According to Sandy Matheson, executive director of the Maine Public Employees Retirement System (MainePERS), there is good reason to be optimistic that the public pension system in the U.S. may be turning a corner towards greater stability and financial strength.

She says this because she has seen firsthand how a troubled public pension system can be reformed. In addition to her description of the MainePERS turnaround, she points out that a good portion of the unfunded liabilities on the books of public retirement systems today were actually created years ago—under employer contribution and benefit structures that have since been reformed. In Maine’s case, after decades of irresponsible management, the plan today is far more conservative about its long-term assumed rates of returns and its projected liability discount rates, and it forbids the creation of any new unfunded liabilities.

“I like to say our plan is a case study in how to turn around a troubled pension system,” Matheson said during a briefing held by ICMA-RC and the Center for State and Local Government Excellence in New York. “In the 1980s, we had a funded status that ranged below 20%. We were in about as bad a situation as you could be.”

Today the system is far better funded, Matheson said, approaching 85%.

“Some states are lagging in their recovery due to the more constrictive nature of their unique laws governing public pensions,” Matheson said. “That is an additional layer to this conversation that can make fixing public pensions even more difficult. But in states where there is flexibility, a lot has already been done to put public pensions on a better path. Maine is a state that has made great progress and may serve as an example for other states to follow.”

The Maine story

At a high level, the recovery of the MainePERS system started in earnest in 1995, when a public outcry successfully propelled an amendment to the Maine State Constitution, setting the goal of achieving a 100% funded status by 2028. Under the Constitution, any new benefits created in the system had to be paid for with defined funding streams arranged up front, Matheson noted, which essentially meant the system would permit no new unfunded liabilities. Matheson recalled that the fund has also benefited from an additional technical overhaul in 2011.

As Matheson explained, apart from mandating more realistic return assumptions and interest rate projections, the core of the new policy was to ensure that contributing government employers would have predictability and stability in their required contributions. In fact, she called contribution volatility the top challenge facing public pension systems today. 

“Of course the unfunded liability is a serious problem, but we realized it was important to acknowledge that you only get unfunded liabilities when there are required contributions that are not being made,” Matheson explained. “We came to realize that, if we could smooth out the volatility in required contributions, this would be a very practical way to start to bring our funded status up over time.”

The operational details are complicated, but one salient feature of the reformed MainePERS is that any excess investment losses the system faces in the equity markets are offset by amortized reductions to the system’s variable benefit cost-of-living increases. This approach is taken in contrast to simply requiring greater employer or employee contributions when a the plan’s funded status slips in a given year. Under the first round of reforms, the amortization period was set at 10 years, but eventually the leadership proposed and adopted a 20-year amortization period to create an even smoother contribution figure.

She said this realization about the interplay of funded status and contribution volatility is important for all pension plans, but especially for public plans which rely on budgets that are a matter of law. In the case where the markets have a bad year and a much greater contribution is necessary, the market issues can cause the state or local government to experience a short-term budget crunch that will make a larger contribution all but impossible. Thus a funded status drop is also all but impossible. 

Matheson said the cost of living adjustment (COLA)-reduction approach was settled upon after more than two years of analysis and discussions. She said a very important part of the success of the reforms was a concerted communications campaign, targeting both the participating employers and employees. Eventually, stakeholders came to see this new approach represented a balanced way to parcel risk between all the parties.  

Significant progress yet to be made

Matheson encouraged other states to learn more about the changes that Maine has put into place, which have dramatically improved funded status. She noted that, thanks to the reforms put in place, the MainePERS funded status is commonly seen to increase when other pension systems’ are suffering funding setbacks.

Stepping back, Matheson set the context for Maine’s success by reflecting on where the broader public-sector defined benefit pension system stands today. She recalled that, as recently as the year 2000, the average funded status for state and local government retirement systems was about 85%. Today the figure is closer to 72%.

As Matheson explained, there is a plethora of related causes that have driven the collective state and local government pension funded status so low, and it’s not just the lingering effects of the “dotcom” market crash or the Great Recession.

“A big part of the challenge is more structural and fundamental than the occasional recession,” Matheson said. “The whole defined benefit model was created at a time when individuals’ working and private lives looked different than they do today. When pension plans were first designed and popularized, people didn’t commonly live late into their 80’s and 90’s. Furthermore, as fixed-income returns have fallen over time to the very low levels we have seen persist for the last decade, this drove pensions to hold more in equities to meet their return needs, which left them very exposed during the market crashes in the 2000s.”

According to Matheson, a more stable future for public pensions will only come about if states get serious about implementing the principles of liability-driven investing (LDI), and if they seriously consider making the kind of changes MainePERS has embraced.