States Face Huge Unfunded Liabilities in Their Pension Plans

On Tuesday, March 9, the New York Times reported about how state and local pension funds are changing their investment strategies to improve their funds’ fiscal status. Private companies have eschewed an emphasis on stocks in their pension plan portfolios, but states have taken the opposite track and are taking bigger risks as they hope to gain enough investment return to fund future benefits. The New York Times found that:

Most {states} have been assuming their investments will pay 8 percent a year on average, over the long term. This is based on an assumption that stocks will pay 9.5 percent on average, and bonds will pay about 5.75 percent, in roughly a 60-40 mix.

So, why have states pursued a riskier investment strategy, just as private companies have begun to shift their investments?

First, a little background. State and local pension benefits, as with private pension plans, are generally either defined benefit plan or defined contribution plans (or some combination of the two). Most states have defined benefit plans which determines future retirement benefits based on a formula based on an employee’s years of service and annual pay. Generally, employees contribute some small percentage of their wages to the plan and the government also is supposed to make annual contributions. Neither type of state plan has much protection under the rules that cover private pension pensions. The Employee Retirement Income Security Act of 1974 (ERISA), as amended, sets the rules for private plans (defined-benefit and defined contribution). And it created the safety net for private defined benefit plans, the Pension Benefits Guaranty Corporation (PBGC) which funds retirement benefits for employees covered by private defined benefit plans that end. ERISA does not apply to either type of state and local government pension plan and the PBCG’s safety net excludes state and local government plans.

In 2007 testimony, GAO found that 58 percent of state and local governments surveyed had a funded ratio of 80 percent (80 percent of plans’ liabilities were funded through the plans’ assets, a standard that experts believe is relatively secure). The percentage was a decline from 2000 and due mainly to a decline in the stock market and its effect on the value of plans’ assets. GAO also found that governments were not contributing the full amount of their annual share to the pension plans and thus, increasing the potential future problem. And this data was collected before the Great Recession’s devastating impact on state finances. GAO found:

When a government contributes less than the full ARC, the funded ratio can decline and unfunded liabilities can rise, if all other assumptions are met about the change in assets and liabilities. Increased unfunded liabilities will require larger contributions in the future to keep pace with the liabilities that accrue each year and to make up for liabilities that accrued in the past. As a result, costs are shifted from current to future generations.

And this looming gap isn’t limited to state and local pension plans, but to other retirement benefits. In a report issued last month, the Pew Center for the States found that a trillion dollar gap existed between the “the $3.35 trillion in pension, health care and other retirement benefits states have promised their current and retired workers as of fiscal year 2008 and the $2.35 trillion they have on hand to pay for them.” Pew gave only 16 states the grade of “solid performer” when it came to funding their pension plans, but only 9 states when health benefits were factored into the grading system. (Pew also notes that this data does not reflect the financial losses of late 2008). While some states have begun to make reforms to their retirement plans (about 15 states in 2009), the demand that these liabilities will put on state budgets will decrease the amount states can spend on other priorities.

It is also a cautionary tale for Federal policymakers who are avoiding the future fiscal gap in federal pension programs, including civil service retirement, military retirement, and Social Security and the future fiscal gap of PBGC (to meet the known future demands from pension plans and firms that have already gone out of business).