Summary of H.F. 2773 (Knoblach); S.F. ____ (       )

H.F. 2773 (Knoblach); S.F. ____ (       ) amends Minnesota Statutes, Chapter 354A, the governing law for the first class city teacher retirement fund associations, to implement the following changes:

1. Transfers MTRFA Investment Authority to Special School District No. 1. The Board of Education of Special School District No. 1, Minneapolis, is given the authority to invest the Minneapolis teachers retirement fund instead of the Minneapolis Teachers Retirement Fund Association (MTRFA) Board (Sections 1, 2, 8, 9, and 10).

2. Special School District No. 1 Reimbursement of MTRFA Investment Underperformance. Special School District No. 1, Minneapolis, would be required to make an additional employer contribution equal to the amount by which the MTRFA investments have underperformed the State Board of Investment investment of the various statewide retirement plans, as determined by the State Auditor (Section 3).

3. State Investment of State Contributions to the Minneapolis Teachers Retirement Plan. The direct State aid payable on behalf of the Minneapolis Teachers Retirement Fund Association is required to be deposited with and invested by the State Board of Investment in the Income Share Account of the Minnesota Supplemental Investment Fund unless the State Board of Investment, upon consultation with the Board of Education of Special School District No. 1, determines that a different portfolio mix is more appropriate (Sections 4, 5, 6, and 7).

4. Reduced Threshold for Minneapolis Teacher Administrative Expense Surcharge. Members of the Minneapolis Teachers Retirement Plan would be required to pay a surcharge based on the amount by which the retirement plan administrative expenses exceed $428,381, the current average of $79.91 of the administrative expenses of the General State Employees Retirement Plan of the Minnesota State Retirement System (MSRS-General) and the General Employee Retirement Plan of the Public Employees Retirement Association (PERA-General) per active member, multiplied by the MTRFA active membership, and indexed over time, rather than the TRA administrative expense percentage of covered payroll (Section 6).

5. Modification of MTRFA Post-Retirement Adjustment Mechanism. The MTRFA post-retirement adjustment mechanism is modified, with a continuation of the annual two percent adjustment and the replacement of the investment performance-related post-retirement adjustment with an indexation to the investment performance-related portion of the Teachers Retirement Association (TRA) post-retirement adjustment mechanism, payable once the MTRFA funding ratio equals or exceeds 100 percent (Sections 11 and 12).

Background Information on Minneapolis Teachers Retirement Fund Association (MTRFA)

The Minneapolis Teachers Retirement Fund Association (MTRFA) was created under Laws 1909, Chapter 343. The Legislature authorized the creation of a teachers retirement fund for Minneapolis by the teaching body with the consent of the City Council. The school authorities formulated the plan for the formation and incorporation of a retirement association, which was submitted to the City Council for approval. A majority of all teachers were required to approve the plan before the retirement association was created. The association was incorporated on September 17, 1909. Under the bylaws of the association, any amendments required the approval of the City Council of the City of Minneapolis. The law provided that up to 0.1 of a mill property tax could be levied in the City of Minneapolis to pay for the pension fund.

The Legislature created the first statewide teachers pension fund, the predecessor to the Teachers Retirement Association (TRA), in 1915. The Minneapolis Teachers Retirement Fund Association (MTRFA), the St. Paul Teachers Retirement Fund Association (SPTRFA) and the Duluth Teachers Retirement Fund Association (DTRFA), referred to as the first class city teacher pension funds, remained separate funds from the predecessor of the statewide TRA fund when it was created in 1915.

In 1924, the Minneapolis teachers pension plan was restructured to address major pension funding problems. Under the restructuring, the defined benefit plan for existing retirees remained unchanged. However, teachers with 20 or more years of service were able to elect between the old defined benefit plan or elect the new defined contribution plan, and teachers with less than 20 years were moved into a defined contribution plan for all future service. In addition, all senior teachers were now required to become members of the pension plan. The Legislature increased the property tax levy limit from .2 of one mill to 1.5 mills.

In 1952, the pension benefit formula changed from a defined contribution (pension is based on the individual’s account plus interest) plan to a defined benefit plan. The defined benefit plan provided a formula annuity equal to 1.667% of average salary for the teacher’s high five consecutive salary, payable at any age with 30 years of service or at age 60. The funding for the pension plan continued through the property tax. The amount levied was based on a percentage of payroll plus an amount to cover administrative and a portion of unfunded annuity payments, as certified by the retirement fund board. The school district, as a legal entity separate from the City, was established in 1953.

In 1967, State aid for teacher retirement plans was enacted. The Minneapolis teachers pension plan received State aid equivalent to the funding provided to the statewide TRA. The local property tax levy otherwise to be certified for the Minneapolis teachers pension plan was reduced by the amount of the state teacher retirement aid.

