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1 City of Newton Retiree Benefits A Primer Ruthanne Fuller with Gail Deegan Dan Fahey Ellen Grody Tony Logalbo Rob Mashal Howard Merkowitz Mal Salter Becky Searles Terry Yoffie April 22, 2014 Updated October 22, 14 TABLE OF CONTENTS
2 I. EXECUTIVE SUMMARY AND INTRODUCTION 1 II. THE BASICS A. Newton s Pension System 4 B. Newton s Retiree Healthcare Insurance (OPEB) Plan 5 III. PRE-FUNDED PENSIONS VS. PAY-AS-YOU-GO RETIREE HEALTHCARE INSURANCE (OPEB) 8 IV. THE HEALTH OF NEWTON S PENSION AND RETIREE HEALTHCARE INSURANCE (OPEB) PLANS A. What do the Historical Numbers Tell Us? Size and Growth Rate of the Unfunded Liability 2. Funded Ratio 3. Covered Payroll Ratio 4. Paying the Annual Required Contribution 5. Comparing Newton s Expenditures on Benefits & the Annual Required Contributions to Newton s General Operating Budget B. What Do the Projections Tell Us? Pension Projections 2. Retiree Healthcare Insurance (OPEB) Projections 3. Combined Pension and Retiree Healthcare Insurance (OPEB) Projections C. How Does Newton s Situation Compare to Other Cities and Towns? Pensions 2. Retiree Healthcare Insurance (OPEB) 3. Overall Health V. CONCLUSION: MOVING FORWARD 30 Questions or comments? Ruthanne Fuller at Note: The report was updated on October 22, 2014 to improve the information on pensions. One sentence on page 5 was changed in the answer about the role of the Retirement Board. A few other changes were made in the appendices.
3 APPENDICES 1. Tables Pension Basics 42 A. How Does Newton s Pension System Work? 1. Who Gets a Pension? 2. How Many People Are Participating in Newton s Pension System? 3. How Much Do Employees Contribute? 4. How Much Does the City of Newton Contribute? 5. How Much Are the Pensions? 6. What about Disability Benefits? 7. What Is the Role of the City of Newton Retirement Board? 8. How Are the Funds in Newton s Pension Plan Invested? 9. What Does It Mean that Newton Has a Defined Benefits Pension Plan? 10. Do Retirees from the City of Newton Receive Social Security? B. What Key Changes Have Been Made in State Laws Regarding Pensions? C. What Are the Key Changes in Accounting Requirements for Pensions? 3. Retiree Healthcare Insurance (OPEB) Basics 52 A. Who Gets Retiree Healthcare Insurance Benefits? B. What Are the Retiree Healthcare Insurance Benefits? 1. What Is the Role of the Commonwealth vs. Role of the City of Newton for Retiree Healthcare Insurance Benefits? 2. What Key Changes Are Proposed in State Laws Regarding Retiree Healthcare Insurance? 3. What Is the Role of Unions and Collective Bargaining with Respect to Retiree Healthcare Insurance Benefits? 4. What Is the Role of Medicare? C. How Many People Are Participating in Newton s Retiree Healthcare Insurance Plan? D. Can Changes Be Made to Retiree Healthcare Insurance Benefits? E. How Much Do Employees Contribute to Retiree Healthcare Insurance Benefits? F. How Are the OPEB Funds Invested? G. What Are the Key Changes in Accounting Requirements for Retiree Healthcare Insurance? 4. Interest Rates, Rates of Return, Discount Rates, Investment Return and Wage Growth Assumptions Glossary of Terms Sources Information about the Approach to OPEB by Other Massachusetts Cities and Towns Smoothing: Market Value of Assets vs. Actuarial Smoothed Value of Assets Critical Assumptions in the Projections 75 A. Investment Return B. Age at Retirement C. Life Expectancy D. Medical Costs E. Wages
4 CHARTS AND TABLES Chart 1: Pension Contributions in 2012 for Unfunded Liabilities from Previous Years vs. Current 9 Service (Pre-Funding) Chart 2: City of Newton Total Unfunded Liabilities for Pension and OPEB 13 Chart 3: Funded Ratio of Newton s Pension System 14 Chart 4: City of Newton Pension System Annual Return, Chart 5: City of Newton Pension System Average Investment Returns 16 Chart 6: Pension and OPEB Covered Payroll Ratios, Chart 7: Percent of Annual Required Contribution (ARC) Paid, Chart 8: Pensions and OPEB: Current Contributions and Full Annual Required Contributions (ARC) 20 as a Percentage of General Operating Fund, Chart 9: Total Pension and OPEB Annual Required Contribution Projections as a Percent of General 22 Fund Revenues, Table 1: Comparative Pension Data 25 Table 2: Comparative Assessment of Pension Systems 26 Table 3: Amortization Percentage Increase, Type of Funding Schedule & Pension Funding Deadline 27 Table 4: Comparative OPEB Data 28 Table 5: City of Newton Pension and OPEB Unfunded Liabilities 31 Table 6: City of Newton Pension Trust Fund Statement of Changes in Net Assets 32 Table 7: City of Newton, OPEB Funded Ratio, Table 8: City of Newton Pension and OPEB Funded and Covered Payroll Ratios, Table 9: Percent of Annual Required Contribution (ARC) Paid, Table 10: City of Newton Contributions to the Pension and OPEB Plans, Actual and Annual 34 Required Contribution Table 11: Projections for City of Newton Pension Expenditures 35 Table 12: Projections for City of Newton Retiree Healthcare Insurance (OPEB) Expenditures 36 Table 13: OPEB Trust Fund Projections 37 Table 14: Projected Medical Cost Trends 37 Table 15: Annual Returns, City of Newton Pension System and Massachusetts Pension 38 Reserves Investment Trust (PRIT) Fund Table 16: City of Newton Pension Participants 39 Table 17: City of Newton Net OPEB Obligation 39 Table 18: Schedule of City of Newton Employer OPEB Contributions, Pay-As-You-Go vs. Pre-Funding 40 Table 19: City of Newton Contributions to the Pension and OPEB Plans, Actual and Required, as a 41 Percent of the General Fund Table 20: Average Employee Salaries and Retiree Benefits 45 Table 21: City of Newton Pension Benefits 47 Table 22: PRIT Core Fund Long-Term Asset Allocation 48 Table 23: Participants in Newton s Retiree Healthcare Insurance (OPEB) Program 56 Table 24: Effect of Discount Rate Changes on Massachusetts State Pension Contributions 61 Table 25: City of Newton Market Rate of Return vs. Expected Long-term Investment Return 76 Contributory Retirement Pension System Table 26: Age at Retirement Assumptions 77 Chart 10: Projected Medical Cost Increases 78
