Pavement Preservation Concepts: Pay Me Now, or Pay Me MUCH More Later

Roads deteriorate over time, due to climate (water, freeze and thaw, sunshine, heat, etc.) and traffic. From the moment the road is constructed, it begins to age.

"Most pavements will deteriorate through the phases listed in the [PASER (Pavement Surface Evaluation and Rating)] rating scale. The time it takes to go from excellent condition (10) to complete failure (1) depends largely on the quality of the original construction and the amount of heavy traffic loading. Once significant deterioration begins, it is common to see pavement decline rapidly. This is usually due to a combination of loading and the effects of additional moisture. As a pavement ages and additional cracking develops, more moisture can enter the pavement and accelerate the rate of deterioration." PASER Manual - Asphalt Roads, page 14.

Water is deemed the roads' worst enemy. Most of pavement preservation is designed to prevent the damage that water causes. Once a pavement cracks, whether it be concrete or asphalt, water in the cracks freezes and thaws with enormous force, causing further damage to the pavement. Water in the cracks washes out particles of pavement as traffic hits the cracks and the cracks become potholes. Water infiltrating the surface into the subsurface or "base" begins to undermine the surface causing the surface to sag. Water infiltrating from the sides through improper drainage causes similar damage. So, when we are talking about pavement preservation, and particularly so in the early stages of the pavements' life, we are talking about preventing these water damages.

However, asphalt naturally aging is also something we need to be concerned about. Asphalt is composed of asphaltenes and maltenes. The maltenes are the volatile components that escape into the atmosphere over time, drying out the asphalt which causes the asphalt to shrink and ultimately develop cracks. Thus, some of the more recent pavement preservation methods involve replacing some of the maltenes to “rejuvenate” the asphalt. These relatively low cost treatments are usually applied very early in the asphalt’s life, to prevent the cracks from even starting. (So now you know one of the reasons road agencies are doing work on roads that look in perfect condition, while other roads in worse shape are left alone.) (For an excellent introduction to asphalt aging and the use of rejuvenators, see Bob Boyer’s presentation.)

The PASER pavement condition ratings are generally related to the maintenance or repair that is needed

Rating 9 & 10 No maintenance required
Rating 8 Little or no maintenance
Rating 7 Routine maintenance, crack sealing and minor patching
Rating 5 & 6 Preservative treatments (sealcoating)
Rating 3 & 4 Structural improvement and leveling (overlay or recycling)
Rating 1 & 2 Reconstruction

However, the potential treatments vary widely and must be matched to the age of the pavements, the specific defects in the pavements, the climatic conditions, and the traffic, as well as the budget.

Typical defects in an asphalt pavement include:

• Surface defects: Raveling, flushing, polishing.
• Surface deformation: Rutting, distortion—rippling and shoving, settling, frost heave.
• Cracks: Transverse, reflection, slippage, longitudinal, block, and alligator cracks.
• Patches and potholes
  See PASER Manual - Asphalt Roads, pages 3-13 for excellent descriptions and photos of these distresses for asphalt.

Source:Asphalt Pavement Rejuvenation, presentation by Robert E. Boyer, PhD, PE, Consultant Engineer-Asphalt Pavements, Lynn Haven, Florida, at the August, 2012 National Pavement Preservation Conference.

See descriptions of several asphalt pavement preservation methods demonstrated at the August, 2012 National Pavement Preservation Conference.

Asset Management and Pavement Preservation are “Best Practices” for Michigan’s Roads and Bridges

Getting value for our taxpayers’ money is critical in spending our limited dollars for road and bridge maintenance. Applying the principles of asset management and pavement preservation are ways Michigan road agencies are attempting to get the biggest bang for our bucks.

“The term ‘asset management’ means a strategic and systematic process of operating, maintaining, and improving physical assets, with a focus on both engineering and economic analysis based upon quality information, to identify a structured sequence of maintenance, preservation, repair, rehabilitation, and replacement actions that will achieve and sustain a desired state of good repair over the lifecycle of the assets at minimum practicable cost.’’ H. R. 4348 (2012) MAP-21 Sec. 1103(2) (The new law passed this summer authorizing the Federal highway program for fiscal years 2013 and 2014 named “Moving Ahead for Progress in the 21st Century Act”, but more commonly called MAP-21.)

“Pavement preservation” methods are the techniques used to implement "asset management", i.e., a structured sequence of cost-effective capital preventive maintenance, preservation, repair, rehabilitation, and replacement actions that will achieve and sustain a desired state of good repair over the lifecycle of the assets at minimum practicable cost.

“The goal of infrastructure preservation is to cost-effectively and efficiently improve asset performance, as measured by attributes such as ride quality, safety, and service life.

Infrastructure preservation programs represent a departure from traditional approaches to maintenance, in which deficiencies are addressed as they occur. Preservation seeks to reduce the rate of deterioration.

The preventive approach is generally less costly and time-consuming than the traditional, more reactive approach. However, a strategy of prevention may be more difficult to justify because the public’s expectation is that the worst roads demand immediate attention. Furthermore, the public often interprets activities related to pavement preservation as “fixing something that isn’t broken.” . . . .

[T]ools such as life-cycle cost analysis . . . have the potential to demonstrate that implementation of a preservation strategy may cost less over the life of an asset than more “traditional” approaches that wait until the deficiencies are evident.” http://www.pavementpreservation.org/library/getfile.php?journal_id=628

In selecting an optimal pattern of preservation practices, one considers the normal life cycle of a specific stretch of pavement and performs the appropriate “fix” at the appropriate time to lengthen the useful life of the pavement at the lowest life cycle cost. Doing the preventive maintenance early in the pavement’s life extends the life of the pavement at a much lower cost per lane mile life than postponing any treatments until the pavement needs more drastic and more expensive treatments.

Most people understand this concept, which is why we change the oil in our cars rather than wait for the engine to fail. “Pay me now, or pay me MUCH more later,” as the oil change ad says.

So how do you incorporate a sound Capital Preventive Maintenance (“CPM”) element into an overall asset management program? In asset management we are MANAGING GROUPS OF PAVEMENTS not simply individual road segments. This is a critical distinction.

When considering an entire network of roads, whether it be a statewide network such as the state trunkline system MDOT is responsible for administering, or the roads that a county road commission is responsible for, an additional analysis is required.

This additional level of analysis is more complicated than will be discussed here (but discussed in exceptional clarity in Larry Galehouse’s presentation). Suffice it to say here that responding to political pressure and fixing the worst roads (“worst first”) will not purchase the optimal increases in lane mile lives. That is, not only do we need to select the right fix at the right time, but also on the right roads to fully implement pavement preservation into the asset management program. To preserve or increase the value of the transportation system asset the road agency is responsible for, the right combination of roads need to be worked on utilizing the limited resources utilizing the appropriate fix for the condition of the road.

With today's limited resources, pavement preservation must take top priority in the spending of our transportation dollars. Taxpayers are demanding value for money spent on all government services, including roads and bridges.

P.S. (Some of these cost effective pavement preservation methods implemented in Michigan were highlighted at the August 16 “Best Practices Conference on Road and Bridge Maintenance” held in Lansing. The presentations from the conference can be viewed at http://ourmiroads.com/ .

Lost Opportunity: MPSERS Reform and SB 1040

By Rep. Rick Olson, 55th District
August 16, 2012

Senate Bill 1040 as passed by both the House of Representatives and Senate today takes a major step forward in many respects, but also represents a lost opportunity.

The now $50 Billion unfunded liability and 27% and rising employer contribution were crying for a solution. The approximately $5 billion of savings achieved from benefit reductions and increased employee contributions and another about $10 billion of reduction in the calculated unfunded liability due to beginning prefunding the health care obligations are major steps forward.

Nonetheless, I regard this as a lost opportunity because:

1. A major cause of the skyrocketing employer contribution rate is what are called "stranded costs", about which I have written in detail in my blog at http://repolson.blogspot.com/2012/07/stranded-costs-in-mpsers.html, has not been addressed. The version of SB 1040 previously passed by the House as "H-3" contained the solution known as the "COE" approach. This provision was stripped in the ultimate compromise and pushed into merely study language. The ultimate resolution is put off until the lame duck session after the study report is received on or before November 15. If agreement is not reached at that time, the MPSERS system will fail and a future legislature will again be faced with the thorny issue of what to do about MPSERS.

