Florida Retirement System

Many states are facing serious problems with their retirement programs. Florida’s is in relatively good condition, but still merits reform. • New accounting standards show that Florida’s funding level is 10 percent less than the state reported. • The state should shift to a defined contribution system before unfunded liabilities become a larger problem. • The plan should shift entirely to private firms after the last defined benefit pensioner receives his or her last check.

Florida retirement system history. The Florida Retirement System (FRS) is primarily a defined benefit pension plan that is offered to state government employees and to some local government employees. A defined contribution option was added in 2003 and has become more popular, although it remains a small part of the FRS. Local governments in Florida can run their own pension plans or choose to join the FRS. The defined benefit plan, which currently makes up the bulk of FRS pensions, means that retirees’ pension benefits are determined by a formula based on how much they are paid and how many years they have worked. As they are working, the state contributes to the FRS with the idea that upon an employee’s retirement, the FRS has sufficient assets to pay the contracted retirement benefits.

Table 12 shows a breakdown of those receiving pensions in 2012 from the FRS defined benefit program. The table shows that by far the largest group of pension recipients are former school district employees, who make up 46.3 percent of recipients. Retirees from county governments make up 22 percent of recipients, which is slightly larger than the percentage of retirees from state government jobs. Retirees from universities and community colleges (now state colleges) make up about 8 percent and city and special district retirees make up only about 3 percent of recipients. The last fgure reflects, at least partly, the fact that many cities run their own retirement programs, whereas school districts are more inclined to enroll their employees in the FRS.

Table 13 shows total membership in the FRS for almost two decades, so it includes current workers in addition to retirees who are collecting pensions. The table shows that membership is no longer growing and in fact has been declining over the past several years. The trend follows the decline in state government employment, although as table 12 showed, only about a fifth of retirees are retired state workers. In the 2003/04 year, FRS members were offered the opportunity to choose a defined contribution plan (called an investment plan in the table) instead of the defined benefit plan that had previously been the only option. About one-sixth of members have opted for the defined contribution plan, and that number will likely increase in the future. One reason is the possibility that future reforms will force enrollment into the defined contribution plan (as discussed below), but some reforms that have already taken place that make the defined benefit plan less attractive. The plan originally had a generous cost-of-living escalator built in, but it is being phased out. Also, there was a generous deferred retirement option plan (DROP) that would allow members to enroll and work for five more years. During those five years, employees would receive both a salary and a retirement payment. The retirement payment would be deposited into an interest-earning account, and the employees would receive the account in a lump-sum payment when they retired after that five-year period. The return earned during that five years was cut significantly, lowering the payout at the end and reducing the program’s appeal.

Table 13 shows that the plan was overfunded through 2007/08 according to the state’s calculations. The funding ratio has fallen to 86 percent in the aftermath of the recession,[1] giving some indication of the degree to which the FRS has unfunded liabilities. However, the figure is driven by a number of assumptions, including the rate of return the FRS will earn on its assets (which currently is 7.75 percent), the final earnings on which retiree pensions will be calculated, and how long retirees will survive and draw pensions after they retire.[2] While the FRS appears to be in relatively good financial shape, especially when compared to the pension programs of other states,[3] these uncertainties mean that there are risks that FRS unfunded liabilities could increase in the future if the assumptions are overly optimistic.[4]

There is another problem that exists more generally for government-run defined benefit programs: Because slight changes in assumptions can make large differences in the degree to which the programs are funded, there is always the political temptation to change those assumptions and promise current workers larger retirement benefits without putting more money into the system. The benefits of doing so come immediately to workers, and there may be gains in terms of political support for elected officials. Meanwhile, the costs are deferred into the future. With a defined contribution program, these temptations are eliminated.

New accounting standards introduced by the Governmental Accounting Standards Board (GASB) in 2012 suggest that most states are more underfunded than they have previously reported. The new GASB 68 standard indicates that Florida’s funding level in 2012 was 76 percent rather than the 86 percent that the state was reporting.[5] The new standards are relevant to the pension reform policy debate in Florida because they serve to question one argument in support of the status quo: that the current system is in good financial shape, and so not in need of reform.

