Episode 33 – How pensions are guaranteed in Washington state
Episode transcript:
[music intro]
Jenny
Welcome back to Fund Your Future with DRS. Today we have Mitch from the Office of the State Actuary to help us learn a little bit more about how pensions work in Washington state. Welcome, Mitch!
Mitch
Hello. Thank you for having me. Yeah. Before we jump into any questions, just a couple of notes for me off the top. Nothing I’m sharing today is going to constitute an actuarial opinion or should be taken as one. And then everything I discuss today is my personal opinion.
Jenny
Excellent. Just to start off, could you tell us a little bit about what an actuary does? Maybe give us the “explain like I’m five” or what your elevator pitch would be?
Mitch
Yes. Happy to do that. I have spent the better part of a decade trying to explain to people what I do. So, I have plenty of practice at that. So, I think the simplest explanation of what an actuary does is comparing an accountant with an actuary. So, both are financial service providers, and an accountant is going to tell you what has happened.
Imagine when they do your taxes, they tell you how much money you earned last year. They tell you how much taxes you owe. Things like that. In contrast, a actuary is going to look forward. They are going to build financial models to estimate what will happen in the future. So, both financial service providers, but one is looking backwards, one is looking forwards. And actuaries come in all different practice fields.
I work in the pension field and so our primary duties are around valuing pension benefits. So, if we were to distill it all the way down, a pension actuary builds a model to estimate the benefits to be paid for the plan and then calculates contribution rates to fund those benefits. That’s what it does at the most basic level.
Seth
So Mitch, you probably get this question a lot and you kind of already hit on it with your answer. But one of the important things that you have to guess at is when I’m going to die or when all of us are going to die. Could you just talk a little bit about, what are the different sort of assumptions that you’re making or that kind of fit into the pension model for Washington state?
Mitch
Yeah, definitely. Before we dive into the assumption discussion, I just want to talk a little bit about assumptions and predictions. I do hear quite often that actuaries make predictions about the future, and we don’t really think of ourselves as making predictions. Predictions imply some sort of accuracy in the short term and accuracy at the individual level. And instead, actuaries are setting assumptions that are going to be applied over the long term and are going to be applied at the system level.
So, we can’t really make predictions on, say, when Seth is going to die. Our assumptions are more telling us how the life experience of the entire Public Employees Retirement System is going to play out. We do that because of how pensions are set up. Pensions are long term obligations, people are going to be drawing pensions for 20, 30 years, sometimes after a 20- or 30-year career.
So, you’re looking out 50, 60, 70 years sometimes in the future to value these pension obligations. So, your assumptions really need to be consistent with what you’re trying to measure. You’re trying to measure long-term obligations. You set long term assumptions, and then how Washington funds their plan is they fund their plan with a aggregated contribution rate from all plan members.
That is then charged… the same rate is then charged across all members. So, we set assumptions that apply that are set across and apply to all members. We’re not funding an individual member benefit, so we don’t set assumptions that can be used for an individual. So yeah, that’s just a little bit of background on our assumptions and, and really kind of their uses and how we think about them because often we get: “how long am I going to live?”
And yeah, we can’t really say, we don’t really have the accuracy to say that for an individual. We’re really speaking to, the system level. Does that make sense?
Seth
I love that explanation and it actually helped me think a little bit more about all sorts of different public pensions in Washington state. And you’re thinking about the way that the people who are in the Teachers’ Retirement System as a group are the same and different than the people in the Law Enforcement Retirement plan. And that means different things for those plans.
The plans have different rules, but there’s also different underlying assumptions that your office is making.
And the other thing I think that is important to maybe contrast this with when you’re talking about pensions is kind of like you gave the example of an actuary and an accountant. But it’s also the difference between an actuary and an insurance provider where if I smoke or if I have a history of heart disease that changes what sort of — I’m going to try not to use the word “prediction” now going forward. But that would change what you would think about my opportunities in the future. Is that fair?
Mitch
Yes, that’s exactly right. And really, you know, actuaries are doing both those sorts of calculations when you’re thinking about like a life insurance benefit and a pension benefit and if we kind of take that example a little deeper. A life insurance actuary is going to look at an individual and they are going to do detailed health records.
They’re going to look at their occupation, if they have a dangerous occupation — smoker, or non-smoker. Because if we’re thinking about a product like a 30-year term life insurance, an actuary in that life sector gets one chance to calculate that benefit. And then that’s the premium that that person is going to be charged for 30 years. In contrast, on the pension side of things, we’re looking across everybody and we do a rate setting valuation every two years.
So now we’re allowed to update assumptions and essentially recharge a rate every two years by updating our assumptions. So, our jobs are both actuaries, but we’re approaching the valuing of a life insurance benefit and a pension benefit really differently between those two actuaries.