In 1975, the local property tax levy authority was eliminated and the employer contribution was based on a percentage of payroll. The MTRFA was funded by the State of Minnesota, with payment made directly to the retirement fund from the State’s general fund, initially based on the state aid provided to the statewide TRA and eventually based on a specified percentage of covered pay. The 1975 legislation also interrupted a pending benefit increase and the Legislative Commission on Pensions and Retirement was directed to study teacher retirement benefit levels. The 1975 benefit increase was approved by the Legislature in 1976.

The MTRFA coordinated program for teachers with Social Security coverage was created for new members hired after July 1, 1978 and any existing members who elected the program. The coordinated program was patterned on the statewide TRA coordinated program. Before 1978, MTRFA was a "basic" program, meaning that its members had retirement coverage solely by the local retirement plan and without Social Security coverage by virtue of the Minneapolis teaching service. A Social Security referendum was conducted in 1978 for MTRFA basic program members who desired Social Security coverage to elect to have Social Security coverage, to be supplemented by the MTRFA "coordinated" program. The MTRFA coordinated program substantially replicated the coordinated program of the Teachers Retirement Association (TRA). All newly hired Minneapolis teachers after July 1, 1978, automatically were covered by Social Security and the MTRFA coordinated program. When a person was entitled to federal Social Security program coverage, the statute of limitations on correcting past omitted contributions is three years. The level of state funding for the MTRFA Basic Program was increased by approximately 1.1 percent of covered payroll in 1979.

In 1985, the State funding was converted to a categorical education aid to the school district. The direct payment of employer contributions by the State was replaced by employer contributions from the school district. In 1987, the categorical teacher retirement and Social Security aid was folded into the general education aid program.

Since the mid-1990s, the Legislature has made a considerable effort to address the MTRFA contribution deficiency by creating new State aid programs, which has resulted in many millions of State dollars paid directly to the MTRFA. In 1993, a supplemental $2.5 million annual State contribution to the MTRFA was enacted, to match additional contributions by Special School District No. 1 and by the City of Minneapolis. In 1996, some State funding from local police and paid firefighter relief associations was redirected to MTRFA if Special School District No. 1 and the City of Minneapolis make additional contributions to MTRFA ($1 million each in 2003 and thereafter). In 1997, an additional annual State contribution to MTRFA was also enacted, which provided $13.3 million in 2003.

Background Information on the MTRFA Funding Problem

The Minneapolis Teachers Retirement Fund Association (MTRFA) is the worst funded large Minnesota public pension plan and has been so for decades. The following summarizes the funded condition and financial requirements of MTRFA every five years for the last 30 years as indicated in the official actuarial report for the plan:

If the market value of assets, rather than the actuarial value of assets, is used to determine the funded condition and the financial requirements of MTRFA, the current funding situation of the retirement plan is worse, as indicated for fiscal years 2002 and 2003 as follows:

The computed actuarial value of assets, intended to smooth the recognition of short-term volatility in the investment markets, is functioning to overstate the value of assets during a prolonged bear market.

Background Information on MTRFA Investment Performance

In Minnesota, statewide retirement plan assets are invested by the State Board of Investment and local retirement plan assets are invested by the governing board of the retirement plan.

The investment performance of the local retirement plans has typically lagged the investment performance of the State Board of Investment, even when the State Board of Investment has had average or below average investment performance. The Minneapolis Teachers Retirement Fund Association (MTRFA) has underperformed the State Board of Investment over the last decade or decade-and-a-half by between one percent and 1.5 percent. The following sets forth the year-by-year time weighted rate of return results for the State Board of Investment and for the major local retirement plans, based on reports filed with the Legislative Commission on Pensions and Retirement (before 2001) or with the Office of the State Auditor (after 2000):

Various Minnesota Public Pension Funds:

Annual Total Portfolio Time-Weighted Rates of Return

* 1/1/03-9/30/03

From 1995 forward, the State Board of Investment had higher returns than MTRFA in each year except for 1999. When the investment markets ran into a troubled period from calendar year 2000 through 2002, MTRFA had strongly negative returns, lower in each of those years than any other fund in the table.

The average annual investment returns for the entire period can be compared, as follows:

Various Minnesota Public Pension Funds:

Annualized (Average) Total Portfolio Returns

* SBI Combined Fund after 12/31/93, and SBI Basic Fund prior to that date.

If MTRFA had replicated the investment returns of the State Board of Investment, MTRFA assets would be more than $100 million greater than the current asset figure.

