Authors note: Generally speaking, I like to talk about general economic principles in this column and not promote my own research. However, recently a BYU colleague, Richard W. Evans, and I completed a preliminary study on the Utah pension system that is probably of general interest to the readers of the Deseret News.
2008 was a bad year for anyone investing in the stock market. The Dow Jones Industrial Average lost almost 34 percent, and the S&P 500 lost 37 percent. Among those hit with big negative returns was the Utah Retirement Systems, the agency that manages the state pension system. It reported a slightly less devastating loss of just under 25 percent on the pension portfolio.
One of the consequences of this loss is that it left the pension system substantially underfunded. The degree to which a pension system is funded is most commonly measured by what is known as the funded or funding ratio. This is more or less the expected present value of future contributions and earnings on the pension fund divided by the expected present value of future benefits to be paid out. A fully funded pension system has a funded ratio of one, meaning the expected future receipts are equal to the expected future payments. In 2008, the URS funding ratio fell from 95 percent to 87 percent. Many state pension funds around the country found themselves in even worse fiscal condition.
The Utah Legislature responded to this shortfall by passing Senate Bill 63 during the 2010 legislative session. The law closed the current pension plan to new employees and gave them the option of enrolling in a hybrid pension plan or a defined contribution plan like the 401(k) retirement plans many private firms offer.
As a natural extension of our joint research on the U.S. Social Security System and the inherent instabilities of defined benefit pension programs, we developed an economic forecasting model for state pension systems. Using the publicly available data and actuarial assumptions from URS, we forecast the effect of the 2010 Utah pension reform on the balance of the Utah pension fund as compared to what would have happened if the reform had not passed (see the illustration). We focused our analysis on the largest portion of state employees and retirees, the Noncontributory (employer pays the premiums) System, which accounts for more than 85 percent of Utah workers and retirees.
Our best estimates show that, without the 2010 pension reform, the Utah retirement fund would have had a 50-percent chance of becoming insolvent (hitting a zero balance) by 2028, with a 10-percent chance of insolvency by 2022. In contrast, the 2010 pension reform rendered the expected balance of the fund to be solvent over the foreseeable future. However, it is important to note that we still find a 10-percent chance that the fund becomes insolvent by 2024, even with the reform. This is because there is always the chance that the Utah economy will be hit with a few bad economic years in a row.
Our results are only estimates, and our analysis is based on our best reconstruction of the characteristics of current state employees and retirees from publicly available data. More precise information on the age and job tenure distribution of employees and retirees would give more precise forecasts about the future of the pension fund. But our finding that the fund had a high probability of insolvency before the reform of 2010 is undisputed. What is less widely understood is that, even with reform, defined benefit pension programs will always pose a risk of insolvency and some type of painful policy change. Utah’s 2010 reform of its pension system was commendable and rare when compared to other state pension funds and the U.S. Social Security System. The reform reduced the probability of insolvency but did not eliminate it.
In the end, it is a policy question rather than an economic question as to how much risk should be borne by the state, taxpayers, and employers for employee retirement benefits and how much risk should be borne by employees. But economics can help us understand how big those risks are.
Associate professor Kerk L. Phillips and assistant professor Richard W. Evans teach economics at BYU.
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