Jenny
Yeah, so really kind of getting back to that 101. So, if with any sort of state employee, there’s a percentage of my paycheck that is going into an account that is going to fund my retirement system, but your office is the one that gets to decide what that percentage is?
Mitch
I wouldn’t go quite so far as [saying] that our office is making that decision. A lot of how pensions are to be funded is set in statute and we are carrying out that calculation when we do an actuarial valuation. So, a fair bit is already decided for us. Now there is quite a bit of modeling a judgment that we go through when we do all those contribution rate calculations.
But in a lot of senses, we are taking a what they call an actuarial cost method, which is just a way to divide up somebody’s cost to fund their ultimate benefit. We take this actuarial cost method, we take certain funding policies that the legislature has set, and then we combine those all to then determine the contribution rates for the plan and those funding policies.
A lot of them have to do around certain goals that the legislature wants for pension funding. If we think about these assets are invested and there is a fair bit of bumpiness per se in the market, I think we’ve all seen that over the last decade and a lot of the funding policies that that we use are to smooth out some of that bumpiness so that contribution rates aren’t jumping around so much from year to year.
Seth
Mitch, I’m wondering if you could talk a little bit about what causes those contribution rates to go up or down over time? Maybe not necessarily. As you said, contribution rates can change every two years, but kind of general trends in what would make contribution rates go up versus what would make contribution rates go down.
Mitch
Yeah, I think you can kind of bucket changes in contribution rates in two really large buckets. You have plan experience, things that happen that we didn’t expect. So, we have assumptions for how this plan experience is going to emerge. But as we talked about, those are really long-term assumptions and short-term things can get really bumpy. I think a prime example of that is inflation.
We have an inflation assumption. Inflation got really high the last couple of years. So, things can happen that you don’t expect. So, when plan experience differs from what we assume that will change contribution rates.
And then the other one is assumptions. When we change assumptions, that also changes our estimate of the future benefits from the plan, which will also change our calculation of contribution rates. To kind of tie it back to the mortality assumption or the or the life expectancy discussion, we have an assumption for mortality, which is our way of estimating how long members will live and 10, 15 years ago, we implemented mortality improvements, which is an assumption where mortality as we keep going into the future, mortality is going to get less and less in the future. If we think about the last 100 years, people are definitely living longer in 2023 than they are in 1923. So that wasn’t… when we implemented that assumption that increased the contribution rates of the plan. So that wasn’t exactly a plan experience that emerged.
We changed assumptions and that changed contribution rates as well. Lots of times we’re changing assumptions to get ahead of plan experience, plan, experience that we know is going to come. If we know certain things are going to show up, we try to include them in the valuation before they change contribution rates.
Jenny
That’s great because I was going to ask for an example about where you would change assumptions.
Mitch
Yeah, definitely. We do review assumptions every two years for economic assumptions and every six years for demographic assumptions. And this makes sure that we stay on top of any changes in these assumptions that are necessary. Any changes in things in the profession in general.
That mortality improvement piece that I talked about; that is a really evolving piece in the in the actuarial profession. Like obviously how long people are going to live is very important to valuing pensions. These are life annuities. They keep paying as long as somebody is alive. And if you’re going to project that people will continue living longer in the future. Okay, that’s great. But to what degree? Is it going to exactly be equal to what you’ve seen in the last hundred years, 50 years, 20 years, something different?
Because we think technology is going to advance in different ways. I bring this up to show the uncertainty in the assumption, but also how it’s such an evolving space and that we try to review these assumptions on set cycles, but we also look at assumptions with every valuation to make sure that they remain reasonable.
Jenny
Could you talk a little bit about exactly how these pensions are funded? We know that basically it’s coming from two sides. There’s the employee that’s paying into their pension and the employer that’s also paying into that.
Mitch
Yeah, definitely. So yes, there’s a contribution rate that our office calculates and then that is then adopted by the Pension Funding Council or the legislature, and then that rate is charged to members and employers. And then depending on members plan selection Plan 2 or Plan 3, will determine what they pay. If a member is a Plan 2 member, they get a 2% pension benefit.
So, the cost is split evenly between the member and the employer. If they’re a Plan 3 member, they only get a 1% pension benefit and only the employer funds that pension benefit because those Plan 3 members have their own 401k style of benefit. So, there are actually a couple options for pension funding kind of at the highest level.
There’s just sort of three examples: you could do pay as you go funding, which is literally no prefunding, no contribution rates at all. In that case, benefits would just be paid to retirees. Once they retire, you then pay the retiree. That saves quite a bit of money on the front end because you don’t have to contribute to fund those benefits.
