Are PERA and TABOR on a collision course?

Absent changes to the Colorado Public Employees’ Retirement Association, PERA, or Colorado’s Taxpayer’s Bill of Rights, TABOR, Colorado’s public employee retiree population will be on a collision course with the Colorado taxpayer population in the years to come. PERA, like many government pension programs, has made promises to retirees that cannot be honored without increased funding or benefit reductions. The two possible funding sources are increased taxes from the taxpayer or increased contributions from potential retirees. PERA needs more money. TABOR restricts unilateral taxation without voter approval. There is no escaping the problem ahead.

According to the following table (based upon research from the State Data Lab)1, Colorado state employees and school district employees represent the largest number of PERA pension beneficiaries while being the least well-funded of the PERA population.

Plan NameFunded Ratio

Total Normal Cost/Payroll

Employer Required Contribution/Payroll

Percent of Required

Contribution Received

Total Participants

Colorado Municipal

73.1 9.9 10.6 116.0 41,275

Colorado School

60.3 11.7 19.8 79.0 283,399

Colorado State

57.5 10.3 20.0 79.0 159,434

Denver Employees

76.4 10.2 10.3 101.9 21,948

Denver Schools

81.2 12.4 11.5 37.0 27,640

Source: Public Plans Database (as of 2013)

Financial professionals agree PERA is in serious trouble. Sheila A. Weinberg, CPA, Founder, and CEO of Truth in Accounting, recently stated that the PERA funding shortfall would require either a cut in benefits, increased taxation, or some combination of both, to resolve the benefit-funding gap.2 The board of advisors for Truth in Accounting

1 http://publicplansdata.org/quick-facts/by-state/state/?state=CO2 Independent Thinking television show 4-17-15. KBDI.

includes David Walker, the former Comptroller General of the United States and former head of the US Government Accounting Office (GAO). Walker held service appointments from three different Presidents of the United States.

Morningstar, an independent investment research company, published the State of the State Pension Plans in 2013. Their research confirmed that PERA’s actuarial liabilities increased far faster from 2008 through 2013 than did the plan assets, resulting in an approximately $25 billion shortfall. Sadly, this substantial increase in liabilities occurred during a significant (and unsustainable) improvement in the equity markets (which boosted PERA asset performance substantially).3 As the PERA funding ratio has declined since 2008, there are clear indications from the professional finance community that the PERA funding problems are real and getting worse despite political assurances to the contrary. Since annual contributions are less than the annual required contribution (ARC) limits, there is a large and growing funding deficit, and the size of the deficit is large relative to the state general fund budget (approximately $9 billion) the PERA problem will continue to get worse.

The timing and magnitude of the PERA problem is not unique. Many states in the US have similar pension obligation problems. According to the National Institute on Retirement Security, NIRS, these challenges are coming at a time when 45% of US households do not own any retirement account assets, whether in an employer-sponsored 401(k) type plan or an IRA.4 NIRS is a non-profit, nonpartisan research institute established to contribute to informed policy making by fostering a deep understanding of the value of retirement security to employees, employers, and the economy as a whole.

Who might be the easiest targets for remedy? It is likely that the next generation will be burdened with the sacrifice. Defined benefit plans (PERA) have two important objectives. First, the plan should impose minimal risk to the beneficiaries and second, there should be complete intergenerational (intertemporal) equity (meaning that the benefits are to be fully funded by the recipient generation of beneficiaries—obligations are not to be passed down to future workers). This is how it is done in correctly managed plans. This is how it is done in the Dutch pension plan, the best managed pension plan in the world.5 It is the responsibility of the PERA board, the Colorado legislature, the Colorado governor, and the Colorado judiciary to prevent intergenerational inequity and address the deficits facing PERA beneficiaries while protecting Colorado voters from further taxation. These groups must be held accountable.

Many states have similar financial troubles that the government and the taxpayer can’t solve. Truth in Accounting published a comparison of all 50 states government debt per capita surplus/deficits.6 This analysis included ALL financial obligations (not just pension obligations). The top five states (with an average per taxpayer surplus of

3 http://corporate.morningstar.com/US/documents/Retirement/StateofPensions2013.pdf. P.224 The Continuing Retirement Savings Crisis. March, 2015. National Institute on Retirement Security.5 http://www.dutchdailynews.com/dutch-pension/6 http://www.truthinaccounting.org/library/doclib/2013-FSOS.pdf

