Physicians at academic medical centers often have an option to contribute to a state teacher’s pension plan. Although a pension can be an important component of a diversified retirement portfolio, some public pensions are currently in danger. How safe is your state’s public pension and should you contribute to it? The answer is in the pension’s vital signs.
- Most physicians employed by public universities can participate in their state’s public pension
- Each state’s public pension is managed separately
- Some public pensions are healthier than others
- The funded ratio and the funding period are two important vital signs that indicate the health of a public pension
In Ohio, the State Teachers Retirement System (STRS) is our state’s public pension for academic physicians at state-funded universities (such as the Ohio State University). STRS is similar to Social Security or an annuity in that it gives university-employed physicians an option to participate in a defined benefit plan that will pay you a fixed amount of money every month that you are alive after you retire. There is also an option for survivor benefits so that your spouse can continue to receive a monthly payment after you die. The advantage of defined benefit plans, such as STRS, is that you never run out of money in retirement. The disadvantage is that as an investment, you may be able to come out ahead by investing the money yourself rather than contributing to the pension during your working years.
In the past, most American workers had access to employer-sponsored pensions but many private employers have abandoned pensions and replaced them with 401(k) plans. However, pensions are still quite common for employees of state and local governments. Everyone’s retirement portfolio should be diversified and contain several different types of investments, such as stocks, bonds, and real estate. A pension can be an important component of those investments, less risky than bonds but also having a low rate of return.
However, all types of investments have risk and a pension is no different. Social Security is generally considered to be very low-risk, as investments go. But even Social Security is in danger of running out of money in 2035, unless action is taken by the U.S. Congress in the future. Private company pensions occasionally run out of money, leaving retirees with reduced or no monthly pension payments. State public pensions are somewhere in-between Social Security and private company pensions with respect to investment risk.
In some states (such as Ohio), academic physicians have an option of either participating in the public pension (STRS) or self-directing payroll deduction retirement savings into investments of their own choice. In other states, participation in the public pension is mandatory and there is not an option to self-direct. When deciding whether or not to participate in a public pension or deciding whether or not to take a university job in a mandatory public pension state, you should look carefully at the state’s public pension. Some states’ public pensions are considerably safer than others. When researching a state’s public pension, there are two pension vital signs that are important: (1) the funded ratio and (2) the funding period. Understanding these two numbers is critical to understanding the health of a public pension.
The Funded Ratio
The funded ratio is the ratio of a pension’s assets to its current and future liabilities. In simple terms, the assets are all of the money that the pension currently has in cash and in investments. The liabilities are the total amount of money that the pension plan will pay out to retirees now and in the future plus the administrative cost of the pension. In an ideal world, the funded ratio should be 100% or higher. In other words, the pension plan should have enough money to pay for the pensions of all of its current participating members. A funded ratio below 100% can be cause for concern and a funded ratio below 80% can be a sign that the pension plan is in jeopardy. The Equitable Institute recently released its annual State of Pensions report for 2022 and there are some concerning findings. From the map below, it is apparent that some states’ public pensions have very strong funded ratios and others have very poor funded ratios.
Washington, Utah, South Dakota, Wisconsin, Tennessee, New York, the District of Columbia, and Delaware all have funded ratios greater than 90% (dark green). On the other hand, Illinois, Kentucky, South Carolina, New Jersey, Connecticut, Hawaii, and Rhode Island all have severely low funded ratios that are below 60% (dark red). In between these extremes are thirteen states that mildly low funded ratios between 80-90% (light green). Fourteen states have moderately low funded ratios between 70-80% (yellow). And nine states have moderate-severely low funded ratios between 60-70% (light red).
One of the main reasons that many states’ funded ratios have recently fallen is the downturn in the stock market in the past 7 months. Public pensions do not just keep all of their money in a checking account, they invest the money in order to keep up with inflation and to ensure that they have sufficient money to pay their retirees in the future. Most public pensions estimate that their investments will have an average 6.9% annual return. Last year, in 2021, the average pension plan’s rate of return was 25.3% – an extraordinarily high rate of return, primarily because stock markets had an exceptional year. So far in 2022, the average pension plan has had a -10.4% rate of return. In other words, instead of gaining 6.9% this year, the average pension has already lost 10.4%.
There are several reasons why a state might have a low funded ratio:
- Inadequate funding. Public pensions are funded by a combination of employee contributions (payroll deductions) plus employer contributions (usually as a fixed percentage of gross salary). If the contribution rates are set too low, then the public pension fund will not have sufficient funds to pay monthly retirement benefits. Currently, the average employee contribution is 8.07% of total salary, an increase from 7.06% in 2001. In addition to employee contributions to the public pension, there are also employer contributions to the pension and these currently average 29.8% of total payroll, an increase from 9.13% in 2001.