5 I. EXECUTIVE SUMMARY AND INTRODUCTION On June 20, 1928, seventeen years before the statewide uniform public employee contributory retirement law was enacted, the Board of Aldermen established a pension plan for its municipal employees, the City of Newton Contributory Retirement System. 1 On September 4, 1951, Newton s Board of Aldermen accepted the provisions of the statewide public employee retirement pension law. 2 Unfortunately, the City of Newton has not set aside sufficient reserves in a trust fund to meet its pension obligations. In addition, prior to 2010, the City had not set aside any reserves for its obligations to retirees healthcare insurance. The City of Newton now has a combined pension and retiree health insurance unfunded liability of $846 million. This is the difference between the present value of what we expect to owe retirees and what we have set aside to pay them. 3 Current residents and future generations of the City of Newton are now faced with this dilemma. DEFINING THE PROBLEM City of Newton employees, like some private industry employees, earn two types of compensation current and deferred. Salaries and other forms of current compensation reflected in paychecks are received by employees during their employment. Deferred compensation is received after the employee retires and only when vesting and age requirements have been met. There are two major categories of deferred compensation for City of Newton employees. First are pensions, monthly payments to a retiree from an investment fund to which both the person and the City of Newton have contributed. Notably, public employees in Massachusetts, including employees of the City of Newton, are not covered by, and therefore do not receive, Social Security benefits. The second category is non-pension post-employment benefits retiree healthcare insurance and life insurance. These are known as Other Post-Employment Benefits or OPEB. 4 Pensions Pensions for municipal retirees in Massachusetts both eligibility and the amount are prescribed by the Commonwealth s laws. 1 Acts, 1928, c M.G.L. c. 32, A government entity such as the City of Newton has an obligation to pay deferred compensation benefits in the future once they have been earned. The dollar value of this is known as the total pension and retiree health care insurance (OPEB) liability. When the total pension and/or OPEB liability exceeds the pension or OPEB plan s net assets (referred to as the plan s net position ) available for paying benefits, there is a net liability. This is often referred to as an unfunded liability. The combined unfunded liability for pension and retiree healthcare insurance benefits, $846 million, should be used with caution. Because retiree healthcare insurance benefits are different in nature than pension benefits, adding the two together can be misleading. Retiree healthcare benefits are not guaranteed in the same way that pensions are. They are also a function of future health care costs which are uncertain. The state can also make changes to the provisions or rules regarding these benefits. Pension costs are a function of past salaries which are known and future projected salaries which are uncertain. 4 This report often uses retiree healthcare insurance when referring to Other Post-Employment Benefits, a category that includes one other non-pension benefit, life insurance. Retiree healthcare insurance, however, constitutes over 99% of the costs for Other Post-Employment Benefits. 1
6 I. Executive Summary and Introduction State law requires cities and towns to pre-fund pension obligations for current employees. Both the City and the employees set aside money now to pay for the pension benefits later. Current state law also requires cities and towns to fully fund previous, accumulated pension obligations by The City of Newton s funding plan has mid-2037 as its target for full funding. Newton has a $244 million pension unfunded liability as of January 1, We have enough money in a fund to cover 52.3% of our pension obligations, assuming the future return on assets averages 7.75%. Wide disparities exist in how well prepared comparable cities and towns are to fulfill their pension obligations. Lexington is in the best position with 78% of its pension obligations funded. At the other end of the spectrum, Arlington is more poorly funded than Newton with a 48% funding level for pensions. 5 Retiree Healthcare Insurance or OPEB In addition to our pension obligations, Newton provides healthcare insurance to retirees. The Commonwealth prescribes the minimum percentage that a city or town must contribute towards retiree healthcare insurance and the minimum level of benefits. The City of Newton provides more than the minimum level of contributions and benefits. In contrast to pensions, the state does not require pre-funding for retiree healthcare and life insurance benefits. The City of Newton has just begun to pre-fund these benefits. As of June 30, 2013, Newton has $602 million (in present value) more in OPEB obligations than we have reserved to cover these retiree healthcare insurance benefits. Newton has set aside enough money to cover less than 1% of retiree healthcare insurance benefits. Instead of pre-funding, most municipalities use a policy of pay-as-you-go for retiree healthcare insurance benefits. In other words, the city or town pays the cost of healthcare insurance benefits for retirees from current operating revenues as those benefits come due. While Newton has just begun to set aside a small amount of funding through pre-funding, the city s policy is primarily pay-as-you-go. This is problematic. Financial experts note that this policy transfers costs to future Newton tax payers, costs that are appropriately borne by the current ones. The year in which residents receive services from employees is the year the employer should set aside funds to pay for the compensation the employees will receive in their retirement. Moreover, the pay-as-you-go approach fails to take advantage of the power of compounding of investment assets that pre-funding permits. Cities and towns that Newton uses as benchmarks have more in common when it comes to gaps in funding for retiree healthcare insurance and other non-pension benefits. In our comparison group, the majority of cities and towns have set aside little or nothing to meet these OPEB obligations. Three communities have set aside meaningful sums: Wellesley (17% funded), Needham (11% funded), and Brookline (6% funded). 6 5 As discussed in the report, cities and towns calculate their unfunded liabilities using different assumptions so apple to apple comparisons can be difficult. 6 The Massachusetts Taxpayers Foundation in October 2013 detailed the level of unfunded pension and retiree health care insurance obligations for the State and local governments. The Commonwealth s pension system is 75% funded, the teachers 61% and the average of all municipalities is 57%. Both the Commonwealth s and municipal retiree healthcare insurance systems are less than 1% funded. The combined unfunded liability of the Commonwealth s and municipal pension and OBEB totals $83 billion. (Massachusetts Taxpayers Foundation, Crippling State and Local Retiree Liabilities, October 10, 2013.) 2