But it costs quite a bit of additional money on the back end because there is no investment earnings. So any dollar that’s put away early is invested. And when those investments earn money that offsets some of the cost that needs to be paid from contributions. So, pay as you go funding: good early, kind of bad late.
The polar opposite of that one would be a lump sum funding where a member joins the retirement system and their entire benefit is funded immediately. In one big lump sum right when they’re hired. Obviously, this has some practical challenges to it. It’s challenging budget wise to come up with a large lump sum like that. And you would have to get very precise in your assumptions if you didn’t get to recalculate any additional contribution rate for future years. You would have to be really precise in exactly the lump sum amount that you’re going to need for that member.
So then the third, the sort of Goldilocks option here is pay over time, which is what Washington state uses, where there is a trust account that members and employers contribute money into, that money is invested, and then the goal is to fund those active member benefits throughout their working lifetime so that when they retire, there’s enough money in those trust accounts to pay their benefits for their total retirement.
So that’s Washington’s funding policy and that policy can be really powerful because plan assets like I said, are invested and investments can make up a large portion of those benefit payments. I looked at the last 20 years of history and we’ve observed about 70% of benefit payments are paid from investment returns. So that means your contributions and my contributions only need to fund about 30% of our benefit payments and the other 70% is covered by investment earnings.
And that really makes pensions a lot more affordable rather than having us all to fund 100% of it.
Jenny
That’s awesome. Kind of one of my takeaways is that before I got into this line of work, not realizing that different states do fund their pensions differently, the average person would assume it’s just the same across the board, and every state does the same thing, but it’s not the case.
Mitch
Yeah, we do see some pretty different funding policies and even benefit structures across the country. There are some states that will actually reduce benefits when certain conditions are met. Washington doesn’t do that. But all of that, it’s just really up to the funding goals of the state, what they want to accomplish and the sort of risk profile that they want for their pension plans.
Seth
Mitch, I don’t want to get too nerdy here or too deep in the weeds, and I know you’re very good about not getting that way. But Jenny talked a little bit about in comparison to other states, and there’s just a lot of negative news about pensions.
I tell this story often, but, when my wife started working for a school district and she was choosing between her retirement plans, she kind of asked me my opinion. And I wasn’t working for the DRS at the time and was like: “It doesn’t matter. There’s not going to be a pension when you retire anyway.” Like, that’s sort of the narrative that’s out in the public space. And Jenny and I have tried really hard to remind people that this is a contractual right in Washington state. You are going to receive this benefit.
But I think it helps people hear how these plans are funded to help maybe reassure that. And so, could you just talk maybe at the highest level about how your office calculates how well-funded these plans are? I don’t know if that’s a fair way to state that question.
Jenny
Yeah, just sort of reassure us that we have a good pension.
Mitch
Yeah, well, yeah. I mean, I don’t want to make any broad, sweeping, declarative statements about the state of Washington pensions, but I think a good place that you can look is the plan’s funded status. That’s a measure that a lot of people look at, and its “funded status” or “funded ratio.” You hear those two terms.
That is a measure of plan’s accrued liability. That’s a pretty technical term. But all that means is, is the benefits earned as of the valuation date. So, we take the benefits earned as of a valuation date and we compare that to the plan’s assets also on the valuation date. And what that tells us is: how on track are we with the plan’s funding goals? Because you’re just looking at how much has been earned compared to how much is in assets.
And Washington has one of the better funded plans in the nation. I believe it’s in the top four. Our valuation report, our 2022 valuation report that was released a few months ago, has the funded status or funded ratio for every retirement plan, if you’re interested. Yes, that can be a very good measure to get yourself comfortable with the funding level of the plan.
You know, there are a couple things to keep in mind with funded status. There are some shortcomings of it. It is a good place to start, but it doesn’t tell the whole story. Like I said, it is telling kind of how on track you are with your funding. But funded status alone doesn’t tell if you’re in trouble or not.
So, a plan with a funded status below 100% doesn’t mean the plan is at risk. A plan can be below 100%, and as long as there still is a plan to get the plan back to 100%, then actuaries wouldn’t be concerned on where it’s at. And I think looking at Washington, a key example for that would be PERS and TRS, Plan 1.
That’s the Public Employees’ Plan 1 System and the Teachers’ Plan 1 System. If you look back to 2013, they were, I think, 55% and a little over 60% funded. So, ten years later, they’re now 75% and 80% funded. So back then they had a low funded status, but there was a plan to get them back to full funding.
That plan has been implemented over the last decade and they’re well on their way now. And now they’re projected to be to be fully funded later this decade. So funded status can give you a sense, but it doesn’t tell you the whole story. So just want to caution about running too wild with that figure. And then just one other note, which I think is really important, because I see people get this confused every now and then: funded status also isn’t enough to know if contributions to the plan can stop.