Discussion

H.F. 2773 (Knoblach); S.F. ____ (       ) modifies the investment practices of the Minneapolis Teachers Retirement Fund Association (MTRFA) by transferring the investment authority for the retirement fund from the MTRFA Board to the Minneapolis School Board, by requiring the Minneapolis School Board to reimburse the fund annually for any investment underperformance, requires that all future State aid to MTRFA be invested by the State Board of Investment in the Minnesota Supplemental Investment Fund, resets the trigger for the imposition of MTRFA administrative expense surcharge, and revises the MTRFA post-retirement adjustment mechanism.

H.F. 2773 (Knoblach); S.F. ____ (       ) raises several pension and related public policy issues that may merit Commission consideration and discussion, as follows:

1. Extent of Remedy to MTRFA Funding Problem by Proposed Legislation. The policy issue is the extent to which the proposed legislation would resolve the funding and related problems of the Minneapolis Teachers Retirement Fund Association (MTRFA). A strong argument can be made that there are seven problems with respect to MTRFA that contribute directly or indirectly to its funding problem, which are:

• a significant default risk,
• a funding ratio decline,
• a growing contribution rate deficiency,
• overrepresentation of membership interests in plan governance,
• high administrative and investment expenses,
• investment return underperformance, and
• undeserved past and potential future post-retirement adjustments.

2. Appropriateness of Additional MTRFA Funding Problem Remedies. The policy issue is the extent of the remaining need to address the MTRFA funding problem and the appropriateness of any additional remedy or remedies. After the potential for additional funding leakage is resolved, which the proposed legislation largely does, the remedy to a funding problem is additional funding from some source or sources. The two significant approaches to remedy the MTRFA funding would be a one-time infusion of significant additional assets or would be an ongoing increase in annual contributions or aid paid to the fund. A lump sum infusion could come from local sources, perhaps bonding by Special School District No. 1, or from State sources, from a special appropriation. Because of bond rating declines for Special School District No. 1 and State budget limitations, a lump sum infusion does not seem possible. Additional member contributions, additional employer contributions, or additional State aid could provide additional funding, but an increase in member contributions would significantly burden MTRFA members in comparison to other teachers, an increase in employer contributions would arise in the context of recurring budget shortfalls for Special School District No. 1, and an increase in State aid to MTRFA would displace revenue for some other set of state-funded services.

3. Appropriateness of Transferring Minneapolis Teacher Retirement Fund Investment Responsibilities to Special School District No. 1. The policy issue is the appropriateness of ending the MTRFA Board of Trustees as the investment authority for the retirement fund and transferring that investment authority to the Board of Education of Special School District No. 1, Minneapolis. While the MTRFA Board has not demonstrated any considerable investment prowess and has pursued some problematic investment strategies in the past, such as its fast food retail real estate investment portfolio, which it only recently ended, or its attempt at "portfolio insurance" through derivative investments in the late 1980s, it is not clear that the Minneapolis School Board will bring any greater investment ability to bear on the problem. In an actuarially funded retirement plan, investment income can be expected to finance two-thirds or three-quarters of the eventual benefit payouts from the fund, so the investment function of a retirement plan is more important than the contribution function in many respects. If the Minneapolis School Board cannot be reasonably expected to improve the MTRFA investment performance, the proposed legislation will not accomplish this major default potential prevention. Combined with the investment underperformance reimbursement requirement, discussed in policy issue #4, the proposed change will induce the Minneapolis School Board to invest MTRFA assets with the State Board of Investment in the Minnesota Supplemental Investment Fund, an investment operation akin to a family of mutual funds established in part for the purpose of investing local retirement plan assets. If the Minneapolis School Board is not the appropriate choice for a substitute investment authority, there are relatively few alternatives, which include the State Board of Investment, the Minneapolis Employees Retirement Fund (MERF), or the St. Paul Teachers Retirement Fund Association (SPTRFA). The investment performance of MERF and SPTRFA in the past has not matched the State Board of Investment. The State Board of Investment historically has been a slightly above-average investment performer.

4. Appropriateness of Investment Underperformance Reimbursement. The policy issue is the appropriateness of a proposed requirement that Special School District No. 1, Minneapolis, would reimburse the Minneapolis Teachers Retirement Fund for any investment underperformance when compared to the performance of the State Board of Investment. Currently, if the MTRFA underperforms the State Board of Investment in its investments, the unfunded actuarial accrued liability of the retirement fund will either be larger (i.e. actuarial loss) or will not be smaller (i.e. reduced actuarial gain). The proposed legislation would create more interest on the part of the school district in the investment function and would be a strong impetus for transferring the investment function to the State Board of Investment to avoid any potential unexpected additional contribution requirement. If the goal is to have the Minneapolis Teachers Retirement Fund invested by the State Board of Investment, the Legislature has the authority to mandate that change directly. If there is investment underperformance, the reimbursement requirement could impose a considerable financial burden on Special School District No. 1, Minneapolis, which is not well equipped to bear it.