Recent reform attempts. While the FRS looks relatively solid compared to many other state retirement systems, it is underfunded now and vulnerable to the same types of financial uncertainties that plague other defined benefit pension plans. The three main uncertainties for the FRS are overly optimistic estimated rates of return (as discussed above), underestimates of base salaries for pension purposes, and uncertainties about retiree life expectancies. The booming stock market of the 1990s helped states keep their pension plans funded. With rates of return on investments falling in the after the year 2000, many pension plans, including Florida’s, were overly optimistic about the rate of return they could earn on their assets. Another uncertainty is that while contributions into the FRS are made on behalf of employees throughout their careers, their pensions are determined by their salaries in the last three years of their employment, and that salary can often turn out to be higher than anticipated. Also, because pension benefits are paid to retirees until they die, if life expectancies are underestimated, the plan can become underfunded.

These factors affect all pension plans, not just government plans, and the uncertainties of defined benefit pension plans have led to a major migration away from them in corporate America, toward defined contribution plans. Under a defined contribution plan, the employer (in this case, the state) contributes to an account that belongs to the employee, and the money in the account is invested and earns a return. Upon retirement, the retiree’s pension benefit is determined by the amount in that person’s account. If the account’s investments have done well, the retiree will have more at retirement; if they have done poorly, the retiree will have less. Looking at the risks noted earlier, a defined contribution plan has the employee bear those risks; a defined benefit plan has the employer bear the risks.

There has been a major push in the Florida legislature to restructure the FRS in order to place all new employees in a defined contribution plan, rather than the defined benefit plan now offered by the FRS.[6] Public employee unions have come out in opposition to defined contribution pension plans, and so far, while a defined contribution plan has been created, it has not found sufficient legislative support to have it replace the defined benefit plan. Several smaller reforms have been passed in the past four years, including requiring employees to contribute 3 percent of their salaries to the FRS—the state paid the entire cost before—and a significant reduction in cost-of-living adjustments for future retirees. These changes have made the existing defined benefit plan substantially less attractive.

One argument against reform is that even though the FRS is currently underfunded, it is still relatively healthy, both compared to other states and in absolute terms. This leads to the “if it ain’t broke, don’t fix it” justification for retaining the status quo. The argument is weak because the time to fix the system is not after it has substantial unfunded liabilities—as now exist in Illinois and California—but before those big problems arise. In 2013 the state budget allocated $500 million to the FRS to cover unfunded liabilities; those costs will continue to be imposed on the state budget unless the system is reformed. There are strong arguments from the state’s standpoint to shift to a defined contribution plan. Ultimately, there may also be good arguments when looking at the interests of future retirees. Retirees own their accounts under a defined contribution plan, but there is always the possibility that benefits could be cut under a defined benefit plan.

The reforms that the legislature has considered thus far have been aimed at shifting the FRS to a defined contribution plan, but if Florida decides to go in this direction, a better option would be to completely privatize the system and eliminate the FRS. Many private firms operate defined contribution retirement plans. The state could choose one or offer employees alternatives and completely remove itself from the pension business once the last FRS retiree has died. It would likely be infeasible to move current defined benefit retirees off the state system and into a private one, but it would be easy to create private accounts, run by private firms, for new employees. Over time, the FRS would shrink and eventually disappear. Florida already offers the private option to university employees, who can either join the FRS or participate in a private-sector defined contribution plan.

Local government pension plans. Local governments in Florida have the option of participating in the FRS or of running their own systems. Many local governments have chosen to participate in the FRS, but others—especially at the city level—have chosen to run their own plans instead. Whereas the FRS is in reasonably good financial shape, the same cannot be said of the local systems. Roughly a quarter of the local government pension plans are more than 80 percent funded, but another quarter of the plans are less than 60 percent funded.[7] Underfunding often occurs when local governments bargain with labor representatives over employment contracts. It is easy to concede overly generous pension benefits rather than wage increases because the costs of pensions only come years, and even decades, down the road, whereas wage increases come out of the current budget. Government representatives who do the bargaining may believe with some justification that if their estimates turn out to be overly optimistic, that will be someone else’s problem. Pension costs can be pushed into the future, but for many Florida local governments, the future has arrived.

There are a number of factors that cause local government pension plans to be underfunded.[8] First, in some cases, pension plans guarantee cost-of-living increases that exceed inflation, so that over time, retirees collect larger and larger pensions. Plans may specify a fixed annual percentage increase regardless of the inflation rate.

Second, plans may be underfunded because of spiking, which can occur when the base on which the pension is calculated includes more than just an employee’s base salary. If overtime pay is included in the base, employees can work lots of overtime before retirement and have that built into their pensions. Spiking can also occur if retirees receive large raises just before retirement. Typically, the employee’s average final compensation (AFC) determines the pension level, and AFC is calculated from the employee’s final years of service. Sometimes this is as short as three years. So employees who can spike their salaries in the final three years will get larger pensions, putting pension plans further in the hole.