- Excessively high retirement benefits. Similarly, if the amount of money that retirees receive in their monthly pension payments is set too high, then the funded ratio will fall as the pension gradually runs out of money. The amount of the pension fund contributions and the amount of the pension fund distributions requires a very careful actuarial analysis and this in turn requires well-trained and highly skilled actuaries. Not every state has equally high-quality actuaries working for their public pensions. Public pensions should have periodic external audits to validate the conclusions and recommendations of the pensions internal actuaries. These audit reports should be available to pension participants and can be a valuable source of information about the pension’s health.
- Poor investment choices. Each state’s pension is managed differently – some by internal fund managers and some by external investment companies that employ their own fund managers. Inevitably, some fund managers will be better than others at selecting winning investments. However, as has been shown with managed mutual funds compared to index funds, most fund managers will not beat the overall stock market. This year, one of the particularly bad investment choices was in Russian investments. Prior to the Russian invasion of Ukraine, U.S. public pensions held approximately $5.8 billion in Russian market assets, securities, and real estate. These investments have lost enormous value since 2021. Over the past 15 years, there has been a growing trend to outsource investment decisions – currently 15% of public pension funds are managed by either a hedge fund or a private investment company.
- Unrealistic projected rates of return. The average annual rate of return on public pension fund investments is 6.9%. If a fund projects a higher rate of return, say 8.5%, then there is a high likelihood that their investments will not meet their projected rate of return, leading to lower than anticipated asset value. A pension fund’s rate of return on its investments will be largely determined by the ratio of stocks:bond:real estate in the fund’s investment portfolio. This ratio is in turn determined by the decisions made by the pension fund managers.
- The value of stocks and bonds fall. Some years, the stock and bond markets go up and some years they go down. Because public pension funds are mainly investing for the long-term, it is expected that the funded ratio will fall during short-term market downturns but then go up when the market recovers. 2021 and 2022 exemplify this perfectly with large losses in stock and bond values in 2022 but even larger gains in 2021. This resulted in a higher average funded ratio in 2021 that then fell in 2022 (graph below). It is more important to look at public pension fund investments over a several year period to determine how well the fund is doing.
- Inflation. If the public pension fund retiree distributions are tied to inflation, then there can be large cost of living increases in monthly pension payments during years that there is a high inflation rate. In these pensions, when inflation rises unexpectedly high (as in the previous 12 months), then the funded ratio can fall due to higher than expected monthly pension payments. Of 372 public pensions, 204 of them have automatic cost of living increase provisions with the majority of these linked to the inflation rate or the fund’s overall performance. Because of the danger of inflation eroding the funded ratio, other public pensions limit or do not give any regular cost of living increases in pension distributions.
- Increased life expectancy. This is often cited as a cause of a low funded ratio because if retirees live longer than expected, then the overall amount that the pension fund pays those retirees will be higher than expected. However, it turns out that annual increases in life expectancy have only a very small effect on funded ratios. It remains to be seen whether the opposite effect (shorter life expectancy) will improve funded ratios in the next few years since the majority of the more than 1 million U.S. COVID-19 deaths in 2020 and 2021 were in retirees.
The Funding Period
When a public pension’s funded ratio falls, or when actuarial analysis projects that it will fall in the future, there are a number of tactics that the pension can take to rectify the low funded ratio. For example, the pension managers can suspend cost of living increases in pension distributions. Or they can increase the contributions by increasing the percentage of employed pension members’ salaries going into the pension fund. Or they can increase the number of years a member must work before being eligible for full retirement benefits. When a public pension makes these corrective actions, it can take many years for the funded ratio to increase to 100%. The projected number of years that it will take to reach 100% is called the funding period.
Simply having a low funded ratio may not necessarily be bad as long as the public pension managers have taken corrective actions to improve the funded ratio. How effective these corrective actions are projected to be is measured by the length of the funding period. In general, the shorter the funding period, the better. In Ohio, the State Teachers Retirement System is required by state statute to have a funding period of less than 30 years. Funding periods in excess of 30 years are generally too long and can be a sign of an unhealthy public pension.
Many of the same variables that affect the funded ratio also affect the funding period. For example, the Ohio State Teachers Retirement System funding period dropped from 30 years to 8 years in 2021 due to the unusually large rate of investment return in 2021.
Public pensions with both a low funded ratio and a long funding period are in trouble. These pensions are in danger of being unable to meet future obligations. From a retirement portfolio standpoint, they are poor investments.
