New Study Examines Pension Underfunding in Alabama

A recent in-depth case study of The Retirement Systems of Alabama (RSA) by Daniel J. Smith and John A. Dove from Troy University finds the pension plan has significant room to improve. RSA is situated similarly to a number of other public pension systems in the country, ranked in 30th place by funding level by the Pew Foundation as of 2013. However, this ranking is down from 20th place in 2003. The primary reason is the funded ratio has fallen from 92.7% in 2003 to 65.9% in 2013. Smith and Dove note that RSA has made some sensible changes in recent years, including switch to a “closed amortization period” for unfunded liabilities, but the system is still in need of further improvements in it’s accounting standards, transparency and oversight, and the use of economically targeted investments.

The Smith and Dove paper analyzes factors influencing the declining performance of RSA, and it examines the limitations of using Actuarially Determined Employer Contribution (ADEC)* in interpreting a system’s fiscal health. In particular, the authors cite a 2015 Pew Charitable Trusts study to show that even though states like Alabama, Tennessee, and West Virginia contributed on average 100% or more of their ADEC from 2003 to 2013, their unfunded liabilities kept on rising regardless. For example, both Tennessee and Alabama systems were almost fully funded in 2003 with 98.6% and 92.7% levels respectively. Then 10 years later when Tennessee still maintained it’s healthy status at 94%, Alabama’s funded level dropped to 65.9%.

One of the more apparent reasons for RSA’s decline, like many other state retirement systems, is the poor investment performance, including the years of the financial crisis. In order to maintain a long-term investment return target of 8%, the change in financial markets since the crisis has forced RSA to adopt riskier investment allocations, which leaves the state at risk of greater fiscal burdens in the future. Unlike more than one-half of state public pension funds, which have lowered their assumed rates of return since 2008, the RSA’s assumed rate of return on investments has not been adjusted.

A less apparent reason cited by Smith and Dove is that RSA also devotes sizeable portion of its portfolio toward the economically targeted investments (ETIs)—that is, making investment decisions based on their state-level economic impacts rather than on investment returns they generate. Not only is this suspect from a fiduciary responsibility standpoint, but it also suggests the possibility that RSA may have in some cases foregone higher returns due to political motivations.

Another cause of RSA’s rising pension debt is the fact that until recently Alabama used a so-called “open amortization” method for calculating annual payments on unfunded liabilities. The open amortization schedule allowed RSA to basically reset the amortization period each fiscal year, instead of trying to pay off retirement debt within a fixed time frame. Generally speaking, open amortization periods results in lower amortization payments made by the employer each year than would be the case with a “closed amortization” schedule.

One solution proposed by the paper, besides curtailing or eliminating ETIs, is to adopt a much greater degree of transparency and reporting, which was recently emphasized by the Actuarial Standards Board’s Pension Task Force.

Overall, the report suggests that in order to develop a holistic picture of a state retirement system, a more focused review of state systems is required. Detailed analysis of state pension systems like this, unlike the aggregate studies, gives an opportunity to account for the unique political, economic, demographic, and financial landscape factors that a particular retirement system faces. This could prove to be especially helpful when it comes to informing policymakers and supplying concrete recommendations for reform.

*Formerly the Annual Defined Contribution (ARC), which was replaced by the 2014 GASB standards

To read the full paper, go here.