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MUNICIPAL CREDIT RESEARCH

18 May 2011

MUNICIPAL RESEARCH SPECIAL REPORT States' Pensions: A Manageable Longer-Term Challenge

Given that unfunded pension liabilities of the states have been estimated at $0.7trn to more than $3trn, or up to six times the amount of bonds outstanding, the health of public pension plans has become a focus area for municipal bond investors (both tax-exempt and taxable). In this primer on public pension plans, we aggregate some of the key data for all of the states and take a closer look at the four with the largest aggregate unfunded pension liabilities (California, Illinois, Massachusetts, and New Jersey), providing estimates as to when they would deplete their assets under various scenarios, assuming they take no further action to reduce liabilities and/or increase contributions.

Austin Applegate, CFA +1 212 526 0751 [email protected] Jormen Vallecillo +1 212 528 1289 [email protected] Katharine Cheng +1 212 528 7157 [email protected] www.barcap.com

Pensions Are a Longer-Term Liability Unlikely to Cause Defaults for the Vast Majority of Issuers

We believe that public pensions are a challenge for state and local governments, but will not cause defaults for the vast majority of issuers. Though the size of the pension shortfall is large, pension liabilities are longer term, and the plans have sufficient assets to pay annual benefits for at least the next 17 years, on average, before including future contributions and investment earnings. Moreover, state and local governments have begun to take action to reduce the pension liabilities and/or grow assets, including increasing employee contributions and reducing benefits for future employees. Though most of these actions affect only future employees and do little to address the unfunded liabilities currently reported by the states, they represent a step in the right direction.

Growing Pension Fund Contributions Could Pressure Budgets and Weaken Credit Profiles

It will be important for investors to monitor the health of public pension plans as growing pension fund contributions could pressure state and local budgets and be an important factor in rating actions. Those states with relatively large unfunded liabilities that are unwilling to take corrective actions (e.g., increase contributions or reduce benefits) could experiencing weakening credit profiles.

Solvency Not a Near-Term Problem

Almost all of the state pension funds we analyzed in California, Illinois, Massachusetts and New Jersey have sufficient assets to ensure solvency though at least the early 2030s. Any actions taken by them to increase contributions (employer and/or employee) or reduce benefits would strengthen the pension funds and ensure longerterm solvency.

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

CONTENTS

Why Are Pension Liabilities Important to Bondholders? ................................................................... 4 Unfunded Pension Liabilities Represent Up to 6x the States' Debt Burden ............................ 4 Increasing Pension Contributions Will Further Pressure Budgets............................................. 4 Pensions Cited As Key Driver in Ratings Actions; "Most Significant Risk".............................. 4 S&P Cites Pensions in Downgrade of New Jersey, and As "Most Significant Risk"............... 4 Deteriorating Pension Funding Levels Could Cause Rating Downgrades for Illinois............ 5 Headline Risk Heightened by Focus on Public Sector Pensions ................................................ 5 Rating Agencies Include Pensions as Part of Ratings Criteria.......................................................... 5 Rating Agencies: Pension Funding Pressures Can Strain Budgets and Weaken Credit Profiles .................................................................................................................................................... 5 Combining Bonds and Unfunded Pensions to Evaluate "Debt" Burden.................................. 6 Fitch Attempts to Create Apples-to-Apples Comparison ........................................................... 6 S&P Uses As-Reported Data; Moody's Makes Some Adjustments .......................................... 6 States Have up to $1trn of "Adjusted Debt".................................................................................. 6 Median Adjusted Debt Ratio is 6-7% .............................................................................................. 6 Moody's and S&P's Adjusted Debt Ratios Are Consistent, but There Are Differences ........ 7 Quantifying the Pension Challenge ­ Balance Sheet Approach ...................................................... 9 Reporting Standards Offer Wide Flexibility .................................................................................... 9 Asset Valuation Method ..................................................................................................................... 9 Discount Rate Equal to Expected Asset Return...........................................................................10 Varying Cost Methods Limit Comparability .................................................................................11 Assessing Pension Fund Health......................................................................................................12 $1.1Trn of Unfunded Liabilities and Average Funded Ratio of 64%, As of FY09 ................12 Market Returns Since FY09 Have Significantly Reduced Unfunded Liabilities and Increased Funded Ratios; Estimated $880bn of Unfunded Liabilities and Average Funded Ratio of 74%, As of FY11..................................................................................................................12 Using Assets-to-Benefits to Estimate Solvency...........................................................................12 Averages Can Be Deceiving .............................................................................................................13 Quantifying the Pension Problem: Income Statement Approach .................................................13 Pensions Do Not Necessarily Have to Be Pre-Funded ...............................................................13 State Required Contributions Have Increased Significantly, to $68bn in FY09 Compared with $27bn in FY00............................................................................................................................13 Shrinking Active Workforce Relative to Retirees.........................................................................13 Third-Party Forecasts of Insolvency Dates...................................................................................13 Estimating Insolvency Dates for Key State Pension Plans ........................................................14 How Can States Address the "Pension Problem"? ...........................................................................15 Make Changes for Future Employees............................................................................................15 Make Changes for Current Employees and Retirees..................................................................16 Three States Attempt to Change Benefits for Current Retirees...............................................16 Various Legal Approaches for Public Pensions ...........................................................................16 Contracts Approach ..........................................................................................................................17 Property Interest.................................................................................................................................18 Gratuity Approach .............................................................................................................................18 Promissory Estoppel ..........................................................................................................................18 Issue Bonds to Plug the Unfunded Liability..................................................................................18 Funding Pension Shortfall with POBs Would Result in 4-5% of State and Local Tax Revenues Being Devoted to POB Debt Service............................................................................18

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

Move from Defined Benefit Plans to Defined Contribution or Hybrid Plans.........................19 DC Plans Shift Risk from Employers (State and Local Governments) to Employees..........19 State-by-State Analysis...........................................................................................................................19 California ..............................................................................................................................................19 Illinois ....................................................................................................................................................19 Massachusetts ....................................................................................................................................20 New Jersey ...........................................................................................................................................20 California Pension Funds ........................................................................................................................20 Description of Funds .........................................................................................................................20 Key Takeaways ...................................................................................................................................21 Steps the State Can Take..................................................................................................................21 Illinois Pension Funds ..............................................................................................................................23 Key Takeaways ...................................................................................................................................24 Steps the State Can Take and Has Taken.....................................................................................25 Massachusetts Pension Funds ..............................................................................................................27 Key Takeaways ...................................................................................................................................27 Steps the State Can Take..................................................................................................................28 New Jersey Pension Funds .....................................................................................................................30 Key Takeaways ...................................................................................................................................30 Steps the State Can Take and Has Taken.....................................................................................31 APPENDIX A: DATA TABLES APPENDIX B: PUBLIC PENSION PLAN SUMMARY APPENDIX C: BARCLAYS CAPITAL ASSUMPTIONS APPENDIX D: INTRODUCTION TO PENSIONS 34 38 40 42

Defined Benefit vs. Defined Contribution Pension Plans.................................................................43 Pension Plans Are Funded by Employer Contributions, Employee Contributions, and Investment Earnings ................................................................................................................................43 Characteristics and Assumptions Vary among Pension Plans.......................................................44 APPENDIX E: PENSION PLAN LEGAL PROTECTIONS 48

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

Why Are Pension Liabilities Important to Bondholders?

Unfunded Pension Liabilities Represent Up to 6x the States' Debt Burden

States have approximately $460bn of tax-supported bonds outstanding (Source: Moody's). This figure includes general obligation bonds, appropriation bonds, and any other bonds payable from state tax revenues. Estimates of states' unfunded pension liabilities range from approximately $0.7trn to more than $3trn (depending largely on the discount rate), or 1.56.0x the amount of bonds outstanding. Because public pensions are often afforded at least some protection or guarantee by state law and/or constitution, investors should consider unfunded pension liabilities along with bonds outstanding to measure an issuer's overall debt burden, in our view.

Increasing Pension Contributions Will Further Pressure Budgets

Like bonds, underfunded pensions represent liabilities that state and local governments are obliged to pay. Those governments with significant unfunded pension liabilities will likely need to take actions to address these shortfalls. Although there are ways state and local governments can make changes to pension plans that do not result in increased contributions from them (e.g., higher retirement age, increased employee contribution rate, decrease pension benefits), they will also likely be making ever-increasing contributions to pensions plans to reduce unfunded liabilities. States typically devote only 4% of their budgets to pension fund contributions (Source: Center for Budget and Policy Priorities, May 12, 2011). There are two things to keep in mind when considering that figure. First, that figure is an average, and does not reflect the situation in those states with significantly underfunded pensions. For example, we estimate that pension contributions and debt service on pension obligation bonds (issued to fund prior year contributions) will represent more than 20% of the State of Illinois' general funds' state revenues and transfers in FY12. Second, the 4% figure is a historical number. The reality is that because of less-than-expected investment returns in recent years and a reduction in pension contributions by some states in recent years, pension contributions will comprise an increasing proportion of state and local budgets in the years ahead.

Pensions Cited As Key Driver in Ratings Actions; "Most Significant Risk"

Significant unfunded pension liabilities and other post employment benefit (OPEB) liabilities have been key drivers in recent negative rating actions. For those state and local governments that have sizable unfunded liabilities, and fail to take the action to address those liabilities, we would expect further ratings pressure.

S&P Cites Pensions in Downgrade of New Jersey, and As "Most Significant Risk"

In February 2011 Standard and Poor's (S&P) downgraded the State of New Jersey's general obligation (GO) rating to AA- from AA, citing its "concern regarding the stresses posed by the state's poorly funded pension system, its substantial post-employment benefit obligations and its above-average debt levels." Moreover, S&P stated that "pension funding is a major budgetary pressure for New Jersey and remains the most significant risk to its long-term credit quality" (emphasis added by Barclays Capital), and referenced the decline in the state's pension funded ratio to 56% in FY10 from 100% in FY02.

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

Deteriorating Pension Funding Levels Could Cause Rating Downgrades for Illinois

In September 2010, Moody's revised the outlook for the State of Illinois from Stable to Negative, citing, among other factors, the state's inability to meet statutory pension funding requirements. In January 2011 S&P indicated that if Illinois' pension funding levels continue to deteriorate and debt levels increase significantly, the state's ratings could be downgraded.

Headline Risk Heightened by Focus on Public Sector Pensions

Public pensions have become a hot topic not only for municipal bond investors, but also for taxpayers (i.e., voters) and elected officials at the federal, state, and local levels. One has to only look to recent Congressional hearings on the municipal bond market (e.g., February 9, 2011, "State and Municipal Debt: The Coming Crisis?") and public pension plan legislation (e.g., May 5, 2011, "The Transparency and Funding for State and Local Pension Plans") as evidence that the electorate and federal legislature are taking a hard look at public pensions and their affect on the finances of state and local governments. Although continued focus on public pensions may produce some positive results in that it may lead to structural changes to limit or reduce the unfunded liabilities, it may also lead to an increased number of media reports about pension liabilities and the challenges faced by state and local governments. Such media attention will further shed light on the unfunded pension liabilities and fiscal challenges facing some state and local governments. Retail investors may choose to avoid or limit their exposure to those credits that continue to garner the negative media attention. Similarly, institutional investors may choose to avoid or limit their exposure to those credits that generate the most questions/inquiries from their clients.

Rating Agencies Include Pensions as Part of Ratings Criteria

All three rating agencies released reports during the first quarter of this year addressing how they consider pension obligations as part of their overall ratings criteria, although each agency's approach is different. What is consistent, however, is that unfunded pension liabilities and how the states have (or have not) addressed those liabilities have been the drivers of some recent negative rating actions, and will likely continue to be so. S&P and Moody's calculate adjusted debt ratios that combine unfunded pension liabilities and outstanding bonds at a state level for enhanced transparency and to evaluate states' overall "adjusted debt" burden. Both agencies rely largely on the pension plan reported data, though Moody's makes some adjustments for certain multi-employer cost-sharing plans. Fitch, however, is taking a different approach and is attempting to create a framework that will better allow users to make an "apples-to-apples" comparison of the states' debt and pension liabilities.

Rating Agencies: Pension Funding Pressures Can Strain Budgets and Weaken Credit Profiles

The rating agencies believe, as do we, that although sizable unfunded pension liabilities and the related increase in pension funding requirements will not cause the vast majority of issuers to default on their debt obligations, it will put pressure on government budgets and could weaken credit profiles. More specifically, S&P believes that "states will be able to meet their debt service obligations despite increasing contribution requirements from pension plans, although these can weaken the state's relative credit profile." Similarly, Moody's believes that "pension funding pressures will continue to have a negative impact on state credit quality and state ratings." Fitch views that the "vast majority of governments will

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

withstand the substantial pressures they face from their pension obligations" and believes that these obligations will place "considerable pressure" on government budgets.

Combining Bonds and Unfunded Pensions to Evaluate "Debt" Burden

Comparability between states is muddled because pension plans use different combinations of assumptions, including actuarial cost methods, discount rates, and asset value smoothing methodologies. In addition, most state-run, cost-sharing multi-employer plans do not disclose sufficient information to allocate the accrued actuarial liabilities properly among the participating state and local governments, making it difficult to determine each employer's share of an unfunded pension liability.

Fitch Attempts to Create Apples-to-Apples Comparison

Unlike Moody's and S&P, Fitch is not providing a combined "adjusted debt" ratio at the state level because of the difficulty in allocating the liabilities of cost-sharing, multi-employer plans. As part of its "enhanced framework," Fitch requests from the states their estimates of the portion of the unfunded liability attributable to the state and participating local governments. If Fitch is able to allocate the pension fund's unfunded actuarial accrued liability (UAAL) among the state and local governments, it will consider adding a new ratio for long-term liabilities that combines debt and entity-specific UAAL using 1) a 7% expected investment return (and discount rate), rather than the rate assumed by the system and; 2) an asset valuation adjustment that will remove the effect of disparate smoothing methods by calculating a system's asset value based on a rolling five-year average of the market value of assets. Although these adjustments get us closer to an apples-to-apples comparison, there remain a number of other actuarial assumptions (e.g., mortality rate, inflation, etc.) that differ from plan to plan, making a true comparison very difficult.

S&P Uses As-Reported Data; Moody's Makes Some Adjustments

In its analysis of state liabilities, S&P includes all plans for which the states provide at least some of the funding and generally includes the plans reported within the states' financial disclosures. Importantly, many of the plans are cost-sharing, multi-employer plans. These plans include not just state employees, but also local government employees. Consequently, typically both state government and local governments make contributions into these plans. It is usually not clear, however, how the unfunded liability of such cost-sharing, multiemployer plans should be allocated among the participating state and local governments. Moody's takes a similar approach as S&P, but adjusts the pension liability amounts attributable to Ohio and Nevada in response to the state' estimates of their shares of liabilities in their multi-employer, cost-sharing plans.