7 I. Executive Summary and Introduction THE CHALLENGE FOR NEWTON These funding gaps matter. Newton s employees, like all Massachusetts public employees, do not pay into, nor do they receive, Social Security in their retirement. Police, firefighters, and other Newton employees depend on these benefits for income and for healthcare insurance in their retirement. The funding gaps also matter because if a greater portion of Newton s budget is needed to fund commitments to retirees that were made years ago, funds available for current services may be impacted. The challenge lies in proactively managing tax revenues, operating expenditures, capital investments and retiree benefit expenses while maintaining an Aaa credit rating. The magnitude of the pension and retiree healthcare liabilities and the complexity of the issue as well as changes in accounting requirements led Ruthanne Fuller, with substantial input from a group of knowledgeable Newton residents, to write this primer. We used information sometimes verbatim from many sources. The sources range from the City of Newton, the Commonwealth of Massachusetts, professional associations, various Commissions and Centers, and credit rating agencies to articles from newspapers and magazines. The goal is to explain the current status of the pension and retiree health insurance systems, and the underlying formulas and assumptions. Understanding the various figures and calculations can be surprisingly difficult. The cost of the benefits provided to employees and the costs of those benefits that have been promised but not funded is calculated using a complicated range of assumptions. The terminology that accountants use to describe pensions and retiree healthcare insurance is often hard to understand. We hope this common fact base will allow more informed discussions going forward about our choices. 3
8 II. THE BASICS A. Newton s Pension System What Are Pensions? Pensions are monthly payments to a retiree as long as he or she lives (and often as long as his or her spouse lives) from an investment fund to which both the person and the City of Newton have contributed. What Does the Commonwealth of Massachusetts Prescribe? Massachusetts Contributory Retirement System pension benefits are uniform across all cities and towns. In other words, pension benefits for City of Newton retirees are prescribed by the Commonwealth s laws, including benefit levels and contribution rates. Massachusetts has recently made some important changes in pension benefits for recently hired employees. 7 For most employees, the minimum retirement age was increased by five years to age 60; the age of eligibility for a full pension was increased for most employees to age 67; and the pension was changed to be based on the average of the highest five years of earnings, instead of three. What City of Newton Employees Get Pensions? Virtually all full-time City of Newton employees with the important exception of teachers are required to participate in the City of Newton pension system. Teachers and certain school administrators have a separate pension system. For teachers, the Commonwealth of Massachusetts, not the City of Newton, is responsible for paying the employer portion of the pensions and for paying pension benefits. The City of Newton is responsible for paying the employer portion of non-teachers who work in the Newton Public Schools (e.g., aides, custodians, and clerical staff) and for the pensions of all other municipal employees. In Fiscal Year 2013, there were approximately 800 active non-teacher positions in the Newton Public Schools and 890 active municipal positions in Newton s pension system. How Many People Are in the Newton Pension System? As of January 1, 2013, Newton s pension system included 1,616 current (active) employees and 1,162 retirees and beneficiaries. How Much Do Employees and the City Contribute to Pensions? The contributions of employees toward their pension depend on when the employee started working for the City of Newton. The contribution rate has been raised repeatedly so that the rates now range from 5% to 12% of pay. In 2012, current employee contributions were $7.1 million. In 2012, the contributions by the City of Newton were $11.3 million, $8.1 million of which is to pay down the unfunded liability for benefits for current retirees and $3.2 million is pre-funding the future benefits of current, active employees. 8 How Much Does Newton Pay Annually for Pensions? The Newton retirement system paid $33.4 million in pension benefits in 2012, an increase of 4.9% over the previous year. 7 Reforms were made in both 2009 and The changes in 2011 mostly impacted employees hired on or after April 2, The City of Newton retirement pension system operates on a calendar year while the retiree healthcare insurance plan (OPEB) operates on a fiscal year. 4
9 II. The Basics For a person who is 65 years old, has worked for the City for 20 years, is not a public safety officer or a veteran, and had the three highest years of salaries averaging $60,000, the pension would amount to $29,000 to $30,000 a year for the rest of his or her life. If that same person had worked for 10 years, the payment would be approximately one-half or between $14,000 to $15,000. Each year, the pension amount is partially adjusted for inflation, otherwise known as the cost of living (COLA), if Newton s Retirement Board votes to do so. Traditionally they have. What Is the Role of the Newton Retirement Board? The Newton Retirement Board has important decision making rights. The Board decides the appropriate long-term investment rate of return to use to determine the contributions that the City of Newton needs to make in order to fund appropriately the pension plan. The Retirement Board also determines the eligibility for enhanced pensions, either through disability or higher group classification, based on strict eligibility and procedural requirements of Chapter 32 and also subject to PERAC oversight. The Board, as mentioned earlier, votes on cost of living adjustments. The Board determines how to invest the funds in the trust. These decisions determine the amount of the annual pension appropriation by the City of Newton. Do Newton s Retirees Get Social Security? Public employees in Massachusetts, including employees of the City of Newton, are not covered by Social Security. Who Invests the Assets in Newton s Pension Fund? Starting on July 1, 2007, the City of Newton transferred all pension system assets, except those in real estate limited partnerships, to the management of the Commonwealth of Massachusetts Pension Reserve Investment Trust (PRIT) Core Fund. Significantly more detailed information about Newton s pensions can be found in Appendix 2. B. Newton s Retiree Healthcare Insurance (OPEB) Plan What are Retiree Healthcare Benefits? Retiree healthcare insurance or Other Post-Employment Benefits (OPEB) is the portion of the cost of health insurance that the City has agreed to provide for retirees. Who Gets Retiree Healthcare Insurance? City of Newton retired employees -- including teachers -- and their spouses and dependents receive subsidies for healthcare insurance and life insurance, OPEB benefits, for their lifetime. For Newton employees, the eligibility requirements for receiving retiree healthcare insurance are the same as those for receiving a pension. Thus, virtually all full-time City of Newton employees, including teachers, are eligible if they retire while a City of Newton employee and meet vesting and age requirements. Generally, to be eligible, an employee needs to have worked for more than 20 hours per week for at least 10 years. What Does the Commonwealth of Massachusetts Prescribe? Benefits for retirees both pensions and healthcare insurance are largely prescribed by the Commonwealth s laws. The Commonwealth of Massachusetts determines: 5