A Story Of 3 States
To illustrate the variability in public pension health, let’s examine three states: one that is in trouble, one that is in great shape, and one that was in trouble but has taken effective measures to improve.
Illinois. Illinois has 5 different state government public pension programs and all of them have a long history of being underfunded. At the end of 2021, these public pensions had an average funded ratio of only 46.5%, the highest ratio for the Illinois public pensions since 2008, before the great recession. Although improved, this is still among the lowest of all states’ public pension funded ratios. The state legislature has created a plan to increase the funded ratio to 90% by the year 2045. However, the state’s actuary and outside actuarial consultant have advised that a 90% funded ratio target in 23 years is insufficient and instead have advised a funding period to a 100% funded ratio of no more than 25 years. So far, no legislative action has been taken to improve the funding period. As a consequence, participation in the Illinois public pension is very risky compared to other states’ public pensions.
Wisconsin. The primary state public pension is the Wisconsin Retirement Benefit. It has a track record of being well-managed and as a consequence, it has a funded ratio that exceeds 100%. In fact, the funded ratio at the end of 2021 was 120.6%. That puts its funded ratio as the eighth highest out of 167 statewide public pensions in the country. Academic physicians can feel secure that their contributions to the Wisconsin public pension will be safe and that they can count on their monthly pension benefits in retirement.
Ohio. There are 5 statewide public pensions in Ohio. Academic physicians have the option of participating in one of them, the State Teachers Retirement System of Ohio. In 2001, STRS was in good shape with a funded ratio of 91%. The great recession severely impacted STRS and by 2012, the funded ratio had fallen to 56%. By 2017, the funding period to reach a funded ratio of 100% had risen to 60 years, putting the entire pension in jeopardy. STRS enacted three corrective measures to stabilize the pension fund: (1) suspension of annual cost of living increases in retiree pension distributions, (2) a 2.91% increase in the employer contributions to the pension fund, and (3) an increase in the number of years of service to full retirement benefits from 30 years to 35 years. By the end of 2021, the pension’s funded ratio was 80.1% and the funding period was 8 years. STRS’s willingness and ability to make hard decisions to increase contributions and limit distributions has resulted in it once again becoming a safer retirement investment for participants.
Even healthy public pensions are vulnerable to forces that can destabilize them. For example, the next pension fund manager could make poor investment choices. The state legislature could enact statues that acquiesce to lobby pressure to increase retiree benefits or decrease employee/employer contributions. The next actuaries may make faulty life expectancy projections. For these reasons, it behooves all participants to periodically check the status of their public pension. At a minimum this should entail reviewing the current funded ratio and funding period of the pension. In this sense, a pension is an investment and should be monitored similarly to how one monitors their 401(k) or 403(b) fund.
“If you’ve seen one public pension, you’ve seen one public pension”
A strong and secure retirement investment portfolio is one that is diversified. Ideally, one’s portfolio should consist of a mixture of stocks, real estate, bonds, fixed income, and cash. For each of these types of investments, the potential long-term return is directly related to the short-term risk of the investment.
For most Americans, the fixed income component is Social Security. But academic physicians and other employees of state-funded universities usually do not participate in Social Security. The public pension substitutes for for Social Security and is thus the main component of the fixed income portion of academic physicians’ retirement portfolio.
Some financial pundits have argued that it is better to not participate in a public pension and instead take the money that would have gone into the pension fund from payroll deduction and invest that money into stocks. The argument is that in the long-term, the rate of return from stock investments will be greater than the return from pension distributions in retirement. However, a more accurate view of a public pension is that it forms a crucial low-risk/low-return component of a balanced retirement portfolio. By having a public pension in the portfolio, the academic physician can devote a larger percentage of other retirement investments (403b, 457, IRA, etc.) into higher risk stocks and real estate.
In addition to functioning as a fixed income retirement investment, public pensions have other features that can increase their value to the participant. Survivor benefits for one’s spouse and dependents can replace the need to purchase separate life insurance. Disability benefits can replace the need to purchase separate disability insurance. Access to group rates for health, dental, and vision insurance can result in insurance premiums that can be thousands of dollars less per year than equivalent insurance policies purchased individually. And access to financial counselors at the public pension can provide some elements of free financial planning advice.
But each state’s public pension has different degrees of risk as evidenced by their varying funded ratios and funding periods. Before committing to participating in a public pension, it is important to carefully examine the health of that particular state’s public pension. Do a routine vital sign check of the pension by following its funded ratio and funding period.
July 22, 2022