$18,960) were Alaska, North Dakota, Wyoming, Utah, and South Dakota. The bottom five states (with an average per taxpayer deficit of $36,500) were Connecticut, Illinois, New Jersey, Massachusetts, and Hawaii. The top states fall into the “red” category politically while the bottom five fall into the “blue” category politically (as measured by the last four Presidential elections.)7 Blue states typically have higher tax rates, slower growth rates, and higher probabilities of insolvency over time. Colorado ranked as the 32nd worst state in the US in this analysis with 98% of retirement liabilities not clearly disclosed. Two of the leading state pension studies estimate that the total amount of state employee pension liabilities is over $2.5 trillion.8 Colorado, unlike other states, has a constitutionally established taxpayer protection from the indiscriminate tax increases that many states will pursue to address this enormous liability. This protection, TABOR, will be under increasing assault from PERA advocates as they see the looming pension deficits materialize and the need for rescue from Colorado taxpayers.

Small steps buy time but not answers. The prospect of imposing additional taxation on taxpayers (who cannot afford to retire themselves) to fund government pensioners will not be politically pleasant. Consequently, it is likely that solutions will be postponed until a crisis is imminent. However, small steps have been taken in Colorado. Colorado lawmakers have approved three separate bills, over the past 11 years, to increase PERA funding with the intent of digging out from an over $25 billion deficit. On June 4, 2014, the Colorado governor signed SB 14-214 to commission a total compensation study (including retirement benefits) that requires the state personnel director to present compensation findings to the governor and the Joint Budget Committee every eight years. These are small (and inadequate) steps to address a big, and growing, problem.

The magnitude of the problem is daunting. PERA has approximately 500,000 members (including active workers, retirees and beneficiaries). There are approximately 2.9 million active voters registered in Colorado.9 Consequently, the PERA population directly represents approximately 17% of all active registered voters (representing the largest single interest group in Colorado) and may influence up to half of all Colorado households. This quantitative reality makes voter opposition to a tax increase problematic should the PERA financial problem eventuate into a vote. TABOR, in effect, assures that such tax increase proposals come before the electorate.

The interim reality of the PERA budget shortfall will likely be that school districts have to reduce teacher expense while increasing PERA payments. The canary in the coal mine for PERA will probably take the form of smaller school districts facing financial crisis, if not bankruptcy. According to former Colorado Treasurer Mark Hillman, a remedy comes at high cost, “Ultimately, policy makers must ask whether spending nearly $1,000 per student (or 14.5 percent of the total K-12 program) on pensions [a cost that would recur annually] is in the best interest of our students.”10 Since the 1940’s, the number of PERA members (and retirees) has grown at average annual rates of 6.6% and 10%, respectively, with no end in sight. This is a demographic

7 http://en.wikipedia.org/wiki/Red_states_and_blue_states8 http://www.statebudgetsolutions.org/doclib/20110304_StatePensionLiabilityMarch4.pdf9 http://www.sos.state.co.us/pubs/elections/VoterRegNumbers/2014/December/VoterCountsByStatus.pdf10 Policy Changes to Make a Difference. Independence Institute. 2013. P.37

time bomb. Keep your eyes on the financial problems facing rural and smaller school districts as

possible signs of the inevitable PERA-TABOR showdown.

PERA understates the severity of the funding shortfall by using a high discount rate. The present value assessment of plan assets to plan obligations is critical to the ultimate solvency of the plan. The discount factor utilized for model assumptions will determine the size of the gap that needs to be closed. The actuarial value of assets (AVA) is the current value of the plan’s assets. The actuarial accrued liability (ACL) is the present value of future benefits already earned. Currently, the ACL exceeds the AVA by approximately $25 billion, a recipe for disaster. The choice of the present value discount factor is critical because if the factor is too low then contributions will be too high. Conversely, if the discount factor is too high, then it will very likely be unable to pay the promised benefits as they come due. The PERA discount factor (established by the PERA board) is 7.5% which far exceeds similar pension plans in the private sector. Many states assume a higher discount factor than the private sector because they are not held to as stringent accounting guidelines as is the private sector. Further, by overstating the discount factor, it reduces political opposition because PERA understates the true liability thereby mitigating opposition.

The PERA board is composed of 12 members (who are elected by PERA members) 3 members (appointed by the Governor), and the State Treasurer (who serves as an Ex officio member). Clearly, the board composition looks less like an objective board of trustees fulfilling a fiduciary responsibility than it does a group of self-serving interests (who are both PERA members and future beneficiaries) who can shift the burden of responsibility to the future, and less informed, taxpayers. The implications can be huge. According to the State of State Pension Plans 2013 Standards of Plan management report from Morningstar (September 2013) there is a $25 billion deficit in the Colorado PERA plan and it is only 61.5% funded (as of 2013). The funding ratio has been in a downward trend since 2008. When the funding ratio continues to decline, the magnitude of the liability is high relative to the state general budget, and the demographic reality is increasingly negative, the prospects for a happy ending grow considerably dim.