10 II. The Basics - Who is eligible for retirement benefits, - What the minimum amount of benefits must be, - What the minimum amount of the healthcare premium the municipality must pay (currently the Commonwealth requires cities and towns to pay a minimum of 50%), and - What changes to health care plans must be negotiated with collective bargaining units. What is the Role of Unions in Retiree Healthcare Insurance? Changes to healthcare plan design and contribution rates for retirees do not need to be negotiated via the collective bargaining process. (Changes for active employees are subject to the collective bargaining process.) This, however, is currently being challenged in the courts. What about Medicare? Starting in 2009, both the Commonwealth and the City of Newton officially required people age 65 and older to go on Medicare if they were eligible. Since retirees from the City of Newton who are eligible for Medicare must enroll in the program, the City becomes the second payer. Medicare requires retirees to pay a premium each month for Medicare Part B to cover outpatient medical insurance. The City pays 80% of the Medicare Part B premium, with the amount being capped at $925 per year. State law only requires a 50% contribution. Since Medicare Part B does not pay all of a covered person s medical costs, many retirees buy supplemental healthcare insurance. The City of Newton also pays 80% of any supplemental healthcare insurance. State law does not require any contribution by a municipality for supplemental insurance. How Many People Are in the Newton Retiree Healthcare Insurance System? For the fiscal year ending June 30, 2013, the number of people participating in the City s health insurance plan was 5,714. (While Newton s pension system does not include teachers, Newton s retiree healthcare insurance system does.) There are 3,397 retirees currently receiving retiree medical insurance and another 2,317 active employees who will be eligible to receive health insurance when they retire. Can Changes Be Made to Retiree Healthcare Insurance Benefits? In general, courts have been less likely to view non-pension benefits as a protected right. 9 As a result, many observers think these retiree healthcare insurance benefits are not guaranteed and can be changed at the state level. Retirees do not have bargaining rights, so the City of Newton has authority to change retiree healthcare insurance benefits unilaterally, as long as they meet the minimum standards set by the Commonwealth. As mentioned earlier, this is currently being challenged in the courts. How Does Newton Pay for Retiree Healthcare Insurance Benefits? Currently, the City (with a small exception explained later) is not contributing to a retiree healthcare insurance reserve fund. In other words, except for a small amount of money, the City is not setting aside funds now for the later years when the employee retires. Rather, once the employee retires, both the City and the retired employee pay for the retiree health insurance costs in a pay-as-you-go manner. Eligible retirees are required to pay a specified percentage of their healthcare insurance costs. 9 The PEW Center on the States, A Widening Gap in Cities: Shortfalls in Funding for Pensions and Retiree Health Care, January,
11 II. The Basics What Were the Recent Changes to Retiree Healthcare Benefits? In Newton s most recent union negotiations, two significant health insurance plan changes were implemented in The first change was that all active employees must elect one of the less expensive Advantage plans. The second change was that all new municipal employees hired after July 1, 2011 and new school employees hired after August 31, 2011 were required to contribute either 25% (for unions constituting 88% of current employees) or 30% (for the other 12%) instead of the previous 20%. These plans and contribution rates will be in effect when these employees retire. 10 In addition, all early retirees and non-medicare eligible retirees now retire out on these newer plans. What Does Newton Owe for Retiree Healthcare Insurance Benefits? New accounting standards issued on OPEB by the Governmental Accounting Standards Board (GASB) in 2004 required municipalities for the first time to disclose the total amount of the actuarially determined future liabilities for retiree health insurance benefits and the amount required to be paid currently to cover these future healthcare insurance costs. The City of Newton implemented the reporting requirements in the fiscal year ending on June 30, The expected retiree healthcare insurance benefit obligation as of June 30, 2013 for the City of Newton is $905.7 million. When discounted by 2% (the City s expected short-term rate of return) to the present value, the full actuarial liability for such benefits stood at $602.3 million. 11 With assets of approximately $538,000 in the OPEB Trust Fund, the unfunded actuarial accrued liability was slightly less, $601.8 million. Significantly more detailed information about Newton s retiree healthcare insurance plans can be found in Appendix These contributions are towards the health insurance policies that currently cover the employees. They are not contributions that are made now and invested for future health insurance policies. 11 Starting in 2008, Newton s reports show the difference between the amount needed to fund current benefits and eliminate the unfunded liability, known as the annual required contribution or ARC, and the pay-as-you-go appropriation for retiree health care insurance. For the year ended June 30, 2013, the liability increased by $30.2 million for a total of $177.7 million. The Net OPEB Obligation of $177.7 million is the cumulative sum of differences between the City s annual costs and the amounts the City actually contributed, starting in The $602.3 million unfunded actuarial accrued liability reflects the total unfunded status that will be amortized or spread over a thirty year period. 7