States Have up to $1trn of "Adjusted Debt"

Per Moody's and S&P, the states have $900bn-$1trn in combined bonds outstanding and unfunded pension liabilities (i.e., "adjusted debt"). According to Moody's, the states have $460bn of net tax-supported debt and $462bn in unfunded pension liabilities, for a total of $922bn of adjusted debt. S&P reports the states have $429bn of tax-supported debt and $656bn of unfunded pension liabilities for a total of $1,085bn of "adjusted debt." The unfunded liabilities are based on the actuarial asset and liability figures reported by the states.

Median Adjusted Debt Ratio is 6-7%

The median state adjusted debt ratio (adjusted debt/gross state product), as calculated by S&P and Moody's, is 7.3% and 6.4%, respectively (Figure 34). There is wide dispersion

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

around those medians, however. Connecticut, Hawaii, and Mississippi have adjusted debt ratios above 15.0% (as calculated by Moody's), while Indiana, Nebraska, North Carolina, South Dakota, and Tennessee are below 2.0% (Figure 1).

Moody's and S&P's Adjusted Debt Ratios Are Consistent, but There Are Differences

The adjusted debt ratios are fairly consistent between the two rating agencies. Nonetheless, there are differences of greater than 5pp in those of Alaska, Maine, Nevada, Ohio, and Rhode Island. The difference in Ohio's adjusted debt ratio is due largely to Moody's adjustments to unfunded pension liabilities figures to account for the state's share of liabilities in the multiemployer, cost-sharing pension plans. In Ohio, the unfunded pension liability used by S&P is $64bn, while the amount used by Moody's is $3bn, showing how pension liability figures can differ significantly for states with multi-employer, cost-sharing plans. Debt burden (including unfunded pension liabilities) is clearly an important factor in credit ratings, as can be seen in Figure 2. However, it is just one of many factors. For example, California's adjusted debt ratio of 7.4% is consistent with the average among all 50 states (7.3%), yet it is the lowest rated state (along with Illinois) largely because of its budget, liquidity, and governance challenges.

Figure 1: State Funded Ratio (%)

90% 80% 70% 60% 50% 40% 30% AL AK AZ AR CA CO DE FL GA HI ID IL IN IA KS KY LA ME MD MA MI MN MS MO MT NE NV NH NJ NM NY NC ND OH OK OR PA RI SC SD TN TX UT VT VA WA WV WI WY Funded Ratio Market Value (MVA/AAL)

Source: Center for Retirement Research, Boston College; Barclays Capital

State Average

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

Figure 2: States' Adjusted Debt/GSP Ratio and Ratings

Adjusted Debt/GSP (%)

16

HI MS CT WV MA KY RI NJ

14

IL

12

NM OR SC

10

MD AK MT CO AL ID NH KS

OK ME LA

8 MN

CA

6

VT UT GA VA DE

AZ WA FL AR PA ND OH MI NY WI NV SD

4

2

NC

MO TX IA IN TN

0 Aaa Aa1

NE Aa2 Aa3 A1

Note: Adjusted debt equals the sum of the net tax-supported debt and unfunded pension liabilities. GSP equals gross state product. Data are as of FY09. Source: Moody's: Combining Debt and Pension Liabilities of U.S. States Enhances Comparability (January 26, 2011).

One way to evaluate the states is to look at pension funding ratios and adjusted debt/GSP. In Figure 3, on the bottom right-hand quadrant of the table are the states with the largest debt burdens and lowest funded ratios, including Hawaii, Missouri, West Virginia, Rhode Island, Kentucky and Illinois. On the upper left-hand quadrant are those with the lowest debt burdens and the highest funded ratios, including North Carolina, South Dakota, Tennessee and Nebraska.

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

Figure 3: States' Funded Ratios and Adjusted Debt/GSP

Funded Ratio

90% WI

80% NC SD TN TX 70% IA NE

DE

NY WY AR GA UT WA FL ID OR

OH 60% MO ND NV MI VA VT AZ

CA MN CO MT AK MD ME NM

MA

50% KS

NH

LA

NJ SC RI OK IL

WV KY

MS

HI

40% 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% Adjusted Debt/GSP

Note: Adjusted debt equals the sum of the net tax-supported debt and unfunded pension liabilities. GSP equals gross state product. Data are as of FY09. Source: Moody's: Combining Debt and Pension Liabilities of U.S. States Enhances Comparability (January 26, 2011); Center for Retirement Research, Boston College; Barclays Capital

Quantifying the Pension Challenge ­ Balance Sheet Approach

Reporting Standards Offer Wide Flexibility

Reporting guidelines covering the measurement of the value of public pension obligations are governed by the Governmental Accounting Standards Board (GASB). Although there are disclosure standards, they allow much flexibility in the use of assumptions. Some of the key assumptions and methodologies are discussed below.

Asset Valuation Method

Rather than using the market value of assets, most plans recognize investment gains and losses over multiple years. Thus, the actuarial value of assets (AVA) can be much different than the fair market value of a plan's assets, particularly after significant increases or declines in the financial markets. Approximately 88% of public pension plans have a smoothing period of four years or longer, with five years being the most common (Source: S&P).

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

Discount Rate Equal to Expected Asset Return

The discount rate assumption has proven to be the most controversial assumption. GASB standards allow pension plans to discount future pension benefits at the "estimated longterm yield of plan assets." Approximately two-thirds of plans use a discount rate of at least 8% (Figure 4). Some financial economists, however, have argued that because public pension benefits are nearly riskless (i.e., protected by state constitution and/or statute), actuaries should use a discount rate that reflects this. In other words, they argue that public pensions should use a "risk-free" Treasury rate or a rate equal to the state's borrowing rate. Figure 4: Public Pension Plans' Discount Rate (%)

n/a 8.50% 11% 8.25% 12% 12% 12% 44% 6.00% 7.00% 7.25% 7.50% 7.75% 7.80%

8.00%

Note: Data are for 126 state and local pension plans, and is as of FY09. Source: Center for Retirement Research, Boston College

Using a risk-free rate of 4% as the discount rate results in total unfunded pension liabilities of more than $3trn, rather than the $0.7trn figure reported by the states (Figure 5). Although the discount rate has no bearing on what the future pension benefits will be, it typically affects how state and local governments fund their pension systems (i.e., contribution rates). A lower discount rate results in a larger unfunded liability, thus increasing the actuarially required contribution (ARC). Figure 5: Aggregate State and Local Pension Unfunded Liability under Alternative Discount Rate Assumptions, 2009, $trn

3.5 3 2.5 2 1.5 1 0.5 0 8% 6% 5% Unfunded Liability 4% $0.9 $1.8 $2.4 $3.2

Source:: National Bureau of Economic Research, Public Pension Funding in Practice, October 2010

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

To demonstrate the effect of changing the discount rate, we look to the California State Teachers' Retirement System (CalSTRS). Using a discount rate of 6.00%, rather than 7.75%, increases the required contribution rate (employer and employee contribution as a percentage of payroll) to 42% from 27% (Figure 6). Under such a scenario, the funded ratio declines to 61% from 76%, and the unfunded liability increases nearly $50bn, from $83bn to $131bn.

Figure 6: California State Teachers' Retirement System, Actuarial Valuations, June 30, 2009

Actuarial Value of Assets Investment Return Assumption 6.00% 7.50% 7.75% 8.00% 9.00% Market Value of Assets

Funded Ratio 61% 74% 76% 78% 88%

UAAL 93,465 51,949 46,112 40,541 20,627

Funding Rate 42% 29% 27% 25% 18%

UAAL 130,718 89,202 83,365 77,794 57,880

Note: Funding rate represents the total contributions needed from both employers and employees as a percentage of covered payroll, to meet the 30y funding goal. Source: California State Teachers' Retirement System Annual Report, June 30, 2010

Varying Cost Methods Limit Comparability

There are a number of cost methods permitted by GASB that actuaries can use to determine a pension plan's actuarial accrued liability (AAL) and the actuarially required contribution (ARC). The most common one used in the entry age normal (EAN) method in which new service liabilities accrue as a fixed percentage of a given worker's salary throughout his or her career. Approximately 13% of plans use the projected unit credit (PUC) method and 16% use the aggregate cost or other method. Plans using the EAN method recognize a larger accumulated pension obligation for active employees and require a larger contribution than the PUC method. The aggregate cost method allocates unfunded liabilities as future normal costs, so plans using this method report no current unfunded liabilities (i.e., funded ratio = 100%). GASB requires plans that use the aggregate actuarial cost method to also disclose the funded status and present a multi-year schedule of funding progress using the EAN cost method. Figure 7 shows the funded ratios for nine pension plans that use the aggregate cost method. Clearly, the cost method used to estimate liabilities has a significant effect on funded ratios. We recommend caution when using the "as reported" figures to compare pension plans with different cost methods.

Figure 7: Public Pension Plans Using Aggregate Cost Method, Funded Ratios, FY09

Plan Name DC Police & Fire DC Teachers New York State Teachers NY State & Local ERS NY State & Local Police & Fire Washington LEOFF Plan 2 Washington PERS 2/3 Washington School Employees Plan 2/3 Washington Teachers Plan 2/3 Aggregate Cost 100% 100% 100% 100% 100% 100% 100% 100% 100% Entry-age Normal 40% 92% 84% 75% 77% 93% 77% 78% 79%

Note: Aggregate cost funded ratios are based on actuarial assets and liabilities. Entry age normal funded ratios are based on market value of assets and actuarial liabilities. Source: Center for Retirement Research, Boston College

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Assessing Pension Fund Health

$1.1Trn of Unfunded Liabilities and Average Funded Ratio of 64%, As of FY09

To calculate the unfunded pension liabilities at the state level, we used the market value of assets and actuarial accrued liability calculated using the EAN method. We then summed each state's plans to determine the state's aggregate unfunded liability and funded ratio. We note, however, that the assets of one plan cannot be used to pay the liabilities of another plan. We believe that using the market value of assets provides for better comparability among plans, given the varying asset smoothing and actuarial methods. We calculate aggregate unfunded pension liabilities for states of $1.1trn and an average funded ratio of 64% (Figure 35). Indiana (38%), Oklahoma (45%), Illinois (46%), and Rhode Island (47%) have the lowest average funded ratios, while Wisconsin (88%), Delaware (79%) and New York (79%) have the highest.

Market Returns Since FY09 Have Significantly Reduced Unfunded Liabilities and Increased Funded Ratios; Estimated $880bn of Unfunded Liabilities and Average Funded Ratio of 74%, As of FY11

The data we (and most others) have used are as of FY09 (June 30 for most plans). The financial markets have risen significantly since then, however. Although we do not have the asset and liability figures as of FY10 for all plans, we can estimate the former based on market returns and asset allocation data. We can estimate accrued actuarial liabilities based on average annual growth in recent years. Assuming an investment return of 28% since June 2009 and average growth in liabilities of $150bn annually, we estimate total unfunded pension liabilities will be approximately $880bn as of FY11 and the average funded ratio will be approximately 74%, based on the discount rate used by each pension plan (typically ~8%).

Using Assets-to-Benefits to Estimate Solvency

A crude way to evaluate how many years it will be until a pension plan exhausts its assets is looking at the net assets-to-annual benefits ratio. The metric is crude because it does not consider future contributions (employer and employee), investment earnings, and a change in the level of annual benefits. Nonetheless, it provides a simple way to rank pension plans. As of FY09, the average state net assets-to-annual benefits ratio was 13.5x. Given market returns since then, however, we estimate that the ratio has increased to approximately 17x. This suggests the plans have sufficient assets to pay benefits through FY28, not accounting for any future contributions and investment earnings and an increase in annual benefits. Figure 8: State Pension Plans: Funded Ratios, FY09

# of Plans 35 30 25 20 15 10 5 0 30% 40% 50% 60% 70% Funded Ratio 80% 90% 100%

Source: Center for Retirement Research, Boston College

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

Averages Can Be Deceiving

Within each state there are various pension plans, some of which are better funded than others. In the right-most column below we indicate the funded ratio of the plan with the lowest funded ratio. States such as Missouri, Minnesota, and Washington all have plans with significantly lower funded ratios (up to 17%-22%) than the average of all the state plans (Figure 35).

Quantifying the Pension Problem: Income Statement Approach

Another way to evaluate a pension plan's health is to forecast, under various scenarios, when the plan would become insolvent (i.e., assets fully depleted). At that point, the participating state and local governments would have to pay for pension benefits on a payas-you-go basis, likely putting significant pressure on their budgets.

Pensions Do Not Necessarily Have to Be Pre-Funded

Generally, state and local governments do not have to pre-fund future pension benefits. Rather, they could act on a pay-as-you-go basis. This is how most state and local governments pay for retiree health costs (i.e., other post-employment benefits, or OPEB1). Nonetheless, virtually all state and local governments have chosen to pre-fund pension benefits. Doing so has allowed them, in combination with employees, to contribute an amount equal to approximately 60% of the annual benefits that are paid out. The other 40% is funded from investment earnings. Median annual investment returns have been strong over the past 25 years at 8.7%. More recently, however, the median annual return for the five years through 2010 was 4.5%.

State Required Contributions Have Increased Significantly, to $68bn in FY09 Compared with $27bn in FY00

Following a decade of strong equity market returns, public pension plans were approximately 100% funded in 2000, and total state pension required contributions were $27bn. From 2000 through 2008, however, equity markets declined over 30%, and in response, actuarially required state contributions increased significantly, to $68bn in FY09.

Shrinking Active Workforce Relative to Retirees

Over the past nine years, state pension plan annual benefits as a percentage of covered payroll have increased from 18% in FY01 to 25% in FY09, largely because a decline in the ratio of active employees to retirees (Figure 9).

Third-Party Forecasts of Insolvency Dates

The Center for Retirement Research at Boston College (CRR) and Professor Joshua Rauh of Northwestern University independently conducted studies to estimate the insolvency date for public pension plans under various assumptions. Rauh's approach assumes the pension plans are essentially terminated and only the assets in the plan at time of termination are available to pay accrued benefits. The CRR conducts a similar analysis ("termination method") but also provides estimates if the pension plans remain "ongoing" entities (i.e., future contributions can be used to pay benefit payments).

1

Approximately $600bn outstanding as of FY09, according to the PEW Center on the States.