At a 7.5% discount rate, the unfunded liability is approximately $25 billion. At a 4% discount factor (typically used by the private sector and recommended by the Biggs-Smetters pension model),11 the unfunded liability balloons to $55 billion, or six times the state of Colorado’s general budget. The rate of return for “AA” or better rated 20 year municipal bonds is in the 2-4% range. The 7.5% to 4% difference represents a gap that no one in the private sector could hide. KPMG, who audited the PERA plan stated, “These funded ratios were derived using a 7.5% investment rate of return and discount factor to determine the actuarial value of the assets. Any significant deviation in the actual rate of return from the assumed rate of return over a 30-year period would have a material impact on the reported actuarial liability as of 31 December 2013.” Donald Kohn, former Vice-Chairman of the Federal Reserve, said “While economists are famous for disagreeing with each other on virtually every other conceivable issue, when it comes to this one there is no professional disagreement: The only appropriate way to calculate the present value of a

11 http://www.aei.org/publication/understanding-the-argument-for-market-valuation-of-public-pension-liabilities/

very-low-risk liability is to use a very-low-risk discount rate.”12 Whether it is an auditor or the Federal Reserve, it is clear that high discount rates may be politically pleasant but financially problematic.

Leading US economists agree that bigger problems are coming from excessive public pensions. The higher rate used by PERA, like many other state pensions, is an expression of how uncertain it is for the long term viability of the plan. The Initiative on Global Markets (IGM) Forum is a panel of experts (sponsored by the University of Chicago’s Booth School of Business) that focus on financial markets and the role of policies and institutions. The forum is composed of 75 of the brightest academic economists in the U.S. The panel comprises professors from elite universities throughout the country and is considered to be left-of-center in their political orientation. Despite political differences, the panel displays remarkable consensus regarding certain economic truths.

These experts were asked (8-26-14) to rank their degree of agreement with the statement, “By discounting pension liabilities at high interest rates under government accounting standards, many U.S. state and local governments understate their pension liabilities and the costs of providing pensions to public-sector workers.” 93% agreed or strongly agreed. They were then asked to rate their degree of agreement with this statement, “During the next two decades some U.S. states, unless they substantially increase taxes, cut spending, and/or change public-sector pensions, will require a combination of severe austerity budgets, a federal bailout, and/or default.” 84% of the expert economists from around the US either agreed or agreed strongly. Clearly, the nation’s leading economists recognize the egregious problem of how state pension funds are being managed.

Their suspicions are corroborated by the generous nature of state pension payments relative to private sector pension payments. In 2013, the average monthly benefit for PERA retirees was $3,068 (an increase of over 34% in the past nine years), while the average age of PERA retirees was 58.2 years old with 23.5 years of service. This is far superior to averages in the private sector from whom most of the taxes for PERA beneficiaries comes. Anyone with a discerning eye can see that PERA liabilities grew faster (with a 7.5% discount factor) than did PERA assets during one of the great bull markets of our era (2009-2013). It is highly likely that PERA advocates (board, beneficiaries, legislature, governor, or judiciary) will not reduce benefits to themselves. Conversely, it is highly likely that they will dump the shortfall on the taxpayer. It is clear that the PERA model is broken, the PERA advocates are “kicking the can” down the road, economists and industry professionals are deeply skeptical of its viability, and voters (both unaware and too trusting of politicians and institutions) are empowered only by voting. This is where TABOR comes in.

TABOR can save taxpayers from funding a PERA bailout. On January 1, 1993, TABOR (Taxpayer’s Bill of Rights) became part of the Colorado Constitution. It was approved by Colorado voters (54% to 46%) on November 3, 1992. Simply stated, it requires statewide voter approval of tax increases that exceed an index created by combining inflation and population increases. A lengthy study of its effects was completed in 2002 confirming that the

12 http://www.heritage.org/research/reports/2013/02/nine-fallacies-used-to-defend-public-sector-pensions

post-TABOR Colorado government spending did not exceed the combined growth in inflation and population, while the growth in state government jobs lagged behind the growth of private sector jobs.13 TABOR has been good for growth, has constrained government mission creep, and has made Colorado taxpayer-friendly. TABOR is still paying dividends to the taxpayer. In 2013, powerful political interests put a billion dollar tax increase (the largest tax increase proposal in Colorado history) on the ballot in the form of Amendment 66 and promoted it as a school funding measure. Colorado tax payers saw through the ruse and rejected it at the ballot box by an almost 2 to 1 margin.14

TABOR has been attacked through litigation since its inception by opposing interests. Typically, the opposition to TABOR comes from the bigger government crowd who seeks state solutions and more of them. TABOR has been interpreted in 40+ Colorado appellate court decisions, and has been at issue in numerous additional lawsuits that have settled (or have not been appealed beyond the district court level). The intensity of TABOR litigation reached its zenith in the late 1990’s, but appellate decisions have continued through the early 2000’s, including consideration by the Colorado Court of Appeals in late 2012, and by the Colorado Supreme Court in 2011.

