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Public Pension Asset Exhaustion Only a Remote Possibility Print E-mail

istock_000014496774xsmallSome Members of Congress have suggested that Congress alter its long standing position of allowing the states and local governments to address their retirement funding issues without interference from the federal government, which the Congressional Research Service (CRS) outlines in its legal overview report, “State and Local Pension Plans and Financial Distress.” The rationale supporting such a dramatic policy shift is possible future shortfalls in the assets public pension plans hold in trust to pay benefits to retirees over future years.

This paper focuses on two economic studies that evaluate pension sustainability based on the ability of pension trust funds to pay benefits promised over the coming years. The paper will examine the strengths and weaknesses of these studies and assess their value as a tool for policymakers.

Key Findings

  • Existing studies result in different estimates. Overly simplified economic models that diverge from legal requirements and actual funding practices are inadequate to inform the public and policymakers on significant retirement plan design changes.
  • Studies that evaluate pension plans on an ongoing plan basis indicate that plans have on average 30 years of breathing room. Due to the long-term nature of their liabilities, state and local governments can adjust to changes in financial and economic conditions. Moreover, public pension are quickly recovering from financial downturn and could emerge even stronger thanks to a myriad of recently enacted legislative changes.
  • While the exhaustion of retirement savings is a clear danger for workers who rely solely on the modest amounts accumulated to date in defined contribution (DC) accounts, public pension asset exhaustion is, at worst, a remote possibility.
Background

On February 9, 2011, the Public Employee Pension Transparency Act (H.R. 567) was introduced. Unless public pension plans disclose their liabilities based on a so-called “risk-free rate,” the bill would increase borrowing costs for state and local governments by eliminating the favorable tax treatment that municipal bonds investors receive. In testimony before the House Oversight and Government Reform Subcommittee on TARP and Financial Resources, Dean Baker, co-director of the Center for Economic and Policy Research (CEPR), described this proposal as “likely to lead to the end of defined benefit pension funds. This will increase the cost to taxpayers of hiring public sector workers” (CEPR Testimony here).

Representative Devin Nunes (CA), the bill sponsor, argues the case for the legislation by asserting that states will run out of pension money.  The Nunes website features a leaflet, “Public Pension Reform: Transparency & No Bailouts” containing “year of funding exhaustion” estimates by Professor Joshua Rauh of Northwestern University.   Monique Morrissey with the Economic Policy Institute disagrees with such assertions, and believes there is virtually no risk that these pension funds will run out of money since benefit outlays are a small fraction of assets (EPI Policy Memo here).

Public pension plans pay retirement benefits to millions of workers over decades and plans take a corresponding long-term view of funding. Public employees and state and local governments face the challenge of making up for the extraordinary 2008 investment losses while the slowly recovering economy also places other immediate demands on limited fiscal resources of states.

H.R. 567 also clarifies that the federal government will not "bailout" public pensions. Just like the sponsors of private sector defined benefit plans after the market crash, public plans have not asked Congress for a federal bailout. In fact, when testifying before the House Judiciary Committee’s Subcommittee on Courts, Commercial and Administrative Law, Keith Brainard with the National Association of State Retirement Administrators emphasized: “State and local government retirement systems do not require, nor are they seeking, any Federal financial assistance” (NASRA Testimony here). Rather, state-by-state, plans are taking action to assure their financial sustainability because they are sovereign entities, unlike private companies in bankruptcy that can place pension liabilities on the Pension Benefit Guarantee Corporation  (See comprehensive analysis of state by state changes according to the National Conference of State Legislatures).

However, public plans need to be able to use the time provided in their funding formulas to get back to more secure funding ratios. Already in the 18 months since June 30, 2009, financial markets have seen a general upward trend, and most public pension trusts have regained much of the asset value lost during market downturn. At the end of 2010, aggregate public pension asset values were $2.93 trillion, growing by nearly 25 percent since June 30, 2009 (See data from NASRA here). 

Funding Evolution of Public Pensions

Most state and local government employee retirement systems have substantial assets set aside for current and future retirees. State and local government pensions are not paid from general operating revenues, but from trusts to which retirees and their employers contribute during employees’ working years.  These trusts held aggregate pension assets of $2.93 trillion as of December 31, 2010.  Thus, public plans are pre-funded.  Public pension plans represent promises to pay retirement benefits to millions of workers over decades, and plans take a corresponding long-term view to investing the employee and employer contributions, which are also made over time.  Pre-funding means that compounding of investment returns eases the out-of-pocket cost of paying pension benefits.