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

Figure 9: State Pension Plans ­ Ratio of Active Employees to Retirees

2.5x 2.3x 1.8x 1.3x 0.8x 0.3x 2001 2002 2003 2004 2005 2006 2007 2008 2009 2.4x 2.3x

2.2x

2.1x

2.1x

2.1x

2.0x

1.9x

Source: Center for Retirement Research, Boston College; Barclays Capital

Under the termination approach, and assuming 6% investment returns, both estimate that state and local pension plans would, on average, become insolvent in 2023 or 2024 (Figure 10). Assuming an 8% investment return pushes that out to 2028 or 2033. Under the CRR's "ongoing" approach, the public pension plans, on average, would go insolvent in 2025 or 2041, assuming 6% or 8% investment returns, respectively.

Figure 10: Assumptions Used in Models by Professor Rauh and Boston College

Boston College Assumption Criteria Population Contributions Inflation Rauh FY06 for 115 Major Plans Termination Ongoing

FY09 for 126 Major Plans Benefits fully covered by future contributions n/a

Benefits fully covered by Benefits fully covered by future contributions future contributions 3% n/a

Insolvency Dates under Different Investment Returns Boston College Investment Return 6% 8% 10% Rauh 2024 2028 2045 Termination 2023 2033 n/a Ongoing 2025 2041 n/a

Source: "Can State and Local Pensions Muddle Through?" Center for Retirement Research, Boston College; "Are State Public Pensions Sustainable?" Joshua D. Rauh, Professor at Northwestern University

Estimating Insolvency Dates for Key State Pension Plans

We used an "ongoing" model, which permits us to change various assumptions (e.g., projected benefit payments, employee and employer contribution rates, and investment returns) to estimate when the pension plans in California, Illinois, Massachusetts, and New Jersey would go insolvent. In our base case, we assume that the participating governments do not take any actions to change significantly their contribution rates and benefit levels for current employees and retirees. A summary of our base case is presented in Figure 11, and more detail is provided in Appendix B. To put these estimates in context, we note that the trustees for the Social Security and Medicare trust funds recently indicated that the Social Security and Medicare trust funds are projected to become depleted (i.e., insolvent) in 2036 and 2024, respectively.

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Figure 11: Estimated Insolvency Dates

Rauh Termination Investment Return California California PERF California Teachers Illinois Illinois SERS Illinois Teachers Illinois Universities Massachusetts Massachusetts SERS Massachusetts Teachers New Jersey New Jersey PERS New Jersey Police Fire New Jersey Teachers 2019 2021 2022 2019 2022 2025 2020 2029 2030 2029 2034 2037 2036 2030 2035 2021 2037 2042 2022 2026 2021 2019 2023 2020 2028 2025 2033 2028 2028 2031 2031 2036 2018 2016 2019 2018 2017 2019 2019 2021 2029 2020 2022 2035 2021 2037 2033 2024 >2052 2038 2026 8% 2030 2026 2025 2029 2029 2036 2071 2064 >2100 2037 2030 2044 2035 Boston College Termination 6% 8% Ongoing 6% 8% Our Model Ongoing 6% 8%

Note: Our model assumes that state and local governments do not significantly change their contribution rates, nor change the pension benefits levels for current employees and retirees. Source: "Can State and Local Pensions Muddle Through?" Center for Retirement Research, Boston College; "Are State Public Pensions Sustainable?" Joshua D. Rauh, Professor at Northwestern University; Barclays Capital

How Can States Address the "Pension Problem"?

Broadly, there are two approaches to reducing unfunded pension liabilities: increase the value of the assets and/or reduce the liabilities. The former can be accomplished by increasing employer (state and local government) contributions, employee contributions, and/or investment returns. Another approach involves the issuance of bonds (typically either general obligation or appropriation-backed), the proceeds of which are contributed to the pension system. As for reducing liabilities, it is relatively easy to change benefits for future employees, but significantly more challenging to do the same for current employees and retirees. Importantly, the unfunded liabilities reported by state and local governments do not reflect future employees. So although a reduction in benefits for future employees will produce savings over the long term, it does not materially address the currently reported unfunded liabilities. In other words, reducing future employees' benefits is likely a step in the right direction, but does not solve any near- or medium-term challenges.

Make Changes for Future Employees

Altering pension plan attributes for future employees (e.g., benefit levels, employee contribution rate, retirement age) is relatively easy for state and local governments. There are many examples of states taking action to reduce pension liabilities and/or increase employee contributions for future employees. Below are three examples: California Public Employees' Retirement Fund (PERF): For new hires, the normal retirement age for "general state employees" has been increased to 60 from 55, and the final average salary period has been increased to three years from one year. For state

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public safety employees, the benefits multiplier has been reduced to 2.5% from 3.0% or to 2.0% from 2.5%, and the retirement age has been increased to 55 from 50, depending on classification. Illinois statewide plans (ex-judges and legislators): Among other changes, for new hires after January 1, 2011, the normal retirement age has been increased to 67 from 60; final average salary will be determined from the highest eight of the past 10 years, up from the final four; the annual pension benefit is limited to 75% of the final average salary or $106,800 (indexed to the lesser of 3% and half of CPI). In addition, benefits will be suspended for those who return to work for another public employer in the state ("double dipping"). Pennsylvania State Employees' Retirement System: For new hires as of January 1, 2011, the benefits multiplier is reduced to 2.0% from 2.5%; vesting is increased to 10 years from five; and the retirement age has been increased to 65 from 60, and to 55 from 50, depending on class. As noted above, enacting changes to benefits levels or contribution rates for future employees does not directly address the unfunded pension liabilities currently reported by the state and local governments The tougher decisions, from both a political and legal perspective, are whether the state and applicable labor unions are willing to enact similar changes to current employees.

Make Changes for Current Employees and Retirees

State and local governments can fairly easily change pension benefits for future employees via legislation and/or negotiation with labor unions. It is generally understood that a state cannot make changes to pensions for retirees, although that is being challenged in three states (Colorado, Minnesota, and South Dakota) which are attempting to reduce retirees' cost of living adjustments. There is much more uncertainly, however, surrounding the states' abilities to modify pension plans for current employees. Public pension plans are exempt from the anti-cutback rule, which protects private sector pension plans from eliminating or reducing the benefits already accrued by plan participants. Rather, there is a web of state laws, state constitutional language, and court cases that determine whether the states have the ability to alter the pension benefits of current employees.

Three States Attempt to Change Benefits for Current Retirees

In 2010 the Colorado legislature reduced cost of living adjustments (COLA) for current and future retirees to the lesser of inflation or 2.0% from 3.5%. The action is being challenged in a class action lawsuit (Justus v. State of Colorado). Similarly, Minnesota and South Dakota reduced COLAs, and tied future COLAs to pension funding levels. Those actions are also being challenged (Swanson v. Minnesota, and Tice et al. v. South Dakota et al.). Although the state court rulings in these cases will not apply to other states, they may provide at least some guidance to states that have similar protections and laws concerning pensions and are considering reducing benefits for current employees and/or current retirees.

Various Legal Approaches for Public Pensions

Public pensions and the participants' right to pension benefits are generally analyzed under one of four approaches: contracts, property interest, gratuities, or promissory estoppel. In most states, public pensions are either considered contracts or property interests. On balance, it is easier for states to modify or "impair" the pension benefits for current employees under the property interest approach than it is under the contracts approach. Making changes to pension plans in states that adhere to the gratuity approach (Texas and

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Indiana) is relatively easy. Minnesota views a public employee's interest in a pension plan as promissory estoppel, which is difficult to distinguish from the contract approach taken by other states.

Contracts Approach

For states where pension benefits are determined to be a contract either by statute or implied by facts and circumstances, the state is limited in its ability to make changes to the pension plans for current employees. The courts must address any changes to the pension plans by looking to the US Constitution's contract clause ("no state shall...pass any law impairing the obligations of contracts") or the particular state's contract clause, which usually mirrors the federal clause. The legal analysis under the contract clause entails a three part test: 1) does a contractual relationship exist? 2) does the state's action constitute a substantial impairment of the contractual relationship? and 3) is the change justified by an important public purpose and is the action reasonable and necessary? The state's ability to make modifications to public pension plans for current employees varies directly with the time at which a contract is deemed to exist (i.e., at time of employment, or upon becoming eligible for retirement). The sooner the contract becomes effective, the more difficult it will be for a state to make changes to the pension plan. A state is permitted to make changes to a pension plan if the changes that "impair" the pension contract are "reasonable and necessary" to achieve an "important public purpose"; however, that has proven to be a high hurdle. Impairing a contract to simply save money is not sufficient justification. Rather, the state must establish that no less drastic modification could have been implemented to accomplish the state's goal, and the state could not have achieved its goal without the modification. Previous court cases have made clear that it is quite difficult to establish that modifications of a public pension plan are the least drastic solution available. Some states, including California, however, allow certain modifications to public pension plans under a test specific to public pension plans. That is, changes to a pension plan that result in "disadvantages to employees should be accompanied by comparable new advantages." This standard is applied on a participant-by-participant basis. State courts have reached varying conclusions as to whether a more fiscally sound pension plan is a "comparable new advantage" accompanying a modification of pension benefits and/or an increase required employee contributions. In 1958, a California appellate court ruled (Houghton v. City of Long Beach) that a new requirement that pension participants contribute 2% of their salary to the pension plan was offset by "comparable new advantages," namely that the change would result in an insolvent plan becoming a solvent plan. In 1980, however, the Supreme Court of Kansas ruled (Singer v. City of Topeka) that increasing the contribution rate of employees was not offset by a comparable benefit, even though the new law required pension plans to be actuarially sound: "As the trial court pointed out, there was no evidence that the City will not be able to meet its obligations in the future, no evidence that plaintiffs' pensions are in jeopardy, no evidence that plaintiffs would receive any benefit from an actuarially sound system which plaintiffs would not otherwise receive." It leaves open the question, however, how a court would rule if a state or local government made pension plan modifications (e.g., increased employee contributions) because the government would not otherwise be able to meet its obligations in the future.

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Property Interest

At least six states (Connecticut, Maine, New Mexico, Ohio, Wisconsin, and Wyoming) approach public pensions under a property interest framework. If a participant's rights in a public pension plan are considered property, they are protected under the Fifth and Fourteenth Amendments to the U.S. Constitution, which protect the rights from deprivation without the due process of law and prohibit the taking of property without just compensation. On balance, state courts have allowed states that use the property rights framework to modify public pension plans if they are "rationally related to a legitimate state interest." Importantly, changes to pension plans that deal with state financial crises have been found to be "legitimate state interests." As to the issue of the Fifth Amendment and the prohibition of the taking of property, courts have found that pension plan participants cannot have any investment-backed expectation, and that changes to public pension plans represent "an adjustment to the benefits and burdens of economic life" rather than the taking of property without just compensation.

Gratuity Approach

Two states (Indiana and Texas) follow the gratuity approach, which holds that public pensions are gratuities that do not vest and can be modified at any time by the state.

Promissory Estoppel

The promissory estoppel approach in Minnesota provides that a promise may be "enforced to prevent injustice if the promisor should have reasonably expected the promisee to rely on the promise and if the promisee did actually rely on the promise to his or her detriment" (Black's Legal Dictionary). This approach requires a case-by-case analysis, and any actions to modify the pension plan must be permissible under the state and federal contract clauses.

Issue Bonds to Plug the Unfunded Liability

Some state and local governments have opted to issue bonds ("pension obligation bonds" or POBs), using the proceeds to fund current year contributions and/or reduce the pension system's unfunded liability. Such bonds are typically backed by the general obligation or appropriation of the issuing entity. Because pension funding is not a qualified purpose to issue tax-exempt bonds, POBs are taxable. The largest such issue was the State of Illinois' issuance of $10bn of POBs in 2003, which includes the $7.65bn of 5.10% due 2033. The entity that issues POBs is effectively assuming it will be able to earn a higher return on the bond proceeds than the cost of borrowing. The use of POBs also reduces the financial flexibility for the issuer. In tough economic times it is relatively easy to skip a pension contribution, while skipping a debt service payment would have very serious financial and political consequences.

Funding Pension Shortfall with POBs Would Result in 4-5% of State and Local Tax Revenues Being Devoted to POB Debt Service

To put the state and local government unfunded liability in context, we estimated what would happen if the unfunded liability were funded entirely with pension obligation bonds. To be clear, we do not expect many entities to pursue this avenue, but we find it helpful in putting things in context. Using the approximately $700bn unfunded pension liability reported by the states, and assuming a tenor of 30 years and an interest rate of 6.00%7.50% (~T+170-320bp), we estimate annual debt service on the POBs would equal approximately 7%-8% of total state tax revenues, or 4%-5% of aggregate state and local

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tax revenues. Of course, these figures are an average, across all 50 states, and do not reflect the fact that some states' pension systems are in better/worse position that others'.

Move from Defined Benefit Plans to Defined Contribution or Hybrid Plans

Some states have moved away from defined benefit (DB) plans, and instead are requiring employees to participate in a defined contribution (DC) or hybrid plan (combination of a DB and a DC plan). Six states now require employees to join a DC or hybrid plan (Alaska, Georgia, Indiana, Michigan, Oregon, and Utah), while six states offer employees a choice between DC and DB plans (Colorado, Florida, Montana, Ohio, South Carolina, and Washington). Although there may be an increase in the number of states moving away from DB plans to DC and/or hybrid plans, it is important to note that new DC and hybrid plans address retirement costs associated only with new employees. A move to DC and hybrid plans does not address the unfunded pension liabilities currently reported by state and local governments.

DC Plans Shift Risk from Employers (State and Local Governments) to Employees

DC plans shift responsibility and risk from the employer (i.e., state and local governments, and thus, taxpayers) to the employee. With a DC plan, the employee typically decides how much to contribute, how to allocate the assets in the plan, and when to withdraw the assets. That is in contrast to a DB plan, in which the employer determines the contribution rates, manages the investments and pays an annuity to the employee upon retirement. The characteristics of DC plans may be attractive to state and local governments looking to reduce the risk to taxpayers of shortfalls in DB plans (i.e., taxes will have to increase to cover funding shortfalls produced by less-than-expected investment returns). The benefit of shifting risk away from taxpayers to employees, however, is at least partially offset by the higher administrative costs associated with DC plans and the ability of DB plans to attract and retain employees. The human resource benefit, however, may be declining. In its move from a DB plan to a hybrid plan, Georgia indicated the move was partially because younger workers prefer wages over benefits. Moreover, with the DC component of a hybrid plan, the young, mobile workers will have something to take with them should they leave state employment.

State-by-State Analysis

The ten plans we modeled exhibit a variety of fiscal health, with funded ratios ranging from a low of 31% (Illinois SERS) to a high of 63% (CalSTRS and Massachusetts SERS). Similarly, net assets-to-annual benefits ratios range from 7x (Illinois SERS) to 15x (CalPERS).

California

California's pension plans are in the strongest financial position of the four. Assuming investment returns of 6-8% and absent any actions to increase contributions or reduce benefits, we estimate that CalSTRS would be the first California pension plan to go insolvent, in the early 2030s.