It is clear that taxpayers benefit from TABOR while government interests must persuade the taxpayer of new tax merits (if their desire for more taxes goes beyond the population plus inflation rate). Although Colorado has dropped to 22nd in the 2014 "Rich States, Poor States 2014" ranking, (conducted for the American Legislative Exchange Council by economists Arthur Laffer and Stephen Moore) it used to be #2 in 2009 because the authors said "The only reason Colorado is ranked so high is the presence of TABOR." The study examines many politico-economic factors such as tax rates, extent of regulations, and freedom of markets, etc. Colorado has dropped precipitously in the past few years for reasons other than TABOR (policies hostile to growth and freedom, etc.).

PERA advocates will paint TABOR as the obstacle to a solution. PERA advocates will be targeting the dismantling (or overturning) of TABOR because of their fear that taxpayers will not approve new taxes to close the unfunded liabilities gap. Former Colorado Governor (and former Chairman of the Democratic National Committee from 1997-1999) Roy Romer publicly advised current Colorado Governor John Hickenlooper, in January 2015, to lead an effort to “repeal TABOR.”15 Romer went on to say, “We need to return the power, the authority, that decision, to the people’s representative, the legislature and the governor.” The vested interests of government are opposed to the power of the taxpayer to vote for tax increases. This will be all the more true when it comes to choosing between cutting benefits for PERA or shifting the burden to taxpayers. PERA advocates will “trot out the toddlers” saying that taxes for PERA is “for the children” or is an “investment in Colorado’s future.” No matter the deception or the craftiness of the message, be forewarned, further TABOR attacks are coming and they will not stop.

13 http://i2i.org/articles/tabor2003.PDF14 http://www.denverpost.com/breakingnews/ci_24461186/15 http://blogs.denverpost.com/thespot/2015/01/13/romer-tabor-hickenlooper/116318/

Colorado taxpayers and legislators must protect and defend TABOR from the coming assaults. Colorado taxpayers must steel themselves for the battle that is coming. TABOR is in the crosshairs of big government interests who want the freedom to levy taxes for many reasons, only one of which is a PERA bailout. Taxpayers should demand that PERA beneficiaries pay more for their retirement similar to the private sector. PERA beneficiaries often have a better retirement, earlier retirement, and often have fewer years of service than their counterparts in the private sector.

Colorado taxpayers should demand that PERA pensions be brought into alignment with those in the private sector. Taxpayers should demand that PERA leadership include taxpayer representation within PERA leadership. Taxpayers should also demand that the Colorado legislature exert more fiscal responsibility in the leadership, management, and reporting regarding PERA realities.

TABOR reflects the will of the Colorado people. It is embedded in Colorado’s constitution. It has prevented Colorado from becoming the fiscal mess that is California or New York (despite the significant investments that outsiders like Michael Bloomberg and Bill Gates are making to change Colorado into a state more like their own). TABOR has restrained excessive government spending and encouraged economic growth for the Colorado taxpayer.

PERA needs to be changed. Colorado will not be able to fulfill the expectations of future PERA beneficiaries. TABOR is the mechanism to protect the Colorado taxpayer from the future bailouts of PERA that are coming. PERA and TABOR are on a collision course. PERA requires a nonstop bull market to mask the flawed financial model that underlies it. We all know bull markets end in bear markets. Warren Buffett once said, “Only when the tide goes out do you discover who's been swimming naked.” When (not if) that happens, PERA problems will become a crisis. The first signs that a crisis is coming will likely be the failure or bankruptcy of some small Colorado school district. We should take steps now to mitigate the problem and to protect the taxpayers.

Opponents of TABOR will attempt to eviscerate it, evade it, misrepresent it, or overturn it. Proponents of PERA will attempt to dismiss or discount the problems, prevent benefit reduction or increased beneficiary contributions, and will blame the shortfall on inadequate taxes from the Colorado taxpayer. TABOR is the only wall between the excesses of PERA and the taxpayer’s wallet.