12 III. Pre-Funded Pensions vs. Pay-As-You-Go Retiree Healthcare Insurance (OPEB) There are two approaches to funding retiree benefits. One approach is to pre-fund the expected future costs by setting aside funds as employee services are rendered. The second approach, pay-as-you-go, is to pay each year only the pension or health insurance costs for the retirees without setting aside monies to pay the future costs related to current employees. Pensions and retiree healthcare are compensation that employees earn each year, even though these benefits are not received until after employment has ended. A fundamental accounting principle, interperiod equity, is that the year in which residents receive services from an employee is the year the employer should set aside funds to pay for the compensation they will receive in their retirement. In other words, the cost of these future benefits is a part of the cost of providing public services today. This matches the timing of when services are received by residents with the cost of providing services and results in pre-funding of retiree benefits. Pre-funding also usually reduces the total liability by taking advantage of investment growth and the power of compounding. The City of Newton has been prefunding pensions since In contrast, the City of Newton does not pre-fund retiree healthcare insurance (OPEB), but instead uses the pay-as-you-go funding method. Thus, the City of Newton is financing the cost of its two major retirement benefits in two very different ways. A. Pre-Funded Pensions The City of Newton is pre-funding its pension obligations. For current employees, the City sets aside funds each year to pay their pensions in the future. Starting in the early 1990s, state law required all cities and towns to pre-fund pensions. In accounting terms, pre-funding is an actuarial approach. An actuary analyzes the cost of future benefits and determines the amount of money to be set aside currently to fund them. 13 The City of Newton pays an amount each year into the pension plan that is expected to be sufficient, if invested now, to finance the benefits of employees after they are no longer working for the City. 14 The future returns on the investments and the cost of the future benefits to be paid are projections. The City of Newton began pre-funding in 1984, before being required by law to do so. In 1984, as part of the pre-funding approach, the City of Newton Retirement Board simultaneously adopted a funding schedule and started setting aside money to pay the past, accumulated obligations by 2028 for retirees and the current employees for whom no funds had been set aside previously. 15 Similar 12 To be clear, Newton is currently pre-funding the pensions for almost all its current employees. Since the City did not pre-fund in the past, the City is also using a funding schedule to pay over a period of many years the liabilities it has incurred for current retirees and employees who began working for the City prior to An actuary is a business professional who mathematically evaluates the probability of events and quantifies the contingent outcomes. See Appendix 5 for a glossary of terms. 14 Interestingly, state law also requires cities and towns to increase their pension contribution each year, even if the amount is larger than its annual required contribution. 15 Prior to 1984, the City of Newton funded its pension system on a "pay-as-you-go" basis the same way the City currently funds retiree health care insurance (OPEB). The City paid out retirement benefits as employees retired. 8
13 III. Pre-Funded Pensions vs. Pay-As-You-Go Retiree Health Care Insurance (OPEB) to a loan one would take out for a home, the unfunded liability is paid incrementally on a schedule extending out over several decades. The schedule is calculated to eventually bring the fund up to "full funding," when the City will have set aside enough funds to cover the unfunded pension obligations and will only have to pay the costs for current employees (i.e., in accounting terminology, the normal costs ). Even now, most of the payments the City makes into the pension investment fund are to cover the costs of the pensions for retirees and beneficiaries, rather than to pre-fund the future costs for current employees. In 2012, 83 percent of the total $18.4 million City of Newton payment for pensions went to fund the previous, accumulated unfunded liability. 16 This $15.2 million was paid entirely by the City of Newton. The additional $3.2 million paid by the City was for pre-funding the normal cost, the cost of benefits earned by current employees that year which will be paid in the future after they retire. Employees contribute significantly to Newton s Contributory Retirement Pension System. While the City paid the aforementioned $18.4 million into the pension plan in 2012, employees contributed $7.1 million as well. In fact, of the total normal cost of $10.4 million, employees paid 69% of the total. Thus, current employees are the major contributors to their pensions. When employee and City of Newton contributions are combined, 60% of the total goes to pay for the unfunded liabilities generated prior to 1984 when the pension funding policy was pay-as-you-go. Chart 1: Pension Contributions in 2012 for Unfunded Liabilities from Previous Years vs. Current Service (Pre-Funding) 40% Current Service 60% Unfunded Liabilities for Previous Years B. Pay-As-You-Go Retiree Healthcare Insurance (OPEB) In contrast to pensions, Newton has not pre-funded for retiree healthcare benefits (OPEB) until recently. The City of Newton is essentially using a pay-as-you-go approach. Each year, the City pays an amount through annual appropriations equal to the benefits distributed to or claimed in that year by retirees. In FY2013, the cost to the City of the pay-as-you-go method came to $16.3 million. The City did not set aside the amount of retirement benefits that employees were accruing yearly throughout their employment. Rather, it accumulated an unfunded liability. 16 The $18.4 million payment includes both the City of Newton and employee payments. 9