Illinois

By most measures, Illinois' pension plans are the most underfunded and at risk of exhausting their assets. Assuming investment returns of 6-8% and absent any actions to increase contributions or reduce benefits, we estimate that the Illinois SURS would be the first Illinois pension plan to go insolvent, in the mid-2020s. Although the state has recently enacted pension reform, that affects only those employees beginning employment in 2011

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and beyond. An expected increase in state contributions to the pension funds will continue to put pressure on the budget. We estimate pension contributions and debt service on pension obligation bonds will account for more than 20% of the state's FY12 general funds' tax revenues.

Massachusetts

Massachusetts's plans are in better fiscal shape than those in Illinois and New Jersey. Assuming investment returns of 6-8% and absent any actions to increase contributions or reduce benefits, we estimate that Massachusetts SERS would be the first Massachusetts pension plan to go insolvent, in the late 2020s or early 2030s.

New Jersey

Assuming investment returns of 6-8% and absent any actions to increase contributions or reduce benefits, we estimate that the New Jersey TPAF would be the first New Jersey state plan to go insolvent in the early to mid-2020s. The state has significantly reduced its contributions in recent years, and we have assumed that trend continues. It has, however, indicated that it will gradually increase its pension contributions over the next several years.

California Pension Funds

Description of Funds

The State of California has two component units that administer pension and other employee benefit trust funds: The California Public Employees' Retirement System (CalPERS) and the California State Teachers' Retirement System (CalSTRS). CalPERS is the largest public pension fund in the U.S. and administers pension and health benefit plans for state employees, non-teaching school employees, and employees of California public agencies. It comprises 15 funds, including four defined benefit retirement plans: the Public Employees' Retirement Fund (PERF), the Legislators' Retirement Fund (LRF), the Judges' Retirement Fund (JRF), and the Judges' Retirement Fund II (JRF II); three defined contribution retirement plans; one defined benefit post-employment health care plan; one health care plan; and six other plans. The PERF, JRF, and JRF II are multiple-employer defined benefit pension plans. The LRF is a single-employer defined benefit plan. As of June 30, 2010, the four had approximately 806,000 active members, 443,000 retirees, and 64,000 survivors and beneficiaries. At June 30, 2010, the State of California and 1,543 public agencies and schools (representing more than 2,600 entities) contributed to these plans. The plan uses the entry age normal cost method and assumes an annual investment return of 7.75%. In March 2011, the board recently voted to keep that rate despite a recommendation from staff of CalPERS to lower the discount rate assumption to 7.5%.

-

We model only the PERF defined benefit plan, which is the largest component of CalPERS (~99.8% of members).

CalSTRS administers retirement, disability, and survivor benefits for California's 852,000 public school educators and their beneficiaries, from pre-kindergarten through community college, with the state and 1,604 employers contributing to the plan as of June 30, 2010. It comprises the State Teachers' Retirement Plan (STRP), Pension2 Program (IRC 403(b) and 457 Plans), Teachers' Health Benefits Fund (THBF), and Teachers' Deferred Compensation Fund (TDCF). The STRP comprises four programs: Defined Benefit Program (DB), Defined

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Benefit Supplement Program (DBS), Cash Balance Benefit Program (CB), and the Replacement Benefit Program (RBP).

-

We model only the defined benefit plan for CalSTRS (CalSTRS-DB), which is a costsharing multiple-employer pension plan. It uses the entry age normal cost method and assumes an annual investment return of 8.0%.

Key Takeaways

Funding ratios declined from ~100% in FY07 to 61% in FY09 (Figure 12): Funding ratios for PERF and CalSTRS-DB declined, largely as a result of investment losses. It increased to 63% for CalSTRS-DB in FY10 (the FY10 funding ratio is not yet available for CA-PERF). The combined unfunded pension liability increased from -$3bn (overfunded) in FY07 to $188bn in FY09 (Figure 14): Fund assets decreased significantly from FY07 to FY09, while liabilities increased, resulting in increased unfunded pension liabilities. PERF's pension assets decreased significantly as a result of investment losses totalling $71bn for FY08 and FY09. For FY10, its realized net investment income of $25.6bn. CalSTRS-DB assets decreased significantly as a result of investment losses, and liabilities increased as a result of increasing benefit payments (by 8.6% and 9.9% y/y in FY08 and FY09, respectively). As of FY10, net assets to annual benefits was 15.5x and 13.5x for CA-PERF and CalSTRS-DB, respectively (Figure 13): Assuming no future contributions or investment earnings and no growth in annual benefits, these ratios suggest that the pension plans could continue to pay benefits for the next 15 and 13 years, respectively. Insolvency estimates: We have estimated when PERF and CalSTRS-DB would go insolvent under various scenarios. Key assumptions can be found in Appendix B (Figure 37).

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CA-PERF: Using our baseline assumptions of 5.85% investment return and contributions of 16% of payroll by the state and other employers and assuming that the state does not increase contribution rates or modify pension benefits, we estimate CA-PERF would go insolvent in FY36. If investment returns are 9%, we estimate the insolvency date to extend to FY51 (Figure 15). CalSTRS-DB: Using our baseline assumptions of 6.37% investment return and contributions of 12.5% of payroll by the state and other employers and assuming the state does not increase contribution rates or modify pension benefits, we estimate CalSTRS-DB would go insolvent in FY31. If investment returns are 9%, we estimate the insolvency date extends to FY38 (Figure 16).

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Steps the State Can Take

Reforms in 2010: California enacted cost-cutting reforms in 2010 that included higher contributions for current employees (increasing from 2% to 5% of pay for most employees, depending on bargaining unit and employee classification). They also included changes for new hires, such as raising the retirement age for most employees from 55 to 60, increasing the final average salary period to three years from one year, and changing the benefit formula for state public safety employees. Increasing contributions: Using our model assumptions (Appendix B, Figure 37), we calculate how much contributions would need to increase so that plans remain solvent beyond FY52. These can come from the state, other employers, or employees.

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-

Under a 6% investment return scenario, CA-PERF and CalSTRS-DB would need to increase contributions (as a percentage of payroll) 18% and 22%, respectively. For FY11, this represents an additional $13.8bn in contributions, or approximately 14.8% of estimated FY11 state general fund revenues. Under an 8% investment return scenario, CA-PERF and CalSTRS-DB would need to increase contributions (as a percentage of payroll) 7% and 13%, respectively. For FY11 this represents an additional $6.6bn in contributions or approximately 7.1% of estimated FY11 state general fund revenues.

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Governor Brown's pension reform proposals: In late March, Governor Jerry Brown outlined several pension reform proposals, including imposing a benefit cap, limiting post-retirement public employment, providing hybrid defined contribution/benefit options, stopping pension spiking and abuse (gimmicks used to inflate final average salary), renegotiating benefit amounts for new employees, stopping retroactive pension increases, increasing employee contributions, prohibiting pension holidays (reducing or temporarily stopping contributions into pension plans when investment returns are high), and improving retirement board governance. An update on the proposal's status has not been provided.

Figure 12: Funded Ratio

120% 100% 80% 60% 40% 20% 0% FY05

Figure 13: Net Assets to Total Annual Benefits

30x 25x 20x 15x 10x 5x 0x

FY06

FY07

FY08 CalSTRS-DB

FY09

FY06

FY07 CA-PERF

FY08

FY09

FY10

CA-PERF

Source: Pension Fund CAFRs, Barclays Capital

CalSTRS-DB

Source: Pension Fund CAFRs, Barclays Capital

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Figure 14: Unfunded Liability ($mn)

200,000 150,000 100,000 50,000 0 -50,000 FY05 FY06 FY07 FY08 FY09

Figure 15: CA-PERF: Insolvency Date Sensitivity Analysis

Investment Return 5.0% State & Other Employer Contributions as % of Payroll 0.0% 12.0% 16.0% 20.0% 24.0% FY26 FY32 FY34 FY37 FY40 6.0% FY28 FY34 FY37 FY40 FY43 7.0% FY29 FY36 FY40 FY43 FY48 8.0% FY31 FY40 FY44 FY49 NA 9.0% FY33 FY45 FY51 NA NA

NA = Projected to remain solvent through FY52 (end of estimation period)

CA-PERF

Source: Pension Fund CAFRs, Barclays Capital

CalSTRS-DB

Base Case Assumptions State and Other Employer Contributions: 16.00% Investment Return: 5.85%

Source: Barclays Capital

Figure 16: CalSTRS-DB: Insolvency Date Sensitivity Analysis

Investment Return 5.0% State & Other Employer Contributions as % of Payroll 0.0% 10.0% 12.5% 15.0% 20.0% FY24 FY27 FY29 FY30 FY33 6.0% FY24 FY29 FY30 FY32 FY35 7.0% FY25 FY30 FY32 FY34 FY39 8.0% FY27 FY33 FY35 FY37 FY43 9.0% FY28 FY36 FY38 FY41 FY50

NA = Projected to remain solvent through FY52 (end of estimation period)

Base Case Assumptions State and Other Employer Contributions: 12.50% Investment Return: 6.37%

Source: Barclays Capital

Illinois Pension Funds

The State of Illinois administers five pension systems, the largest being the State Employees' Retirement System (SERS), State Universities Retirement System (SURS), and Teachers' Retirement System (TRS). In 1994, Illinois enacted a funding plan for its pension systems, requiring it to make contributions so that by the end of FY45, the ratio of actuarial value of assets to actuarial accrued liabilities would be 90%. All three pension systems use the projected unit credit actuarial cost method. In FY03, FY10, and FY11 the state issued bonds of $10bn, $3.5bn, and $3.7bn, respectively, to make its pension contribution and reduce unfunded liabilities. For FY12, the governor's proposed budget assumes a $4.6bn state pension contribution payment. These contributions, combined with debt service on pension bonds of approximately $6.2bn, account for 21% of the governor's FY12 budget proposal's general funds' tax receipts of $29.5bn. SERS is a single employer retirement system, administered by the state, with more than 64,000 active state employees and 58,000 benefit recipients. Membership is automatic

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for most state employees who are not eligible for another state-sponsored retirement plan. Contributions are 4% of salary for members covered by Social Security and 8% for those not covered. Total contributions as a percent of payroll were 32.6% for FY10, with 27% coming from the state. In FY10, the system changed its assumed investment return and, thus, the discount rate, from 8.5% to 7.75%. SURS is a cost sharing, multi-employer retirement system, which serves 193,769 members in its defined benefit plan and 18,467 members in its self-managed plan. We model only the former, which contains 94% of total assets. Contributions for FY10 were 27.8% of payroll, with 19.9% coming from the state. The employer contributions for FY12 and beyond should be approximately 24% of payroll, as required by the funding plan. Even with the state funding plan, the projected deficit of contributions compared with expenditures will continue, forcing SURS to continue to liquidate investments of $500-700mn annually in order to pay current benefits. SURS is the sole source of retirement income for its participants, as they are not eligible to receive Social Security upon retirement. In FY10, the system changed its discount rate from 8.5% to 7.75%. The 10y and 22y average returns for the system were 2.9% and 8.1%, respectively. TRS is the administrator of a cost-sharing multi-employer defined benefit retirement system with 372,251 members, of which 170,275 are active employees and 201,976 retirees and inactive members entitled but not yet receiving benefits. It provides retirement, disability and death benefits to teachers employed by Illinois public elementary and secondary schools outside Chicago. Total contributions as a percent of payroll were 34% in FY10, with 22% coming from the state. The system's discount rate was 8.5% as of FY10.

Key Takeaways

Illinois state pension plan funding ratios are among the lowest among states at 3141%, as of FY09 (Figure 17): Funding ratios for Illinois pension plans declined consecutively from FY07 to FY09 as asset valuations fell 31% over the two-year period as a result of poor market performance. In FY10, we saw these valuations bounce back approximately 10%, but funding ratios continued to decline for both SURS and SERS to 40% and 31%, respectively. Declines were primarily due to an increase in liabilities as the discount rate was decreased from 8.5% to 7.75%. The funded ratio for TRS increased from 39% to 41% for FY09 compared to FY10. TRS did not change its discount rate of 8.5%. The combined unfunded pension liability has doubled from $40bn in FY07 to more than $80bn as of FY09 (Figure 19): Over the past five years assets have not kept pace with benefit growth. Since FY06, net assets, on average for the combined plans, have fallen 3.1% per year, while annual benefits have grown 6.0% per year. The number of retirees has grown 2.6% per year, and the benefits per employee have increased 3.3% per year. Net assets to annual benefit ratios have declined considerably, from 10-14x in FY07 to 6-8x as of FY09 (Figure 18): For FY10, it was 6.6x, 8.0x, and 8.2x for SERS, TRS, and SURS, respectively. Assuming no future cash inflows into these pension plans (e.g., contributions and investment earnings) and no growth in annual benefits, these ratios suggest that the pension plans could continue to pay benefits for 6 to 8 years. Insolvency estimates: We have estimated when SERS, TRS and SURS would go insolvent. Key assumptions can be found in Appendix B (Figure 37).

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-

SERS: Using our baseline assumptions of 6.65% investment returns and an annual state contribution equal to the statutorily required contribution and assuming the state does not increase contribution rates or modify pension benefits, we estimate SERS would go insolvent in FY41. If investment returns are 9%, we estimate the system would not go insolvent before FY52. (Figure 20) TRS: Using our baseline assumptions of 7.60% investment returns and an annual state contribution equal to the statutorily required contribution and assuming the state does not increase contribution rates or modify pension benefits, we estimate TRS would go insolvent in FY38. If the investment returns are 9%, we estimate the insolvency date would extend to FY42. (Figure 21) SURS: Using our baseline assumptions of 6.51% investment returns and an annual state contribution equal to the statutorily required contribution and assuming the state does not increase contribution rates or modify pension benefits, we estimate SURS would go insolvent in FY25. If the investment returns were 9%, we estimate the insolvency date would extend to FY27. (Figure 22)

-

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Steps the State Can Take and Has Taken

Reduce benefits for new hires: Illinois took steps in 2010 to reduce its pension obligation by making changes to benefits for new hires beginning January 2011. It extended the retirement age from 62 to 67 for those with 10 years of service and extended the early retirement age from 55 to 62 for those with 10 years of service; increased the minimum vesting period from five years to 10; and capped the maximum salary for the pension calculation to $106,800 plus an inflation assumption. Borrow to close unfunded pension liabilities and/or fund annual contributions: In FY03, Illinois issued $10bn in general obligation bonds to narrow the pension unfunded liabilities gap. This is the largest pension bond offering issued. At the time, Illinois had a $34.9bn actuarial unfunded pension liability. The state is effectively assuming it will be able to earn a higher return on the bond proceeds than the cost of borrowing. In FY10 and FY11, it issued general obligation bonds of $3.5bn and $3.7bn, respectively, to make its annual pension contribution. Increase state contributions to reduce unfunded pension liabilities: Using our model assumptions (Appendix B, Figure 37), we calculated how much contributions would have to increase so that the plans remain solvent beyond FY52.