2. Major cost savings were left on the table:

a. The provision that retirees pay a larger portion of the health care costs from 10% to 20% was watered down by exempting anyone over age 65 from that new requirement, significantly reducing the potential savings.

b. The cliff vesting provision of qualifying for retiree health care benefits after 10 years of service was not changed to a "graded premium" approach which was changed in 2007 for anyone hired after that. The cliff vesting approach was never actuarially sound and is no more sound today than ever before.

c. Retirees may still retire early and fully qualify for health care benefits, instead of having to wait until age 60 as the original SB 1040 provided.
Collectively, the lack of these changes deprives the system of billions of dollars of savings drastically needed in the system.

3. Conversely, the requiring of the retirees to pay a larger portion of their health care premiums may be harsher on low income retirees than necessary. I have previously proposed a sliding scale approach from 10% to 20% based on certain percentages above the household income poverty level. This has never been seriously discussed. This surely would reduce the savings needed by the system but may be the more humane approach, especially for the numerous retired support service people who worked for very low wages and who will have a very small pension, but with the expectation for the retiree health care benefits.

Despite the shortcomings I perceive listed above, I voted with the majority to take a major step forward, with the hopes that the legislature can adequately address the stranded cost problem in lame duck. At the same time, we will review the results of the study on the closing of the defined benefit program and substituting a defined contribution program for new hires. I trust that the study will be done on an objective basis without bias for or against the conversion. Bottom line, we have much more work to do before we can say we have reformed the system in a lasting manner, and I pledge my efforts to getting that result achieved.

Stranded Costs in MPSERS

Definition and Causes of Stranded Costs

“Stranded costs” are caused when an employee leaves the system as an employee with vested retirement or health care benefits, with unfunded liability associated with them, but with no requirement for either the employee or any employer to fund that unfunded liability. Examples:

• Normal retirements of employees where benefits are not fully funded.
• Early retirements induced by early retirement incentives with benefits not fully funded.
• “Retire-rehire” schemes to shift responsibility of unfunded liabilities to remaining system
• Privatization of support services (custodial, transportation, food service) – if the released employees have vested benefits but neither employee or employer no longer contributes to the funds
• Privatization of substitute teachers – if these subs have vested benefits
• Charter schools, if the schools caused a departure of employees from the MPSERS with vested benefits with no contributions being made for them in the future.

Note: Of course, if there were no unfunded liabilities (caused by unrealized investment rate of return, mortality and other assumptions used in calculating the “normal costs”, there would be no “stranded costs”.

Misconception

The fact that there are fewer people as active current employees does NOT cause the unfunded liability, although the “missing” employees will not be there to share the burden of prior incurred unfunded liabilities. I.e., the problem is that there were benefits “promised” that have not been funded and now there aren’t new people to shift the cost to, similar to a Ponzi scheme that ultimately fails, but that in itself does not cause “stranded costs”.

Conclusion re Charter Schools

Future potential rapid expansion of charters or charter school enrollment has the potential of creating stranded costs IF they cause displacement of employees from MPSERS participating districts with vested benefits.

Why Current Operating Expenditures ("COE")?

Many districts over the years have converted significant payroll costs to contracted services. Many of the former employees had unfunded pension and health care costs associated with them which was shifted to the remainder of the MPSERS system. A mechanism is needed to restore onto the districts responsible for those "stranded" unfunded liabilities the responsibility to pay for them. Applying a percentage charge to Current Operating Expenditures ("COE") statewide that will collect the current year charge for those unfunded liabilities spreads the responsibility more broadly, including onto contracted services which is included in COE.

Why Current Operating Expenditures ("COE") Instead of a Simpler Allocation Per Pupil?

There is an "equity gap" currently, with some districts receiving a larger foundation grant per student than others. We should not increase this equity gap.

Payroll per pupil is higher in high foundation grant districts than in lower foundation grant districts. If the unfunded liability were recovered charging the districts their proportionate share on a per pupil basis, the high foundation districts' share would be lower than their proportionate share of the state total payroll costs. Therefore, a per pupil allocation of the unfunded liability would disproportionately favor the high foundation districts, contrary to our attempt to ultimately close the "equity gap" between the high and low foundation grant districts.

Stated another way, 12.49% (the current calculated UAL percentage) of a districts payroll per student is a different amount from district to district. The higher the payroll per student in a district, the more MPSERS burden is taken off that district with a flat across the board per student categorical. The districts with high payroll per student would be the winners and the low payroll per student would be the losers in a flat across the board per student categorical.

The flat across the board per student categorical would increase the equity gap, and therefore is not a preferred solution.

The H-3 Approach to Stranded Costs

The H-3 House approved version of SB 1040 contains a solution to the stranded cost problem via the COE or "current operating expenditures" mechanism. Beginning in 2013-14 fiscal year for traditional public schools, their total MPSERS assessment will be split into two parts:

• 11.9% will be applied to Current Operating Expenditures and
• 3.5% will be applied to payroll to cover the normal costs for the revised retirement and healthcare benefits.

Together, this is equivalent to 24.46% of systemwide payroll.

Non-K-12 entities (i.e., libraries, community colleges, ISD's and MPSERS participating charters) would pay 24.46% on payroll, because of their vastly different cost structures. Universities would continue paying their remaining liability under the current plan.

Key Point: The foundation grant received by the districts would not change. However, the MPSERS payments made by the district would be in two pieces,

(1) the lump sum UAL amount based on Current Operating Expenditures and

(2) the remaining MPSERS contribution percentage of wages.

For example, assuming we wish to collect 24.46% total MPSERS contribution rate across all payroll, first we would subtract the amounts due from the libraries, community colleges, ISD’s, MPSERS participating charters and the universities. Next we subtract 3.5% (the percentage set in the bill) of payroll from the remaining K-12 districts. The remainder is then divided by the total COE of the remaining K-12 districts, which based on historical data, equals 11.9%. A computation similar to this would be done each year to set the COE rate.

Because the UAL would be paid by the districts as a percentage of their combined COE (a much larger number than total payroll), the remaining MPSERS contribution rate based on wages can go down accordingly. Thus, the payment made for their share of the UAL based on COE would be offset by a lower MPSERS contribution rate on their wages. However, because districts which have privatized significantly will now be paying the UAL based on their Current Operating Expenditures rather than their wages, the stranded costs of their privatizing will now be covered.

Other Options Explored

Several other options were investigated, but allocating the UAL according to the Current Operating Expenditures (COE) appears to match the district's responsibility for the unfunded liability the best. It is not perfect, but it works as it is a readily accessible figure to obtain by the state due to its being reported by the school districts and published in the DOE annual bulletins 1011 and 1014. See Appendix A for definitions and what is included and what not included.

Cost Control Encouraged

Also, to the extent that we wish to encourage cost control, using current operating expenditures as the factor which affects the UAL allocation creates the most incentive. The higher the Current Operating Expenditures per Pupil, the higher the District UAL per Pupil, which reduces their remaining unallocated funds.

Conclusion

If the stranded cost problem is not addressed now, it is equivalent to sitting in a boat swamped with water, bailing furiously to get the water out of the boat, but failing to plug the hole in the bottom of the boat. Privatization of support services is expected to increase in the future, because of the lower cost usually of the contracted for services (due to a combination of lower retirement benefit costs, health care costs and wages). Any MPSERS reform that does not account for and deal with these stranded costs which are expected to increase in the future will be a reform that does not last.

Appendix A: Definition of “Current Operating Expenditures” from H-3, page 18.