14 III. Pre-Funded Pensions vs. Pay-As-You-Go Retiree Health Care Insurance (OPEB) By state law and GASB accounting rules, the City has to report how much we should be setting aside now if we pre-funded healthcare insurance benefits. This amount, known as the annual required contribution or ARC, was $49.1 million in FY2013. The ARC payment of $49.1 million represents 15% of the City s total annual general operating budget. The annual required contribution is an accounting term that defines how much a city or town would need to contribute if it wants to pay down its unfunded liability in thirty years. Some cities or towns in the United States are, by law, required to contribute the annual required contribution. In Massachusetts, the law does not require cities and towns to pay into a fund the annual required contribution for retiree health insurance. Thus, municipalities are allowed to underfund their benefits, thus raising the annual payment in subsequent years. Mayor Warren and the Board of Aldermen have taken two important, albeit small, steps towards prefunding retiree healthcare insurance. In the spring of 2010, the City had a $595 million actuarial accrued OPEB unfunded liability and no assets in an OPEB trust fund. For the FY2011 budget, Mayor Setti Warren recommended and the Board of Aldermen approved a transfer of $137,000 to an OPEB Trust Fund. This represented an important, albeit quite small, first step in addressing the challenge of the retiree healthcare and life insurance liability. In FY2012, $175,000 was transferred. Beginning on July 1, 2012, the City also began making a contribution of 2.5% of compensation for new employees that participate in the City s healthcare plan to fund partially their healthcare benefits when they retire. A contribution level of 12% of salaries/wages of all employees is required to cover fully the anticipated future retiree healthcare insurance costs for all employees. The far lower 2.5% contribution for only new employees is expected to be reviewed annually by the Warren administration and gradually adjusted to come closer to the actuarial required contribution (12%) to fund the normal cost for the health benefits. 17 The Mayor held the percentage at 2.5% for FY The budget for FY2015 increases the percentage to 3%. The 2.5% pre-funding for new employees who started work after July 1, 2012 resulted in approximately $225,000 being put into the OPEB Trust Fund in FY $545,000 is projected to be added in FY2014, and approximately $900,000 in FY15. The amount should increase by approximately $300,000 a year as new employees join the City s workforce. Nonetheless, it is still significantly less than the 12% that should be set aside for both current and new employees. The Mayor stated in the Proposed Budget for 17 The normal cost is the present value of the future benefits earned that year by current employees. 18 The present value is a future amount of money that has been discounted to reflect its current value since money has interest-earning potential. Actuaries calculate the current value or cost of all benefits earned by the retired participants as well as the value of all benefits earned and expected to be earned in the coming years by the active participants (i.e., current employees) given a specified discount rate; the higher the discount rate, the lower the present value of the future cash flows; determining the appropriate discount rate is critical to properly valuing future cash flows. 19 See Appendix 1 for Table 13: OPEB Trust Fund balances and projections. 10
15 III. Pre-Funded Pensions vs. Pay-As-You-Go Retiree Health Care Insurance (OPEB) FY2014 (released on April 16, 2013) that the Administration intends to continue the policy of pay as you go for all OPEB liabilities for current and former employees. 20 The pay-as-you-go method that Newton (like many other cities and towns) is using for OPEB is problematic. The alternative, saving early and regularly, can dramatically reduce the total liability. According to an analysis by the Commonwealth of Massachusetts, full pre-funding following the guidelines of Generally Accepted Accounting Principles for Governments reduces the liability by 45%. 21 Starting in FY2007, an actuary working for the City of Newton has provided information on the financial impact of pre-funding the retiree healthcare insurance obligations. Pre-funding allows for the possibility of the funds growing through positive investment returns. Investment returns are not guaranteed and, as we have seen in the last five years, significant losses can occur. Generally, though, most financial advisors think that over the long-run, investing will lead to positive returns. The City (more specifically, the Retirement Board) currently assumes that investment returns on our pension assets will be 7.75% over the long-term. They are currently discussing whether to lower the return assumption to 7.65%. (A discussion of the merits of a 7.75% investment return assumption follows later in the report.) Coupled with the effect of compounding, pre-funding the OPEB obligation should result in significantly lower amounts of money needed to pay for retiree healthcare insurance. In Newton s actuarial valuation report for FY2012, the actuary determined that the annual savings for the following year alone if Newton had established a funding schedule and contributed the annual required contribution (ARC) would have been $22.2 million. As shown in Table 18: Schedule of City of Newton Employer OPEB Contributions, Pay-As-You-Go vs. Pre-Funding in Appendix 1, the City of Newton s independent actuary calculated cumulative savings of $1.6 billion from 2012 to In the FY2013 OPEB actuarial valuation report, the actuary calculated that there is approximately a 21% impact on costs for every 1% change in the discount rate assumption. In other words, the City of Newton has a $602.3 million actuarial accrued liability for OPEB using a 2% discount rate, as of June 30, With a 5% discount rate, the liability drops to $584.4 million while at 7.75% it decreases to $568.5m. One fundamental decision for the City of Newton is whether to start pre-funding retiree healthcare insurance (OPEB) more than 2.5% or 3% of compensation of new employees. In the future, when meaningful sums are in the OPEB Trust Fund, the City will also have the important decision whether to increase the discount rate from 2%. 20 Another important step was taken in May 2013 when the Board of Aldermen approved making the OPEB Trust Fund irrevocable. 21 Special Commission to Investigate and Study the Commonwealth s Liability for Paying Retiree Health Care and Other Non-Pension Employee Benefits, Reporting and Funding OPEB Liabilities, July Please note in the table that since Newton s retiree health insurance (OPEB) Trust Fund has so few assets relative to its liability and is not funding the ARC, the Governmental Accounting Standards Board (GASB) requires the City to use a risk free rate of return equivalent current risk-free marketplace yields, 2% currently. As the OPEB Trust Fund assets are de minimis, the return on these assets is not used. If Newton had significant funds set aside, then the discount rate would be the historical average for equity market investment returns, or the 7.75% currently used by the Retirement Board for pensions. It is unclear what level of assets triggers the change to the higher rate of return. 11
