Strapped state pension funds take scalpel to COLAs for relief

State pension plan executives and state legislatures increasingly are turning their attention to cost-of-living adjustments to pensions for current and future retirees as a way to get immediate and dramatic results in retirement program reforms.

Modifying COLAs is an immediate fix that keeps more money in the systems. Other changes, which include reduced benefits, increased employee contributions and switching to defined contribution or hybrid plans, might take years to show savings.

Just since 2009, 11 states changed COLAs for the pensions of current retirees, five changed them for current employees and five changed them for future hires, according to a new brief from the National Association of State Retirement Administrators.

COLA changes for current retiree benefits were made by the Arizona State Retirement System, Public Employees' Retirement Association of Colorado, Kansas Public Employees Retirement System, Maine Public Employees Retirement System, Massachusetts State Employees Retirement System, Public Employees Retirement Association of Minnesota, Public School Retirement System of Missouri, New Jersey Division of Investment, Oklahoma Public Employees Retirement System, Employees' Retirement System of Rhode Island and South Dakota Retirement System.

COLA changes affecting the retirement benefits for current employees were made by the Florida Retirement System, Kansas public employees' plan, Maryland State Retirement & Pension System, Virginia Retirement System and Washington Public Employees' Retirement System.

Future hires' benefits were changed by the Employees' Retirement System of the State of Hawaii, State Employees' Retirement System of Illinois, Kansas public employees' plan, State of Michigan Retirement Systems and Utah State Retirement Systems.

For some states that have curbed their COLAs, including Colorado and South Dakota, it has brought billions of dollars in much-needed relief to their state retirement systems and avoided more painful choices on the investment side. “It can put the plan in a more positive cash flow near term, and with less money flowing out, there is more money to be invested,” said Ron Snell, senior fellow at the National Conference of State Legislatures in Denver.

The saving that comes from changing COLAs depends on how dramatic the changes are, and how long the cuts will last. The $10.6 billion Augusta-based Maine retirement system canceled its COLA for three years so far, while the $58.8 billion Olympia-based Washington state fund eliminated it for some employees' retirement benefits and limited it for others. Virginia will cap COLA increases in retirement benefits at 3% for non-vested participants and 5% for vested participants in the $53.6 billion Richmond-based fund.

Several pension funds, including the $6.5 billion Oklahoma City-based Oklahoma Public Employees and $72.1 billion Trenton-based New Jersey Division of Investment, tie any resumption of COLAs to specific levels of prefunding or investment returns. Some funds, like the $6.9 billion Providence-based Rhode Island Employees, tie it to both.

“It's very tempting,” said Alicia H. Munnell, director of the Center for Retirement Research at Boston College, in an interview. “You get a big reduction in your liability immediately. There are very few (other) things you can do. I think that COLAs are vulnerable.”

The concept of a COLA is straightforward, but the design is another matter. “We were impressed with the wide variety of them,” said Keith Brainard, research director for NASRA in Georgetown, Texas, in an interview. NASRA identified a dozen basic COLA configurations, including adjustments that are automatic or provided ad hoc by a governing board. Some state and local governments base COLAs on a fixed rate, typically 3%, or the consumer price index, while others tie it all or in part to the investment performance or funding level of the plan.

And plan administrators are getting ever more creative, Mr. Brainard noted, with some applying COLAs to a limited portion of a retiree's annual benefit — for example, the first $35,000 — or making retirees wait longer for it. One variation pegged to investment returns involves the creation of a separate reserve account that is funded and distributed only when the main fund has excess earnings.

One of the richest COLAs, offered by 10 states, is an automatic 3% boost compounded on the accrued benefit. That can add 26% to a plan's benefits cost, according to an analysis by Gabriel Roeder Smith & Co., an actuarial and pension consulting firm. Even a modest 1% COLA can add 7% to total costs, according to the analysis.

That makes COLAs ripe for cost-cutting. That was the case in South Dakota, where a previously automatic 3.1% COLA that had to be prefunded accounted for 25% of present benefit costs. “That's $2 billion that we knew were out there,” said Robert A. Wylie, executive director/administrator of the $8 billion South Dakota Retirement System, Pierre, in an interview. “It is a huge leverage on the overall cost of the plan, and people don't recognize that.”

It helped that state statute required retirement system officials to make changes when the funding threshold fell below 80%. When that happened in 2010, they calculated that getting back to 80% would take $400 million. They got three-fourths of the way by simply changing the COLA to 2.8% from 3.1%. “You can't get that kind of savings with other benefits,” Mr. Wylie said. The fiscally conservative state didn't want to lower anyone's benefit, “but we wanted to slow the growth,” he said.

So far, the change “has worked out amazingly well,” Mr. Wylie said. The plan went to 103% funded in the fiscal year ended June 30, 2011, from 88% in fiscal 2010 and 76% in fiscal 2009. He attributes 8% of that growth to investment performance, and 4% from the COLA change, which also saved on opportunity costs by having more money to invest, he noted. “It's a compounding effect.”

Changing the COLA made a $9 billion difference in Colorado, where the $38 billion Denver-based retirement system made a lot of changes to benefits in recent years but not enough to forestall running out of money before the changes kicked in, said Meredith Williams, executive director of Colorado PERA. “We costed out every element of our benefits — work longer, pay more, receive less — and did a lot of "what if' analysis. It became clear that it was essential to do something with the COLA. You cannot survive without adjusting the COLA.”

Facing a drop below 40% funding would have also forced a more conservative investment approach, Mr. Williams noted. “If we had continued down the same path, we would have had to change the asset allocation.”

The Colorado pension fund's COLA solution, which included replacing an automatic 3.5% increase with an initial one-year freeze and a subsequent 2% cap tied to investment returns for current retirees and employees' future retirement benefits, plus a 1% COLA for new employees, kept $3 billion a year more in the fund since the change was made in 2010.

Spreading the pain around instead of singling out one group helps, noted South Dakota's Mr. Wylie. “COLA was an ideal place to do the change because it impacts everybody. That was very palatable.”

COLA changes also are succeeding where other benefits changes have not — in court.

“I haven't seen any courts reject them,” CRR's Ms. Munnell said. “You see the courts distinguish between core benefits and COLA. But you have to have a reason for doing it.”

“We could demonstrate that we were unsustainable,” Mr. Wylie said. ”We had to do something within legal parameters, and we couldn't change basic benefits. The COLA was a different animal, because it had been changed up and down.”

Just to be sure, system officials conducted a listening tour around the state to convince stakeholders and politicians that it was necessary. That didn't prevent a legal challenge, but like courts in other states, the COLA changes have been consistently upheld as necessary steps that don't violate benefit promises.