“(17) AS USED IN THIS SECTION, "CURRENT OPERATING
3 EXPENDITURES" FOR A PUBLIC LOCAL SCHOOL DISTRICT INCLUDES
4 FUNCTIONS 1XX, 2XX, 45X, AND ALL OBJECT CODES EXCEPT 6XXX, AS
5 DEFINED IN THE MICHIGAN PUBLIC SCHOOL ACCOUNTING MANUAL BULLETIN
6 1022, AND IS EQUAL TO THE TOTAL OF INSTRUCTIONAL AND SUPPORT
7 SERVICES EXPENDITURES, INCLUDING THE TOTAL GENERAL FUND CHARGES
8 INCURRED IN THE GENERAL, SPECIAL EDUCATION, AND VOCATIONAL
9 EDUCATION FUNDS FOR THE BENEFIT OF THE CURRENT FISCAL YEAR,
10 WHETHER PAID OR UNPAID, AND ALL EXPENDITURES OF THE INSTRUCTIONAL
11 PROGRAMS PLUS APPLICABLE SUPPORTING SERVICE COSTS REDUCED BY
12 CAPITAL OUTLAY, DEBT SERVICE, COMMUNITY SERVICES, AND OUTGOING
13 TRANSFERS AND OTHER TRANSACTIONS. CURRENT OPERATING EXPENDITURES
14 FOR A PUBLIC LOCAL SCHOOL DISTRICT ALSO INCLUDE OPERATING FUNDS
15 FOR ANY PUBLIC SCHOOL OR OTHER PUBLIC EDUCATIONAL ENTITY FIRST
16 AUTHORIZED OR ESTABLISHED BY THE PUBLIC LOCAL SCHOOL DISTRICT ON
17 OR AFTER THE EFFECTIVE DATE OF THE AMENDATORY ACT THAT ADDED THIS
18 SUBSECTION.”

“Expenditures

(Note: To avoid counting the same expenditure multiple times, Statewide and Groupings reports DO NOT INCLUDE expenditures paid to another public school (Function 411 and/or object codes 82xx.) )

Instruction - The cost of activities dealing directly with the teaching of students in the classroom or in a classroom situation. These expenditures do not include capital outlay. Per pupil expenditures for Basic and Added Needs Instruction are calculated using only K-12 and Special Education pupil fte as the divisor. Adult Education Instructional Costs per pupil are calculated using only Adult Education Participants as the divisor.

Basic Programs (Function 11x)- The classroom costs related to basic instructional classroom programs. This includes pre-k, elementary, middle, and high school programs.

Added Needs Programs (Function 12x) - The classroom costs of added needs instructional programs offered by the district. These include special education, compensatory education, or career/technical education.

Adult Education Programs - (Function 13x) - The classroom costs of adult/continuing education programs offered by the district.

Supporting Services - The cost of activities which provide administrative, technical, and logistical support to facilitate and enhance instruction. These expenditures do not include capital outlay. Per pupilexpenditures are calculated using the total pupil fte (k-12, special education, and adult education participants.)

Support Services - Pupil (Function 21x) - Those activities which are designed to assess and improve the well-being of pupils and to supplement the teaching process. These include attendance, guidance, health, and social work services.

Support Services - Instructional Staff (Function 22x) - Those activities associated with assisting the instructional staff with the content and process of providing learning experiences for pupils. It includes teacher in-service, curriculum development, educational media services, computer labs, educational television, and program directors.

Support Services - School Administration (Function 24x) - Those activities concerned with the administrative responsibility of a single school (commonly referred to as the principal's office.)

Support Services - General Administration (Function 23x) - Those activities concerned with establishing policy, operating schools and the school system, and providing essential facilities and services to staff and pupils. It includes the activities of the Board of Education and the superintendent of schools.

Support Services - Business Administration (Function 25x)- Those activities concerned with budgeting, accounting, payroll, purchasing, and internal services.

Support Services - Facilities Acquisition (Function 45x) -Those activities concerned with capital leases/purchases of land or buildings.

Support Services - Operations and Maintenance (Function 26x) -Those activities concerned with keeping the physical plant open, comfortable, and safe for use.

Support Services - Pupil Transportation (Function 27x) - Those activities concerned with the conveyance of pupils to and from school and to and from school activities.

Support Services - Other (Function 28x) - Activities other than those mentioned above which support each of the instructional and supporting service programs. It includes research, personnel, and data processing.”

http://www.michigan.gov/documents/mde/b1011-11_381977_7.pdf

SB 1040 H-3 House Floor Speech

Rick Olson, 6/13/2012

I rise to support this proposal to reform the MPSERS program. The changes proposed will put the program on a sound footing and ensure that the benefits offered by the program will in fact be able to be paid when they come due.

The first step in solving any problem is clearly defining it. Here the problems are:

1. An Unfunded Liability totaling $45.2 Billion according to the last Comprehensive Annual Financial Report, and the CAFR expected soon will probably show that to be over $50 billion.

2. The contribution rates that employers pay into the system are projected to grow from 25.7% this year to 35% in just 5 years. This is compared with 12.17% in 2000 that we thought was outrageous when I became the business manager at Adrian Public Schools.

3. This is a tremendous burden on our schools which takes away money that could otherwise be used for educating the kids. This year, the total contributions into the system is about $1,635 per student, and if we do nothing, $2,552 in 2016-17.

Three Potential Solutions

• Increase employee contributions
• Decrease benefits
• Find additional money
• This proposed solution uses all three

This H-3 Proposal:

• Increases employee contribution to 4% for Basic members and 7% for Member Investment Plan (MIP) members. This is not much of an increase from 6.4% for some employees who have been employed since July 1, 2008, while the increase will be a bit higher for longer term employees. Nonetheless, we cannot continue retirement plans that promised more than the state can afford to fund. At the same time, we should acknowledge the efforts of prior legislatures that have tightened the programs through the years. For example,
• Hybrid retirement plan adopted in 2010 will be continued for new employees
• Same health care options for new employees as state employees
• Retirees would pay 20% of their health care, other than those who are age 65 and retired by 1/1/2013
• Total prefunding of health care – instead of the fiscally irresponsible “pay as you go” method of not paying for the benefits as they are earned
• Partially fund the health care plan by continuing employee 3% contribution for health care, placed into individual accounts
• Total prefunding of health care by $603 million additional funding, spread over 2013-2018
• $470 million in health care escrow account
• $133 million in 2011-12 MPSERS set aside

Goals of Reform

• Decrease the unfunded liability
• Lower future projected contribution rates
• Be reasonable with current retirees, current employees and offer reasonable fringe benefits to prospective employees

This proposed solution achieves all three

Fiscal Impact of H-1

• Unfunded liability reduced by $15.6 billion. This is a "game changer" and will send a strong message that Michigan is serious about addressing its fiscal challenges. In all fairness, note that this is comprised of about $5 billion of real savings and about another $10 billion of reductions to the unfunded liability due to changed actuarial assumptions allowed by the GASB rules because we are beginning to fully fund the health care portion of the program.
  
• Cap the employer contribution rate at 24.46%, assuming state payments continue to fully fund the health care program in future years. In the spirit of full disclosure, it must be noted that the cap on MPSERS contributions will have an Impact on future Per Pupil Foundation Grant amounts, dampening the potential future foundation grant increases.

We need to strike a balance between the effects on employees vs. making a difference long-term in reforming the system. I am well aware of the many good people I have worked with in our schools through the years. Again in the spirit of full disclosure, my wife is a vested member of the MPSERS system and I am a non-vested member.

Let's look at the Reasonableness to Employees Under the H-3 proposal:

• The current employee contribution rates of 4% and 7% are on the high side when compared with other states, although comparing apples to apples is difficult
  
• When we compare the ratio of the burden placed on the employee versus the burden placed on the employer, the proposal's implied employee responsibility of 20% for Basic members and 33% for MIP members is less than the 43% borne by state employees’, and yet the school employees do not bear the market risks of the defined contribution plan that state employees do.
  
• The employees (past, current and future) bear about $9 billion of the total $45.2 billion unfunded liability prior to changes, or 20% of the total burden, with the employer picking up the remainder. From these last two comparisons, you can see that any claim that we are "balancing this problem solely on the backs of the employees" is totally wrong.
  
• Retirees will pay more, but the "granny" provision retaining the 10% cost share for those who are age 65 and retired on January 1, 2013 will protect the aged.

Conclusion: No one wants to pay more or receive less. Nonetheless, the $45-50 billion unfunded liability problem must be solved. On balance, this is a reasonable sharing of the burden.

