If S.C. pension fund falters, we all pay

South Carolina taxpayers should expect the amount of money they pump into the state pension system to increase in the coming years as the program struggles to close a widening $13 billion shortfall.

At the same time, the state might be forced to shift resources from areas such as education and transportation to the retirement system to help close that gap, pension experts said.

State lawmakers in recent months have discussed reforms, but those efforts might not be enough to fix the crisis, the experts said.

State and local governments contribute a percentage of public employees' wages to the South Carolina Retirement Systems' trust. That rate has ballooned over the last seven years as state officials enacted four increases in an effort to shrink the pension debt.

In 2005 public employers contributed 7.7 percent of wages for most pensioners; they now contribute 10.6 percent. Over that time, the Legislature raised employee contributions a half-percent to 6.5.

Overly optimistic investment expectations are part of the problem, said experts who have sounded alarms about shortfalls in state pension funding.

Investment income is the pension system's main funding source. South Carolina assumes it will get a 7.5 percent annual rate of return on its investments, a level that is in step with other states' target rates.

The state's Budget and Control Board, which oversees the Retirement Systems, lowered the rate from 8 percent last fall.

Economists said setting rates more conservatively -- between 3 and 5 percent -- would be more appropriate, given that retirees' benefits must be paid regardless of how future investments fare.

"We're not simply saying that they're mis-estimating stock returns, but that they shouldn't be using the expected return on a risky portfolio to determine the value of a bunch of guaranteed benefits," said Andrew Biggs, a resident scholar at the right-leaning American Enterprise Institute in Washington, D.C.

Richard Dreyfuss, a Pennsylvania consultant who studied South Carolina's pension system, made similar comments in a report about the state's retirement system.

"The reality is no one even knows what future returns will be," Dreyfuss said.

Ashley Landess, president of the S.C. Policy Council, called the 7.5 percent rate "pie-in-the-sky territory."

More outgo, less income

To hit high return rates, South Carolina's Investment Commission in 2008 approved making riskier investments that can have big payoffs. But those big risks can come at a cost. After the stock market crashed that year, the state took a $7.6 billion loss. It has recovered somewhat since then but remains below pre-recession levels.

Other issues have amplified the retirement system's funding crisis over the past decade:

This all means that the system is paying out more money but taking in fewer contributions.

Taxpayers make up the difference for what investment income doesn't cover, pension analysts said.

"If the risks don't pay off, you're going to be in trouble," Biggs said. "The person getting screwed is going to be the taxpayer."

Gov. Nikki Haley takes no issue with the 7.5 percent expectation. Her spokesman said in a statement that two independent firms have "told us that this figure is reasonable."

S.C. Treasurer Curtis Loftis, one of six members on the panel that approves pension system investments, also said he is comfortable with the 7.5 percent rate.

"I don't see a problem with it," he said. "Is it high? Yes. Does it cause me great worry? No. We have a 50-50 chance of hitting it."

Pension experts including David Draine, a senior research associate at Pew Center on the States, said South Carolina should be worried. Some states over the past decade have "failed to operate their retirement funds in a financially responsible manner."

"South Carolina is one of them," he said.

'Serious concern'

South Carolina's pension fund has a reported $25.4 billion in assets, according to the July 2011 Comprehensive Annual Financial Report. It also has $38.8 billion in liabilities, the amount of pension money it will owe about 500,000 public workers, retirees and their beneficiaries in the system.

That means its so-called "unfunded liability" is about 65 percent. A Pew report from April put South Carolina near the bottom third of states nationally, ranked by funding level.

Retirement systems can operate safely without being fully funded. But experts recommend systems be at least 80 percent funded, according to the U.S. Government Accountability Office.

Keith Brainard of the National Association of State Retirement Administrators compared state pension systems to mortgages. Even if they don't have all the money up front, financially secure homeowners can afford a house if they pay for it over 20 or 30 years.

Likewise, fiscally sound retirement systems will be able to cover pensions for employees whose expected retirements are decades away.

But South Carolina's system is not financially sound, according to the Pew Center report, which said the state's long-term pension liability is "cause for serious concern."

And that unfunded liability actually could be much higher than the state has reported. Economist Joshua Rauh of Northwestern University's Kellogg School of Management said in a 2010 report that states across the country, including South Carolina, drastically have underestimated their liabilities. South Carolina's pension debt is as high as $53.5 billion, he said.

"Employers don't want to hear that because they don't want to pay more, and elected officials don't want to hear it because they don't want to raise taxes," Biggs of the American Enterprise Institute said.

Service cutbacks

The state expects the system to be fully funded in 30 years, contingent on "a sufficient employer contribution rate" -- that's the amount state and local taxpayers contribute -- among other assumptions.

"It could be a lower rate, or a higher rate, but until the future gets here and the actual plan results are evaluated against the previously projected results we won't know," Lindsey Kremlick, a spokeswoman for the state Retirement Systems, said in a statement.

Beyond increasing contribution rates, strained governments also might be forced to shift existing resources, said Josh Barro, a fellow at the Manhattan Institute. State funds that ordinarily would have paid for road repairs and education could be diverted to the pension system in the future, said Barro, a pension expert at the conservative think tank.

He pointed to California, where state and local governments cut services to cope with huge pension funding shortfalls.

A spokesman for Haley said in a statement that the administration doesn't expect that to happen here.

"We don't have to harm existing services," Rob Godfrey said. "There is more than enough revenue to cover them as long as we budget responsibly and don't waste tax dollars."

Biggs said states across the country "are getting hit up for contributions when they can't afford it. Bigger and bigger shares of what the government spends won't be going to what you think it is," he said.

He offered an example: "Not paying for teachers, but for retired teachers."

'Kicked the can'

South Carolina's unfunded liability trailed most other states in the boom years of the late 1990s and early 2000s, when many retirement systems flourished. In 1999 the system was 98 percent funded, Draine of the Pew Center said. But at that time many systems had surpluses, he said.

Part of the problem then was that South Carolina constitutionally had been forbidden from investing in stocks until 1999. All its funds were in cash and bonds, even in the stock market's boom years.

In 2005, the state established the Investment Commission to manage and diversify the state's investment portfolio in hopes of reaping stronger returns. The state hired a chief investment officer -- Robert Borden, a $485,000-a-year employee who resigned in December -- and set up a six-member panel of political appointees to vote on investment strategies.

The group began making so-called alternative investments in hedge funds and private equity in 2008 -- the same year the stock market crashed. Such bets can deliver higher returns than more conservative investments, but they also carry higher risk.

In the years since the state only has increased the amount of money it puts in alternative investments.

The pension system's critics, including Investment Commission member Loftis, have said the state has put too much money in high-risk bets. Loftis also has said the state has paid too much in management fees, which topped $343 million last year.

Borden couldn't be reached for comment. Commission Chairman Allen Gillespie and Vice Chairman Reynolds Williams did not return requests for comment.

The investment losses were compounded by policy decisions that added to the unfunded liability. In 2000 the Legislature lowered the number of service years needed to retire from 30 to 28. Pension recipients have received annual cost-of-living raises of up to 3.5 percent all but one year since 1999.

"States that are in trouble now have kicked the can down the road and haven't set aside contributions," Draine said. "They've raised benefits without figuring out how to pay for them."

Reach Renee Dudley at 937-5550 or on Twitter @renee_dudley.