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Under a 6% investment return scenario, SERS, TRS and SURS would require an annual contribution above the statutorily required contribution, of 25%, 69% and 180%, respectively. For FY12, this represents an additional $3.0bn, or approximately 10.4% of the state's estimated FY12 general funds' revenues. Importantly, the increased contributions would not have to come solely from the state. Rather, local governments and/or employees could be asked to increase their contributions. Under an 8% investment return scenario, SERS, TRS, and SURS would require an annual contribution above the statutorily required contribution per year of 7.5%, 41%, and 140%, respectively. For FY12, this represents an additional $2.0bn, or approximately 6.8% of the state's estimated FY12 general funds' revenues.

-

Shift to a defined contribution plan: In March a bill was introduced in the Illinois House looking to offer participants and new hires a one-time option to choose between the

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

traditional benefit package or a self-managed plan (if made available by the participant's employer). The outcome of this bill is still pending. Make changes to future benefits for current employees: It is unclear if the state can legally reduce future pension benefits for current employees. The debate centers on the state's constitution pension clause. Some have argued that this protects only previously earned benefits. Others, however, suggest it protects both accrued and future benefits. See the further discussion in Municipal Credit Monthly: December 2010, page 13.

Figure 17: Funded Ratio

80% 70% 60% 50% 40% 30% 20% 10% 0% FY06 FY07 IL-SERS

Source: Pension Fund CAFR

Figure 18: Net Assets to Total Annual Benefits

16x 14x 12x 10x 8x 6x 4x 2x 0x FY08 IL-TRS FY09 IL-SURS

Source: Pension Fund CAFR

FY10

FY06

FY07 IL-SERS

FY08 IL-TRS

FY09 IL-SURS

FY10

Figure 19: Unfunded Liability ($mn)

90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 FY06 FY07 IL-SERS FY08 IL-TRS FY09 IL-SURS FY10

Figure 20: IL-SERS Insolvency Date Sensitivity Analysis

Investment Return 5.0% 0.0% % of Statutorily 25.0% Req'd 50.0% Contribution 75.0% Actually Contributed 100.0% FY18 FY19 FY22 FY26 FY34 6.0% FY18 FY20 FY23 FY28 FY37 7.0% FY18 FY20 FY23 FY29 FY41 8.0% FY19 FY21 FY24 FY31 FY46 9.0% FY19 FY21 FY26 FY34 NA

NA = Projected to remain solvent through FY52 (end of estimation period)

Base Case Assumptions State and Other Employer Contributions: 100.00% Investment Return: 6.65%

Source: Pension Fund CAFRs, Barclays Capital

Source: Pension Fund CAFRs; Barclays Capital

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

Figure 21: IL-TRS: Insolvency Date Sensitivity Analysis

Figure 22: IL-SURS: Insolvency Date Sensitivity Analysis

Investment Return 5.0% % of Statutorily Req'd Contribution Actually Contributed 0.0% 25.0% 50.5% 75.0% 100.0% FY20 FY22 FY24 FY27 FY31 6.0% FY20 FY22 FY24 FY28 FY33 7.0% FY21 FY23 FY25 FY29 FY35 8.0% FY22 FY24 FY27 FY31 FY38 9.0% FY22 FY25 FY28 FY33 FY42 % of Statutorily Req'd Contribution Actually Contributed 0.0% 25.0% 50.0% 75.0% 100.0% 5.0% FY18 FY19 FY20 FY22 FY23

Investment Return 6.0% FY18 FY19 FY21 FY22 FY24 7.0% FY19 FY20 FY21 FY23 FY25 8.0% FY19 FY20 FY22 FY24 FY26 9.0% FY20 FY21 FY22 FY25 FY27

NA = Projected to remain solvent through FY52 (end of estimation period)

NA = Projected to remain solvent through FY52 (end of estimation period)

Base Case Assumptions State and Other Employer Contributions: 100.00% Investment Return: 7.60%

Source: Barclays Capital

Base Case Assumptions State and Other Employer Contributions: 100.00% Investment Return: 6.51%

Source: Barclays Capital

Massachusetts Pension Funds

The Commonwealth of Massachusetts is statutorily responsible for pension benefits of the Massachusetts Teachers' Retirement System (MTRS) and the State Employees' Retirement System (SERS). In addition, it is financially responsible for the cost of living adjustment (COLA) granted to participants in various retirement systems of cities, town and counties for fiscal years 1981-97, with a total actuarial accrued liability of $302mn. The members of the retirement systems do not participate in the Social Security system. The law requires annual contributions such that the unfunded actuarial liability is reduced to zero by June 30, 2025. Under the current schedule, amortization payments to eliminate the unfunded liability increase 4.5% per year. The actuarial valuation uses the entry age normal cost method and an 8.25% discount rate for both systems. SERS is a single-employer defined benefit public employee retirement system with 82,779 active members, 26,169 inactive members, and 54,465 retired members as of December 31, 2009. TRS is a defined benefit public employee retirement system managed by the Commonwealth with 88,673 and 53,951 retired members as of December 31, 2009. The Commonwealth is a non-employer contributor and is responsible for all the contributions and future benefit requirements of the MTRS.

Key Takeaways

Funding ratios for Massachusetts' pension plans declined significantly from FY07 to FY09 (Figure 23): Due to poor market performance and increasing benefit payments. SERS's funding ratio declined from 98% in FY07 to 63% in FY09. TRS's declined from 82% in FY07 to 52% in FY09. The combined unfunded liability has more than quadrupled from $6bn in FY07 to $25bn as of FY09 (Figure 25): As of FY09, it is $15.8bn for TRS and $8.9bn for SERS. For FY10, net assets-to-annual benefits were 12.5x and 9.2x for SERS and TRS, respectively (Figure 24): Assuming no future contributions or investment earnings and no growth in annual benefits, these ratios suggest that the pension plans could continue to pay benefits for 12 and 9 years, respectively

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

Insolvency estimates: We have estimated when SERS and TRS would go insolvent. Key assumptions can be found in Appendix B (Figure 37).

-

SERS: Using our baseline assumptions of 6.36% investment return and contributions of 9.1% of payroll by the state and assuming the state does not increase contribution rates or modify pension benefits, we estimate SERS would go insolvent in FY29. If investment returns are 9%, we estimate the insolvency date would extend to FY34 (Figure 26). TRS: Using our baseline assumptions of 6.35% investment return and contributions of 17% of payroll by the state and assuming the state does not increase contribution rates or modify pension benefits, we estimate TRS would go insolvent in FY31. If investment returns are 9%, we estimate the insolvency date would extend to FY40 (Figure 27).

-

The Commonwealth is responsible for all contributions and future benefit requirements for Boston teachers who are members of the State Boston Retirement System (SBRS), ~30% of the total: On May 22, 2010, the governor signed Chapter 112 of the Acts of 2010, which clarified this responsibility. With this adjustment, the overall Commonwealth unfunded liability would increase approximately $127mn. This change will be reflected in the January 1, 2011, actuarial valuation.

Steps the State Can Take

Increasing contributions to extend solvency: Using our model assumptions (Appendix B, Figure 37), we calculate how much contributions would need to increase so that plans remain solvent through FY52. These contributions can come from the state or employees.

-

Under a 6% investment return scenario, MA-SERS and MA-TRS would need to increase contributions (as a percentage of payroll) 42% and 16%, respectively. For FY11, this represents an additional $2.8bn, or approximately 15.3% of estimated FY10 state general fund revenues. Under an 8% investment return scenario, MA-SERS and MA-TRS would need to increase contributions (as a percentage of payroll) 27% and 9%, respectively. For FY11, this represents an additional $1.8bn or approximately 9.4% of estimated FY10 state general fund revenues.

-

Proposed pension reforms: The governor and legislative leaders have proposed extensive changes to Massachusetts public defined benefit pension plans, embodied in House Bill 35. These include increasing the retirement age for almost all state workers (new employees), eliminating early retirement subsidies, pro-rating benefits based on employment history, introduce an anti-spiking rule, and eliminating "double dipping" (e.g., the right to receive a pension while receiving compensation for service as an elected official). Limit collective bargaining for health benefits: A bill that would allow local officials to set health insurance co-payments and deductibles for their employees passed in the Massachusetts House of Representative passed in late April 2011. This is still pending approval by the Senate. Separately, as part of the FY11 General Appropriations Act, all active employees in Massachusetts will pay an additional 5% of insurance premium costs.

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Figure 23: Funded Ratio

120% 100% 80% 60% 40% 20% 0% FY06

Figure 24: Net Assets to Total Annual Benefits

25x 20x 15x 10x 5x 0x

FY07 MA-SERS

FY08 MA-TRS

FY09

FY06

FY07

FY08

FY09 MA-TRS

FY10

MA-SERS

Source: Pension Fund CAFRs, Barclays Capital

Source: Pension Fund CAFRs, Barclays Capital

Figure 25: Unfunded Liability ($mn)

30,000 25,000 20,000 15,000 10,000 5,000 0 FY06 FY07 MA-SERS

Source: Pension Fund CAFR

Figure 26: MA-SERS Insolvency Date Sensitivity Analysis

Investment Return 5.0% 0.0% State Contributions as % of Payroll 10.0% 12.5% 15.0% 20.0% FY24 FY25 FY26 FY27 FY28 6.0% FY25 FY26 FY27 FY28 FY30 7.0% FY26 FY27 FY28 FY30 FY31 8.0% FY27 FY28 FY30 FY31 FY33 9.0% FY28 FY30 FY32 FY34 FY36

NA = Projected to remain solvent through FY52 (end of estimation period)

FY08 MA-TRS

FY09

Base Case Assumptions State and Other Employer Contributions: 9.10% Investment Return: 6.36%

Figure 27: MA-TRS Insolvency Date Sensitivity Analysis

Investment Return 5.0% 0.0% State Contributions as % of Payroll 25.0% 50.0% 75.0% 100.0% FY21 FY25 FY28 FY29 FY30 6.0% FY22 FY26 FY29 FY31 FY32 7.0% FY23 FY27 FY31 FY33 FY35 8.0% FY23 FY29 FY33 FY36 FY39 9.0% FY24 FY31 FY37 FY40 FY44

NA = Projected to remain solvent through FY52 (end of estimation period)

Base Case Assumptions State and Other Employer Contributions: 17% Investment Return: 6.35%

Source: Barclays Capital

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

New Jersey Pension Funds

The State of New Jersey manages and invests certain assets for seven defined benefit plans. We model three of these: State of New Jersey Teachers' Pension and Annuity Fund (TPAF), State of New Jersey Police and Firemen Retirement System (PFRS) and State of New Jersey Public Employees Retirement System (PERS). According to the State of New Jersey Administrative Code, all obligations of these systems will be assumed by the state should the funds terminate. The funds use an 8.25% discount rate, and the projected unit credit as the actuarial cost method. The State of New Jersey did not make its contribution for FY10 and made reduced contributions for FY08 and FY09. For FY12, it has committed to making a contribution equal to one-seventh of the actuarially required amount. The FY12 budget contains a $506mn payment for pensions. In his FY12 budget, Governor Christie proposes that the discount rate be lowered from 8.25% to 7.5%. TPAF is a cost-sharing contributory defined benefit plan. It contains 235,891 members, with 157,109 active members and 78,782 retired or terminated employees entitled to benefits but not yet receiving them. PFRS is a cost-sharing multiple employer contributory defined benefit plan. The system contains 45,150 active members and 34,364 retirees. PERS is a cost-sharing multiple employer contributory defined benefit plan. It contains approximately 1,700 participating employers, made of up county agencies (65), municipalities (584), school districts (566), other public agencies (484) and the State of New Jersey. The system contains 316,849 active members and 138,619 retirees.

Key Takeaways

Combined funded ratios declined from 70% in FY06 to 51% in FY10 (Figure 28) Asset growth has not kept up with benefit growth over the past five years. TPAF's funded ratio has declined the most since FY06, falling from 66% to 45% in FY10. It also has the lowest funded ratio of the three plans. On average, assets have declined 1.4% per year since 2006, while liabilities have grown 5.1% per year. Average benefit paid per employee has grown 3.2% per year, with total retirees growing at a 2.0% pace per year since 2006. The combined unfunded liability has more than doubled from $32bn in FY06 to $68bn in FY10 (Figure 30): The state has underfunded its pension plans for the past three years, making 27.8%, 5.3%, and 1.2% of its required contribution for FY08, FY09, and FY10, respectively, for the combined plans. Net asset-to-benefit ratios have declined from 14-16x to 9-13x (Figure 29): For FY10, it was 9.9x, 8.6x, and 12.6x for PERS, TPAF, and PFRS, respectively. Assuming that no future cash inflows into these pension plans (e.g., contributions and investment earnings) and no growth in annual benefits, these ratios suggest that the pension plans could continue to pay benefits for 9-13 years. Insolvency estimates: We have estimated when PERS, TPAF and PFRS would go insolvent. Key assumptions can be found in Appendix B (Figure 37).

-

PERS: Using our baseline assumptions of 5.57% investment returns and state and other employer annual contributions of 7.5% as a percent of payroll and assuming the state does not increase contribution rates or modify pension benefits, we

30

18 May 2011

Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

estimate PERS would go insolvent in FY30. If the state and employer annual contributions as a percent of payroll were doubled to 15%, and keeping the same investment return of 5.57%, we estimate the system would not go insolvent before FY52 (Figure 31).

-

TPAF: Using our baseline assumptions of 5.77% investment returns and state and other employer contributions of 1% as a percent of payroll and assuming the state does not increase contribution rates or modify pension benefits, we estimate TPAF would go insolvent in FY21. If the state and other employer contribution rate as a percent of payroll were increased to 15% and the investment returns were increased to 7%, we estimate an insolvency date of FY31 (Figure 32). PFRS: According to our baseline assumptions of 5.76% investment returns and state and other employer contributions of 25% of payroll and assuming the state does not increase contribution rates or modify pension benefits, we estimate PFRS would go insolvent in FY35. If the state and other employer contribution rate as a percent of payroll were increased to 35% and the investment returns were increased to 8%, we estimate the system would not go insolvent before FY52 (Figure 33).