Stranded Costs: “Stranded costs” are caused when an employee leaves the system as an employee with vested retirement or health care benefits, with unfunded liability associated with them, but with no requirement for either the employee or employer to fund that unfunded liability.

If the stranded cost problem is not addressed now, it is equivalent to sitting in a boat swamped with water, bailing furiously to get the water out of the boat, but failing to plug the hole in the bottom of the boat.

I am pleased that the proposal contains a solution to the stranded cost problem via the COE or "current operating expenditures" mechanism. Beginning in 2013-14 fiscal year for traditional public schools, their total MPSERS assessment will be split into two parts:

• 11.9% will be applied to Current Operating Expenditures and
• 3.5% will be applied to payroll to cover the normal costs for the revised retirement and healthcare benefits. Together, this is equivalent to 24.46% of systemwide payroll.

Other entities would pay 24.46% on payroll, because of their vastly different cost structures.

It is unfortunate that this reform proposal is complex, but this is just one of many complex issues we have been given the opportunity to address. Please join me in supporting this historic reform measure.

My Reaction to the Senators Jansen and Pavlov MPSERS Proposal:

Rick Olson
July 18, 2012

[On Wednesday, July 18, Senators Jansen and Pavlov presented an alternative to the House “H-3” version of SB 1040. H-3 was ultimately voted down in the Senate 16-22, so SB 1040 will next be discussed in a conference committee with the hopes of a resolution of the issue at the one-day August 15th session.]

1. Stranded Costs Left Unaddressed. I will have a hard time supporting any proposal that does not make some effort to deal with stranded costs. To do otherwise is to kick the can down the road again, leaving it for a future legislature to again “fix the problem past legislators failed to do”. This “compromise” proposal fails in that regard.

2. Cost of Conversion to Defined Contribution ("DC") Plan. The major reasons our House Work Group recommended against closing the current hybrid plan for new employees in favor of substituting the a defined contribution plan equivalent to that available to state employees were (1) our belief that the DC plan normal cost was less than the cost of the proposed DC plan (with our desire to control costs, not raise them, the DC plan did not seem to make sense) and (2) with the inability to prefund the health care benefits AND fund the faster amortization indicated by the GASB guidelines, we were uncertain how negative the bond rating agencies would be if the state were unable to fund the calculated Annual Required Contribution. However, the DC plan has a number of very attractive features, and we did not wish to reject the idea without further study. So, we asked that a study be completed to assess the risk that the assumptions used to calculate the normal cost would not be realized, raising the risk of future unfunded liabilities for the hybrid plan that in total would cause the DC plan to actually be less costly, rather than more costly as our initial information indicated. The study was also to explore the variance from GASB issue.

Note that the total cost of a defined benefit plan is the "normal cost" (what the actuaries estimate the future cost to be based on a set of assumptions) plus or minus the costs or savings achieved by the fund actually experiencing less or more favorable results. If investment returns are less favorable than the assumed 7% of the hybrid plan, then additional costs in the form of "unfunded liabilities" would occur. The study is intended to evaluate how likely the assumptions would not be realized and what the impacts would be if various departures from the assumptions were to occur.

Investment Rate of Return Assumptions. Since our H-3 House version of SB 1040 passed the House in June, we have recently received more information. In summary, the DC plan is highly likely to cost more than the current hybrid plan, even according to the latest Arnold Foundation memo publicized by the Mackinac Center. The long term investment rate of return would need to average below 6% for the hybrid plan to be of equal cost to the state employees’ DC plan. Kathryn Summers’ estimates put the breakeven investment rate of return at about 5.5% (or even lower if the .55% cost of the disability and life insurance elements of the plan are included to get the total of 6.75% cost of the DC plan).

The difference between the Arnold Foundation results and the ORS paper dated 6/25/2012 (from which one would conclude that the normal cost is not sensitive to a change in the investment rate assumption) is a difference in assumption regarding the size of the fund investment portfolio. ORS looked at it from its current stage with a very small asset balance, while the Arnold Foundation study looked at it when the hybrid plan would be mature and fully funded. With a larger portfolio, the investment rate of return gets proportionately more important to the final, actual cost of the system. However, even by the Arnold Foundation numbers, it is 78% probable that the 6% rate of return will be achieved, and 84% likely that the 5.5% “breakeven” rate of return be achieved. Now, I admit, that leaves a 16% chance the hybrid plan might be more expensive, but that appears to be a small risk compared with the chance to avoid the higher cost of the DC plan.

The historic MPSERS Investment returns have averaged 9.78% over the 30 years through 2010, 8.93% over 25 years, and 8.15% over 20 years. Of course, past results are no guarantee of future performance, so what we will achieve in the future is cloudy in my crystal ball. Fitch believes the 8% used in the other MPSERS fund is optimistic and is evaluating risk based on 8%, 7% and 6%. The current hybrid plan uses a statutorily established 7%. The Arnold Foundation used information from the MPSERS CAFR to calculate the probabilities of various rates of return, but the reasonableness of any assumption depends on how optimistic one is concerning the future of our country and the world's economy.

Those two "studies" are not the end of the investigation needed, however. The Arnold Foundation is hardly an unbiased organization of the type we, as policy makers, should be engaging to get objective, third-party, unbiased information on which to make these serious policy decisions. Which view of the sensitivity of the investment rate is the better view: ORS's or Arnold Foundation's? Further, the investment rate of return is just one of the many assumptions used by actuaries to calculate the normal costs. We do not know what the assumption of 3.5% payroll increase does to the calculated normal cost and now much the actual total costs may vary if payroll actually grows at a slower or faster rate. Similarly, the retiree mortality rate has varied significantly from the actuaries' assumption in the past. Has a modified assumption been substituted? If not, how sensitive is the calculated normal cost to a different assumption? We don't know, but will know if the study called for in H-3 is completed.

When we get the results of the study, we might very well conclude that the attractive features of the DC plan (most importantly being the certainty funding a DC plan achieves) outweigh the risks that the hybrid plan might ultimately be more costly. I am just reluctant to make that decision on incomplete and biased information.

GASB Variance. It has become clear that the GASB guidelines are intended for reporting purposes, and are not funding mandates, despite the unfortunately named "annual required contribution". However, even if not actually required, the question remains what the bond rating agencies response would be if the ARC were not fully funded. My research indicates that Fitch does not see a variance from ARC as an automatic negative, if the variance is small. Their ratings are dependent upon a wide range of factors, however, so I would not expect that a negative reaction would occur if the reforms enacted, in total, reduced costs and more fully funded the liabilities than before, as our H-3 does. So, I believe that moving to a DC plan, with the result of closing the DB plan and needing to amortize the unfunded liabilities on a faster basis than our cashflow would allow, would not result in a negative bond rating agency reaction. However, getting some direct responses from bond agencies would make the answer to that question more certain, which the proposed study contemplates.

Solid Information and Analysis Trumps Ideology with MPSERS

Rick Olson, State Representative, 55^th District
June 20, 2012 Revised version

The Capitol Confidential article “House GOP Hides Behind Rigged 'Study'” dated June 18, 2012 http://www.michigancapitolconfidential.com/17075 is wrong.

When our House four member Work Group on MPSERS began our work months ago, we all leaned toward having all new employees in the school systems enrolled into a defined contribution plan instead of the “hybrid” plan begun with legislation in 2010. Then we learned that if we were to be consistent in providing school employees with what the state employees’ received through their defined contribution plan, the costs may actually be higher than what the state would incur with the hybrid plan.

How can this be, when the current MPSERS employer contribution rates are 25% and rising? First we need to dissect what is contained in the current contribution rates. Of the 27.37% contribution rate for fiscal year 2012-13 for employees hired before July 1, 2010, 15.86% is for the Pension Unfunded Accrued Liability, 2.66% is for the Early Retirement Incentive enacted in 2010 amortized over 5 years, 8.75% is for Retiree Health Care, and only 3.47% is the “Pension Normal Rate”. The “normal” cost is the amount needed to fund the pension benefits earned in that year according to the actuaries’ calculations. This is the rate that must be compared with the cost of a defined contribution plan.

