By Seth McLaughlin

When Gov. Robert F. McDonnell inked Virginia's new two-year budget, state lawmakers will have deferred $620 million in the usual payments to the retirement system, while promising to repay the money over ten years – with interest.

The IOU is one of the budget remedies lawmakers relied on to close a projected $4.2 billion gap over the coming biennium. And it comes after the General Assembly reduced its payment to Virginia Retirement System (VRS) for the fiscal year that run through June 30 by about $150 million. 

The moves allowed the state and localities to delay nearly $1 billion in payments to the VRS, which covers 600,000 teachers, state workers, police officers and judges. 

While the short-term savings are welcome news for the state and for localities struggling to balance their budgets, the bad news is the state and localities eventually will have to pick up the tab.

Lawmakers now are waiting to see when the books close on the current fiscal year if the investments that cover the majority of retirement benefits will have rebounded from major losses in recent years.

During that time, the pot of money set aside to pick up the tab for benefits promised - a combination of investment returns and state and local contributions - shrunk from $58.3 billion on June 30, 2007 to $42.6 billion on June 30, 2009. 

Current employees do not contribute to their retirement. In lieu of a pay raise in 1983, the state agreed to takeover and pay 5 percent employee contribution.

And in December, the Joint Legislative and Audit Commission (JLARC) said Virginia was almost $12 billion short of what it needs to cover its retirement promises over the long run. This represents the system’s unfunded liability, the difference between what the state owes its pension system and what it can pay.

To help make up for investment losses, this legislative sessions lawmakers adopted a series of reforms aimed at saving billions over the next decade

But, at the same time, lawmakers adjusted the way the health of the system is calculated, which resulted in smaller required contributions from the state. They also adopted an assumed rate of return on investments that ignored the bean counters at VRS and has been characterized by some economists as overly optimistic.

While the moves helped localities save upwards of $200 million – some refer to it as the “state stimulus plan” – and freed up more state money to be funneled into other areas, including education, the decisions also have sparked concern. 

Namely whether Virginia – a state known for its conservative bent and where lawmakers preach about fiscal restraint – will be able to keep pace in the future with the cost of covering the benefits promised to state workers.

“If Virginia lawmakers are trying to smooth out temporary funding issues while preparing for the truly significant pension decisions to come, that's fine,” said Andrew G. Biggs, a fellow at the American Enterprise Institute for Public Policy Research, a conservative think tank. “But if they're simply trying to put off pension funding problems for tomorrow without any clear idea on what they're going to do to fix them, then that can be a huge problem.”

Risky Moves or Reasonable Decisions?

Before the VRS Board of Trustees met in October, the teacher's retirement system was 68.4 percent funded.  When the meeting adjourned, the system had ballooned to 76.1 percent funded.

House Appropriations staff said the the board did something it had never done. It advised lawmakers to temporarily suspend the way the state determines its contributions to the system by removing what is known as the “20 percent corridor.” In calculating the state's annual payments into the system, the corridor helps ensure the total assets of VRS stay within a healthy range of its future obligations.

“Why did they do this?” said Robley Jones, executive director of the Virginia Education Association (VEA), which represents teachers statewide said. “This shift in methodology will decrease the amount of funding required of the state and local governments.”

With the corridor, contribution rates for the state employee and teacher plans would have been between 21 percent and 37 percent higher, according to JLARC.

Without the corridor, the burden on local school board budgets fell from 22.8 percent of their payroll to 20.1 percent. And the funding levels of the system increased on paper.

- Teachers system went from 68.4 percent funded to 76.1 percent funded.

- State employees system went from 75.3 percent to 84 percent funded.
- State police system went from 66.1 percent to 73.6 percent funded. 
- Judges retirement system went from 58.7 percent to 64.7 percent funded.
- Law officers retirement system went from 65.3 percent to 72.5 percent funded.

Having followed the VRS board for decades, Jones said it was the first time he could remember since the early 1990s that he has felt “really uncomfortable with the direction the board has taken." 

Asked about the change, Frank Todisco, senior pension fellow at the American Academy of Actuaries, said the General Assembly was most likely spreading out its investment losses over a period of several years, rather than trying to cover it in a single fiscal year. The goal, Todisco said, is to keep the state’s annual contribution rates to the system relatively stable. 

“It is a decision essentially to spread more of the pain from the market crash into the future,” he said. “Clearly you don’t want to kick the can down the road too far and, at the same time, you probably can’t put a big assessment on your taxpayers to make up for it in a single year. So, there is some middle ground that is a sound fiscal approach.”

The Lingering Recession

Changing the way the health of the system is calculated was a part of the General Assembly’s multi-pronged response to VRS investment funds plummeting 21.1 percent in FY 2009 and 4.4 percent in FY 2008. Because lawmakers also missed the 8 percent assumed rate of return that lawmakers assumed in their budget, the losses translated into 29.1 percent and 12.4 percent respectively for those two years.

Those losses will be spread out over the coming years.

That’s because Virginia, like most states, smoothes out its investment gains and losses over a 5 year period in order to avoid having to adjust to dramatic year-to-year swings in the stock market and to maintain relatively stable contribution levels to the VRS.

