University of Arkansas Office for Education Policy

Discussion of the Proposed Arkansas Teacher Retirement System COLA Changes and Stress Testing

In The View from the OEP on February 27, 2019 at 1:19 pm

The Arkansas legislature is considering several bills that would affect the Arkansas Teacher Retirement System (ATRS), but two in particular have drawn the attention of teachers’ groups.

Here at OEP, we think it is important to understand these bills and the implications for current and future educators. We address the bills below, starting with HB1206, which would affect COLAs, before moving to HB1173 which would require plans to perform and publicly report the results of stress testing. HB1206 was withdrawn by its author this morning, but since COLAs will continue to be part of the policy dialog, it is still worthwhile to review the proposed changes. HB1173 is currently with the Joint Committee on Public Retirement and Social Security Programs, and is expected to be considered soon.

COLA Changes

What are COLAs? Cost of living adjustments (COLAs) are annual increases to retirees’ benefit payments that are meant to keep retirees from losing purchasing power due to inflation. When a teacher retires, he/she begins receiving a monthly retirement check based on years of service and average salary over his/her last few years on the job. If this base benefit amount remained constant throughout retirement, the teacher would lose purchasing power over time due to inflation. Prices of everything from groceries to healthcare tend to increase over time, requiring more dollars to purchase the same amount of goods and services. The purpose of COLAs is to increase retirees’ benefit payments at roughly the same rate as inflation so that they get consistent value from their checks throughout their retirement.

Because COLAs keep retirees’ monthly checks from losing value over time, they are a common part of plans that provide lifetime payments (i.e., annuities), including Social Security. Many public retirement systems’ COLAs were designed for a world in which inflation is consistently around 3 percent annually. Since the mid-90s, however, inflation has been far below that level. For example, average annual price inflation (i.e., December to December change in CPI-U as measured by the Bureau of Labor Statistics) for the south region since 1995 has been 2.13 percent and over the last 10 years it has been just 1.75 percent.

When COLAs provided by public retirement systems outpace inflation, retirees’ purchasing power over time is increased, rather than just maintained. Committing resources to COLAs that exceed actual inflation drives up plan cost and leaves less money to pay down pension debt and/or maintain benefit levels for new workers.

As governments across the country have struggled to get a handle on growing pension debt and rising retirement costs, many have made changes to COLAs. Since 2009, 30 states have reduced COLAs, and increasingly, governments are taking the logical step of linking COLAs to actual inflation (see NASRA report on COLAs). Many jurisdictions have also linked the provision of COLAs to their plans’ fiscal condition (e.g., COLAs can only be provided if the plan is greater than 90 percent funded). These types of changes not only keep plan costs in check but also ensure that COLAs fulfill their intended purpose of offsetting the negative effects of inflation on retirees’ purchasing power.

What changes were being proposed?

HB1206 (withdrawn today) would have modified the annual cost of living adjustments (COLAs) that retirees receive.  Under current law, ATRS retirees receive an automatic 3 percent COLA each year that is calculated using their starting benefit amount. HB1206 would have altered this by allowing the ATRS board to choose to provide an annual COLA, but the amount would capped at “the lesser of three percent (3%) or the percentage change in the Consumer Price Index (CPI), South Region as determined by the United States Department of Labor over the one-year period ending in the December immediately preceding the date for which the redetermined amount is being calculated.” In other words, the proposed change would have made the COLA discretionary and would have reduced the potential COLA amount in years when actual price inflation is below 3 percent.

So, why make the proposed change? While we don’t have any particular insight into Representative House’s way of thinking, the change was likely proposed because over the last 10 years the COLA specified in current Arkansas law would have significantly outpaced inflation. Figure 1 shows the value of $1,000 in hypothetical benefit payments growing at actual price inflation over the 10 years between 2009 and 2019 (black line) compared to COLAs under current Arkansas law – a simple 3 percent annually (orange line). To keep retirees purchasing power constant, benefit payments would have needed to increase by about 19 percent over this period, or by $190 for each $1,000 in payments. However, if COLAs had been given according to current Arkansas law, retirees’ benefit payments would have increased by 30 percent or by $300 for each $1,000 in payments. If inflation persists at its currently low level, the state would be committing more resources than necessary to maintain retirees’ purchasing power – resources that could be used to pay down pension debt and prepare the plan for the next downturn.

Figure 1: 10-Year Comparison of Different COLA Structures.

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Figure 1 also includes a blue line showing how the proposed change would have performed over the past 10 years. The COLA structure proposed in HB1206 would have tracked actual price inflation much better over this period, undershooting it by just a bit. However, while the proposed COLA structure would have performed well in today’s low inflation environment, it would significantly undershoot inflation if it were to rise. Figure 2 below is analogous to Figure 1 except it uses the last 20 years of inflation data instead of 10 years. As you can see, over this longer 20-year period the proposed COLA structure would have fallen short of actual inflation by a little more than the current law would have overshot it. To keep retirees purchasing power constant, benefit payments would have needed to increase by about 52 percent over this period, or by $520 for each $1,000. Current law would have increased benefit payments by around 60 percent while the proposed change would have increased payments by around 40 percent.