16 IV. THE HEALTH OF NEWTON S PENSION AND RETIREE HEALTHCARE INSURANCE (OPEB) PLANS A. What do the Historical Numbers Tell Us? There are five indicators commonly used to evaluate the health of a benefit plan. These are (1) the size and growth rate of the unfunded liability, (2) the funded ratio, (3) the covered payroll ratio, (4) the comparison of the benefits and annual required contribution to the City s general operating budget, and (5) the percentage of the annual required contribution paid. 1. Size and Growth Rate of the Unfunded Liability One way to analyze the health of Newton s pension and retiree healthcare insurance benefit programs is to compare how much we owe to retirees to what we have set aside to pay for these benefits. Using accounting terminology, we want to compare how much we are obligated to pay for pensions and retiree health insurance (the Actuarial Accrued Liability or AAL) to what we have set aside in a trust for these payments (the Actuarial Value of Assets). If we owe more than we have set aside, we have an unfunded liability (the Unfunded Actuarial Accrued Liability or UAAL). We have a much smaller unfunded liability for pensions, $244 million, than for OPEB, $602 million. For 2013, the two combined are a very significant sum, $846 million. 23 Both liabilities are growing much faster than Newton s revenues. 24 (See Table 5: City of Newton Pension and OPEB Unfunded Liabilities in Appendix 1.) 23 The Annual Required Contribution or ARC is that part of the Actuarial Accrued Liability (AAL) due in the current year, plus the portion of the unfunded liability to be amortized in the current year. The cumulative sum of differences between our annual costs and the amount we actually contributed to the pension or OPEB plan is our Net Pension Obligation (NPO) or Net OPEB Obligation (NOPEBO). Since the City of Newton pays in full the annual required contribution for pensions (i.e., we pre-fund), the City does not have a Net Pension Obligation. The City of Newton does have a considerable Net OPEB Obligation. The City has never contributed the full Annual Required Contribution for OPEB. Therefore, adjustments are made to the annual required contribution (ARC) to compensate for the additional amount owed to the OPEB plan. The adjusted ARC, known as the Annual OPEB Cost, is the amount reported as the OPEB expense instead of the ARC. For the past three fiscal years, the City of Newton s Net OPEB Obligation has continued to grow substantially since the City did not make its annual required contribution. The Net OPEB Obligation now stands at $177.7 million. The data can be found in the Table 17: City of Newton Net OPEB Obligation in Appendix In the past thirteen years, from 2000 to 2013, the unfunded liability for pensions has grown at a compound annual growth rate of 12.3%. From to , the unfunded liability for OPEB has grown at a lower compound annual growth rate of 7.4%. This incorrectly implies that the unfunded pension liability has gotten worse at a faster rate. The primary reason the unfunded pension liability has grown faster is the two significant investment return losses since (See Chart 4.) Since OPEB has almost no investment assets, it has not experienced the same fluctuation in returns but it has grown much faster in absolute dollars. 12
17 IV. The Health of Newton s Pension and Retiree Health Care Insurance (OPEB) Plans Chart 2: City of Newton Total Unfunded Liabilities for Pension and OPEB (millions) $900.0 $851.9 $832.1 $846.1 $800.0 $786.6 $739.8 $700.0 $600.0 $529.3 $570.9 $500.0 $400.0 $300.0 $200.0 $100.0 $ OPEB $392.7 $433.0 $595.7 $531.7 $639.0 $601.0 $601.8 Pensions $136.6 $137.9 $190.9 $208.1 $212.9 $231.1 $244.3 Due to changes in healthcare benefits negotiated by the City of Newton in 2011, the retiree healthcare (OPEB) liability decreased by $38 million from 2011 to Clearly, changes in benefits jointly agreed on by employees and their unions and the Administration can have a significant impact on the liability. 2. Funded Ratio The most basic indicator of the status of a pension or retiree healthcare insurance plan is its funded ratio. The funded ratio is a comparison of the actuarial value of the assets (how much have we set aside to pay the benefits, smoothed over five years) to the unfunded liability (the present value of what we expect to pay in benefits discounted at the 7.75% projected rate of return on pension fund assets or the 2% risk-free rate of return for OPEB). The actuarial value of the assets is divided by the actuarial accrued liability to derive the funded ratio. This ratio reflects the ability of the pension or OPEB plan to finance the benefits attributable to past service of current and future retirees. A higher funded ratio is better. When a pension or retiree healthcare plan has enough assets (i.e., money) to cover all its accrued liabilities (i.e., the benefits that will have to be paid), it is 100% funded. 25 A funding level under 100% means that the fund does not have sufficient assets as of that date to cover its actuarial accrued liability. 26 While the target level for a pension plan should be 100%, a funded level of 80% has often been used as a standard of fiscal soundness This does not mean that further contributions are no longer required. Rather, the plan is funded at the appropriate level at the date of valuation. The City will need to continue putting aside money for the benefits that current employees are earning. 26 Some people think that governments do not need to achieve 100% funding. As the Civic Federation notes, They argue that governments, unlike private corporations, are not at risk of dissolving and, therefore, can meet their 13
18 IV. The Health of Newton s Pension and Retiree Health Care Insurance (OPEB) Plans Chart 3: Funded Ratio of Newton s Pension System 74% 79% 82% 75% 67% 67% 68% 66% 66% 67% 57% 55% 55% 53% 52% Decline in Funded Ratio: As of January 1, 2001, Newton s pension system was quite well funded with a funded ratio of 81.6%. It was on the path toward the full funding goal of 100%. 28 But, in early 2000, a correction began in the stock market. The bull market (known as the dot-com bubble ) ended in late summer By the mid- 2000s, the value of the assets in Newton s pension fund declined significantly, and the funded ratio dropped to the 66%-67% range. 