By Grace Harrison

State and local pension plans provide retirement benefits and payments to more than 20 million individuals. These obligations are not always fully funded, though, resulting in a projected cumulative $1.3 trillion funding gap for states following negative fiscal year 2022 returns. The stability and participation rates of defined-benefit pension plans vary over time, making investment returns and available assets a cause for concern. Each state has created and executed its plans and funding in differing ways, which allows for detailed comparisons of these plans, their policies and the health of asset holdings.

Putting Pension Plans into Perspective
Pension systems primarily derive revenue from investment returns on assets, which are subject to investment risk, interest rates and economic volatility. For instance, during the 2007-09 financial crisis pension investments lost $889 billion in value after initially standing at $3.2 trillion in 2007. While pension plan values have largely recovered — reaching nearly $3 trillion in 2013 — not all losses have been recouped. In 2021, investment returns reduced outstanding pension plan debt below $1 trillion; however, a rise in aggregate pension debt occurred in 2022, bringing its total to nearly $1.3 trillion.

Assessing Pension Plan Health with Funding Ratios
A pension’s funding ratio is a widely used way of assessing the plan’s overall health. This ratio measures the extent to which a plan’s required payouts are covered by what is currently held as assets. Estimates compiled by the Equable Institute through Dec. 31, 2022, detail state-by-state funding ratios and estimated liabilities using data from 76.4% of retirement systems that provide investment reports. State pension plans range from 103% funded to 47% funded (See Map 1).

Another way to assess pension plan health is by examining pension debt as a share of states’ personal income, which consists of the combined wages, salaries and supplementary benefits of all state residents. According to 2019 data from The Pew Charitable Trusts, the aggregate share of this debt was 6.8%. That percentage is consistently larger than the other two main sources of state debt: unfunded retiree health care and overall outstanding debt, which are respectively 4% and 3%. Across the country, this debt varies by state (See Map 2).

How States Can Address Unfunded Pension Liabilities
States have implemented various reforms in recent years. These reforms include improved risk assessment through stress tests, more realistic projections of investment returns, and costs passed on to public higher education institutions and taxpayers.

A Pew assessment of the 2018 pension funding gap stated that the risk of unfunded liabilities can be reduced by decreasing return goals and discount rates. Since projected returns on pension plans once averaged around 8%, many states have maintained that benchmark. However, recent data predicts rates of return will fall closer to 6.5%. Making this adjustment by decreasing the discount rate would help eliminate some of the gap between calculated liabilities and contributions.

A second option for states to better adjust to economic conditions is to conduct stress tests. The National Conference of State Legislatures explained this as “evaluating how pension systems would respond to a variety of potential scenarios,” such as changing market conditions. Thirteen states now require stress testing for public retirement pension systems, according to the National Conference of State Legislatures. These states include Arizona, California, Colorado, Connecticut, Hawaii, Indiana, Maryland, Montana, New Jersey, North Carolina, Pennsylvania, Virginia and Washington.

Stress test methodology can vary, but analyses generally involve testing the sensitivity of individual variables such as inflation and returns on investment, determining the outcome of scenarios on multiple variables at a time, and/or determining composite results of thousands of random simulations like stochastic modeling. Results from these tests guide the decisions and expectations of lawmakers and advisors as they adjust investments and holdings to be more resilient in future economic downturns.

Impacts of Unfunded Pension Liabilities
There are severe risks that come with underfunded pension plans. Like other gaps in funding, states must either find ways to increase revenue or adjust existing expenditures. The latter has had a detrimental effect on school systems via increased class sizes and cuts to necessary extracurricular and health services.

Public university systems are also impacted by gaps in pension funding on both the administrative and student sides. Professors and university employees can be at risk of losing their expected pension benefits, while students are faced with potential tuition hikes to combat those losses. For instance, Illinois universities have seen an exodus of professors and employees anxious to secure their pension benefits before cuts or changes can be made, even though they otherwise would have delayed retirement. While states previously funded the majority of public pensions, colleges are now facing expectations to fund pensions from a larger percentage of their payrolls. Consequently, universities are turning to increasing tuition rates and decreased rates of funding for educational programs.

In addition to damage to public schools and universities, taxpayers also experience the increased burden from these state pension debts. In California, taxpayer support for state pensions increased from $611 million to $3.5 billion over nine years (2001-10). While adjusting revenue in other sectors might be challenging, increasing taxpayer shares is often less difficult, and thus, a more common option when finding a way to finance rising pension costs.

Looking Ahead
The $1.3 trillion pension debt across more than 5,500 state and local pension plans will not disappear overnight. Existing state law and legal protections can limit what reforms states are able to enact. Some states provide protection for pension plans in their state constitutions, while others treat them as contracts protected by state and federal law. These limitations, in combination with rising cost of living over time and longer lifespans for pension recipients, indicate that more rigorous efforts are needed to close the unfunded pension liability gap.

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