5. Appropriateness of State Board of Investment to Invest MTRFA State Aid Amounts. The policy issue is the appropriateness of supplanting the MTRFA Board of Trustees in the investment of MTRFA revenue attributable to direct State aid to MTRFA. In Minnesota, for statewide pension plans the State Board of Investment is the investment authority, and for local pension plans the pension plan board of trustees is the investment authority. The State Board of Investment, through the vehicle of the Minnesota Supplemental Investment Fund, which is essentially a family of mutual funds, is available as an investment mechanism for most local pension plans. Approximately a quarter of the Minnesota volunteer firefighter relief associations have utilized the Minnesota Supplemental Investment Fund, but there is no express authority for the first class city teacher retirement fund associations to utilize the State Board of Investment and the three plans have not sought such authority. The proposed change would mandate that all future direct State aid for MTRFA be invested in the Minnesota Supplemental Investment Fun’s Income Share Account, which generally mimics the portfolio mix of the statewide retirement plans, unless the State Board of Investment, in consultation with Minnesota Teacher Retirement Plan officials, determines that some other investment mix is more appropriate. The direct State aid to MTRFA annually is almost $19 million, or about 30 percent of the total MTRFA contribution revenue. The argument for the mandate is that the MTRFA has historically underperformed the State Board of Investment in investing pension plan assets and that the likely future investment opportunity losses should be avoided when State money is involved. If the mandate had been imposed since the start of direct State aid in 1993, exclusive of investment gains or losses, the State Board of Investment would currently be investing $113 million in MTRFA assets. An investment mandate would make the overall MTRFA investment process more complex, and if a benefit default potential is relatively imminent, would make the payment of future benefits more difficult, with various asset transfers between the State Board of Investment and the plan required.

6. Appropriateness of MTRFA Administrative Expense Surcharge Modifications. The policy issue is the appropriateness of changing the threshold amount that triggers a surcharge on active and retired members to reimburse MTRFA for administrative expenses deemed excessive. The MTRFA administrative expense surcharge was first imposed in 1993, when the MTRFA administrative expenses were 0.43 percent of covered payroll ($144.52 per active member) while the TRA administrative expenses were 0.15 percent of covered payroll ($49.56 per active member). Since 1993, MTRFA administrative expenses were redefined to exclude investment expenses, more MTRFA expenses have been allocated to investment expenses, and TRA administrative expenses have tripled (percentage of covered pay) or quadrupled (dollar amount). The intent of the 1993 administrative expense surcharge was to compel MTRFA members to bear the additional cost of administering a small local pension plan when compared to a potentially more efficient statewide pension plan. With the huge increases in the TRA administrative expense levels, TRA may not be the best measure of administrative efficiency. The proposed change would set the threshold trigger at the average per-member administrative expense of the General State Employees Retirement Plan of the Minnesota State Retirement System (MSRS-General) and the General Employee Retirement Plan of the Public Employees Retirement Association (PERA-General). The surcharge can be expected to raise about $300,000 annually, or 0.11 percent of covered pay. Some testimony may be necessary from MTRFA about the nature of its administrative expenses and from MSRS-General and PERA-General about the prospects for significant administrative expense changes.

7. Appropriateness of Changes in the MTRFA Investment-Related Post-Retirement Adjustment Mechanism. The policy issue is the appropriateness of the various proposed changes in the investment-related post-retirement adjustment mechanism of the MTRFA. The actual MTRFA post-retirement adjustment mechanism in practice is different from the adjustment mechanism as set forth in the statute, Minnesota Statutes, Section 354A.28. Assets related to the retiree reserves have not actually been segregated from the assets related to active members, as the law clearly requires. The investment performance used to calculate the excess investment income is not measured based on those retiree assets and retiree reserves. The five-year investment performance averaging process lacks a mechanism to recoup the impact of any investment losses and of the continuation of prior adjustments during investment downturn periods. The proposed change would condition future investment-related MTRFA post-retirement increases on MTRFA achieving full funding of its current actuarial accrued liability and would index the investment-related MTRFA post-retirement increases to those paid by the Teachers Retirement Association (TRA) during the previous year. The impact of the proposed change will be to eliminate or diminish future post-retirement adjustments for a period of time. To be sustained upon a legal challenge, a basis for the proposed change will need to be formed in public testimony so that the defects in the current mechanism in practice are clearly demonstrated and the corrective intent and effect of the proposed change becomes more evident.