A third reason local government pension plans may be underfunded is that employee representatives can negotiate changes in multiplier rates for the pension plans, which results in larger payouts for the same AFC. The multiplier rate is the percentage of the retiree’s salary that will be paid as a pension. And finally, unrealistic assumptions about life expectancy, or the rate of return on the plan’s assets, lead to underfunding.

What, if anything, the state government should do to deal with underfunded local government pension liabilities is a complex question.[9] At one extreme, this might be viewed as a local government issue, so the state government should remain uninvolved. At the other extreme, all the powers of local governments are granted by the state, so the state government is responsible for ensuring that those powers are not used to the detriment of Florida’s citizens. Many local governments have chosen to use the FRS rather than create their own pension plans, and the state could mandate that all local government pension plans be administered through the FRS. While this could limit future problems, it would not eliminate current unfunded liabilities. The state could also pass regulations that specify provisions that local governments could use in their pension plans, which again would not eliminate current unfunded liabilities. The unfunded liabilities have already been incurred and either they have to be paid, likely out of general revenues, or pension benefits have to be reduced. The legal issues involved in reducing benefits that have already been promised are formidable, and perhaps unfair to the people to whom the benefits were promised, meaning that local government budgets will likely be burdened with these unfunded mandates well into the future.

While Florida has been more responsible at the state level, there is no guarantee that this fiscal responsibility will continue into the future. That makes a good argument for shifting all government pensions in Florida to defined contribution plans, which the state can mandate for local governments. Although this action would prevent the continued accumulation of unfunded liabilities, governments would still have to deal with the unfunded liabilities they currently have.

[1] The state may be overly optimistic in its estimates of its future liabilities because its discount rate does not account for risk inherent in the future returns it expects, but other states use similar methods so Florida’s funding level still looks good relative to other states. For a discussion, see Robert Novy-Marx and Joshua D. Rauh, “The Liabilities and Risks of State-Sponsored Pension Plans,” Journal of Economic Perspectives 23, no. 4 (Fall 2009): 191–210.

[2] One study that questions these assumptions is Milliman Inc. to State Retirement Director Sarabeth Snuggs, “Study Reflecting the Impact to the FRS of Changing the Investment Return Assumption to One of the Following: 7.5%, 7.0%, 6.0%, 5.0%, 4.0%, or 3.0%,” March 11, 2011, www.floridahasarighttoknow.com/docs/StatePensionActuaryLetter.pdf. See also Barbara Apostolou, Nicholas G. Apostolou, and Richard Brooks, “The GA(A)P in Underfunded State Pension Liabilities,” CPA Journal 81, no. 5 (2011): 17–21. Apostolu argues that current standards for calculating the financial health of pension plans are inadequate to make an accurate assessment.

[3] Florida ranked ninth best among states in its unfunded pension liabilities in 2011. See “State Pension Plans: Liabilities, Funded Ratios,” Governing the States and Localities website, accessed October 7, 2014, www.governing.com/gov-data/state-pension-funds-retirement-systems-unfun….

[4] The Pew Center on the States discusses the problem and puts Florida among the four best states in terms of pension funding. See Trillion Dollar Gap.

[5] See Alicia H. Munnell et al., “How Would GASB Proposals Affect State and Local Pension Reporting?” (Issue in Brief Number 23, Center for Retirement Research at Boston College, November 2011, updated September 2012).

[6] Much of this section is based on Randall G. Holcombe, “Florida Retirement System Reform: Why Now?” (Policy Brief, James Madison Institute, Tallahassee, FL, April 2014), www.jamesmadison.org/issues/2014-policy-brief-florida-retirement-system….

[7] See “Doing It Right: Recognizing Best Practices in Florida’s Municipal Pensions” (Tough Choices Facing Florida’s Governments, Leroy Collins Institute, Tallahassee, FL, August 2013). Florida’s local government pension plans appear to be in increasingly worse shape. See “Report Card Update: Florida Municipal Pension Plans” (Tough Choices Facing Florida’s Governments, Leroy Collins Institute, Tallahassee, FL, September 2014).

[8] These factors are discussed in “Doing It Right” (Leroy Collins Institute).

[9] See Randall G. Holcombe, “Protecting Florida’s Cities through Pension Reform” (Backgrounder 66, James Madison Institute, Tallahassee, FL, January 2011).