Civil Beat met with Employees’ Retirement System administrators to discuss the state of Hawaii’s $10.2 billion pension fund and its $6.2 billion unfunded liability. What follows is an edited transcript of that meeting. We are also publishing an article summarizing the interview and an updated topic page — a quick way to learn about this issue — with more detailed descriptions of concepts raised in this Q&A.

The top administrator, David Shimabukuro took the lead on most of these questions. But Assistant Administrator Wesley Machida and Chief Investment Officer Rodney June were also present. Where it is not Shimabukuro speaking, the change is noted.

What do you think is the most important problem facing the pension program?

One of the problems we have today is the unfunded liability. From 1967 to 2005, a lot of our excess investment earnings were used to reduce the employers’ annual contributions to the ERS. So that, in turn, they could use the money to finance other public programs. More than $1.687 billion of our excess investment earnings were used to finance other programs since 1967.

That’s the actual value, so the real value to the pension fund would be much higher, right? That is, if that money were left in the fund, it would have been able to grow larger.

At one point the actuary said the value of that was $4.5 billion.

It seems like a lot of your potential trouble is buried in that number.

Yes, you’re right on point with that. For many, many years, we were discussing this issue (of employers not making their mandated contributions) with the legislators, saying, “We have to do something about this. There’s no free lunch. This problem is not going to go away. This is a serious problem, so we have to address it.”

The good news is that beginning in 2005 Gov. (Linda) Lingle and the legislators agreed to address this issue. So they adopted a new long-term funding methodology that would enable us to keep the money. It also would help the state and counties smooth out the huge swings in their annual contributions to the ERS. It would strengthen the system, reduce investment risk and it would help make sure that the money is there.

We talked to the actuary. He said that if we had that money, before the market crashed in the fourth quarter of 2008, we would have been over 100 percent funded, at that point.

Can you explain what excess investment earnings are?

Our current investment yield target is 8 percent. And that’s by statute, set up by the Legislature. So the board would develop investment strategies and work with the investment consultant to come up with an appropriate asset allocation mix to hit that target.

In 1990, we exceeded the target by over $200 million. That year, if we didn’t have that statute, the state and county governments would have given us about $170 million as the annual contribution. In 1990, they gave us zero. And when they gave us zero, we could not reduce the large unfunded liability because we don’t have the ability to build a reserve. Every other state public fund, they don’t have this excess investment earnings provision.

It’s over now, but that was unique to Hawaii?

Yes. That was unique to Hawaii. In fact, if that was in a private ERISA fund, that would not be allowable. You are supposed to contribute what you are supposed to contribute. But coming back to 1990, they gave us zero. So the general fund was large because they didn’t have to give us the money. And that year, they said, “You know what, the general fund has a lot of excess money. So we should give refunds to all the people in Hawaii, all the taxpayers — $125 per individual.” So, a family of four got $500. We said, “We have this large, unfunded liability, and you have this large general fund, because you didn’t give [the contributions] to us. This is crazy.”

So they were supposed to give us $170 million. But if we exceeded (our investment return goal) by $70 million, they would say, “OK, you got $70 (million) extra, so we’ll just give you $100 million.”

It was a two-edged sword. The legislators would say, if you don’t make your target, we’ll make up the difference. But that rarely happened. We most of the time made our targets and exceeded it by $1.687 billion over 43 years. More recently, in 1999, we were having a very good investment yield return, and some of the employers were having financial difficulty.

One year, in 2001, the total state and country contributions to the ERS were $8.1 million. We paid out over $500 million in benefit payments. And, at that time, the dotcom bust occurred. Every month, we’d be sending out letters to our investment managers directing them to sell so we can cover the pension payroll. The market was going down, and the counties were contributing very little. We had to sell. The unfunded liability only grew. In fact, we anticipate in 2012, the annual pension payments will exceed $1 billion. This is the kind of discussion we have with all these decision makers.

In 2005, the good news was that they started addressing it and have stuck with the plan. This has given us the chance to start to rebuild.

Employees who are police officers and firefighters contribute 12.2 percent (of their payroll to their pensions. Until 2007, the government contributed 15.75 percent. That figure went up to 19.7 percent that year.) For general employees of the state and counties (who contribute either 7.8 percent or 6 percent, depending on the plan they choose), they (governments) contribute 13.75 percent. In 2005, we did a five-year experience study. We found out that the ERS retirees were living longer. So we said, “We have to increase the employer contribution rate.” And they have. And they (governments) are now paying 15 percent for general employees and 19.7 percent for police officers and firefighters.

If we were fully funded, the rate would be 6 percent. So, over half of that contribution is to catch up for the unfunded liability.

In other words, out of the 19.7 percent retirement contributions for police, 13.75 percent is to amortize that unfunded liability to pay off. And for general employees, about 9 percent of the 15 is to amortize the unfunded liability.

And isn’t part of the problem also the longevity of people’s lives here?

Although it is good that people are living longer, at the same time it increases the pension payments. When our [actuarial firm] did the experience study, they were stunned. Our retirees blew off the charts. They said that for a retired female teacher, the median age is 90. The second group that has the longest life span is the retired male teachers.

So when we talk to the retired teachers, we tell them, “You are causing us tremendous financial problems.” And they love it. They smile.