-

Steps the State Can Take and Has Taken

Change benefits for new hires: In 2010, the membership eligibility criteria were changed for new members of all three plans from the amount of annual compensation to the number of hours worked weekly. TPAF and PERS also changed the benefit multiplier for new members to 1/60 from 1/55 and required that new members have the retirement allowance calculated using the average annual compensation for the past five years of service instead of three years. Change benefits for current members: Christie has proposed a pension reform designed to increase the system's aggregate funded ratio to more than 90% by FY41. The plan would roll back a 9% benefit increase enacted in 2001, raise the minimum retirement age, increase worker contributions and freeze cost of living raises to reduce the $68bn pension gap. In addition, employee contributions to health benefits would gradually increase over a three-year period, beginning with 10% this July and growing to 30% by July 2014. Current pension proposals are still under discussion; we expect an update in June as discussions between Republicans and Democrats continue. Issue pension obligation bonds to narrow the unfunded liability gap or make annual contributions. In 1997, New Jersey issued $2.8bn of state pension funding bonds, subject to state appropriations on an annual basis. At the time, the system had a $3.2bn unfunded pension liability, based on actuarial values, and a $1bn unrecognized unfunded liability arising from COLA. The bond proceeds were used to fully fund the unfunded accrued pension liability gap at the time. Split the unfunded liability between employer and employees: The new pension reform proposal, backed by Christie, calls for any increases in benefits that add to the unfunded liability to be split between the employer and the employee. An unfunded liability as a result of the employer not making its full contribution would still be the sole responsibility of the employer. Increase state contributions to reduce unfunded pension liabilities: Using our model assumptions (Appendix B, Figure 37), we calculate New Jersey's pension plans solvency past FY52.

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

-

Under a 6% investment return scenario, PERS, TPAF and PFRS would require an additional state and other employer contribution per year as a percentage of total payroll of 5%, 26.5% and 19%, respectively. For FY12, this represents an additional $5.8bn, or approximately 20% of estimated FY12 state general fund revenues ($29.3bn). Importantly, the increased contributions would not have to come solely from the state. Rather, local governments and or employees could be asked to increase their contributions. Under an 8% investment return scenario, PERS, TPAF and PFRS would require an additional state and other employer contribution per year as a percentage of total payroll of 2.5%, 20% and 8%, respectively. For FY12, this represents an additional $4.4bn, or approximately 15% of estimated FY12 state general fund revenues ($29.3bn). As above, local governments and or employees could be asked to increase their contributions.

-

Figure 28: Funded Ratio

90% 80% 70% 60% 50% 40% 30% 20% 10% 0% FY06 FY07 NJ-PERS

Source: Pension Fund CAFR

Figure 29: Net Assets to Total Annual Benefits

20x 18x 16x 14x 12x 10x 8x 6x 4x 2x 0x FY08 NJ-TPAF FY09 NJ-PFRS FY10 FY05 FY06 NJ-PERS

Source: Pension Fund CAFR

FY07 NJ-TPAF

FY08 NJ-PFRS

FY09

Figure 30: Unfunded Liability ($mn)

80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0 FY05 FY06 NJ-PERS FY07 NJ-TPAF FY08 NJ-PFRS FY09

Figure 31: NJ-PERS: Insolvency Date Sensitivity Analysis

Investment Return 5.0% 0.0% Employer Contribution as a % of Payroll 5.00% 7.50% 10.0% 15.0% FY22 FY26 FY28 FY33 NA 6.0% FY23 FY27 FY30 FY36 NA 7.0% FY24 FY28 FY33 FY45 NA 8.0% FY25 FY31 FY37 NA NA 9.0% FY26 FY34 FY48 NA NA

NA = Projected to remain solvent through FY52 (end of estimation period)

Base Case Assumptions State and Other Employer Contributions: 7.5% Investment Return: 5.57%

Source: Pension Fund CAFRs, Barclays Capital

Source: Pension Fund CAFRs, Barclays Capital

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

Figure 32: NJ-TPAF Insolvency Date Sensitivity Analysis

Figure 33 NJ-PFRS: Insolvency Date Sensitivity Analysis

Investment Return 9.0% 5.0% 0.0% Employer 15.00% Contribution 25.0% as a % of 35.0% Payroll 45.0% FY23 FY28 FY32 FY39 FY48 6.0% FY24 FY29 FY35 FY43 NA 7.0% FY25 FY31 FY38 FY48 NA 8.0% FY26 FY34 FY42 NA NA 9.0% FY28 FY37 FY50 NA NA

Investment Return 5.0% 0.0% Employer Contribution as a % of Payroll 1.00% 5.00% 10.0% 15.0% FY20 FY20 FY22 FY24 FY27 6.0% FY20 FY21 FY22 FY25 FY29 7.0% FY21 FY21 FY23 FY26 FY31 8.0% FY22 FY22 FY24 FY27 FY33

FY22 FY23 FY25 FY29 FY38

NA = Projected to remain solvent through FY52 (end of estimation period)

NA = Projected to remain solvent through FY52 (end of estimation period)

Base Case Assumptions State and Other Employer Contributions: 10.0% Investment Return: 5.77%

Source: Barclays Capital

Base Case Assumptions State and Other Employer Contributions: 25.0% Investment Return: 5.76%

Source: Barclays Capital

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

APPENDIX A: DATA TABLES

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

Figure 34: 2009 Debt and Unfunded Pension Liabilities

Moody's Net Tax Unfunded Combined Support Pension Debt & ed Debt Liability Pension Adjusted ($mn) ($mn) ($mn) Debt/ GSP Alabama Alaska Arizona Arkansas California Colorado Connecticut Delaware Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland Massachusetts Michigan Minnesota Mississippi Missouri Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota Ohio Oklahoma Oregon Pennsylvania Rhode Island South Carolina 18 May 2011 3,749 940 4,857 900 87,320 2,012 17,094 2,203 20,820 11,011 5,176 831 23,957 3,157 219 3,214 7,270 5,708 1,002 9,166 30,371 7,462 5,463 4,364 4,672 349 27 2,446 881 31,951 2,809 61,260 7,175 212 10,766 2,101 7,111 11,827 2,241 4,184 9,229 3,536 9,869 3,686 49,589 17,926 15,859 429 17,611 9,303 5,168 3,213 62,439 1,240 2,636 5,152 14,919 15,851 3,994 17,488 21,534 11,515 13,956 10,262 1,906 2,645 49 1,644 3,538 30,727 6,922 -10,428 504 744 2,905 13,172 10,739 9,924 4,354 12,053 12,977 4,475 14,726 4,587 136,909 19,937 32,952 2,632 38,431 20,314 10,344 4,044 86,396 4,397 2,855 8,366 22,189 21,559 4,997 26,654 51,905 18,977 19,419 14,626 6,579 2,995 76 4,090 4,419 62,678 9,731 50,832 7,678 956 13,671 15,273 17,850 21,751 6,594 16,237 7.60% 9.30% 5.90% 4.70% 7.40% 8.00% 15.20% 4.30% 5.20% 5.10% 16.20% 7.70% 13.60% 1.70% 2.10% 6.80% 14.20% 9.70% 10.10% 9.80% 14.20% 5.00% 7.40% 15.90% 2.80% 8.30% 0.10% 3.10% 7.40% 13.20% 12.20% 4.40% 1.90% 3.10% 2.90% 10.40% 11.10% 3.90% 13.90% 10.40% S&P Unfunded Combined Pension Debt & Liability Pension Adjusted ($mn) ($mn) Debt/ GSP 10,871 5,994 10,293 5,118 94,664 16,938 15,859 430 18 10,342 6,236 3,186 62,439 12,266 5,085 8,279 17,912 15,851 3,943 17,683 23,157 15,420 17,625 10,292 11,448 2,646 1,167 9,132 3,538 45,809 7,322 -4,872 2,546 834 64,318 14,833 8,081 21,331 4,747 13,179 14,211 6,934 15,480 6,288 169,182 18,580 32,540 1,899 24,646 19,458 11,016 3,465 86,736 15,506 7,245 11,337 27,012 20,998 8,889 26,413 49,476 21,740 23,693 16,366 17,087 2,829 1,167 11,256 4,352 75,865 10,250 41,131 9,446 1,103 74,238 16,742 15,208 31,361 6,623 15,379 5.30% 14.90% 6.10% 6.20% 9.00% 7.40% 13.00% 3.20% 3.40% 4.90% 16.80% 6.50% 14.00% 6.00% 5.30% 9.20% 17.50% 10.10% 17.60% 9.30% 13.70% 6.00% 9.20% 17.20% 7.20% 7.90% 1.40% 9.00% 7.40% 15.90% 13.80% 3.80% 2.40% 3.50% 15.90% 10.90% 9.20% 5.70% 19.30% 9.70%

Rank 21 17 27 33 22 19 3 36 30 31 1 20 8 49 45 25 6 16 14 15 5 32 23 2 43 18 50 40 24 9 10 35 47 41 42 12 11 39 7 13

Tax Supported Debt ($mn) 3,340 940 5,187 1,170 74,518 1,642 16,681 1,469 24,628 9,116 4,780 279 24,297 3,240 2,160 3,058 9,100 5,147 4,946 8,730 26,319 6,320 6,068 6,074 5,639 183 0 2,124 814 30,056 2,928 46,003 6,900 269 9,920 1,909 7,127 10,030 1,876 2,200

Rank 35 8 29 28 21 24 12 46 44 38 5 27 9 32 36 20 3 15 2 17 11 31 19 4 26 23 50 22 25 6 10 42 47 43 7 14 18 34 1 16 35

Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

Moody's Net Tax Unfunded Combined Support Pension Debt & Adjusted ed Debt Liability Pension ($mn) ($mn) ($mn) Debt/ GSP South Dakota Tennessee Texas Utah Vermont Virginia Washington West Virginia Wisconsin Wyoming 110 2,004 12,893 2,666 441 7,056 14,833 1,963 9,726 42 609 2,720 15,125 3,481 1,090 10,733 1,894 6,972 253 1,444 718 4,723 28,017 6,146 1,531 17,789 16,727 8,935 9,979 1,486 1.90% 1.90% 2.30% 5.60% 6.00% 4.50% 5.20% 14.50% 4.20% 4.20%

S&P Unfunded Combined Pension Debt & Adjusted Liability Pension ($mn) ($mn) Debt/ GSP 614 3,539 24,696 3,075 1,054 14,012 4,827 6,350 193 1,444 719 5,283 37,585 4,790 1,512 20,956 19,883 8,009 11,433 1,485 1.90% 2.20% 3.30% 4.30% 6.00% 5.20% 5.90% 12.90% 4.80% 4.00%

Rank 46 48 44 28 26 34 29 4 38 37

Tax Supported Debt ($mn) 105 1,744 12,889 1,715 458 6,944 15,056 1,659 11,240 41

Rank 49 48 45 40 30 37 33 13 39 41

Total Average Median

460,010 9,200 4,274

462,120 9,242 5,160

922,130 18,443 11,661 7.30% 6.40%

429,038 8,581 4,863

655,764 13,115 8,180

1,084,802 21,696 15,294 8.50% 7.30%

Source: Moody's, Combining Debt and Pension Liabilities of U.S. States Enhances Comparability (January 26, 2011); S&P, US States' Pension Funded Ratios Drift Downward (March 31, 2011).

Figure 35: FY09, 104 State Pension Plans Summary

Unfunded Liability Using Market Value of Assets (000's) 17,494 6,348 18,072 5,589 195,297 21,752 1,434 39,872 18,415 8,818 3,069 81,675 11,963 8,045 10,923 24,084 18,476 6,100

State Alabama Alaska Arizona Arkansas California Colorado Delaware Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine

Market Value of Assets (MVA) (000's) 23,800 8,818 23,996 15,368 329,588 32,489 5,393 96,503 53,105 8,818 8,663 70,311 7,199 17,974 10,215 21,141 18,351 8,310

Actuarial Accrued Liability (AAL) (000's) 41,294 15,166 42,068 20,957 524,886 54,241 6,827 136,376 71,520 17,636 11,732 151,987 19,163 26,019 21,138 45,225 36,826 14,410

Funded Ratio Market Value (MVA/AAL) 58% 58% 57% 73% 63% 60% 79% 71% 74% 50% 74% 46% 38% 69% 48% 47% 50% 58%

Rank 32 29 33 11 19 25 2 15 9 39 10 47 49 16 44 46 41 31

Unfunded Pension Liability/ Covered Payroll 177% 296% 161% 149% 243% 310% 82% 150% 138% 219% 114% 357% 276% 125% 167% 309% 285% 296%

Net Assets/ Annual Benefits 10.8x 11.2x 10.7x 16.4x 15.4x 11.8x 14.6x 17.0x 14.5x 10.5x 16.7x 10.0x 7.7x 15.2x 10.2x 7.9x 8.2x 11.7x

Lowest Funded Ratio of Individual Plan 56% 52% 53% 63% 61% 58% 79% 71% 67% 50% 74% 34% 38% 69% 48% 35% 49% 54%

Rank 22 32 31 16 17 20 2 11 14 36 8 49 47 13 39 48 38 28

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

State Maryland Massachusetts Michigan Minnesota Mississippi Missouri Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota Ohio Oklahoma Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas Utah Vermont Virginia Washington West Virginia Wisconsin Wyoming Total

Market Value of Assets (MVA) (000's) 27,043 32,701 48,358 30,848 15,134 34,304 5,300 5,266 18,770 4,315 65,671 15,873 183,410 59,782 2,630 124,808 12,626 42,905 67,657 5,996 20,348 5,649 26,369 140,247 14,153 2,160 39,890 43,458 6,803 69,996 4,971 1,937,482

Actuarial Accrued Liability (AAL) (000's) 46,254 58,601 79,453 52,427 30,595 56,288 9,124 8,092 33,075 8,475 131,489 28,792 232,795 75,983 4,347 197,048 28,242 56,748 111,318 12,739 41,714 7,387 35,199 195,064 19,430 3,646 66,323 60,877 13,538 79,105 6,566 3,048,203

Unfunded Liability Using Market Value of Assets (000's) 19,210 25,900 31,095 21,579 15,460 21,984 3,824 2,826 14,305 4,160 65,818 12,918 49,385 16,201 1,717 72,240 15,617 13,843 43,660 6,743 21,366 1,739 8,830 54,817 5,277 1,486 26,433 17,419 6,735 9,108 1,595 1,110,721

Funded Ratio Market Value (MVA/AAL) 58% 56% 61% 59% 49% 61% 58% 65% 57% 51% 50% 55% 79% 79% 60% 63% 45% 76% 61% 47% 49% 76% 75% 72% 73% 59% 60% 71% 50% 88% 76% 64%

Rank 28 35 21 27 42 20 30 17 34 37 40 36 3 4 23 18 48 7 22 45 43 5 8 13 12 26 24 14 38 1 6

Unfunded Pension Liability/ Covered Payroll 199% 253% 235% 199% 265% 231% 227% 191% 240% 170% 259% 277% 120% 88% 151% 258% 282% 163% 237% 355% 242% 120% 106% 105% 133% 154% 177% 109% 243% 72% 94% 196%