For state employees, the state pays 4% of wages, plus matches up to 3% more if the employee voluntarily contributes into the plan, for a maximum of 7%. The actual history is the state paying about 6.2%, because all employees do not contribute the amount necessary for that state to reach the 3% maximum match. So, knowing that the hybrid plan is much less rich a benefit plan than for employees hired prior to July 1, 2012, we asked what the “normal cost” was for employees in the hybrid plan. We learned that they were 2.24% for fiscal year 2013 and 2.67% in fiscal year 2014. Hmm, these costs were lower than 6.2%. If we wished to reduce the cost of the MPSERS program to employees, did it make sense to adopt a plan that was higher cost? We opted to recommend sticking with the hybrid plan for new employees.

The Senate adopted a version of SB 1040 that would have closed out the defined benefit plan and placed all new employees into a defined contribution plan. This would have the effect under Government Accounting Standards Board guidelines of requiring a quicker amortization of the unfunded liability than if we stuck with the existing plan. This would make it difficult to do both the pre-funding of the health care benefits that the House favored and funding the amount that the GASB rules indicated needed to be reported as the “annual required contribution” (“ARC”).

We in the House recognized that we did not have all of the information we needed to make a fully informed decision to close the defined benefit program and adopt the defined contribution plan the Senate preferred.

a) That is, the lower normal cost of the hybrid plan is a calculated percentage, based on certain assumptions, including a 7% investment rate of return. We want to see some sensitivity analysis of what the cost would be if the actual rate of return were 6%, 5%, 4%, etc. While we will not be able to predict exactly what the future investment return will be, we would know how sensitive the calculated cost of the hybrid plan is to different investment rates.
Any defined benefit plan, including the hybrid plan, contains the risk that the assumptions used by the actuaries in calculating the “normal cost” are overly optimistic. If the cost of the hybrid plan assuming a 6% investment rate of return is greater than the 6.2% cost likely under a defined contribution plan, we might well decide that adopting the defined contribution plan makes sense. If such a small variance from the actuaries’ assumptions makes such large difference in actual cost, the risk is high that the hybrid plan might end up more expensive than the defined contribution plan that does not rely on assumptions. It might make sense to eliminate that risk altogether and adopt the defined contribution plan. On the other hand, if the cost of the hybrid plan is still cheaper with a 2% investment rate of return, sticking with the hybrid plan would most likely be less costly in the long run.

b) Further, the proponents of the defined contribution program claimed that the state was not required to actually fund the program according to the amounts calculated and reported in the financial statements as required by GASB. We don’t know how the bond rating agencies would react to the state failing to fund the ARC. The study is intended to allow time for our bonding professionals to contact the key bonding agencies and attempt to determine what their reaction might be if that were to occur.

With the results of the study this fall, it may turn out that the risk is low that the defined benefit plan will be more costly and that the bonding agencies will not adversely rate our state’s bonds if we were to close out the defined benefit plan but not fully fund the ARC. If so, then it may make sense to take this step, in addition to the pre-funding of the health care benefits as planned in the H-3 substitute Senate Bill 1040 as passed by the House of Representatives.

If not, we will have made significant progress to bringing the costs of the MPSERS program under control, capped the contribution rate employers would pay, reduced the unfunded liability an estimated $15.6 billion, taken a stride toward taking care of the “stranded cost” problem, and all while being reasonable with our valued public school employees and retirees.

This is a case where solid information and analysis trumped the ideological arguments made by the Mackinac Center when the House approved its version of SB 1040.

“Best Practices Conference on Road and Bridge Maintenance” on Thursday, August 16

2012’s “Best Practices Conference on Road and Bridge Maintenance” will be held on Thursday, August 16 in Lansing at the Michigan Municipal League at 208 North Capitol Avenue #1, Lansing, MI), from 9:00 a.m. to 4:00 p.m.  Rep. Roy Schmidt (Grand Rapids) and I are again organizing the event, joined this year by Rep. Doug Geiss (Taylor).

The goal is to enable attendees to leave with concrete ideas they can use in their home road agencies, and to stretch their imaginations for how to do things better, faster and cheaper, as well as to demonstrate the things road agencies are doing to get value for money spent on road projects.

Tentative items on the agenda include:

• Cold In Place Recycling of asphalt as an example of how to maximize customer/driver and local business satisfaction by getting projects done with the minimum of traffic interference.
• “Safety Edge” for asphalt projects to make roads safer.
• Bridge in a Backpack, using carbon fiber tubes filled onsite with concrete to build bridges much more quickly.
• Transportation Funding Findings to Date and Conclusions Reached
• Status of Transportation Funding Bills Introduced
• Winner: Dumbest regulation or engineering specification that increases the cost of road or bridge maintenance or construction
• Winter maintenance: APWA Excellence in Snow and Ice Control Award
• Working lunch (sponsored by CRAM, MITA and MML)
• Best Practices from other states and how these can be/are being transferred to Michigan
• A review of the MDOT Life-Cycle Cost Analysis process and what that does for efficiency and effectiveness in getting value for money.
• Pavement Demonstration Program successes and things learned.
• Panel discussion on Best Practices Ideas at the local Road Commission level for pavement preservation.

This looks to be an even more exciting agenda than we were able to put together last year.

Note, as the tentative agenda says, we will be announcing the winner of “the dumbest regulation or engineering specification that increases the cost of road or bridge maintenance or construction”. Please brainstorm to make a submission, describing (1) the regulation or specification, (2) the source of the regulation or specification, (3) why it is dumb, (4) the suggested cure for the problem and (5) at least a SWAG estimate of what the savings might be if the cure was adopted. I am not sure yet how we will judge the “contest”, but we will figure that out in time and hopefully have a bit of fun with this as well.

The 2011 conference received high marks from the attendees, so I hope you can make it. There is no cost, so as I recall from my days growing up in the U.P., “anything free is worth savin’ up fer”. Spread the word as well.

For lunch planning and handout material purposes, please RSVP by responding to this e-mail message or call my office at 517-373-1792.

Rick Olson, State Representative, 55th Legislative District
989 Anderson House Office Bldg.
517-373-1792, 734-646-5286 cell
rickolson@house.mi.gov
http://repolson.com

Transportation Funding Findings to Date and Conclusions Reached

We have talked much about needing more money for our roads and bridges. For those not intimately involved in those discussions, here is a summary of the findings of various studies done in recent years:

1. TF2 Report.  In 2008, the Transportation Funding Task Force (TF2) recommended that the state increase investment (and accompanying revenue) $3 billion to achieve its “good” option for transportation (considering all transportation needs, including roads, bridges, addressing safety issues, increasing capacity, rail, transit and aviation).

2. House Transportation Committee Work Group. The September, 2011 report “Michigan’s Road Crisis: What Will It Take to Maintain Our Roads and Bridges?” reported on what it would take to just preserve our existing road surfaces and bridges and achieve over a 12 year period 95% of the freeways and 85% of all other paved roads in the state at a “good” or “fair” condition. It found that it would take an investment of at least $1.4 billion more per year than current spending. The study used the asset management approach of what would be the least cost long-term combination of “fixes” and timing of fixes to maintaining the value of the state’s assets of roads and bridges – a business approach. This approach emphasizes doing the capital preventive maintenance to avoid the much higher cost “fixes” of rehabilitation or reconstruction necessary much sooner in the road life than if the capital preventive maintenance is not done.

3. House Transportation Committee Work Group Update. The “Michigan’s Road Crisis: What Will It Take to Maintain Our Roads and Bridges? 2012 Update” released in March, 2012 indicated that the shortfall to achieve the 95%/85% goals had risen to $1.542 billion per year and rising over the 12 years studied. This study was updated to reflect the year delay from 2012 that the first additional moneys were assumed to be available in the initial study due to the failure to achieve any funding increases in 2011. The study also utilized additional road condition data unavailable in 2011. The study also found that the year’s delay will cost the hardworking taxpayers in the state an additional $1.8 billion over the next 12 years compared to the costs had the legislature acted in 2011.

4. TRIP Report. “Where Are We Going? Current and Future Pavement and Bridge Conditions, Safety, and Congestion Levels of Michigan’s Roadways and the Impact on Michigan Households, Based on Investment Levels over the Next Decade,” was issued by TRIP, a Washington, DC, based national transportation research organization in late March, 2012. The report concluded: “Increased transportation investment is critical to Michigan's economic recovery and to lower costs for state's residents; each Michigan household could save nearly $2,000 annually by 2022 if funding is increased to allow for significant improvements.”

