North Carolina has a long track record for managing one of the best public pension plans in the U.S. Moody’s Investors Services recently reported that North Carolina has one of the top pension plans in the nation when looking at its Adjusted Net Pension Liability. And CEM Benchmarking ranked North Carolina’s pension system as the most efficient in North America.
But the financial stability of the Teachers’ and State Employees’ Retirement System (TSERS) and State Health Plan could take a dramatic turn for the worse if the legislature doesn’t quickly take action to remedy a provision in the recently enacted $30 billion state budget.
A provision in the new budget will make new UNC Health Care (UNCHC) and East Carolina University Health (ECU) employees ineligible for the state pension plan. Instead the new employees will have health and retirement benefits outside of the traditional options offered to other state employees and teachers. To date, it’s not clear how those plans would be structured.
Republican State Treasurer Dale Folwell said these changes are a “direct attack on the state pension system and the state health care system” and would allow “UNC and ECU to leave their liabilities behind for everybody else to pay.” Moreover, a State Treasurer’s new release says the changes “will negatively affect workers at both organizations,” and “the potential impact on the rest of the system could cost teachers, state employees, and taxpayers billions in unfunded liabilities and taxes.”
Governmental Plan IRS Tax Status Could Be At Risk
Equally troubling, the universities could be at risk of violating federal tax laws, exposing themselves, the state pension plan, and workers to scrutiny and penalties from the Internal Revenue Service (IRS).
According to the Office of the State Treasurer, providing a choice of a new retirement plan at UNCHC and ECU could constitute an impermissible arrangement. If the IRS decides that the new plan does not meet its requirements for a governmental plan, “the entire system’s tax qualification status could be put in jeopardy, forcing state employees to pay taxes on the 6% they have contributed and, potentially, back taxes going to the beginning of their participation” in the pension plan. This could mean “billions in back taxes having to be paid by teachers and state employees.”
And some question whether TSERS would even remain a governmental plan if UNC Health were to merge or otherwise engage with nongovernmental entities.
The Pension Changes Will Mean Big Cost Shifts to TSERS Employers
A pension plan is funded in part by future payroll contributions to the retirement system. Generally, pension plans assume that payroll will grow over time. However, if there is a halt to employees entering the plan – as is planned for UNC Health Care and ECU Health employees – the plan’s payroll trajectory looks dramatically different as depicted in the chart below.
For example, if a pension plan requires eight percent of payroll to fund future liabilities, but then projects a decline in future payroll contributions, there will be a funding shortfall. This means current employers and employees must pick up that slack because the lower total projected payroll will mean a rate higher than the eight percent that initially was required to properly fund the pension plan.
This represents a cost shift in the plan, with the scale dependent on the size of the withdrawn employees relative to the total plan. This clearly is unfair to the workers and employers currently participating in the pensions plan that will absorb the costs for UNC Health workers’ benefits.
Fortunately, the TSERS pension is mostly pre-funded. However, retiree health benefits are managed on a pay-as-you-go basis. By withdrawing from the system, UNC Health employees will continue to be owed significant benefits, but the costs of those benefits will be shifted to taxpayers as noted in the fiscal note:
“The State currently funds retiree medical benefits primarily on a pay-as-you-go basis, so contributions on behalf of current employees are in fact used largely to pay for healthcare for current retirees. The loss of these future contributions will mean that other employing entities and the tax revenue or other resources used to support those entities will bear some of the burden of paying for retiree medical benefits for the existing UNCHCS employees and retirees. As of June 30, 2022, the Net OPEB Liability related to UNCHCS was $1.1 billion.”
Indiana Has Been Down this Path, But Course Corrected
In 2015, both Indiana and Purdue Universities wanted to leave the Public Employees’ Retirement Fund (PERF). The departure plan came to the attention of legislators because it would mean an unfair cost-shifting to employers and employees participating in the retirement plan.
This cost shift was recognized in a fiscal note:
“Consequently, when these entities froze enrollment into PERF, they shifted some of the liabilities for their current and former employees in PERF to the other PERF employers. This is due to the fact that the affected entities are paying a contribution rate based on a gradually shrinking affected payroll (since the contribution rate is only paid on the portion of the employer’s payroll that is covered in PERF).”
Legislators wisely responded by creating a withdraw liability policy that would freeze the unfunded accrued liability (UAL) to ensure the universities paid their share of liabilities over time via House Bill 1466. The legislature was controlled by Republicans, but the bill enjoyed bipartisan support, passing both the Indiana House and Senate unanimously and signed into law by then-Governor Mike Pence.
The bill, however, did not require the calculation of the withdrawal liability on a more cautious financial basis, as some plans use to insulate the on-going plan from risk. As a result, some future market risks could result in cost shifting.
Risk Also is Shifted To Current Employees and Employers
Given that a withdrawing employer’s payroll (as a share of plan payroll) will decline much more quickly than the liabilities owed to that employer’s workers, there likely will be a risk shift even if an employer pays its current share of existing unfunded liabilities. The change in the share of a withdrawing employer’s payroll and liabilities is illustrated in the chart below.
For instance, if one assumes a withdrawing an employer’s employees accounts for 20 percent of plan payroll and liabilities at the time of departure, those liabilities will be paid over many decades. However, the plan payroll would start dropping quickly once future worker enrollments in the plan are halted.
Thus, if a pension plan experiences another Great Recession-like market event 15 years down the road, the impact on legacy costs would be significant. However, plan payroll of the withdrawing employers would have fallen to the point where other employers would be forced to make up the difference for their employees’ benefits. Again, an unfair risk shift.
Plan Demographics Worsen, Too
There is good reason why pension funds track demographic changes over time. Running a plan successfully with mature demographics (that is, more retirees and few workers) is more challenging.
Among private sector multi-employer plans that experienced difficulties rebounding from the Great Recession, plan demographics proved a much better predictor of financial problems than investment returns or the willingness to increase contribution rates.
In fact, the average plan in “declining status” in 2020 had 7.2 retirees per worker. The healthiest plans, in contrast, had 1.4 retirees per worker. Accordingly, it is important to avoid becoming a provider of legacy benefits that enrolls few new workers, even if the only goal is to meet current obligations. TSERS could find itself in the unfortunate position as a provider of legacy benefits under the current law rather than the thriving system it has been for more than 80 years.
North Carolinians Deserve a More Thorough Analysis
To avoid leaving state employees and taxpayers with a billion dollar bill, lawmakers must take a deeper dive into UNC and ECU future plans and cost projections. In addition to probing about the share of obligations for UNC and ECU health employees, lawmakers must determine:
- What type of retirement and healthcare plan will be established by UNC and ECU? Will any future merger and acquisition plans put the the TSERS favorable IRS tax status at risk?
- What is the impact if in 10 or 15 years the assets put aside for pension benefits decline by 20 percent? Is there a cost-shift? How much would that impact other employers in the system? Who picks up the tab?
- What share of the $1 billion in health benefits will be shifted to taxpayers?
- How will plan demographics change over time if these two employers leave?
- What is the risk if other employers want to follow suit and how would that impact the plan?
North Carolina has been a national leader in pension fiscal responsibility. The state can sustain that reputation by asking tough questions today about UNCHC and ECU and taking appropriate action in short order to protect state employees and taxpayers.