Episode 72 – LEOFF Plan 1: How a pension turned into an endowment
Episode transcript:
[music intro]
Jenny
Welcome back to Fund Your Future with DRS. Well, we’ve previously talked with State Actuary, Matt Smith about how pension plans are funded in Washington. And today we’re excited to have him back on the podcast to kind of walk through a simple example of how to measure the health of a pension plan. How do we make sure that we still have money enough to pay everyone’s pensions? So welcome back, Matt.
Matt
Thank you. Great to be back.
Seth
Matt, so I wanted to start off by just acknowledging that there’s a lot of negative news about pensions. Jenny and I have talked about this on other episodes that there’s a sort of doomer-ism like, doom sells, doom gets clicks and oftentimes pensions are associated with negative news. But Washington has some of the best funded pensions in the country.
We’ve talked about that with you in the past. We’ve talked with other folks from your office, but we want to spend a little bit time today talking about a pretty unique situation in the country, in that we also have a pension plan that is significantly overfunded. So, I want to give a little bit background for our listeners who might not be totally in the weeds on all things pensions, but there is a retirement plan for law enforcement and firefighters called LEOFF Plan 1. It was originally opened in 1970 and then closed to new enrollments in 1977, and since the early 2000’s, the plan has been recognized as being overfunded.
And this episode, we’re not going to get into too many details about how the plan became overfunded, but Matt, I’m hoping you can just give our listeners, like, a one-minute explanation on the background of how we’ve gotten here with LEOFF Plan 1.
Matt
Yeah, I’m happy to, might be a little bit challenging, but I would give it my best shot. Yeah, normally I’m a little cautious about using the term overfunded, you know, because we’re typically funding ongoing obligations. And, you know, maybe you’re a little ahead of the curve at one point. Maybe you can dial down contributions a little bit, but it’s just this ongoing need, ongoing entity.
But in the particular plan that you mentioned LEOFF 1, that that’s a plan that that’s been closed to new members for quite some time. We’ve set aside more than sufficient money to cover all the expected obligations of the plan throughout the rest of its lifetime. Happy to get into making some follow up questions on how we got there, but, yeah, I guess the short answer is, you know, the state set aside more money than we thought we would need.
The investments have been performing really well, and on a projected basis, the program has significantly more assets than we think it will need to pay all promised benefits.
Seth
And I should have just mentioned for context as well, that almost everyone in LEOFF Plan 1 is retired already, and I think that will be helpful context as we move forward. There are less than two handfuls of people still actively working in the plan, and so we have a pretty good idea of how much we are paying out in retirement benefits every month and every year going forward, and there aren’t a lot of new benefits being earned.
Matt
That’s a great, great point. And the other thing too, you know, you mentioned the contributions were stopped, you know, ceased to this program in 2000. So, I mentioned earlier, like one thing you can do is reduce or turn down contributions. There’s been no member employer contributions to this plan for over 20 years. And we’re still in the situation that we’re in.
Jenny
So, Matt kind of walk us through this scenario. So, assuming that DRS keeps paying out the same amount each year and investments don’t grow, we’ve run the numbers and the money would only last about 17 years. But then are there those big concerns about if the money is going to run out?
Matt
Yeah, I think this is where, you know, it might be helpful to put a little bit of a simple handle on it, if you will, for folks that you know, maybe are as close to the number as, you know, is my office is. That’s just looking at the money that we’ve set aside and the benefit payments, you know, that are currently being paid.
We look at this on a fiscal year basis every June 30th. As of June 30th, 2023, our last full audited measurement, the program LEOFF 1, had about $6.8 billion in assets and was paying out about $384 million in annual benefit payments. So, one very simple way of looking at it is how long could we pay that $384 million if it stayed flat and the program didn’t earn any additional investment earnings, and also didn’t lose any investment earnings, that would be just over 17 years.
It’s a very, very simple way of looking at the sufficiency of the assets. Average age of the population is in their late 70s, and from an actuarial perspective, look at all the payments for all of these beneficiaries, probably roughly about 17 years of benefit payments expected for that population on average. So, at a very high level, sends a, I think, a very clear message of how well funded that program is, that it has that much in assets, and you could pay that many years of benefits without hurting additional dollar investment earnings.
Jenny
That’s incredible.
Matt
And that was sort of the no investment earnings and how long could this corpus of assets, if you will, sustain current benefit payments. Another way of looking at it is what if we earned what we expect from that amount of assets? So, if we have it just under 6.9 billion in assets and we earn 7% return on that each year, we won’t do that every year.