Net Assets/ Annual Benefits 12.7x 9.7x 10.6x 11.5x 10.3x 13.3x 13.0x 17.8x 14.1x 9.5x 9.9x 13.1x 15.1x 15.6x 14.3x 13.9x 9.8x 15.4x 9.8x 10.3x 10.3x 18.4x 24.3x 15.6x 23.6x 13.5x 15.2x 17.1x 9.6x 18.4x 17.8x 13.5x

Lowest Funded Ratio of Individual Plan 55% 51% 60% 39% 49% 39% 53% 65% 54% 51% 46% 51% 75% 78% 54% 55% 39% 76% 57% 45% 48% 76% 72% 69% 73% 54% 60% 54% 41% 88% 76%

Rank 23 33 18 46 37 45 30 15 27 35 41 34 7 3 29 24 44 6 21 42 40 4 10 12 9 25 19 26 43 1 5

Source: Center for Retirement Research, Boston College; Barclays Capital

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APPENDIX B: PUBLIC PENSION PLAN SUMMARY

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Figure 36: Public Pension Plan Summary for Top 50 States by Market Value of Assets

Assets and Liabilities Funded Ratios Unfunded Liability Unfunded Accrued Using Actuarial Liability Market Value of Assets (UAAL) 49,078 115,142 40,541 67,253 35,001 44,529 36,538 41,345 17,611 39,872 21,645 39,376 15,739 32,525 (1,302) 30,894 19,738 29,537 13,138 26,433 11,982 22,187 15,612 21,928 11,967 19,333 18,926 18,925 14,298 16,820 12,477 16,429 9,997 15,460 12,034 15,283 7,234 14,471 7,196 14,410 9,463 14,353 10,567 14,002 4,927 13,970 8,919 13,843 (2,744) 13,590 13,163 824 2,362 12,902 2,360 12,756 9,358 12,110 11,133 11,963 8,514 11,885 9,339 11,589 9,512 11,499 6,955 11,416 5,592 11,135 6,929 11,095 7,677 10,923 5,843 9,472 5,232 9,281 193 9,108 6,236 8,818 5,641 8,683 6,594 8,365 4,895 8,045 6,036 7,359 4,140 7,307 2,720 7,106 2,682 7,094 6,887 5,487 4,517 6,770 654,846 1,156,739 Mkt. Value of Assets / Benefit Payments 15.1x 14.3x 8.2x 11.7x 17.0x 14.0x 9.3x 16.1x 8.7x 15.2x 10.5x 9.8x 10.1x 15.7x 7.3x 8.6x 10.3x 8.0x 13.1x 10.5x 12.4x 12.6x 15.3x 15.4x 14.3x 16.8x 25.2x 14.7x 11.8x 7.7x 9.2x 7.7x 8.5x 10.7x 10.9x 13.3x 10.2x 11.5x 10.0x 18.4x 10.5x 11.7x 11.0x 15.2x 4.7x 8.9x 23.7x 13.4x 9.2x 11.6x 13.1x Actuarially Required Contribution (ARC) 6,912 4,547 2,109 1,502 2,536 2,141 1,761 1,963 1,601 1,501 989 1,286 828 1,043 1,003 1,106 657 874 670 754 1,048 753 847 631 1,096 1,026 0 472 735 820 600 697 714 754 644 994 674 647 355 699 527 381 481 473 310 284 584 530 492 375 74,625 Asset Allocation Unfunded Liability / Covered Payroll 255% 246% 498% 383% 150% 112% 260% 128% 303% 177% 224% 183% 249% 151% 418% 298% 265% 441% 326% 147% 391% 218% 213% 163% 96% 124% 164% 96% 309% 276% 365% 296% 302% 183% 188% 222% 167% 201% 247% 72% 219% 182% 351% 125% 387% 366% 117% 122% 269% 262% 198%

Name California PERF California Teachers Illinois Teachers Ohio Teachers Florida RS Texas Teachers Pennsylvania School Employees NY State & Local ERS New Jersey Teachers Virginia Retirement System Michigan Public Schools New Jersey PERS South Carolina RS Ohio PERS Illinois SERS Massachusetts Teachers Mississippi PERS Illinois Universities Missouri Teachers Arizona SRS New Jersey Police & Fire Maryland Teachers LA County ERS Oregon PERS New York State Teachers Georgia Teachers University of California North Carolina Teachers and State E Colorado School Indiana Teachers Kentucky Teachers Louisiana Teachers Oklahoma Teachers Alabama Teachers Pennsylvania State ERS Nevada Regular Employees Kansas PERS Massachusetts SERS Minnesota Teachers Wisconsin Retirement System Hawaii ERS Minnesota PERF Colorado State Iowa PERS Kentucky ERS Chicago Teachers TN State and Teachers Texas ERS Louisiana SERS New Mexico Teachers Total (126 State & Local Plans)

FYE 30-Jun-09 30-Jun-09 30-Jun-09 30-Jun-09 30-Jun-09 31-Aug-09 30-Jun-09 31-Mar-09 30-Jun-09 30-Jun-09 30-Sep-09 30-Jun-09 30-Jun-09 31-Dec-09 30-Jun-09 31-Dec-09 30-Jun-09 30-Jun-09 30-Jun-09 30-Jun-09 30-Jun-09 30-Jun-09 30-Jun-09 30-Jun-09 30-Jun-09 30-Jun-09 30-Jun-09 30-Jun-09 31-Dec-09 30-Jun-09 30-Jun-09 30-Jun-09 30-Jun-09 30-Sep-09 31-Dec-09 30-Jun-09 30-Jun-09 31-Dec-09 30-Jun-09 31-Dec-09 30-Jun-09 30-Jun-09 31-Dec-09 30-Jun-09 30-Jun-09 30-Jun-09 30-Jun-09 31-Aug-09 30-Jun-09 30-Jun-09

Actuarial Market Value of Actuarial Value Accrued Liability (AAL) Assets (MVA) of Assets (AVA) 178,900 244,964 294,042 118,430 145,142 185,683 28,498 38,026 73,027 50,096 54,903 91,441 96,503 118,765 136,376 88,653 106,384 128,029 42,995 59,782 75,521 94,242 126,438 125,136 25,039 34,838 54,576 39,890 53,185 66,323 34,498 44,703 56,685 22,543 28,858 44,470 17,817 25,183 37,150 57,630 57,629 76,555 8,478 11,000 25,298 17,310 21,262 33,739 15,134 20,598 30,595 11,033 14,282 26,316 21,589 28,826 36,060 19,880 27,094 34,290 18,089 22,979 32,442 17,171 20,606 31,173 30,499 39,542 44,469 42,905 47,829 56,748 72,472 88,806 86,062 42,479 54,818 55,642 32,259 42,799 45,161 45,422 55,818 58,178 18,303 21,055 30,413 7,199 8,030 19,163 11,516 14,886 23,400 11,250 13,501 22,839 7,452 9,439 18,951 16,121 20,582 27,537 24,662 30,205 35,797 14,993 19,158 26,088 10,215 13,461 21,138 15,391 19,019 24,862 13,834 17,882 23,115 69,996 78,911 79,105 8,818 11,400 17,636 10,117 13,158 18,799 11,612 13,383 19,977 17,974 21,124 26,019 3,974 5,297 11,333 8,376 11,543 15,683 21,949 26,335 29,055 19,098 23,510 26,192 7,100 8,500 13,987 7,114 9,366 13,883 2,095,481 2,523,660 3,178,506

Actuarial (AVA/AAL) 83% 78% 52% 60% 87% 83% 79% 101% 64% 80% 79% 65% 68% 75% 43% 63% 67% 54% 80% 79% 71% 66% 89% 84% 103% 99% 95% 96% 69% 42% 64% 59% 50% 75% 84% 73% 64% 76% 77% 100% 65% 70% 67% 81% 47% 74% 91% 90% 61% 67% 79%

Market Value (MVA/AAL) 61% 64% 39% 55% 71% 69% 57% 75% 46% 60% 61% 51% 48% 75% 34% 51% 49% 42% 60% 58% 56% 55% 69% 76% 84% 76% 71% 78% 60% 38% 49% 49% 39% 59% 69% 57% 48% 62% 60% 88% 50% 54% 58% 69% 35% 53% 76% 73% 51% 51% 66%

% of ARC Contributed 100 63 65 89 111 108 29 100 6 81 101 49 100 100 77 74 100 52 84 100 68 89 100 100 100 100 100 100 65 104 67 113 87 100 39 93 72 65 68 100 110 86 61 88 41 70 100 68 103 86 78

Investment Return Assumption 7.75% 8.00% 8.50% 8.00% 7.75% 8.00% 8.25% 8.00% 8.25% 7.50% 8.00% 8.25% 8.00% 8.00% 8.50% 8.25% 8.00% 8.50% 8.00% 8.00% 8.25% 7.75% 7.75% 8.00% 8.00% 7.50% 7.50% 7.25% 8.00% 7.50% 7.50% 8.25% 8.00% 8.00% 8.00% 8.00% 8.00% 8.25% 8.50% 7.80% 8.00% 8.50% 8.00% 7.50% 7.75% 8.00% 7.50% 8.00% 8.25% 8.00%

Equities Fixed (%) Income (%) 44 28 54 22 50 19 53 11 56 29 54 24 32 29 44 34 46 21 35 33 49 19 46 38 11 33 63 26 51 16 39 23 69 26 61 26 50 27 65 26 48 29 57 20 48 28 37 30 56 20 56 42 67 25 47 42 59 22 52 30 61 33 52 19 55 43 59 27 25 12 56 34 50 31 39 23 61 22 57 28 52 35 60 22 59 22 35 41 52 25 57 24 40 49 58 39 50 24 47 36 48 27

Other (%) 28 24 31 36 16 22 39 23 33 32 32 16 57 12 33 38 5 13 23 9 23 24 24 32 24 2 8 11 19 18 6 29 2 14 63 10 20 38 17 15 13 18 19 25 23 18 11 4 26 17 22

Covered Payroll 45,100 27,327 8,945 10,801 26,573 35,097 12,525 24,099 9,747 14,948 9,884 11,995 7,762 12,548 4,027 5,510 5,832 3,464 4,439 9,835 3,674 6,412 6,548 8,512 14,201 10,642 7,874 13,252 3,922 4,339 3,253 3,912 3,808 6,237 5,936 4,992 6,532 4,712 3,761 12,622 4,030 4,779 2,384 6,439 1,900 1,996 6,055 5,814 2,563 2,586 584,925

Benefit Payments 11,832 8,256 3,487 4,299 5,670 6,342 4,639 5,871 2,870 2,617 3,278 2,307 1,771 3,661 1,164 2,017 1,466 1,372 1,652 1,889 1,463 1,365 1,995 2,789 5,086 2,534 1,283 3,081 1,551 934 1,253 1,464 876 1,512 2,265 1,130 1,000 1,343 1,381 3,798 839 864 1,058 1,183 846 941 928 1,426 771 611 159,600

Note: Highlighted rows are pension plans that we included in our model. Source: Public plans database produced by the Center for Retirement Research, Boston College; Barclays Capital

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APPENDIX C: BARCLAYS CAPITAL ASSUMPTIONS

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Figure 37: Barclays Capital Assumptions for Select Pension Plans

California CA-PERF Contributions (1) State Contributions as % of Total Payroll (1) Other Employer Contributions as % of Total Payroll Total (2) % of Statutorily Req'd Contrib. Actually Contributed Active Employees: (1) Salary Growth Contribution as % of Salary Benefits (1) Average Annual Benefit Growth Member Statistics Change in # of Total Active Employees: (3) Annually through FY13 (3) Annually Thereafter Investment Portfolio: (4) Fixed Income (4) Public Equities (4) Other (Private Equity, Real Estate, Cash) Total

(1)

Illinois SERS NA NA NA 100.00% 3.00% 6.00% 4.50% TRS NA 1.90% NA 100.00% 2.70% 10.00% 4.70% SURS NA NA NA 100.00% 3.00% 8.00% 3.50% SERS 9.10% NA 9.10% NA 1.60% 9.80% 4.80%

Massachusetts TRS 17.00% NA 17.00% NA 3.30% 11.00% 3.70% PERS 1.00% 6.50% 7.50% NA 4.00% 6.00% 5.00%

New Jersey TPAF 0.90% 0.10% 1.00% NA 3.00% 6.10% 4.00% PFRS 1.00% 24.00% 25.00% NA 3.50% 8.90% 4.00%

CalSTRS-DB 4.50% 8.00% 12.50% NA 3.75%

6.50% 9.50% 16.00% NA 3.25% FY11 8.00% 5.25%

FY12+ 11.50%

6.50% 4.50%

-2.00% 0.80% Allocation 33% 45% 22% 100%

-2.00% 0.80% Return Allocation Return 2.83% 22% 2.83% 7.25% 52% 7.25% 7.60% 27% 7.60% 5.85% 100% 6.37%

-1.00% 0.40% Allocation 18% 47% 35% 100%

-1.00% 0.40%

-1.00% 0.40%

-2.00% 0.60% Allocation 23% 43% 34% 100%

-2.00% 0.60% Return Allocation Return 2.83% 23% 2.83% 7.25% 43% 7.25% 7.60% 34% 7.60% 6.36% 100% 6.35%

-2.00% 0.30% Allocation 39% 48% 13% 100%

-2.00% 0.30%

-2.00% 0.30%

Return Allocation Return Allocation Return 3.24% 21% 2.83% 18% 2.83% 7.25% 46% 7.25% 65% 7.25% 7.60% 33% 7.60% 17% 7.60% 6.65% 100% 6.45% 100% 6.51%

Return Allocation Return Allocation Return 2.83% 35% 2.83% 35% 2.83% 7.25% 48% 7.25% 44% 7.25% 7.60% 17% 7.60% 20% 7.60% 5.57% 100% 5.77% 100% 5.76%

Note: (1) We assume contribution rates, salary growth, and benefit growth are consistent with recent years' history. (2) In 1994, Illinois enacted a "funding plan" for its pension systems requiring the state to make contributions so that by the end of FY45, the ratio of actuarial value of assets to actuarial accrued liabilities would be 90%. Funding projections are provided in the State of Illinois FY11 Budget Summary prepared by the Commission on Government Forecasting and Accountability. (3) We assume the number of employees declines through FY13 (due to budget challenges and proposed expenditure cuts), then grows at a rate consistent with state population trends. (4) We assume an asset allocation consistent with recent disclosures. Fixed income investment return assumption is the YTW as of June 30, 2010, of the Barclays Capital US Aggregate Index (except for IL-SERS, which uses YTW as of June 30, 2009, of the Barclays Capital US Government/Credit Intermediate Index as a benchmark). Public equities investment return assumption is Wilshire Consulting's 2011 forecasted assumption for public equities. Other investments (private equity, real estate, and cash) assumption is an average of Wilshire Consulting's 2011 forecasted assumption for private equity and real estate. Total return is calculated as weighted average return based on asset allocation. Source: Barclays Capital

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APPENDIX D: INTRODUCTION TO PENSIONS

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Defined Benefit versus Defined Contribution Pension Plans

Most state and local governments offer their employees a defined benefit (DB) pension plan. Approximately 75% of state and local government employees take part in an employer-provided pension plan. Of these employees, 80% have a DB plan, 14% have a defined contribution (DC) plan, and 6% have hybrid plans (Center for Retirement Research, November 2007).

