clear that inflation is done with us. In the 1970s, inflation came in waves, and it’s possible that the last, largest, and most sustained wave is still to come. Sustained inflation is guaranteed to bring political pressure from teachers unions and Colorado’s new public employee unions to mitigate its effects on retirees, who are seeing increases in their cost of living with paltry COLAs. This has taken the form of trying to redirect the public’s TABOR refunds into the pockets of retirees, but the lack of an organized taxpayer lobby might mean that progressives try to alter SB18-200’s deal further.
What PERA gets right
By now, people who support PERA will be thoroughly angry with me, but there are some things that PERA does right, and deserves credit for.
In the first place, their Comprehensive Annual Financial Reports (CAFRs) are comprehensive and informative, which is a bigger deal than you might think at first, consistently winning awards for being clear and well-organized. For anyone who’s interested in delving into PERA’s situation, a great deal of information is easily available.
Second, their average rate of return should no longer be a major concern on its own. An expected nominal rate of return of 7.25% is reasonable, and its recent returns have more than met that.
The most hopeful development is the creation of ways for defined contribution members to participate in PERA’s returns on stocks and bonds through separate funds. PERA has also announced a preliminary look at creating an investible fund out of its entire portfolio. If that were to happen, it might provide a path to transition from a defined benefit plan into a defined contribution plan, while still allowing members to participate in PERA’s returns.
That has always been the best way out of this mess. Defined benefit pensions are inherently unstable, subject to market and political forces beyond their control. None of that has changed, even with PERA’s potentially improved fiscal position, and serious threats to its balance sheet remain.
Joshua Sharf is a senior fellow in fiscal policy at the Independence Institute, a free-market think in Denver. He has been the state House Republican citizen expert appointee to the legislative Pension Review Subcommittee since its inception in 2019.
