Hawaii’s largest public pension plan, dragged down during the 2015 fiscal year by a 3.6 percent return in its investment portfolio, saw its shortfall swell to $8.77 billion despite steps that have been implemented to shore up the Employees’ Retirement System.

The pension plan remains 26 years away from being fully funded — the same as last year, according to a new report by independent Dallas-based actuary Gabriel Roeder Smith & Co.

But former ERS Executive Director Wes Machida, who became the state finance director on Dec. 27, 2014, said the effect of legislative changes and steps taken over the past five years by the pension plan’s trustees, former Gov. Neil Abercrombie and Gov. David Ige will begin to be felt within the next decade.

“A number of the initiatives or actions that have been taken will take time to feel the full effects of everything that has been done,” said Machida, who is one of eight ERS trustees. “It takes decades for the full impact to kick in.

“The important thing to remember is that we should stick to the plan. The actions that have been taken thus far will benefit the system as long as we stay the course and as long as we can get as close to all the (actuarial) assumptions as possible.”

Machida said Gabriel Roeder Smith’s 30-year projection in the report shows that Hawaii’s unfunded liability in its pension plan is expected to increase but will start to decrease after nine years.

“By that time, a significant portion of the pension reforms should be impacting the retirement system’s pension liability because you have a lot more of the new employees under the reform benefit structure,” Machida said.

The ERS pension plan, which provides retirement, disability and survivor benefits to 118,993 active, retired and inactive state and county employees, had a market value $14.5 billion as of the end of the fiscal year on June 30, 2015. That’s up from $14.2 billion in fiscal 2014, $12.4 billion in fiscal 2013 and $11.3 billion in fiscal 2012.

Even with its increasing assets, the pension system’s unfunded liability, or shortfall, has continued to grow. It was $8.58 billion in fiscal 2014, $8.49 billion in fiscal 2013 and $8.44 billion in fiscal 2012. The unfunded liability is derived from the total pension liability minus the assets that the ERS has in its portfolio. If the pension liability continues to grow at a higher rate than the assets, then the unfunded liability will grow as well.

But there is a silver lining in that the pension system’s funded ratio improved in the fiscal year ended June 30 to 62.2 percent of where it needs to be to pay all the pensions promised. That’s up from 61.4 percent in June 2014, 60 percent in June 2013 and 59.2 percent in June 2012.

Despite the improvement, Hawaii’s funded ratio remains among the worst in the country.

In a July study by The Pew Charitable Trusts of the nation’s state-run retirement systems, Hawaii’s funded ratio was ranked in a tie for the ninth worst in the country with a 60 percent funded ratio that was based on 2013 data for all the states. Only two states, South Dakota and Wisconsin, were 100 percent fully funded. Illinois (39 percent) and Kentucky (44 percent) were the worst.

Thom Williams, the former executive director of the Wyoming Retirement System who took over a similar post at the Hawaii ERS on Nov. 2, is confident the pension fund is on track to sustainability.

“The ERS’ unfunded liabilities, while substantial, are quite manageable,” Williams said. “Lower benefit commitments to new hires and increased employer contributions will slow growth in our liabilities and eventually reduce them. Forecasts show our liabilities growing moderately over the next few years followed by a gradual but increasing decline as we progress toward full funding.”

Williams said it will take “patience and a best-in-class governance structure (implementing best practices) and investment program” to become fully funded.

“We must be allowed to realize our potential as a sophisticated financial services and investment organization, and be afforded the operational flexibility necessary to do so,” he said.

Machida said the reason the pension plan’s unfunded liability, or shortfall, worsened in fiscal 2015 while the funding ratio improved is because the ERS trustees reduced the assumed rate of investment return for future years from 7.75 percent in fiscal 2015 to 7.65 percent in fiscal 2016 to 7.55 percent in fiscal 2017 and then to 7.50 percent in fiscal 2018 and beyond. The decision by the ERS trustees to reduce the targeted returns was made based on reports from Gabriel Roeder Smith and the ERS’ investment consultant, Portland, Ore.-based Pension Consulting Alliance Inc.

