Editor’s Note: This is the second in a series on Hawaii’s retirement system. You can find definitions of terms used in this story here.

In Part 1 of this series, I explained that the “actuarial accrued liability” (AAL) is today’s value of retirement and ancillary benefits owed by taxpayers to government workers tomorrow under the “retirement plan” defined by Hawaii Public Law 88 (PL-88) and administered by the Hawaii Employees’ Retirement System (HERS).

I also documented the decade-long deterioration in funding for the AAL in good times (2000 to the Fannie Mae meltdown), and bad (meltdown to 2010). More specifically, that the 2000 Annual Actuarial Report showed assets set aside by taxpayers in the HERS exceeded the AAL, while the 2010 report shows them being almost $9 Billion — almost two Honolulu rail systems — short of the AAL.

Stopping that deterioration, and eliminating the shortfall, will require a difficult debate everyone should prepare to fully understand, and this series is intended to help with that preparation. This article (the 2nd in the series) will describe the consequences, the current design features and flaws, and the actions by responsible parties that are associated with so much debt, growing so steadily, over a full decade, so invisibly, i.e. without material public attention or lawmaker action to stop it.

One immediate consequence is this statement from the 85th Annual Actuarial Valuation Report as of June 30, 2010: “The [taxpayers] aggregate funding period [of the Actuarial Accrued Liability (AAL)] … is not adequate to meet requirements of [Government Accounting Standard Board] GASB [Statement] No. 25.”

That inadequacy triggers PL-88-122, which states the annual amount transferred to the HERS to fund the AAL “shall be subject to adjustment”. Today, the amount is 19.7 percent of the police and fire payroll and 15.0 percent of all other payroll: $548 million in FY2010 and $604 (est.) in FY2011. (Government worker contributions are additional, but are not at issue, or at risk). The report states minimal compliance requires 22.33 percent and 16.23 percent, respectively — approximately $54 million more, but it recommends more than $54 million today “Otherwise, it is likely the [HERS] Board will need to go back [to lawmakers] … for another increase … ” later.

An ancillary consequence is the risk that inadequacy will prompt bond rating agencies to lower Hawaii state and county bond ratings. That would increase the interest paid by the state and counties on already large public debt (adding to today’s budget deficit), and on new debt like the billions of borrowing rail requires.

Three features contribute to the AAL’s invisible growth:

  • The “retirement plan” defined in PL-88 is of such mind numbing complexity it requires months for the HERS to “finalize” a worker’s benefit amount after payments begin, while estimating the AAL requires the actuary to estimate every possible payment many decades into the future.
  • The inescapable uncertainty introduced by the 12 pages of “assumptions” used by the actuary to estimate the AAL about which the actuary advises “Actual results … almost certainly will differ … from the assumptions”.
  • The unchallenged claim by unions, that even if the actuary materially underestimates the cost of a benefit formula increase when it is negotiated, current workers get to keep the increased formula for life. In the private sector, an increase whose cost was underestimated can be renegotiated in future years (only for years after the renegotiation).

The design flaws are best illustrated by a comparison with administration of private sector retirement plans where the flaws do not exist.

Shared features:

  • Stockholders/taxpayers are represented by a president/governor in negotiations. Workers are represented by unions.
  • In negotiations the president/governor is primarily interested in the total cost of wages and benefits negotiated.
  • The union’s right to split the total between wages and benefits is generally respected.
  • Boards of directors/lawmakers approve the result, and Personnel departments/HERS administer payments.

Differences:

  • Stockholder liability is limited to assets in the corporation. Taxpayer liability is not limited to assets in the HERS. Their full faith and credit is pledged to payment.
  • Presidents and unions rely on separate independent actuaries. Governors and unions rely on one actuary employed by the HERS board.
  • Ditto boards of directors and unions. They rely on independent actuaries, while lawmakers and unions theoretically rely on the HERS’s actuary. In practice, direct access to the HERS’ actuary by Hawaii’s governor and lawmakers seems limited to the point of non-existence.
  • Corporations must calculate the amount they annually set aside in a trust using an “accepted actuarial funding method”. Lawmakers can, and have since 2005, set the amount set aside in the HERS by legislative fiat.
  • Actuaries who calculate the AAL for a corporate plan must certify the “actuarial assumptions” used in that calculation are her or his “best estimate”. The HERS actuary does not have to do the same. For example: The most powerful assumption is that the HERS board can sustain an 8 percent average investment return indefinitely, and the actuary’s report says it is “Set by the Legislature”. (See Part 1 of this series for the actual averages over the last decade). Note: Assuming 7 percent instead could add 15 percent to the AAL increasing the shortfall from almost $9 billion to more than $11 billion.

Part 3 will discuss why “retirement systems” were created to administer the “retirement plan” governed by PL-88 and the original purposes and powers assigned to them. It will also explore how “retirement systems” have expanded those powers and purposes, and the contribution of that expansion to the decade’s invisible growth in the taxpayer’s ALL shortfall. Finally, Part 4 will examine the most common solutions proposed for stopping the growth, eliminating the shortfall and preventing another recurrence.