5. Phase In? Another run of the funding model was run to see what the result would be if the legislature were to phase in funding increases of $200 million the first year, then $400 million, then $600 million, then $800 million and finally $1 billion, rather than do a $1.4 billion increase all at once. The result was that, although these amounts of money are far better than no additional money, we would actually see a decrease in the average quality of our roads in the future from the current condition. That is, the roads would still be deteriorating faster than the capital improvements to them.

6. Just Maintain Our Current Poor Quality? The House Transportation Committee Work Group set the 95%/85% goals and then sought to see what the lowest cost combination of “fixes” and timing of “fixes” was to derive the additional funding needed. A follow up question was asked, “What would it take to just maintain the road conditions with no average road system improvement?” The funding model was again used and the following was the result (i.e., we would still need over $1 billion more per year, and rising):

Year	Total Funds Needed to Maintain Roads in 2011 Condition	Total Additional Funding Above Current Investment Needed to Maintain 2011 Condition
(millions)	(millions)
2013	$2,796.95	$1,104.53
2014	$2,796.42	$1,104.00
2015	$2,700.99	$1,008.57
2016	$2,276.56	$584.09
2017	$2,567.96	$875.14
2018	$2,734.69	$1,042.25
2019	$2,916.46	$1,224.16
2020	$3,062.21	$1,369.87
2021	$3,035.90	$1,342.37
2022	$3,012.37	$1,320.52
2023	$3,122.45	$1,429.25
2024	$3,315.41	$1,623.00
2025	$3,485.79	$1,793.37
Total	$37,824.16	$15,821.15
Avg	$2,909.55	$1,217.01

7. Anderson Economic Group/Michigan Chamber Foundation. The economic report entitled “Economic Impact and Policy Analysis of Four Michigan Transportation Investment Proposals” (June, 2012), which was commissioned by the Michigan Chamber Foundation and prepared by Anderson Economic Group (AEG), concludes that:
   1. funding for Michigan roads has declined in both real and nominal terms in the past decade – fuel taxes have not been indexed to inflation and those funds do not stretch as far as construction costs have escalated,
   2. the quality of Michigan’s roads will decline rapidly if more funding is not raised for additional repairs and maintenance,
   3. fixing the rest of the state’s deteriorating roads and bridges would create an additional 11,000 jobs,
   4. money invested in roads and bridges has a higher economic multiplier than household spending because some of the money would have otherwise been spent out of state and because road construction work and its related supply chain is based largely in state. The study estimated the net economic benefit of these scenarios by accounting for both the benefits of infrastructure spending and the costs associated with forgone expenditures by taxpayers (which negative impact is rarely seen in economic impact studies justifying a special interest group’s position),
   5. job providers benefit from a well-maintained infrastructure, and
   6. the four most talked-about funding proposals of $1.4 billion additional road funding would provide adequate funding to complete the necessary infrastructure repairs, with increased wholesale gas taxes and vehicle registration fees – or some combination of the two – all very close in terms of the economic boost they would provide to the state.

Conclusions Reached:

1. We need at least $1.542 additional funding or savings to maintain our roads and bridges and achieve the 95%/85% good or fair condition in the next 12 years.

2. To avoid another $1.8 billion cost to the taxpayers caused by delay, action needs to be taken timely in 2012 to avoid missing the 2013 construction year as well. Time is not on our side.

3. We need to be bold in filling the funding gap in one fell swoop, as incrementalism does not achieve the goals.

4. Doing less than the total need would expend considerable political capital and end up disappointing the taxpayers with higher costs, but no better roads. That is, if we are to take action, we might as well achieve the goals, rather than take the potential political heat for the higher costs AND still have poor roads.

5. While it will cost motorists money in terms of higher gas taxes and vehicle registration fees, there will be offsetting savings in vehicle repairs, longer life vehicles, safety, etc.

6. There are both short term job benefits and long-term benefits of creating an environment for businesses to flourish from maintaining our roads and bridges.

Solid Information and Analysis Trumps Ideology with MPSERS

The Capitol Confidential article “House GOP Hides Behind Rigged 'Study'” dated June 18, 2012 http://www.michigancapitolconfidential.com/17075 is wrong.

When our House four member Work Group on MPSERS began our work months ago, we all leaned toward having all new employees in the school systems enrolled into a defined contribution plan instead of the “hybrid” plan begun with legislation in 2010. Then we learned that if we were to be consistent in providing school employees with what the state employees’ received through their defined contribution plan, the costs may actually be higher than what the state would incur with the hybrid plan.

How can this be, when the current MPSERS employer contribution rates are 25% and rising? First we need to dissect what is contained in the current contribution rates. Of the 27.37% contribution rate for fiscal year 2012-13 for employees hired before July 1, 2010, 15.86% is for the Pension Unfunded Accrued Liability, 2.66% is for the Early Retirement Incentive enacted in 2010 amortized over 5 years, 8.75% is for Retiree Health Care, and only 3.47% is the “Pension Normal Rate”. The “normal” cost is the amount needed to fund the pension benefits earned in that year according to the actuaries’ calculations. This is the rate that must be compared with the cost of a defined contribution plan.

For state employees, the state pays 4% of wages, plus matches up to 3% more if the employee voluntarily contributes into the plan, for a maximum of 7%. The actual history is the state paying about 6.2%, because all employees do not contribute the amount necessary for that state to reach the 3% maximum match. So, knowing that the hybrid plan is much less rich a benefit plan than for employees hired prior to July 1, 2012, we asked what the “normal cost” was for employees in the hybrid plan. We learned that they were 2.24% for fiscal year 2013 and 2.67% in fiscal year 2014. Hmm, these costs were lower than 6.2%. If we wished to reduce the cost of the MPSERS program to employees, did it make sense to adopt a plan that was higher cost? We opted to recommend sticking with the hybrid plan for new employees.

The Senate adopted a version of SB 1040 that would have closed out the defined benefit plan and placed all new employees into a defined contribution plan. This would have the effect under Government Accounting Standards Board guidelines of requiring a quicker amortization of the unfunded liability than if we stuck with the existing plan. This would make it difficult to do both the pre-funding of the health care benefits that the House favored and funding the amount that the GASB rules indicated needed to be reported as the “annual required contribution” (“ARC”).

We in the House recognized that we did not have all of the information we needed to make a fully informed decision to close the defined benefit program and adopt the defined contribution plan the Senate preferred.

• That is, the lower normal cost of the hybrid plan is a calculated percentage, based on certain assumptions, including a 7% investment rate of return. We want to see some sensitivity analysis of what the cost would be if the actual rate of return were 6%, 5%, 4%, etc. While we will not be able to predict exactly what the future investment return will be, we would know how sensitive the calculated cost of the hybrid plan is to different investment rates.
  
  Any defined benefit plan, including the hybrid plan, contains the risk that the assumptions used by the actuaries in calculating the “normal cost” are overly optimistic. If the cost of the hybrid plan assuming a 6% investment rate of return is greater than the 6.2% cost likely under a defined contribution plan, we might well decide that adopting the defined contribution plan makes sense. If such a small variance from the actuaries’ assumptions makes such large difference in actual cost, the risk is high that the hybrid plan might end up more expensive than the defined contribution plan that does not rely on assumptions. It might make sense to eliminate that risk altogether and adopt the defined contribution plan. On the other hand, if the cost of the hybrid plan is still cheaper with a 2% investment rate of return, sticking with the hybrid plan would most likely be less costly in the long run.
  
• Further, the proponents of the defined contribution program claimed that the state was not required to actually fund the program according to the amounts calculated and reported in the financial statements as required by GASB. We don’t know how the bond rating agencies would react to the state failing to fund the ARC. The study is intended to allow time for our bonding professionals to contact the key bonding agencies and attempt to determine what their reaction might be if that were to occur.