I’ll also add that in 2007, they (the Legislature) placed a three-year moratorium on any benefit enhancement proposals. But in the past, even without that moratorium, we were still able to hold the line (and not increase benefits) for 13 years.

When we went to initiate this proposal, a number of the finance and budget people in the counties were against it because of the large cost.

I said, “We have to address it, and this is the funding methodology used by everybody else. It’s just like social security. You make a contribution based on salaries. None of this other stuff with the adjustment. You are not putting the money in the system, which you should. So we can’t build a reserve. The market is going up and down every year.”

We had a lot of good discussions. We also shared some of the other stories of what was happening in other parts of the country with funds that ignore the problem.

That’s the value of having good actuaries. I said (to our actuary), “Why don’t you share the story about the other client you had?” And he did. He told the story of how he had this client. The fund had $7 billion in assets. It was 50 percent funded. And the legislators, every election year, weren’t funding it. So the board asked the actuary, “Give us a long-term projection to know about what happened.” So they did, and they said in 13 years, there will be no money. The $7 billion will be gone. So they were forced to increase their contribution rate, and they did incrementally. Their long-term plan was to contribute up to 29 percent to catch up.

So we said, “These problems don’t go away. And once you fall behind, it gets worse. So, it’s not only pay me now or pay me later.” A previous finance director, when we would be trying to do this thing, would say, “What the ERS is saying is doom and gloom. Hawaii will always be there to meet its obligation.” So even though we are a part of the Department of Budget and Finance, we would testify on different sides on this issue and say, “The state can’t pay $1 billion, no way. So yes, they’re obligated, like you said, but let’s be realistic.” They told me I’m putting (out) fear, and I’m an alarmist. I said, no. I’m just saying (the truth).

Fortunately, in 2005, a change was made, and after sharing that story like that, they did not object. We went to the employee organizations to share this information and the need to properly fund the retirement program. We were able to get it through.

We also talked to some of the mayors. We said, “Hey, we gotta do something.” And in 2007, they increased their contributions.”

From the actuarial standpoint, young people could be hugely expensive.

Actually, no. Because the new ones really don’t have any past liability. And if you funded it without any past liability, we’re only supposed to put in 6 percent for them.

So you need them paying the 15 or the 19 percent to pay off the older people? Isn’t that the problem where the young will be working for the old, and then there won’t be enough young?

We have less liability, though. That’s part of the funding method.

For us, the problem has been the economy. And the global economy affects our investment returns.

How realistic is the 8 percent growth target (for fund investments) when we’re seeing these very dramatic market swings?

Machida: The last 43 years, our annual average investment return is over 8 percent. It includes, during that period from 1967 to current, seven recessionary periods. So we’ve been able to average over 8 percent annually.

Do you ever adjust that rate for recession periods?

No. By statute, if we drop, and the actuary determines that we are not able to amortize the unfunded liability within 30 years, we go in for an adjustment. So if we got stronger, the rate would be reduced.

Annually, if things really get out of whack and it’s going to take more than 30 years to amortize, we go in for a statutory adjustment. Otherwise, every five years, we look at what has happened and also look forward.

The 8-percent assumption is used by many of the large pension funds. So it’s not way out there. And the board has a good discussion with the actuary about it. We want to be realistic.

In 38 of the 43 years, we’ve had positive returns.

June: We use conventional quantitative modeling, which almost every pension plan uses to determine how can we best build a portfolio with various assets to achieve the 8 percent but keep the risk as low as possible.

So when you read the press and academic research that says pensions are in trouble, how do you respond to it? When you read the study by Northwestern professor Joshua Rauh that says by 2020, the Hawaii pension system will be insolvent, what’s your take on that?

WM: We have a difference of opinion on the Rauh study. There are certain assumptions in his study. One in particular is for the normal costs. Normal costs are for the active members. When they accrue service time in the current year, that’s considered something to be paid if they become vested. So the assumption was that the contributions that come in would only be able to cover that current year’s cost.

For example, in 2007, we got $454 million in employer contributions. Our normal cost rate was 5.85 percent, which equated to about $205 million. So as you can see, the $454 million in employer contributions more than covers the normal cost by over 2 to 1. So assumptions like those were not accurate to determine that the fund would run out of money by 2020.

Shimabukuro: That study assumes the employers would not pay any money to pay off that unfunded liability, which is not true here.

So we got this study, we said, “Whoa. It’s not helpful.”

What about the Pew Study? They said Hawaii’s pension program was “lacking progress with taking the necessary steps to ensure their pension plans are financially secure.”

Machida: We’ve earned positive returns for 38 out of the 43 years. And over those years, we’ve had seven recessions from 67 through 2009. And even with that, we’re still able to average investment returns of 8 percent or more.

Shimabukuro: They said we’re “lacking progress to take necessary steps.” We said, “This is what we’ve done.”

Machida: So as far as the Pew report is concerned, we have a difference of opinion on that, too. We feel we’ve taken the necessary steps. It’s just sticking to those plans.

Shimabukuro: They did not talk to us.

Any parting thoughts?

Machida: Our pension beneficiaries, a majority of them live in Hawaii. They spend their money in Hawaii. We pay out $840 million plus a year in benefits, which helps to sustain the state economy. Which helps to maintain jobs for those in the private sector as well, too. So that’s a critical point of emphasis if you’re talking to the general taxpayer at large.