I am writing in response to your article on the May 27 budget hearing in the hope of clarifying issues surrounding Watertown’s pension funding decisions. [Click here to read the article.]
The article reports the misleading claim, made by the Town Manager in the April 29 budget presentation document and again during the May 27 budget presentation, that moving the end-date for eliminating our unfunded pension liability from 2022 to 2019 will save the Town $32 million. This inaccurate claim leads to the false and damaging impression that the pension appropriations for FY2015 and subsequent years cannot be reduced because doing so would eliminate substantial savings. To the contrary, in order to realize $5 million savings by 2022 (not $32 million!), by 2019 the Town must make $10 million more in contributions than had been previously scheduled through 2019.
Before addressing arcane aspects of pension funding, we need to ask: Why is this important to Town residents?
The misunderstanding about the $32 million has the effect that pension contributions have been inappropriately taken off the table for discussion, thereby avoiding any consideration of using the rare good news in the most recent pension review (valuation) as an opportunity to improve current town services. Prior to the completion of this 2013 valuation, the schedule used by the Town to fund the liability was already one of the fastest in the state: the projected full funding date of 2022 put us in a tie for fourth place among all governmental entities in Massachusetts. The new “fund to 2019” schedule will surely move us even higher in the rankings, suggesting that we prioritize pension funding more highly than do other towns with similar populations, budgetary needs, and cost pressures.
The problem of unfunded liability began with the inception of municipal pension plans during the early to mid-20th century because most towns and cities, Watertown included, did not properly fund for their future benefits before the 1980s. The current generation of taxpayers is already burdened by having to pay unfunded costs for previous generations’ pensions in addition to current costs. Shortening the funding period exacerbates this intergenerational inequity by concentrating the burden on a compressed subset of residents.
Finally, the urgency to revisit funding schedule decisions is due to a provision in Chapter 32, the state law governing pension plans: each subsequent year’s contribution must be 95% of the prior year’s contribution until the plan is nearly fully funded. Despite Watertown’s status as an early-funding town, we are subject to this restriction, too. The additional $1.6 million in the Town’s FY2015 contribution, which increases from $10.6 million in FY2014 to $12.2 million in FY2015, locks us into making payments of at least $11.6 million (95% of $12.2 million) for FY2016 forward. In fiscal 2016-19, yearly $1.5 million increases are also scheduled, bringing the FY2019 contribution to nearly $18 million.
Now we can return to the explanation of why adopting a shortened schedule that includes moving up $10 million of payments from fiscal 2020-2022 to fiscal 2015-2019 does not result in $32 million of savings… fasten your seatbelt!
As background, a pension plan promises benefits to retirees in the future, requiring savings now; “unfunded liability” arises when not enough money is saved for future payments. Unfortunately Watertown, like most cities and towns, did not begin “funding” (i.e., saving for) its pension plan until the 1980s. The pension plan is reassessed every year or two. Each new actuarial assessment (“valuation”) re-calculates the unfunded liability based on actual history of demographic changes and salary increases, refreshed projections based on assumptions for future growth in benefits, and updated asset values. All these factors interact and must be taken into account together to calculate the yearly schedule of contributions that will lead to full funding. The liability includes benefits being earned by current employees who have yet to retire along with the value of all future benefits already earned by current retirees; meanwhile, a portion of the assets already in the plan are constantly being used to pay benefits to current retirees. Each time the Town resets its pension funding schedule, we must submit it to the state’s pension regulator (PERAC) for approval. These valuation reports are prepared at the end of each year and the new schedule begins the following fiscal year.
The key to this analysis is the difference between the 2012 and 2013 valuations. (Because of the lag in report preparation, the FY2014 appropriation is the same in each schedule; differences begin in 2015.) From 2012 to 2013, two things changed.
First, based on the 2013 valuation, the yearly contributions required to fund the liability over the period from fiscal 2015-22 would have been $27 million less than those derived from the 2012 valuation. This change happens because the 2013 valuation resulted in a liability that was much lower than had been projected in 2012. The good news was the result of a combination of several factors: the adoption of less conservative assumptions, slower than expected growth in projected benefits, and asset growth. Had we simply adhered to the schedule from the 2012 valuation all the way through 2022, the updated projections from the 2013 valuation show that the previously planned $114 million in scheduled contributions would have over-funded the plan by $27 million.
Second, in response to the 2013 valuation, the Town decided to move $10 million of contributions from later years to earlier years: from fiscal 2020-22 to fiscal 2015-19. Making contributions earlier allows for more time for investment returns to accumulate and therefore reduce future contributions, in this case a savings of $5 million. Put another way, adding $10 million to the previously scheduled $66 million in contributions over the next five fiscal years will allow us to reduce contributions by $5 million (not 32 million!) over the entire eight year period.
Needless to say, over-funding the plan is not on anyone’s agenda. In response to the favorable 2013 valuation results (the first change), the Town could have chosen to maintain the original funding date of 2022 and reduce total contributions by an estimated $27 million, from the scheduled $114 million to $87 million. Instead, the Town made the second change: we chose to adopt a new schedule that not only maintains the contributions for fiscal 2015-19 but increases them by $10 million in order to move up the date for full funding to 2019 (disregarding a small, residual liability for the Housing Authority). Total scheduled contributions (increasing until 2019 and dropping off steeply in 2020) for the eight years from 2015-2022 are now $82 million. The $10 million of incremental increases in contributions for fiscal 2015-19 produce almost $5 million of expected investment return over the eight-year period from 2015 to 2022. Therefore, the $27 million in reduced contributions and the $5 million in extra asset growth from investment return combine for a total reduction over the eight years from $114 million to $82 million.
It’s important to reiterate that most of the $32 million reduction in contributions is the result of the new 2013 actuarial valuation, NOT the shortening of the funding period. Furthermore, to achieve that last reduction through the $5 million of investment return over eight years, the Town must, in the next five years, direct an extra $10 million of revenue – over and above its previously scheduled contributions
– away from other purposes. In FY2015, the pension contribution increases 15%, the largest increase of any material line item in the budget. In FY2019, the new scheduled contribution will be nearly $18 million, a 67% increase above the FY2014 contribution, or an average of 11% per year.
I urge the Town Manager and Town Council during this year’s budget deliberations to fully weigh the costs and benefits of higher current pension contributions against the costs and benefits of underfunding other crucial needs.
Fellow, Society of Actuaries