“Instead of the assets growing at 7.75 percent, it’s projected at 7.50 percent,” Machida said. “The assets aren’t going to grow as expected originally while the liability is still going to grow at the regular pace. It’s like if you have to pay a certain amount for your mortgage and get a reduction in pay from your job, you’re not going to have as much money to pay it off.”

Besides the pension reforms that have been implemented, a carryover from 2014 investment gains helped improve the funded ratio this past fiscal year to 62.2 percent. That’s because any investment return above 7.75 percent — or whatever the targeted rate is for that year — is carried over as part of a smoothing process over the subsequent three years.

In fiscal 2015, the pension plan finished with just a 3.6 percent investment gain after a robust 17.8 percent return in the fiscal year ended June 30, 2014, and a 12.3 percent gain the previous year.

“The funded ratio improved because of the carryover investment gains from the 2014 year as well as — to a lesser degree — some of the reforms that are kicking in,” Machida said. “While we were hoping we could meet the investment return rate assumption (7.75 percent), compared with other public funds our 3.6 percent was better than most of the funds, according to our investment consultant’s quarterly report.”

Despite the improved funded ratio, the actuary calculated that it now will take an additional year before the pension fund is fully funded. That is because of the lower assumed rates of return that are now targeted for future years. The actuary now expects the ERS fund to be 100 percent funded by June 30, 2041, rather than June 30, 2040, as was estimated last year. So it still will take 26 more years — the same as last year.

“We are remaining cautious with respect to the funding of the retirement system and we will continue to look at alternatives such as purchase-of-service legislation that was passed in the 2015 legislative session that helps to properly fund the retirement system and better ensures its sustainability going forward,” Machida said.

Purchase of service, probably the most significant pension reform during the 2015 legislative session, changes the way that a person who left the state system and then returns can purchase back months or years of service.

“There was an old methodology that was used that was significantly underfunding the system,” Machida said. “Now there’s an actuarial calculation to determine the purchase amount that would more accurately determine what needs to be in the fund to pay for those years of service.”

In addition, previous pension reforms adopted to combat the pension shortfall called for the level of overall benefits to be lowered for new members after June 30, 2012. The vesting period was extended for those members, and the amount that both the members and employers must contribute to the system was increased. The employer contribution for police and fire employees was increased to 25 percent of payroll as of July 1, 2015, from 22 percent on July 1, 2012, and for all other employees, such as teachers, it was boosted to 17 percent from 15.5 percent during that same period. For most new members, employee contributions increased to 8 percent from 6 percent. But for police and fire, it increased to 14.2 percent from 12.2 percent.

The Legislature also previously passed measures that eliminated and reduced, for new members, the availability of pension spiking, a practice in which employees would work a lot of overtime toward the end of their careers to significantly boost their retirement benefits. For an existing member, an employer will have to pay the ERS for pension spiking in the year after the employee retires. That is accomplished by paying the difference between what was funded at the lower salary and what should be funded as a result of the pension spiking at the higher salary. In addition, a moratorium was placed on any enhanced pension benefits until the system is 100 percent funded.

While the state’s largest public pension fund is facing an upward battle, the state’s general fund is in better shape. The Ige administration said it had an $828.1 million budget surplus in fiscal 2015, according to the governor’s six-year financial plan. That’s higher than the $664.8 million budget surplus in fiscal 2014.

TRACKING THE MONEY

The Hawaii Employees’ Retirement System unfunded liability worsened in fiscal year 2015 even as the actuarial funded ratio improved:

* Fiscal years end June 30 of each year ** The number of years to become fully funded that is based on open group projection, recognizing new benefits for members hired after June 30, 2012, and increasing contribution patterns for future fiscal years Source: Gabriel Roeder Smith & Co.