And that’s because funded status is just comparing the earned benefits. So especially if we look at open plans like PERS and TRS and LEOFF, that’s the Public Employees, the Teachers and then the Police and Fire plan. Those are open to new entrants and they are relatively younger than the Plan 1s. For those plans, people are still earning benefits. And as they are still earning benefits, those benefits need to be funded so their ongoing contribution rates are still required.
I typically will see people get a little confused saying, “Hey, the plan has over 100% funded status so we can stop contributing.” Not the case when plans have a younger population, and especially if they’re still open to new entrants.
Seth
That makes sense to me in the way that you described it, because what you said is that funding status is just the point in time. Everything that’s been earned prior, all the money that’s currently in the plan. But there’s still things that are going to be happening in the future. And one of the things that’s really nice about the way Washington plans are designed from a perspective of making sure they stay fully funded is that the contribution rates can change every two years. That the Office of the State Actuary and Legislators are able to look at how that changes over time.
And should more money be going in in the future or can we dial that back a little bit, depending on what has changed over the last two years, what your office has seen, there’s that flexibility. I know sometimes members might be a little bit anxious about that. “How high could my contribution rates go when they’re trending up?” But as we’ve seen recently, they’re starting to trend down.
And that flexibility is to your point, Mitch, I think because the plans are seen as being fully funded or close to fully funded.
Mitch
Yes. On their way, which is a great place to be. I will also just point out a lot of the same things also apply to funded status that I talked about with contribution rates, where it is a point in time measurement and funded status will change with plan experience either good or bad and changes in assumptions. So we do see funded status change around with investment earnings.
I highlight investment earnings because it can be pretty volatile from year to year. But then also if we make changes to plan assumptions which have a big impact on contribution rates, that will typically also be reflected in the funded status as well. So Washington does have very well-funded pension plans. And I will just point out a couple of reasons for the strong levels of funding.
I think it’s worth highlighting what got us here. If we’re in the top four, top five in the country, what led us to this point. I think first and foremost, Washington is a little bit ahead of the curve on pension reform. In the late seventies, the legislature closed the Plan 1s and opened the Plan 2s and subsequently the Plan 3s later on.
And a lot of the rest of the country is undergoing that pension reform now. So the Plan 2 -3 tend to be typically lower cost plans, and lower cost plans typically are easier to maintain funding for. And then investment returns over the last decade plus have been awesome. The State Investment board is responsible for investing the plan assets.
They’ve had long term vision. They have executed on that vision and the investment returns have been stellar. And then the legislature deserves credit as well. Credit for mostly making their fully required contributions under the plan’s funding policy. So, you have all of these things working in tandem to get the plans in the place that they are now.
Jenny
Nice. Yeah, that’s a good way to think about it. Thank you. Yeah.
Mitch
Yeah. I will also just highlight what the challenges can be if pensions become underfunded. So if there’s underfunding, let’s say required contributions aren’t met. That means less money goes into trust accounts, which means less investment returns, which means more contribution rates are required, which means pensions become less affordable, which typically leads to more underfunding. And this negative feedback cycle continues.
And unfortunately, we’ve seen this play out in a few states across the country where once a pension is in a deep hole, it can be hard to get it out. And so to keep these plans sustainable and to keep these plans healthy, it takes funding discipline to keep on all of the levers it takes to keep a healthy and well-funded plan.
Jenny
Yeah, well, thank you very much. This is very interesting just to kind of get into the deep weeds of how our pensions are funded. It’s not something that I think the average public employees think about, but at the same time, it is important and reassuring to know that we’re okay and our pensions are taken care of. And like you said, it’s well funded, so we don’t have to worry about that money running out.
Mitch
Yeah, absolutely.
Seth
Mitch, thank you for joining us today. I know I could ask you probably a thousand questions and get really excited about this stuff, but really appreciate you taking the time to chat with us.
Mitch
Absolutely, happy to do it.
[music outro]
Disclaimer
Thanks for listening. And now we’d love to hear from you. What topics would you like to hear about? What questions do you have for us? Send an email to drs.podcasts@drs.wa.gov that’s drs.podcasts@drs.wa.gov. The Department of Retirement Systems provides this podcast as a public service, but it’s neither a legal interpretation nor a statement of DRS policy.
References to any specific product or entity do not constitute an endorsement or recommendation. The views expressed by guests are their own, and their appearance on the program does not imply an endorsement of them or any entity they represent. Views and opinions expressed by DRS employees are those of the employees and do not necessarily reflect the view of DRS or any of its officials.