With the results of the study this fall, it may turn out that the risk is low that the defined benefit plan will be more costly and that the bonding agencies will not adversely rate our state’s bonds if we were to close out the defined benefit plan but not fully fund the ARC. If so, then it may make sense to take this step, in addition to the pre-funding of the health care benefits as planned in the H-3 substitute Senate Bill 1040 as passed by the House of Representatives.

If not, we will have made significant progress to bringing the costs of the MPSERS program under control, capped the contribution rate employers would pay, reduced the unfunded liability an estimated $15.6 billion, taken a stride toward taking care of the “stranded cost” problem, and all while being reasonable with our valued public school employees and retirees.

This is a case where solid information and analysis trumped the ideological arguments made by the Mackinac Center when the House approved its version of SB 1040.

SB 1040 MPSERS Reform Necessary

(This is the speech I gave on the floor of the House on June 13 in support of the House (H-3 substitute) version of Senate Bill 1040, which would reform the Michigan Public School Employee Retirement System and put it on a solid financial foundation.)

I rise to support this proposal to reform the MPSERS program. The changes proposed will put the program on a sound footing and ensure that the benefits offered by the program will in fact be able to be paid when they come due.

The first step in solving any problem is clearly defining it. Here the problems are:

1. An Unfunded Liability totaling $45.2 Billion according to the last Comprehensive Annual Financial Report, and the CAFR expected soon will probably show that to be over $50 billion.
   
2. The contribution rates that employers pay into the system are projected to grow from 25.7% this year to 35% in just 5 years. This is compared with 12.17% in 2000 that we thought was outrageous when I became the business manager at Adrian Public Schools.
   
3. This is a tremendous burden on our schools which takes away money that could otherwise be used for educating the kids. This year, the total contributions into the system is about $1,635 per student, and if we do nothing, $2,552 in 2016-17.

Three Potential Solutions

• Increase employee contributions
• Decrease benefits
• Find additional money

This proposed solution uses all three

This H-3 Proposal:

• Increases employee contribution to 4% for Basic members and 7% for Member Investment Plan (MIP) members. This is not much of an increase from 6.4% for some employees who have been employed since July 1, 2008, while the increase will be a bit higher for longer term employees. Nonetheless, we cannot continue retirement plans that promised more than the state can afford to fund. At the same time, we should acknowledge the efforts of prior legislatures that have tightened the programs through the years. For example,
• Hybrid retirement plan adopted in 2010 will be continued for new employees
• Same health care options for new employees as state employees
• Retirees would pay 20% of their health care, other than those who are age 65 and retired by 1/1/2013
• Total prefunding of health care – instead of the fiscally irresponsible “pay as you go” method of not paying for the benefits as they are earned
• Partially fund the health care plan by continuing employee 3% contribution for health care, placed into individual accounts
• Total prefunding of health care by $603 million additional funding, spread over 2013-2018
• $470 million in health care escrow account
• $133 million in 2011-12 MPSERS set aside

Goals of Reform

• Decrease the unfunded liability
• Lower future projected contribution rates
• Be reasonable with current retirees, current employees and offer reasonable fringe benefits to prospective employees

This proposed solution achieves all three

Fiscal Impact of H-1

• Unfunded liability reduced by $15.6 billion. This is a "game changer" and will send a strong message that Michigan is serious about addressing its fiscal challenges. In all fairness, note that this is comprised of about $5 billion of real savings and about another $10 billion of reductions to the unfunded liability due to changed actuarial assumptions allowed by the GASB rules because we are beginning to fully fund the health care portion of the program.
  
• Cap the employer contribution rate at 24.46%, assuming state payments continue to fully fund the health care program in future years. In the spirit of full disclosure, it must be noted that the cap on MPSERS contributions will have an Impact on future Per Pupil Foundation Grant amounts, dampening the potential future foundation grant increases.

We need to strike a balance between the effects on employees vs. making a difference long-term in reforming the system. I am well aware of the many good people I have worked with in our schools through the years. Again in the spirit of full disclosure, my wife is a vested member of the MPSERS system and I am a non-vested member.

Let's look at the Reasonableness to Employees. Under the H-3 proposal:

• The current employee contribution rates of 4% and 7% are on the high side when compared with other states, although comparing apples to apples is difficult.
  
• When we compare the ratio of the burden placed on the employee versus the burden placed on the employer, the proposal's implied employee responsibility of 20% for Basic members and 33% for MIP members is less than the 43% borne by state employees’, and yet the school employees do not bear the market risks of the defined contribution plan that state employees do.
  
• The employees (past, current and future) bear about $9 billion of the total $45.2 billion unfunded liability prior to changes, or 20% of the total burden, with the employer picking up the remainder. From these last two comparisons, you can see that any claim that we are "balancing this problem solely on the backs of the employees" is totally wrong.
  
• Retirees will pay more, but the "granny" provision retaining the 10% cost share for those who are age 65 and retired on January 1, 2013 will protect the aged.

Conclusion: No one wants to pay more or receive less. Nonetheless, the $45-50 billion unfunded liability problem must be solved. On balance, this is a reasonable sharing of the burden.

Stranded Costs: “Stranded costs” are caused when an employee leaves the system as an employee with vested retirement or health care benefits, with unfunded liability associated with them, but with no requirement for either the employee or employer to fund that unfunded liability.

If the stranded cost problem is not addressed now, it is equivalent to sitting in a boat swamped with water, bailing furiously to get the water out of the boat, but failing to plug the hole in the bottom of the boat.

I am pleased that the proposal contains a solution to the stranded cost problem via the COE or "current operating expenditures" mechanism. Beginning in 2013-14 fiscal year for traditional public schools, their total MPSERS assessment will be split into two parts:

• 11.9% will be applied to Current Operating Expenditures and
• 3.5% will be applied to payroll to cover the normal costs for the revised retirement and healthcare benefits. Together, this is equivalent to 24.46% of systemwide payroll.

Other entities would pay 24.46% on payroll, because of their vastly different cost structures.

It is unfortunate that this reform proposal is complex, but this is just one of many complex issues we have been given the opportunity to address. Please join me in supporting this historic reform measure.

Cyber Schools via SB 619: A Cost Effective Opportunity - If We Do It Intelligently

The ability for students to take K-12 courses online is a good thing. Many advanced students can earn credits and advance their college readiness and/or high school graduation date. Struggling students can earn credits to catch up on courses they may have previously failed or to make up for the credits they missed by failing one or more courses. Online learning offers another way to learn that fits some students learning styles better than the traditional classroom.

 

To enhance the use of online learning in our traditional public schools through a “blended model”, I will support the following:

1. Eliminate the need for getting “seat time waivers”, by requiring MDOE to establish an after the fact reporting system instead, based on previously adopted qualifications criteria. HB 5392 (Rep. O’Brien) may be the vehicle to get this accomplished.

2. Require the Michigan Department of Education to execute a Request for Proposal process for online course providers to bid to provide individual courses that public schools across the state can purchase, similar to how MIDeal works for trucks and other items. This has the potential to lower the costs of individual courses students may access to accelerate their progress or make up classes needed to graduate.

3. Amend the Public Employee Relations Act (PERA) to make the offering of online classes, the awarding of credits for online classes or the supervision of students taking online classes an impermissible subject of bargaining. Unless this is so designated, as a “work condition”, it is a mandatory subject of bargaining under current collective bargaining law, and often used as an impediment for school districts to implement online learning, other than as a “pilot program” which currently has that protection.
   
   MCL 423.215  currently states the following is an impermissible subject of bargaining:  “Decisions concerning use of experimental or pilot programs and staffing of experimental or pilot programs and decisions concerning use of technology to deliver educational programs and services and staffing to provide the technology, or the impact of these decisions on individual employees or the bargaining unit.”
   
   The language regarding cyber learning, however, when mixed in with the pilot program language, has been unclear and a continuing point of contention in negotiations with teacher unions. Clarity would help.

Another benefit of cyber schools is that they may be more efficient and thus cost less per student. This is a good thing. But herein lies an issue. "For state aid purposes, the State School Aid Act provides that the per pupil foundation allowance for PSAs (including cyber schools) is equal to the foundation allowance of the school district in which the PSA school is located, subject to a maximum PSA foundation allowance of $7,110." House Fiscal Agency Memorandum dated 12-5-2011http://www.legislature.mi.gov/documents/2011-2012/billanalysis/House/pdf/2011-HLA-0619-5.pdf.