But that’s sort of a long-term expectation. That amount of money itself, just the investment returns on the assets, is more than what we need to pay current benefit payments. And that starts to me, that sort of for those that might be familiar with this financial concept, that feels a little bit like a financial endowment where you can provide what you want, whatever program it might be, we typically see it in like higher education.
You can provide your program solely based on the investment earnings of the fund and not touch the principal at all LEOFF 1 is so well funded, it’s really approaching and not just approaching, I think it has become, an endowment in terms of the financial concept of how well funded it is.
Jenny
Yeah. Because then I guess the question that I jump to then is so once all of these LEOFF 1 retirees have passed away, then what happens with all of that extra money?
Matt
That is a question I hear quite a bit. And it’s a question that the legislature is grappling with. It’s had some legislative proposals on that very topic. The Select Committee on Pension Policy was tasked by the legislature to study that issue this interim. And opinions vary on this topic. The legislature is looking at potentially merging the plan with other plans.
They’ve also looked at potentially terminating the plan and restating it and making sure that you set aside a sufficient amount of assets and then any assets above that could be used for other purposes. They’re complicated proposals. They require legal analysis and a lot of study. But because LEOFF 1 one has approached this level of funding, one way of looking at it, it’s gotten so large, the surplus, that the legislature is definitely interested in seeing how that money could be used and is well aware, Jenny, of the outcome of if we have more than what we need for this program, what are we going to do with this money?
Can we do anything with this money legally? Do we have to wait until the last person literally receives a benefit from this plan until they pass away? Before we can do anything with it? These are really important policy questions that that the legislature is grappling with. And I’m glad that like our agency working with you and other agencies can inform, the legislature on. I think this very difficult question.
Jenny
Well, thanks for that. Like you said, it’s important to address now and start looking at what are the options. They’ve never really had this option before.
Seth
It’s such a good problem to have. Back to my earlier comment about oftentimes really bad news about pensions. This is really kind of amazing news about pensions, at least in Washington.
Matt, I want to circle back to your endowment idea and just think about how that would look for other retirement plans in the state. I’ve heard you say in the past that there are kind of there are different ways to fund pension plans, and there’s the pay-as-you-go model that people think about with Social Security, where basically the money that’s coming in is just turning right back around and paying out the benefits.
And then there’s the model that Washington uses generally for most of our retirement plans, where the money coming in now is invested, and then those contributions and the investment earnings are intended to pay out benefits 20 or 30 years down and in the future. Would it be fair to say a model more like LEOFF 1 would be; say, I start working today as a public employee or as a teacher, and on average I’m going to work 20 years.
The state or the employer could pay in a bunch of money right now and then we don’t have to put in any more money for Seth in this case, and the investment returns over the next three decades or four decades, however long I’m going to work, would then pay my future retirement benefits. Is that sort of where we got with LEOFF 1 with some extra funding early that allowed us to get to this point.
Matt
In a way, and I think I loved your example of service, the spectrum of funding, if you will. That can make it somewhat easier to understand it. I think a lot of us are familiar with that pay-as-you-go approach. Like you mentioned, Social Security, very affordable to the employer or the member in the sense that, right, you’re just making those payments when they’re due, but you’re also not taking advantage of any investment earnings and being able to set aside money that will build and grow.
They can offset some of that obligation. Your example, perhaps, what if we put a large lump sum upfront. Yeah, that would maximize potentially the returns on that but could also be very expensive to fund, you know, to put a lump sum in for everyone, you know, day one, the method that we use in most of our plans, you know, the systematic actual funding is really just sort of trying to set aside enough money during someone’s career to kind of blend those two approaches. Makes it a little bit more predictable, a little bit more affordable.
LEOFF 1 really, I think, started out with unfunded liabilities when it was created. The legislature, I think, did a good job of obviously closing that, trying to do this systematic approach of setting aside money as people were working. But the assumptions ended up being wrong.
Inflation came in a lot lower than what we expected. And even with this systematic approach of making the contributions on an annual basis based on what you think you’re going to need, still ended up in the program having more assets set aside than what it needed and hard to make adjustments. I mentioned earlier, the first thing that they did was to shut off contributions.
Seemed like a very reasonable thing. It looks like we’re ahead of schedule. Let’s cease contributions. 20 plus years later after ceasing the contributions, we’re still ahead of schedule. So wasn’t necessarily, you know, a lump sum approach was systematic, actual funding that that ended up being more than what the program needed. And yeah, now we’re talking about how do we respond to that now that we’re in this situation.
It is fascinating to me how we went from significant unfunded liabilities to a program now, that looks like it has significant over funding. We’re talking about ways that we might need to make explicit statutory changes to manage it. Quite a turnaround.