Defined Benefit Plans Promise Set Lifetime Retirement Benefits

A DB plan promises a set lifetime retirement income that is usually equal to a percentage of final salary (often average of earnings over the last three to five years) times the number of years of service. For example, an employee who retires after working for 10 years and has an average salary for the last several years of $50,000, and is participating in a benefit plan that has a 2% benefit (as % of average salary) will receive a retirement income of $10,000 per year ($50,000 x 2% per year x 10 years). Most DB plans also offer a cost-of-living adjustment (COLA) to retirees, which vary by plan, but often assume a fixed rate of inflation (~3%) or are tied to the Consumer Price Index (CPI). So if a retiree received $10,000 last year for pension benefits and the COLA was 3%, the benefits for this year would be $10,300.

Retirement Income for Defined Contribution Plans Depends on Contributions, and Members Bear the Risk of Market Fluctuations

Another type of pension plan that many people are familiar with is the defined contribution (DC) plan (e.g., 401(k) plan). DC plans function like individual tax-deferred retirement savings accounts. Unlike DB plans, DC plans do not promise specific retirement benefits and instead retirement income depends on employee and employer contributions and investment returns. For DC plans, individuals can decide on the asset allocation of their plan and also bear the risk of market fluctuations.

Figure 38: Defined Benefit (DB) vs Defined Contribution (DC) Plans

Defined Benefit Plan Promises set retirement income Plan sponsor manages asset allocation Defined Contribution Plan Retirement income depends on employee and employer contributions and investment returns Individuals manage asset allocation

Plan sponsor bears the risk of market fluctuations Individuals bear the risk of market fluctuations

Source: Barclays Capital

Pension Plans Are Funded by Employer Contributions, Employee Contributions, and Investment Earnings

Pension plans receive funding from three sources: state/other employer contributions, employee contributions, and investment earnings. From 1982 through 2008, employer contributions represented 28.5% of pension fund revenues; employee contributions represented 14.0%, and investment earnings represented 57.5% (Source: National Association of State Retirement Administrators). These sources are used to pay retirement, survivor, and disability benefits, along with administrative expenses. States have much flexibility in determining the amount they contribute to pension plans each year. In Illinois, for example, the state has established a target funding ratio of 90% (actuarial value of assets/actuarial liability) by FY45. Based on that target, the state has

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determined the annual contributions required between now and then. In other states, the contribution is tied to the actuarially required contribution (ARC). For example, New Jersey state law requires that the state make its full pension contribution; a new state law requires it to make one-seventh of its ARC starting in FY12 and to increase that amount gradually each year until it is making the full ARC payment.

What Are the Funded Ratio, Unfunded Liability, and ARC?

The funded ratio and the unfunded liability are two common measures used to evaluate pension plans. The former is the ratio of assets to liabilities. A general rule of thumb is that 80% is considered adequate. If a plan is 100% funded, there is the risk that elected officials will increase benefits for employees. Such a move could result in severely underfunded liabilities if investment returns fall short of expectations. The latter equals liabilities net of assets. The unfunded actuarial accrued liability (UAAL) is the actuarial accrued liability (AAL) not covered by the actuarial value of assets.

GASB Requires Employers to Report ARC, but ARC Is Not a Government Funding Requirement

To gauge a state's commitment to funding its pension commitments, one measure many people look to is the percentage of the ARC to the actual amount contributed by employers (i.e., state and local governments) each year. ARC is a reporting requirement established by the GASB, but is not a government funding requirement. ARC is equal to the sum of the employer's normal cost (defined below) of retirement benefits earned by employees in the current year and the amount required to amortize any existing unfunded accrued liability over a period of not more than 30 years. The normal cost is that portion of the present value of pension plan benefits and administrative expenses allocated to a given valuation year and is calculated using one of six standard actuarial cost methods (various cost methods described below). State and local governments contribute to their public pensions based on specific rules set by their legislature. While the ARC prescribes what an employer should contribute to cover current (normal) costs incurred and pay down the UAAL, actual contributions do not always equal the ARC because governments are free to determine their own funding schedules. In addition, during times of fiscal stress, states may choose to defer or cut their pension contributions.

Characteristics and Assumptions Vary Among Pension Plans

Pension plans vary by type (single employer, agent multi-employer, cost-sharing multiemployer), actuarial cost method used (entry age normal, projected unit credit, aggregate cost), asset smoothing method, and investment return assumptions. These various factors result in reported figures that are not directly comparable across plans.

Types of Pension Plans

Single Employer

A single employer plan is a plan that covers employees of only one employer. For example, all the members of the Massachusetts State Employees' Retirement System (SERS) are employed by the Commonwealth, which is solely responsible for all employer contributions and future benefit requirements.

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Multi-Employer Plans

An agent multi-employer plan is one in which two or more employers aggregate their individual defined benefit pension plans and pool administrative and investment functions (which produces cost savings). For agent multi-employer plans, employers have separate accounts so that their contributions and related investment earnings are available to provide benefits only to the employees of that entity. A separate actuarial valuation is performed for each individual employer's plan.

Cost-Sharing Multi-Employer Plans

A cost-sharing multi-employer plan includes members from more than one employer. All risks, rewards, and costs (including benefit costs) are shared by the employers. A single actuarial valuation covers all plan members. One contribution rate is determined and applies to all employers. In some cases, states manage multi-employer pension plans and are responsible only for the portion of the liability associated with their employees. In other cases, states manage plans in which they do not contribute as an employer, but are ultimately responsible for the benefits of all participating employees. It remains a challenge to allocate the unfunded liability among all of a plan's participating employers.

Actuarial Cost Methods: Entry Age Normal, Projected Unit Credit, and Aggregate Cost

Different actuarial methods are used to estimate future payments (both timing and amounts) of benefits. They differ in how the funding of benefits is paid over time. Most public pension plans utilize either the Entry Age Normal (EAN), Projected Unit Credit (PUC), or Aggregate Cost (AGG) method. Each is used to calculate the employer's normal cost portion of the ARC (excludes payment required to amortize an unfunded liability). Figure 39: Percentage of Public Sector Plans Using Different Actuarial Methods, 2009

Aggregate cost and other 16%

Projected unit credit 13%

Entry-age normal 71%

Source: Center for Retirement Research, Boston College

EAN Allocates the Present Value of Benefits Equally over the Employee's Career

Plans that use the EAN method allocate the present value of total projected lifetime retirement benefits for each individual on a level basis over the earnings of that member from the age of entry into the plan to the expected age at retirement. The resulting normal

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cost is a level percent of payroll. As each year of the employee's career passes, the allocated portion becomes part of the accrued liability. The EAN method is used in 71% of public sector plans.

PUC Method Determines the Present Value of Benefits Using Expected Future Pay

The PUC method is more commonly used in the private sector. Under this method, the present value of total projected lifetime retirement benefits for each individual is determined for service earned to date using expected future pay. The resulting normal costs (equal to the portion of the projected benefit allocated to the current year) can fluctuate because they are lower for an individual at the start of his or her career and increase over time. Plans using the entry age normal method recognize a larger accumulated pension obligation for active employees and require a larger contribution than the projected unit credit method (Figure 40). Figure 40: Accrued Liability For Active Employees by Method, by Year

$15,000 $12,000 $9,000 $6,000 $3,000 $0 1 2 Entry-age normal

Source: Center for Retirement Research, Boston College

3

4 Projected unit credit

5

AGG Spreads the Excess Benefit Amount Evenly over Future Active Payroll

The AGG method allocates the present value of future benefits less current actuarial value of assets and spreads the excess amount on a level basis over future active payroll. Under this method, the benefits of all participants are rolled into one portion, and the cost base is the combined future salary of all participants. It is similar to EAN in that it allocates the liability evenly over periods. However, unlike EAN and PUC, AGG plans do not have a concept of accrued liabilities. Each year, the AGG method allocates the difference between the total present value of benefits and the actuarial value of assets over future periods and does not consider past allocations as an accrued liability. Thus, a plan using this method will not report unfunded liabilities but will report a funded ratio of 100%.

Various Smoothing Methods Affect Actuarial Value of Assets

The actuarial value of assets is determined using a method that "smoothes" a fund's return to reduce year-to-year volatility. As a result, market losses in 2008 will not be fully incorporated into the actuarial value of pension plan assets for the next few years. The market value of pension assets is equal to the value of the pension's assets as of the most recent valuation

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date. In our view, the market value of assets is a better measure of plan assets because it is more reflective of current conditions and allows comparison between plans.

Investment Return Assumption: What Discount Rate Should Be Used to Calculate the Present Value of Future Liabilities?

Pensions promise benefits that will be paid in the future. Thus, these future benefits need to be discounted at some rate in order to calculate the present value of future liabilities. There is a lot of debate concerning which discount rate is most appropriate. Most often, one sees the actuarial value of pension plan liabilities, which is based upon GASB standards, under which pension plan liabilities are discounted to the present using the long-term expected return on plan assets (GASB 27); most pension plans currently assume an investment return and discount rate of 7-8%. However, some economists argue that the discount rate should reflect the riskiness of those future benefit payments. Thus, since pension obligations are protected by state laws/constitutions and are rarely not paid, then a risk-free rate should be used to value pension liabilities (e.g., U.S. Treasury bonds). Other suggested discount rates include using a state's municipal bond rates, under the assumption that the likelihood of state's defaulting on their pension obligations is similar to that of their defaulting on their bonds. When valuing liabilities, the lower the discount rate, the higher the estimated liabilities and the lower the funded ratio.

Economic and Demographic Assumptions

In addition to investment return assumptions, pension plans also need to make various assumptions, including inflation rate, wage growth, mortality rate, retirement age, disability rates, and withdrawal rates to determine future benefit payments.

Retirement Eligibility Requirements: Vesting Period, Retirement Age, and the Retirement Benefit Formula Are Also Important Characteristics

Important retirement eligibility requirements to consider include the vesting period, retirement age, and retirement benefit formula. For example, for new members of the New Jersey PERS pension plan, the vesting period is eight to 10 years, the retirement age is 62, and the benefit formula is generally determined to be 1/55 (~1.8%) of final average salary for the final five years of service prior to retirement (or highest three years' compensation if other than the final three years). To lower pension obligations, some states have changed benefit formulas, vesting periods, and retirement ages for new employees. For example, in 2010, the Pennsylvania Public School Employees' Retirement System (PSERS) increased the retirement age from 62 with one year of service to 65 with three years of service. For most employees of the California Public Employees Retirement System hired after November 10, 2010, a new formula provides a benefit of 2% of final average salary at age 60 and 2.148% at age 63 or higher (before this legislation, 2% at age 55 and 2.5% at age 63 or higher).

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APPENDIX E: PENSION PLAN LEGAL PROTECTIONS

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Barclays Capital | States' Pensions: A Manageable Longer-Term Challenge

Figure 41: Pension Plan Legal Protections

State Alaska Arizona Arkansas California Colorado Connecticut Hawaii Illinois Indiana Kansas Louisiana Massachusetts Michigan Minnesota Nebraska New Mexico New York North Carolina Oklahoma Oregon Texas Vermont Washington West Virginia Legal Basis State constitution State constitution Contract, once participant is vested under plan terms Contract, upon commencement of employment Contract, at some time prior to eligibility for retirement Property State constitution State constitution Gratuity approach for involuntary plans; contract approach for voluntary plans Contract, upon commencement of employment State constitutional protection once vested Contractual, upon commencement of employment State constitution Promissory estoppel Contract, upon commencement of employment Property, once vested State constitution Contract, once vested Contract, once vested Contract, upon commencement of employment Gratuity Contract, upon making mandatory contributions to the plan Contract, formed at the time of employment Contract, prior to eligibility for retirement Representative Case Municipality of Anchorage v. Gallion, 944 P.2d 436 (Alaska 1997) None Jones v. Cheney, 489 S.W.2d 785 (Ark. 1973) Betts v. Bd. of Admin., 21 Cal. 3d 859, 863 (1978) Police Pension & Relief Bd. of Denver, 366 P.2d 581 (Colo. 1961). Pineman v. Oechslin, 488 A.2d 803 (Conn. 1983) Kaho'ohanohano v. State, 162 P.3d 696 (Haw. 2007) Kraus v. Bd. of Trustees of Police Pension Fund of Niles, 390 N.E.2d 1281 (Ill. App. Ct. 1979) Bd. of Tr. of the Pub. Employees' Ret. Fund v. Hill, 472 N.E.2d 204 Singer v. City of Topeka, 607 P.2d 467 (Kan. 1980) Smith v. Bd. of Tr. of La. State Employees' Ret. Sys., 851 So.2d 1100 (La. 2003) Opinion of the Justices, 303 N.E.2d 320, 327 (Mass. 1973) Ass'n of Prof'l & Technical Employees v. City of Detroit, 398 N.W.2d 436 (Mich. Ct. App. 1986) Christensen v. Minneapolis Mun. Employees Ret. Bd., 331 N.W.2d 740, 747 (Minn. 1983) Calabro v. City of Omaha, 531 N.W.2d 541 (Neb. 1995) None Birnbaum v. New York State Teachers' Ret. Sys., 152 N.E.2d 241 (N.Y. 1958) Faulkenberry v. Teachers' & State Employees' Ret. Sys. of N.C., 483 S.E.2d 422 (N.C. 1997) Taylor v. State and Education Employees Group Insurance Program, 897 P.2d 275 (Okla. 1995) Oregon State Police Officers Ass'n v. State, 918 P.2d 765 (Or. 1996) Kunin v. Feafanov, 69 F.3d 59 (5th Cir. 1995) Burlington Fire Fighters' Ass'n v. City of Burlington, 543 A.2d 686 (Vt. 1988) Bakenhus v. City of Seattle, 296 P.2d 536 (Wash. 1956) Booth v. Sims, 456 S.E.2d 167 (W.Va.1994)

Note: Table provides a general summary of state approaches and cannot account for the many factual variations that may arise in public pension cases Source: "Public Pension Plan Reform: The Legal Framework," Legal Studies Research Paper Series Research Paper No. 10-13, University of Minnesota Law School.

18 May 2011

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