Editor’s note: This article is a response to a four-part series on the financial problems at the Hawaii Public Employees’ Retirement System by actuary George Berish. To read that series:

Civil Beat is also publishing a response from the chair of the Hawaii House Committee on Labor and Public Employment, “Berish Series Misleading.”

Pending before the Legislature are measures aimed at making some fundamental changes to Hawaii’s public employees pension plan. The adoption of these changes is critical. Failure to do so will saddle the State and the counties with future expenses that could overwhelm their ability to pay in the decades ahead.

The best indicator of this threat is the decline in the funded ratio of the Employees Retirement System (“ERS”) from 95 percent to 61 percent during the 10 years since 2000.  If the ERS were fully funded, it would have assets today in excess of $18 billion.  Instead, it has $11 billion in assets and a problematic $7 billion deficiency referred to as the “unfunded liability”.

Why is the unfunded liability a problem? The ERS is a pre-funded pension plan. The public employers (the State and the counties) along with active employees are supposed to contribute amounts that would (together with investment returns on the contributed amounts) enable the ERS to pay the pension benefits the active employees accrue for when they retire.

When the pension plan is underfunded, the investment returns generated on the assets are inadequate to pay the pension benefits due. The forced sale of investments becomes necessary. That sets off a dangerous downward spiral as the plan assets are depleted and the integrity of the investment portfolio compromised.

This would not be a concern if the asset base of the ERS could be restored by additional contributions by its participant-employees and the public employers. However, the burden of funding such additional contributions has become oppressive.

Based upon the current plan design, the public employers should only need to contribute the “normal cost” or approximately 6 percent of the payroll cost of the active employees to fund presently accruing pension benefits. For FY 2010 that amount would have been $223 million. But because of the unfunded liability, they instead must fund a much higher annual required contribution (“ARC”) to close the deficit.
Public employers currently must contribute to the ERS an ARC equal to 15 percent of payroll for general employees and 19.7 percent for police and fire employees.  The differences between the ARC and the “normal cost” (9 percent and 13 percent respectively) represent the “catch-up payments” aimed at closing the $7 billion unfunded liability over a period of 30 years. This represents additional contributions in FY 2010 of $306 million for general employees and $51 million for police and fire.

If nothing in the design of the pension plan is changed, the ARC must be increased to 19.5 percent of payroll for general employees and 28.5 percent for police and fire employees by 2012.  These high contribution rates will burden the public employers with an onerous expense load that they are constitutionally compelled to honor for decades.

Looking at the situation from a cash flow perspective, the ERS will distribute about $1 billion in pension benefits to retirees in FY2011. That amount will rapidly grow as the “Baby Boomers” continue to retire in large numbers. By the year 2040, annual pension benefits payable to retirees is conservatively estimated to grow to almost $3.6 billion. Without an adequately pre-funded plan to offset most of that annual cost, the ARC burden on the public employers will be staggering.

The benefit reform proposals pending before the Legislature seek to reduce the unfunded liability over time by increasing the public employer contribution rates immediately while containing future rate increases by reducing benefits for new public employees. Among the proposals are:

  1. Raising the retirement age for most employees from 62 to 65.
  2. Extending the vesting period for new employees from 5 years to 10 years.
  3. Decreasing the pension benefit multiplier or the rate at which an employee’s pension benefit accrues annually by 12.5 percent from 2 percent to 1.75 percent annually.
  4. Tightening up the formula by which the retirement benefit is calculated by changing the definition of eligible compensation and increasing the number of years used to determine “average final compensation” from 3 to 5 years.
  5. Decreasing the annual post-retirement benefit adjustment from 2.5 percent to 1.5 percent.
  6. Increasing the employee contribution rate in most cases from 6 percent to 8 percent.
  7. Prohibiting future pension benefit increases until the accrued liabilities of the ERS are fully funded.

If enacted, new employees will not enjoy the same level of benefits provided to current and past public employees.  Because the reforms would only affect new employees, the financial relief they will provide is relatively slight in the near term. Over a 5 year period the savings are estimated to total $440 million.

The changes nonetheless will prove to be a key factor in reducing the unfunded liability over the next 30 years. 

Whether the changes proposed are fair to new employees and whether they are fiscally sufficient, are questions that only the Legislature can determine since it is charged with managing the finances for the State. Critics may contend that there are other methods for dealing with the problem of the unfunded liability. However, no one can credibly assert that maintaining the status quo is one of them.

Hawaii’s pension plan made sense during a time when Hawaii was experiencing rapid economic expansion.  Today, our economy is a mature one with much lowered economic growth prospects and with diminished capacity to absorb increases in pension costs. It is not too late to address the situation we face. But doing so will require that we all urge the Legislature to take action and enact proposed reforms.

About the authors: Colbert Matsumoto is chairman of the Board of Trustees of the Employees’ Retirement System of the state of Hawaii. Wesley Machida is the system’s top administrator.

Read an earlier response by Mr. Matsumoto to the series.