Understanding the Funding Crisis in Public Pension Systems

What are Public Pensions?

For purposes of this discussion piece “Public Pensions” refer to the collection of state and municipality sponsored retirement plans covering employees of those jurisdictions. There are thousands of different Public Pension Plans; some plans may cover only a few municipal employees, while other plans cover thousands of workers within large statewide systems. Most of these programs are defined benefit pension plans which promise lifetime benefits based upon an employee’s salary and service.

What is the current funded status of Public Pension Systems?

It is important to remember that each of these programs is unique in its benefit design, its history, its legal framework, and its current funded status. The chart below shows the distribution of funded ratios of the 229 largest state and municipal plans as tracked by the Public Plans Data (compiled by The Center for Retirement Research at Boston College and the Mission Square Research Institute, in partnership with the National Association of Retirement Administrators and The Government Finance Officers Association.) Slightly over 20% of plans are funded at 90% or better; most are underfunded relative to the value of promised benefits; approximately 15% of plans have funded ratios below 60%. In aggregate, the funding ratio is approximately 78% and the total shortfall for the collection of plans is approximately $1.5 trillion.

Distribution of Plans by Funded Ratio

How did things get so bad?

There are many different contributing factors which have impacted some or most of these plans:

  1. Benefit design: In many cases it has been considered appropriate to give state and/or municipal employees relatively more generous retirement benefits because their base salaries were less than may have been prevalent in the private sector. This was seen to be particularly true for “protective service employees” (police and fire); most protective service employee plans have higher salary multipliers and have provision for full retirement benefits at relatively younger ages.
  2. Conscious Underfunding: In the past it has not been unusual for state or municipal legislators to support smaller contributions for pensions than those recommended by the plan’s actuaries. Since the plans had available funds, no immediate benefit payments were jeopardized, and the elected officials got more mileage out of spending the money on other programs. The propensity to contribute less than the actuarial recommendation was greater prior to the turn of the century when Government Accounting Standards Board directives for pension accounting were less specific. Those jurisdictions that employed this tactic find themselves in an ever-worsening spiral of increasing funding requirements. The chart below (also from PPD) shows these shortfalls for years since 2001; more importantly it shows the continuously increasing ARC when expressed as a % of payroll. Can these jurisdictions continue to find revenues to pay these high and increasing costs?
Employer's Annual Required Contribution as Percent of Payroll and Portion Paid
  1. Statewide Legal Restrictions on Benefit Redesign: Most states have laws that prohibit (or at least restrict) the reduction of promised benefits for state or municipal employees. This generally applies not just to benefits already earned, but also to expected future accruals for current employees.
  2. Adverse Experience: As programs have matured, actual economic and demographic experience may have been less favorable than assumed. In many plans participants retired earlier than expected on average (sometimes due to overly generous disability determinations). In most plans retirees are living longer than when the plans were initially designed. Final salaries determining actual benefits are frequently higher than anticipated (often due to overtime being allocated to those participants nearest retirement). Investment earnings may have been less than assumed. Furthermore, fluctuations in interest rates can have significant impact on the measurement of plan liabilities.

What will happen to Public Pensions if nothing is done?

If no changes are made to plan benefits, it is safe to assume that annual funding requirements will continue to increase. Some jurisdictions will have the ability to raise taxes enough to meet these higher requirements. The higher tax burden will likely force trade-offs on the availability of other public services. In extreme circumstances, the increased tax burden will not be sustainable, and we may see an increasing number of municipalities (and possibly even states) seek bankruptcy protection. It is impossible to predict how this eventuality might impact retirement benefits and/or other public services.

What are options for fixing Public Pensions?

In most programs the simple answer is to reduce benefits, and/or increase taxes; as noted in the paragraph above, these solutions face significant problems. Nonetheless, many systems have instituted measures to reduce the underfunding burden on the taxpayers. The chart below compiled and published by the researchers at the Rand Corporation shows some of these efforts. The individual plan results are mixed; but, in aggregate, these changes have not been sufficient to significantly reduce the funding shortfall.

Percentage of Plans Making Benefit Changes to Current or New Employees, by Type of Reform, 2009-2021

Most of these plans are quite mature with decreasing numbers of active members relative to retired members already receiving benefits. While not fully funded, most have asset accumulations which exceed 60% of benefit liabilities. This means that one potential solution is to focus on improved investment performance. If investment return can regularly exceed actuarially assumed investment return, then funding shortfalls will decrease. Most plans are pursuing this solution. From the 1950’s through the 1980’s we observed most plans seeking greater return by modifying their portfolios from mostly fixed income assets, into a majority exposure in traditional equities. The chart below demonstrates the movement since the turn of the century to get even more aggressive through the use private equities and hedge funds. Nonetheless, recent years have not produced excess earnings. The danger in relying solely on this solution lies in the fact that, if not successful, the other options become even more difficult to implement. Furthermore, the more aggressive investment posture exposes the funding ratio to greater volatility.

Asset allocation for State and Local Pensions

There may be an opportunity in some cases to merge smaller, severely underfunded plans into a larger more efficient program. Administrative savings and/or improved investment performance may be possible, although the aggregate impact from these sources alone is not likely to significantly reduce the funding shortfall. Certainly, the smallest and poorest funded plans might benefit, but the largest impact would be to shift some of the underfunding burden to other jurisdictions.

It must be remembered that these are long-term promises with significant impact on the lives of former, current, and future public employees. The key to making progress toward solving the long-term funding issues is for all stakeholders (legislators, municipal officers, employees, unions, even taxpayers) to focus on sustainability when making decisions on benefits, taxes, or administrative issues. In many jurisdictions it is clear that some changes and/or compromises may be necessary to avoid fiscal implosion.

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