Seth
So, I don’t want to throw you too much of a softball here, but not all of our listeners are LEOFF Plan 1 members, obviously, and you mentioned about if a pension plan gets a little bit ahead of schedule, it might make sense to reduce the contribution rates. But in our Plans 2 and 3, what that might mean is if we get 101% funded, that our contribution rates go from 6% to 5.5%, maybe we don’t need to put in quite as much as we were previously putting in.
It doesn’t mean if we get to 101% that we’re in an endowment like LEOFF 1, it means we need to keep putting money in in the future, but maybe not quite as much as we were previously putting in. Is that a fair explanation?
Matt
It’s a great explanation. I’m really glad you brought that up, because I think that was that came up in one of our earlier podcasts or, you know, a plan that is overfunded. Does that mean that, you know, like, oh, we don’t need to put any more money in it? Not normally. Think of it maybe as like your …maybe it’s, your gas gauge in a car that’s just going to keep driving.
We’re going to keep paying benefits, and we expect to pay benefits for the next generation, the current workers, the next generation. You just keep going. Maybe your tank is full, but you’re still going to keep driving, right? So, let’s not no longer put gas in the tank. That’s a really important concept for people to because they think about this, especially if feel like you mentioned or in PERS 2 right? Or even PERS 3, you might hear or, you know, in the next few years that that plan might have a funded status of 102%.
That just means the program is slightly ahead of schedule where it needs to be. You would still expect contributions to continue, but as you mentioned, perhaps contributions can come down a little bit. And we’re like ahead of schedule, meaning that perhaps we’ve funded a little bit of the benefits that people have yet to earn to dial down the contributions responsibly.
We’ll see how the program adjusts and adapts. Very different from a plan that’s like LEOFF 1 that’s 100% retired for the most part, right? In almost every one of the seven people, for example, have retired, and you’re not really expecting or wanting to take contributions anymore.
Seth
I wanted to mention one last thing, because I think people get really worried that the pension funds are going to run out of money. And in this example, we’ve talked about with LEOFF 1, that seems very unlikely, that if you’re just able to live off the investments, it’s very unlikely that it would run out of money. But Washington state has had some pension funds that are Matt, the phrase you use earlier,
Pay-as-you-go where there isn’t a trust fund associated with them anymore. There isn’t a pot of money that’s paying out these benefits. There are some really much older retirement plans that were for judges and judicial employees who now the state is actually providing DRS money every budget cycle from the general fund that DRS then turns around and pays to those retirees.
It’s still an obligation in a contract of the state that have to fulfill. And so those folks are still receiving their pensions, even though you would say that those funds are 0% funded. Is that a fair explanation?
Matt
It is. And I think to another thing to think about, if that’s concerning to folks, you know, I think you have to make sure you put it in the perspective of the state budget. So those are also the plans that you referenced. Some of those older closed plans, closed to new members. They don’t represent really significant obligations to the state.
They’re important benefits, obviously, to the beneficiaries of those programs. The state has, you know, every intention of honoring that obligation. But for the pay-as-you-go impact of that is very, very small and does not represent any threat, financial threat to the state. So it’s not uncommon for the end of a plans life if it’s a closed plan, no longer open to new enrollees, at the end of the plan’s life, if it does reach a point where there is no longer a trust fund, very reasonable outcome for the state to set aside the money it needs on a pay-as-you-go basis. Some might argue that that’s preferred over having, overfunded, right? Because the overfunded situation, like a LEOFF 1 can create lots of questions about what do you do? Like Jenny’s question. What do you do with this money? You know, can you access this money? Should it be used for benefit improvements?
Can it be merged with another plan? Can the state terminate the plan, restate it and use it for other purposes? Those are all very challenging questions and stakeholders have different opinions about them. So it’s a good situation to be in rather be in that situation than underfunded. But if you do happen to have an underfunded, closed plan that’s on a pay-as-you-go basis, if it’s a very small obligation relative to the states book of business, if you will, that’s not concerning either.
Jenny
That’s been very informative.
Seth
It’s good, in that it’s not something that a lot of people pay close attention to. And as we talked about, it’s oftentimes bad news. And I think Jenny’s question about, you know, what happens when a college endowment ends and that there’s money left over, what do you do with it? Like those are really unique questions, but they also provide an opportunity for people to think about how you might use those funds. So, I appreciate that you took the time to chat with us about these things Matt.
Matt
That was quite a bit, but I think all very educational and hopefully accessible for folks.
Seth
Yeah, appreciate it.
Jenny
Thank you Matt.
Matt
Take care.
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