Figure 2: 20-Year Comparison of Different COLA Structures.

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The overall takeaway from these exhibits is that neither current law nor the proposed change would track actual inflation particularly closely when modeled using recent data. The current law increasingly overshoots inflation as it falls below 3 percent, and while the proposed COLA change would have done better at low levels of inflation, it would significantly undershoot inflation if it were to rise toward 3 percent.

So what should we do?

Given the low inflation of the past 10 years, it is reasonable for the Arkansas legislature to want to adjust the structure of COLAs. Why commit more resources to COLAs than is necessary to maintain retirees’ purchasing power? It is also a positive step to make COLA’s more responsive to actual price fluctuations by linking them to CPI. Such a change would continue to protect retirees while also more effectively managing plan costs. However, the COLA structure that was proposed in HB1206 could potentially fall well short of inflation if it were to rise above recent levels, likely necessitating additional modifications down the road.

If the legislature’s goal is to provide retirees with reasonable inflation protection while also not over-committing resources in periods of low inflation, then they should consider COLA structures that better track CPI within some boundaries. For example, if the legislature kept the capped, CPI-linked structure of HB1206 but changed from a simple to a compound COLA (i.e., apply the percentage increase to last years’ benefit amount rather than to the initial benefit), then COLAs would track CPI much more closely (see green line in Figure 3 below).

Regardless of the specifics, we strongly encourage the legislature to maintain adequate inflation protection for retirees and consider linking COLAs to actual inflation so that they more flexibly adjust to changing economic circumstances. We also reiterate our recommendation that any future changes to benefits, like COLAs, or contribution rates should only be made in the context of having a clearly defined funding policy and cost-sharing plan. 

Figure 3: 20-Year Comparison of Different COLA Structures with Proposed New Design.

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Stress Testing

Why is Stress Testing Important?

As noted in an earlier post,  stress testing, as proposed in HB1173, is vital to the prudent and sustainable management of public pensions. We are glad that ATRS agrees that stress testing is important, and of course, the plan already performs some level of stress testing, as the executive director points out in his recent legislative summary. However, on an admittedly quick scan of ATRS’s publicly available documents, we were unable to find any stress testing results that provide projections of future cost under multiple scenarios. We could certainly be missing something, but if stress testing results are not readily available to all stakeholders, including plan members, legislators, and taxpayers, then the value of the exercise is significantly diminished. ATRS has a responsibility to be transparent with and accountable to a broad set of stakeholders.

Given the huge implications for the public school workforce and large potential call on taxpayer resources, it is perfectly reasonable for the Arkansas legislature to place more specific stress testing requirements on ATRS than are included in the general guidelines of the Government Accounting Standards Board (GASB) or the Actuarial Standards of Practice (ASOP). ATRS’s complaints about added cost, frankly, ring hollow given the stakes for teachers and the state and school budgets. Based on our experience, it’s very hard to see how the requirements proposed in HB1173 would meaningfully increase cost above what the plan is already paying their actuaries to do.

Sounds good!  So what’s the problem?

To us, ATRS’s opposition to HB1173 appears to be more about fighting to maintain as much independence as possible rather than any concern about cost, etc. However, in our view, this strategy is shortsighted. Ultimately, it is the legislature and the taxpayers they represent that backstop the plan and ensure that teachers get the benefits that they were promised. Given the challenging times retirement plans face, ATRS should seek out increased productive engagement with the legislature so that legislators have greater ownership and a stronger sense of responsibility to fully fund the plan when the inevitable next recession hits.

We have also been disappointed by the overheated rhetoric of some employee groups regarding stress testing. Arguably their members face the greatest potential impacts from unexpected cost increases, a significant risk given ATRS’s higher than average discount rate and many experts’ investment return expectations. It seems the substantive area of disagreement is with the specific scenarios required in HB1173, which the Arkansas Education Association (AEA) calls “worst case scenarios” in the post linked above. Rather than reject the useful exercise of stress testing out of hand, we encourage the AEA to propose improvements to HB1173 that would make the scenarios acceptable to provide their members and legislators with vital information that would help them plan for whatever the future may hold.

The Takeaway

Retirement policy can be very challenging. It is technically complex, politically charged, and has many legal uncertainties. We are thrilled that Arkansas has done better than most states managing its teachers’ retirement system, but costs have still risen and public retirement plans face some significant challenges going forward. Here at OEP, we think HB1206 (now withdrawn) and HB1173 propose positive improvements that would help ATRS meet the retirement needs of former, current, and future teachers, even if the details need a little work.

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