State Treasurer Denise L. Nappier Keith M. Phaneuf /
State Treasurer Denise Nappier
State Treasurer Denise Nappier

Connecticut faces sharply rising pension costs over the next two decades — but nearly $2 billion less at its worst point than the nightmare scenario Gov. Dannel P. Malloy outlined two months ago, according to a new analysis Wednesday from state Treasurer Denise L. Nappier.

The treasurer also outlined an alternative vision for stabilizing the pension system for state employees that relies heavily on achieving higher investment returns than the Malloy administration anticipates.

But this approach, according to Nappier and her staff, would spare Connecticut from forfeiting pension investment earnings for decades — and passing those expenses on to future generations.

When it comes to assessing how much past pension investments have earned, “when you start the clock can have a really big impact,” Deborah Spalding, Nappier’s chief investment officer, told the state’s Investment Advisory Council at its monthly meeting.

Is pension problem less severe than administration fears?

According to an analysis prepared for Malloy by the Center for Retirement Research at Boston College, this fiscal year’s $1.5 billion pension contribution could more than quadruple by 2032, hitting $6.65 billion.

That warning hinges, in part, on the assumption that future pension investment earnings will average 5.5 percent — as they did between 2000 and 2014. The fund currently assumes annual earnings will average 8 percent — a target set neither by Nappier nor the Investment Advisory Council, but by the State Employees Retirement Commission.

But according to Nappier’s staff, there are two problems with the administration’s scenario.

First, Spalding said, the 15-year period on which the administration bases its projection for investment return begins right as Connecticut heads into a recession, and also includes a second major dip, The Great Recession of 2008-09.

The administration’s 5.5 percent estimate was “overly depressed by the timing” of when it began, Spalding said.

And for nine of the 15 years in this cycle, fund investments enjoyed double-digit growth.

Nappier said her consultants believe an average investment return of 7 percent is more realistic for the next 15 years.

The treasurer would find critics ready to challenge that, though.

When Moody’s Investors Services, a Wall Street-based credit rating agency, offered a new methodology in 2012 for projecting public pension investment returns, it used high-quality corporate bonds as its new guideline, noting that their average yield was 5.5 percent in 2010 and 2011.

Some critics of public pension systems even have argued that, because of the modest yield on long-term U.S. Treasury bonds, plans should assume 4 percent or less.

The second problem with the administration’s pension-spike scenario, according to Nappier’s staff, is that it doesn’t apply one basic mechanism of the pension system.

The state must adjust its contribution every two years to compensate for several factors — including investment returns potentially falling short of targets.

In other words, if future investment earnings average 5.5 percent over any two-year period, Connecticut would have to immediately self-correct and contribute more. This still would drive up pension contributions, but in a much less steep fashion than the administration projected.

“The spike is steepened by a nearly 17-year mismatch” of 5.5 percent returns — and no mitigating adjustments in state contributions, Nappier’s office wrote in its presentation to the advisory council.

So while the Malloy administration warned the $1.5 billion pension contribution could hit $6.65 billion by 2032 or 2033, Nappier’s office places it closer to $4.7 billion at that point, and peaking around $5 billion in 2034, assuming 5.5 percent returns.

More importantly, the treasurer says, if a 7 percent average return is assumed, the state’s contribution peaks around $3.8 billion in 2032.

And while that is still very significant, she says, it’s a target Connecticut should work to meet rather than shift into the future.

Legal questions and ‘lost investment opportunity’

Further complicating matters, Nappier’s general counsel, Catherine E. LaMarr, warned that the legal changes the governor suggests to enable restructuring pension contributions “raise significant legal challenges for the state.”

The basic concept behind Malloy’s solution is to legally split the pension system in two: The assets in the fund would be assigned primarily to cover the benefits of existing workers, most of whom were hired after 1984. That’s when the state dramatically reduced retirement benefits for new employees.

Retirees from the earlier group, commonly referred to as “Tier 1,” would become part of a separate pay-as-you-go system. This means the state, which still expects to pay those retirees more than $14.4 billion in total over the next three or four decades, would have to find funds in its annual budgets to cover those pension benefits.

The remaining pension system would still hold all of the assets — and far less in debts — and wouldn’t need as much in contributions.

But Connecticut might not find it easy to move some retirees out of the official pension fund, even if it still pledges to provide promised benefits. “There’s a good argument that those participants have a right to participate in an actuarially funded plan,” LaMarr said.

“We should not be so quick to partially abandon an actuarially funded system without giving further consideration to how the current system might be better funded,” Nappier said. “ … We are willing to work with all of the key stakeholders to come up with a funding method that is more balanced.”

Under the governor’s proposal, starting in the 2018-19 fiscal year and continuing through 2033, total pension costs would be less than they otherwise would be under the current system. The annual estimated savings range from $200 million to more than $1 billion in 2032.

But total pension costs — which were supposed to drop rapidly after 2033 after two decades of scrupulous savings — now would remain significant for at least another decade and possibly into the mid-2050s.

Christine Shaw, Nappier’s chief compliance officer, noted that the administration’s plan to spread out costs comes with a price: Contributing less for pensions than originally anticipated between 2019 and 2032 means having less to invest as well.

“The governor has advanced a very ambitious proposal” to level pension costs, Shaw said, but “there is a lost investment opportunity” that Connecticut also would pass on to the future. The treasurer’s office said it hasn’t been able to project that lost investment opportunity based on the data it has received to date from the administration.

The governor and treasurer both recognize that Connecticut’s pension fund for state employees, with enough assets to cover less than 42 percent of its long-term obligations, is one of the worst-funded plans of any state’s. Besides unrealistic assumptions about investment returns, it also suffers from decades of inadequate state contributions and from five early retirement incentive programs offered tto workers between 1989 and 2009.

Gian-Carl Casa, spokesman for the governor’s budget office, said later Wednesday that, “We appreciate the treasurer’s thoughtful presentation, and we welcome a discussion on many aspects of the proposals to address the state’s long-standing pension problems.”

Tom Fiore, head of the revenue unit in the governor’s budget office and the administration’s representative at the advisory council meeting, also noted the governor has taken considerable steps to enhance Connecticut’s pension health.

Besides refusing to allow retirement incentive programs, Malloy also worked with state employee unions in 2012 to reverse contract language from the mid-1990s that had allowed the state for years to avoid making its full pension contribution.

Fiore added that the administration remains concerned, though, that much state revenue growth for years to come “is going to be consumed” by surging pension costs.

Nappier responded that she remains “very sensitive of the fact that this office doesn’t have to balance a budget.”

Keith has spent most of his 31 years as a reporter specializing in state government finances, analyzing such topics as income tax equity, waste in government and the complex funding systems behind Connecticut’s transportation and social services networks. He has been the state finances reporter at CT Mirror since it launched in 2010. Prior to joining CT Mirror Keith was State Capitol bureau chief for The Journal Inquirer of Manchester, a reporter for the Day of New London, and a former contributing writer to The New York Times. Keith is a graduate of and a former journalism instructor at the University of Connecticut.

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