The simple truth is, we really don't know just what the costs of the full-time online schools are. But, the sources noted in the Appendix below appear to indicate that the full-time online schools can and do operated at a lower cost per student. If that is true, as a fiscal conservative, it does not appear that we should pay any more than we have to.

It is important when setting up an entirely new system of delivering education that the question be asked, “How should this be funded? Is following the same payment system as for the traditional public school wise if the cyber schools have an entirely different cost structure?”

 

To the extent that the cyber schools can offer the courses at lower cost, the profits would go to the providers. Now, there is nothing wrong or evil about profits in a free enterprise system, but profits offered in a price fixed system are not good. Prices fixed at higher than market clearing prices will not result in an optimal allocation of resources. The supply will proliferate and drain money from the traditional public schools. This is particularly true when SB 619 would allow the online schools to cherry pick the lowest cost grade levels to offer, to maximize profits. My preference would be that if we can get these services at a lower cost for equal or better quality, the savings should go to the taxpayers.

Differing Costs by Grade Level. It is generally acknowledged that it costs different amounts of money to educate an elementary student than a middle school student or a high school student. Middle and high schools offer more extracurricular activities, such as sports, band and drama. A higher proportion of elementary students ride the busses than high school students, many of whom drive themselves to school, and thus cost more for bussing per student. Middle and high schools typically require more administrators per student than elementary schools. The differences go on and on. Nonetheless, when it comes to funding traditional public schools, the foundation grant per student is the same, regardless of the mix of elementary, middle and high school students in a school or school district. Over time, the schools have simply managed their expenses within the funds allocated to them, accommodating the cost differences. Whether traditional public schools should be allocated different amounts for different levels of students is an open question, but one left for another day. Nonetheless, the question is very pertinent for online cyber schools.

Charter Schools? This difference in cost of differing grades issue has been brought up in the context of regular charter schools, also known as public school academies. To the extent that many charters only offer elementary school grades, critics charge that they are unfair competition with traditional public schools because the charters only admit the students that they can educate cheaply. Also, charter school are not required to participate in the Michigan Public School Employees Retirement System, into which the traditional public schools have to pay 24.46% of wages paid into the system in the 2011-12 school year and projected to be 27.37% in the coming school year unless reforms are made. Charter supporters counter with the argument that the charters can only receive the lowest foundation grant that any traditional public school receives and that, in contrast with traditional public schools, charters cannot levy school bond millages for facilities, but must pay for the brick and mortar through the foundation grant funds. The ultimate resolution of this significant argument is also left for another day.

 

A Procurement Model Option? I have explored the possibility of some system under which online education providers would be required to bid to provide the services so that the costs to the state reflect the actual costs plus reasonable profit to the providers. What I would like to create is a free market, competitive system where price discovery occurs naturally. A bidding process would require each provider to adjust its bids according to those different costs of providing the service for whatever combination of education services it seeks to provide or risk being outbid. However, so far I have not come up with how this could be done.

Arbitrary Foundation Grant? Alternatively, an arbitrary "foundation grant" amount will be paid to the cyber schools. If set as the basic foundation grant received by traditional public schools, I don’t know why we would want to pay a Cadillac price for an Chevy Impala product. That simply is not fighting for the hardworking taxpayer, paying more than we have to.

 

Pay for Performance? Another alternative would be for the cyber schools to only get paid for courses successfully completed by the students. Successfully completing an online course is difficult, taking a great deal of discipline, so merely enrolling in courses, and the cyber schools receiving foundation grants simply based on enrollment does not appear to be the answer. If this is based on the schools' self-reported success, this would put an incentive to bias results towards "successful completion" even when students did not learn. On the other hand, there are many courses for which there are no third party testing services to verify the students learning. Nonetheless, without some such "payment for performance", I fear that we will not have the quality of performance taxpayers have a right to expect for the use of their taxpayer funds. It will be argued that good performance is not always achieved in the traditional public schools either, but that does not excuse simply opening up a new potential avenue for student failure while potentially wasting taxpayer money.

 

Compromise Sought. I have previously said that until I see that some of these concerns are addressed, I will be a "No" vote on SB 619. I now seek a compromise.

 

I have learned that the amount paid for online learning is entirely a function of the adoption of the School Aid Bill in the Appropriations process. As such, there is no way within SB 619 to set the appropriate amount cyber schools should be paid, whatever that is. So, I will be proposing an amendment to require the Michigan Department of Education, together with the House and Senate Fiscal Agencies (and perhaps the Department of Treasury and the Michigan Department of Technology, Management & Budget (DTMB)) to study and report on the costs of online learning, to provide objective information on the proper level of funding for these programs in the future. Perhaps this will lead to a more rational approach to the issue of funding online programs than I currently hear.

Appendix: Costs of Online Learning

First, we should distinguish between “supplemental online” courses which are purchased individually by school districts or others from full-time online schools. Supplemental online courses are usually courses with no teacher on the other end, other than the one who previously narrated the recorded lesson. The student is usually overseen be some school employee, usually simply in a monitoring role (although there seems to be some question of whether this needs to be a certified teacher monitoring the students if this is being done in school in the absence of a seat time waiver). The students taking the supplemental courses are usually doing so to make up credits for courses they had previously failed. The school the student is enrolled is responsible for all reporting, etc.

The full-time online schools, on the other hand:

• Must adhere to all state and federal accountability req. (State Assess., NCLB, etc.)
• Special Needs Accommodations (all)
• Student Support Services (Enrollment, Counseling, Extra-curriculars)
• Serve all grade levels
• Data compilation (Tracking students’ academic records)
• Full-time Staff (benefits)
• Student Technology

Now, let’s explore the full time online cyber schools’ cost structure, from what little research currently exists.

1. One study estimated that about $1.6 million was needed for start-up money for a full time virtual school, and then between $3650 and $8300 per student thereafter, depending on program type, size, and quality, as well as level of investment into research, development and innovation. See “Costs and Funding of Virtual Schools”, by Augenblick, Palaich & Associates, October, 2006,

2. Colorado Cyberschools Enrollment, Costs and Funding Per the Colorado Cyberschool Association (2004), they estimated the costs as follows:

• Curriculum/content: $1080
• Instruction: $2400
• Course Mgmt/technology $750
• Student Support $1580
• School Admin $700
• District Admin $700
• The estimated total cost per student $7210

The report also stated the following payments in various states:

• Florida Virtual School: $4,820 per FTE (03-04); FLVS receives funding only for course completions (similar to Texas)
• Minnesota: Full FTE funding at the school district level or$4,600 for students in grades one through six, and $6,000 for students in grades seven through twelve. Based on per course apportionment.
• California: online programs receive FTE funding (termed ADA for Average Daily Attendance in California) at the level of the school district’s “normal” funding.
• Wisconsin: 12 virtual school; $5845 per student
• Ohio: Full-time, multi-district programs. State funding follows the student, districts lose most of the state foundation funding, but none of the local funding. Receive state funds directly from the state; these funds have been transferred from school district allocations

3. http://sfc.virginia.gov/pdf/committee_meeting_presentations/2011%20Interim/September_22/092211_No2.pdf provided the following chart, based on $6500 per student:

This chart reveals a significant opportunity to lower costs long run through economies of scale. As the number of students an online provider serves, the average cost per student for technology and curriculum goes down significantly as those costs are mostly fixed costs. One does not have to recreate the curriculum for each student. The marginal cost per student would be the costs of the textbooks (hard copy or lease costs for online versions if not created inhouse), some other materials, and the computer and Internet access. These would hardly reach 44% of the $6500 or $2,850 per student.

4. K12's Flood is reported in a 2004 article to have said “that states need to allocate approximately $4,800 to $5,000 per student to adequately support virtual schools.” Virtual-School Costs Under Siege, April, 2004.

5. The Wisconsin Virtual Academy employed one teacher for every forty-two students, producing above-average student achievement for half the cost of normal per-pupil expenditures ($5,500 as opposed to $9,000-$13,000). The Rise of Cyber-Schools, Online Education and Its Enemies, by Liam Julian.