29 obligations in perpetuity. But, the report continues, Public pensions should be funded sufficiently to prevent the growth of the unfunded liability. If the unfunded liability is growing and the plan has no practical strategy for reducing it, this is cause for serious concern. (The Civic Federation, Status of Local Pension Funding Fiscal Year 2011, May 21, 2013) 27 The American Academy of Actuaries noted that the standard of 80% funded level has been cited in recent years to assess whether a pension plan is financially sound. However, they recommend using multiple ratios over several years to assess fiscal soundness. The measures include: (1) the size of the pension obligation compared to the financial resources of the sponsor; (2) the financial health of the plan sponsor; (3) the funding or contribution policy of the plan; and (4) the investment strategy and risk level of the plan assets. They also emphasize that pension plans should have a strategy to attain a funded status of 100% over a reasonable period of time. (American Academy of Actuaries, The 80% Pension Funding Standard Myth, July, 2012) The Fitch Rating credit agency considers a funded ratio of 70% or above to be adequate and less than 60% to be weak, using a discount rate of 7% and a rolling five-year average of market value of assets. (Fitch Ratings, Enhancing the Analysis of U.S. State and Local Government Pension Obligations, February 17, 2011) The Pension Protection Act of 2006 changed the federal laws that govern private sector pension funds to require them to meet a 100% funding target. Private sector pension plans that were less than 100% funded were required to amortize, or pay off, their unfunded liability over seven years. Private sector pension plan that are less than 80% funded are considered at-risk, and must make additional contributions to boost their funded ratio. (The Civic Federation, Status of Local Pension Funding Fiscal Year 2011, May 21, 2013) 28 The relatively high funded ratio came after a period of robust investment returns on the funds in Newton s pension plan, in part driven by the internet technology bubble in the stock market. 29 On January 1, 2000, the value of the assets in Newton s pension fund was $236 million. A year later, it had fallen to $214 million. By January 1, 2002, it had fallen further to $191 million. 14
19 IV. The Health of Newton s Pension and Retiree Health Care Insurance (OPEB) Plans In the financial collapse of 2008, the value of the assets in Newton s pension plan dropped by another 28%, or about $85 million, and the funded ratio fell significantly as well to 55%. 30 Newton was not alone. In 2009, funded ratios dropped significantly for all of the pension systems in Massachusetts. Chart 4: City of Newton Pension System Annual Return, % 20% 10% 0% -10% -20% -30% -40% 22.80% 24.71% -9.31% 20.33% % 14.15% Extended Funding Schedule: In response to the dramatic decline in asset values of pension plans and the concomitant drop in funding ratios, Massachusetts changed the law so the full funding requirement was extended from 2030 to The Newton Retirement Board subsequently voted to extend the deadline for actuarial funding of the system s liabilities from 2028 to (Subsequently, they voted to have full funding six months earlier, June, 2037.) To keep the full funding schedule at 2028 would have required an enormous increase in the pension appropriation by the City. Low and Volatile Returns: Neither annual investment returns nor average investment returns explain in full Newton s current funded ratio of 52%. The average rate of investment return for Newton s pension assets has varied. Since inception twenty-eight years ago, the average is 9.3%. From 2000 to 2012, the average return on investments for Newton was 5.2% while the funded ratio fell from 73.5% to 53.1%. For the last five years, it dropped to 3.1% due to the significant decline in (Note: The City of Newton Contributory Retirement System used an expected long-term investment return of 8% from 2006 to For 2012 and 2013, it lowered the assumption to 7.75 %.) The combination of lower returns than expected and the volatility of returns partially explain Newton s low funded ratio. 30 The data for the chart can be found in Appendix 1. 15
20 IV. The Health of Newton s Pension and Retiree Health Care Insurance (OPEB) Plans Chart 5: City of Newton Pension System Average Investment Returns 9.3% 5.2% 3.1% Catching Up After Investment Losses: At the same time, Newton continued to pay into the pension fund the amount the actuaries recommended, the actuarial required contribution (ARC). Why did the funded ratio fall so precipitously even as the City contributed its full actuarial required contribution? The answer partly lies in the math. As noted by the Pew Center on the States, If a pension fund s investment return falls 4% short of its 8% assumption, it cannot simply make up that amount with a 12% return the next year. Every year that a pension system s investments come in under the actuarial assumption, the fund has to make up that amount plus the assumed earnings on the lost amount. 31 In other words, if a city experiences a 50% loss, the fund needs a 100% return just to get back to the balance before the downturn. 32 The funded ratio is also low because of the decision to extend the funding schedule to If the funding deadline remained at 2028, the annual required contributions would have been substantially higher (with a significant impact on current operations) and the funded ratio would have been substantially higher. Costs Higher than Contributions: Newton s low funded ratio for its pension plan despite a relatively strong stock market in the last few years and the City of Newton contributing its full actuarial required contribution highlights another fact: Newton is dependent on investment appreciation and interest from the plan s assets to pay for benefits. Even though the City is contributing the actuarial required contribution, and even though the employees contribute their required amount, the annual costs of the retirement system are sometimes higher than the overall contributions. The previous, accumulated unfunded liability continues to keep the funded ratio low. Thus, any progress on the funded ratio and the health of the pension system seems to depend heavily on investment appreciation and interest on the investments. The data from 2011 and 2012 in Newton s Comprehensive Annual Financial Report (CAFR) tell the story. 33 In Table 6: City of Newton Pension Trust Fund, Statement of Changes in Net Assets in Appendix 1, look first at the data for the year ending 12/31/10. Contributions from the City and Newton 31 Pew Center on the States, A Widening Gap in Cities: Shortfalls in Funding for Pensions and Retiree Health Care, January, Hypothetically, a fund could be at $100 million. It experiences a 50% loss and decreases to $50 million. To return to the $100 million level, it needs a 100% return. 33 Please note that the data in the CAFR runs on a fiscal year that ends June 30 th while the funded ratios and pension return data are on calendar years that end December 31 st so they do not align precisely. 16