As a result, nonpartisan Pew Center on the States says this means that “states’ funding levels will continue to drop for the next four or five years, as major losses experienced in 2008 and the first quarter of 2009 are gradually incorporated.”

That opinion is backed by Virginia's 2009 Comprehensive Annual Finance Report. “Unless the market stages a significant recovery, full recognition of the FY 2009 losses would cause the funded status of these plans to fall further in the next four years to about 60 percent,” it says.

VRS Chairman Robert Schultze pointed this out in a November letter sent to former Gov. Tim Kaine and the chairmen of the House and Senate budget committees. In the letter, Schultze said that if the General Assembly does not increase contributions to the system over the next two years, lawmakers must consider changing the plan design. Investment returns alone, he warned, are not enough lift the funds out of their funding hole. 

The point was again driven home by JLARC. “VRS consulting actuary estimates that to compensate for the loss of 21.1 percent of the fund’s value in FY 2009, future returns would need to be 46.5 percent over the next year, 19.2 percent over the next three years, and 14.4 percent over the next five years,” a recent report stated. “VRS staff do not expect to achieve such high returns.”

Lawmakers this year responded by passing bills designed to reduce the benefits and costs of VRS. Part of the package establishes a two-tier retirement system in which state employees hired after June 30 will be required to pay for 5 percent of their annual retirement contribution. Localities also have the option of requiring new employees to pay up to 5 percent of their annual contribution.

While the new changes to the system will cost nearly $500 million to implement, lawmakers say the moves will save as much as $3 billion in state and local funds over the next ten years. However, that level of savings is dependent upon localities following the state’s lead in charging new employees the full 5 percent.

The legislative push appears to have put The Commonwealth on better financial footing than many of their counterparts  across the country. 

But Virginia is not out of the woods yet, according to economists.  The reason is some of lawmakers’ other budgetary moves – limiting the state’s contribution and assuming an 8 percent return on investments – carry risk. 

David Wyss, chief economist at Standard & Poor's, said Virginia’s 8 percent return is doable, but risky. “I think 8 percent is pushing it,” he said. “I would rather be around 6.5 to 7 percent if I were running a fund, and even that may be optimistic in the current environment.”

VRS statistics from the last couple decades highlight the unpredictable nature of investment returns. Between 1989 and 2009, the state met or exceeded a 7.5 percent return on investments 14 out of 20 times. 

Jeanne Chenault, VRS spokesperson, cited those stats and said, “there is every indication that we will have a similar track record going forward.” She also pointed out that returns through the middle of April were 18 percent, bringing the VRS fund back to about $50 billion.

But since the dot-com bubble burst in 2001, Virginia has missed the mark five out of the last nine years, and averaged a 2.7 percent investment return.

Wyss said he is not surprised by the smaller rate of returns this decade.

“We had a period from 1982 to 2000 that was exceptional – some of the best returns we have ever seen in history. The stock market grew 19 percent per year,” he said. “But it hasn’t happened over the last ten years and it is not going to happen over the next ten years.”

“I think over a 30-year period you should see gains reverting to their historical norm, but the historical norm is not the 80's and 90's experience. The historical norm is substantially lower than that,” he said.

State Lawmakers Vs. VRS Bean Counters

While Jones was concerned about the decision of the VRS Board of Trustees to advise lawmakers to tweak the way they calculate state contributions to the system, he said he has been around long enough to understand why it happened. 

"The Board was in a bind because they feel quite confident that the General Assembly is not going to provide them with the money to adequately fund the system,” he said. "There is a disconnect between the folks with the expertise and the folks that have actually been making the decision.”

Like clockwork, every budget year, the VRS Board of Trustees calculates the state’s contribution rate, an anticipated rate of return on investments and the amortization period – the length of time required to pay off a pension plan’s unfunded liability. And then the governor and the General Assembly adopt lower the contribution rates, a higher assumed rate of return on investments and a longer amortization period, Jones said.

In fact, in 10 of the previous 18 years, the General Assembly has approved contribution rates that are lower than those approved by VRS actuaries. This is a big reason that the state’s unfunded liability had grown since 2001.

“So we end up constantly behind,” he said. “Then when you hit a recession – you were already in the hole before the recession started and your responsibility comes home to roost.”

James Regimbal, a Richmond-based economist and former staff member of the Senate Finance Committee, said it is simply easier for politicians to reduce contributions to the system than to cut additional services or raise new revenues through taxes. 

“They have a $50 billion fund that is sitting there in assets,” Regimbal said. “They can’t touch that by law, but what they can do is just turn the spigot off on contributions and then rely on that $50 billion to hold them over, which will for a long time.”

Otherwise, “they would have had to cut education funding even more than they did if they didn’t raid the retirement system by reducing contributions,” he said.

Double-Edged Sword

Despite his criticism of the General Assembly, Jones, of VEA, said he recognizes that lawmakers are tasked with the difficult job of balancing the needs of today versus the needs of tomorrow.

And in all honestly, he says the recent budget actions are a double-edged sword for him and the rest of the VEA.

“The good news is these are tools used to reduce job loss,” Jones said. “The bad news is that you are passing debt onto future taxpayers.”