The funding levels of state and local pension plans have shifted over decades, moving away from their roots as pay-as you-go arrangements. Since the 1970s, states and local governments gradually moved toward more substantially pre-funding their pension obligations, spurred on by: Congress enacting the Employee Retirement Income Security Act (ERISA); Governmental Accounting Standards Board (GASB) making accounting changes in the 1980s; and equities markets providing exceptional investment returns throughout the 1980s and the 1990s. As a result, at the start of the last decade, aggregate funding ratios for public pensions topped 100 percent (See supporting NASRA data here, p. 6).

“The miraculous aspect of the funding of state and local pensions is that it occurred without any national legislation,” commented the Center for Retirement Research (CRR) at Boston College (See report here).  It was achieved without federal disclosure and funding requirements. While many plans had a solid base of assets in place for paying benefits, plan funding ratios have trended downward throughout the most recent decade due to several years of lagging investment returns.

According to a Government Accountability Office Report “State and Local Government Retiree Benefits,” issued before the 2008 financial crisis, many experts consider a funded ratio of 80 percent or better to be a sound level for public pensions (See GAO study here).  Looking at funding ratios when financial asset prices were still relatively low, the CRR report “Can State And Local Pensions Muddle Through?” investigated the 126 largest public systems and reported that overall funding levels dropped from 84 percent in 2008 to 79 percent in 2009, measured by GASB standards (See report here).

Although the funded ratio is a useful measure of a plan's past commitment to funding, because state and local pension plans are ongoing concerns with their sponsors having a presumed perpetual life, the funding level on any given date does not provide a complete picture (See CRR study here). The long-term nature of governments and pension liabilities give them time to respond to investment declines and other economic shocks. The 2008 GAO study explained further that at funding levels lower than 80 percent, “pension benefits are not a risk in the near term because current assets and new contributions may be sufficient to pay benefits for several years” (See GAO study here). Lower funding levels for public pensions need careful examination and may require adjustments in plan provisions, new contributions, or a combination of both.

In pension plans, the plan actuary determines the cost associated with new benefits earned in that year (normal cost) plus any additional amount that might be required. The additional amounts above the normal cost may include payments to make up for investment losses, or for contributions that were previously due but not made. The total amount needed in a year to fund the pension plan benefits within its funding period is the plan’s Annual Required Contribution, or ARC.

It is important that the ARC be contributed to the pension trust each year, for several reasons. If a plan sponsor does not fully fund the ARC every year, the plan is likely to eventually become underfunded, which means that the plan’s assets will not cover all of the plan’s current and future liabilities. Postponing current year ARC payments only increases the plans unfunded liabilities and the ARC in future years. While unfunded liabilities do not need to be paid in a single year, they are spread or amortized over a number of years with the plan making progress toward closing its funding gap over time.

Even in the face of two financial crises since the turn of the century, a substantial portion of ARCs were paid throughout most of the last decade (See NASRA data here).  According to the National Association of State Budget Officers (NASBO), the general revenue states collect from income, sales, and property taxes declined by $54 billion and $70 billion, respectively, in FY 2009 and FY 2010 (See NASBO summary here). While facing both a short-term cash flow deficit in revenues and higher recommended contributions to fund their long-term pension obligations, states remained committed to paying into their pensions and, in aggregate, made contributions to plan trusts totaling $73 billion in the year ending June 20, 2009 (See Pew Center on the States study here). This represents a slight year over year increase in plan contributions.

The overall ARC paid by public plan sponsors in FY 2009 was 88 percent of the computed amount, and was consistent with levels over the last six years (See NASRA data here). Another overall measure to consider is the percent of plan sponsors that are contributing nearly all of their ARC. While the percent of plans receiving 90 percent or more of their ARC has fallen since 2000, still six in every ten plans in the Public Fund Survey received 90 percent or more of their ARC in 2009, as illustrated in the chart below.

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Source:  NASRA 2009 Public Fund Survey

Do Public Pension Plans Have Time to Take Actions Needed? Two sets of studies come to different conclusions. On one hand, the CRR looks at various risk scenarios and concludes that under an “ongoing pension plan” framework, most plans have enough assets to last for at least 30 years. And states have already begun responding to their shortfalls by increasing employee contributions and by reducing benefits for new employees (See CRR study here). In its analysis, the CRR looked at asset to benefit ratios and projected exhaustion dates under several assumptions, including termination and ongoing plan frameworks. On the other hand, a posting by Rauh on the “Everything Finance” blog of the Northwestern University’s Kellogg School Finance Department entirely ignores the ongoing nature of public pension plans. Rauh paints a different picture than CRR, indicating that 37 states would run out of money before 2030, and North Carolina would be the only state not to run out of money (See Rauh posting here).

It is instructive to compare some of the CRR results with those produced by Rauh. Figure 1 (Attachment) puts estimated exhaustion dates based on an assumed investment return of 8 percent into a rough side-by-side chart. One difference between the analyses is readily evident. Rauh simplified his calculations by combining public pension plans in a state, while the CRR’s estimates are done at the public plan level. CRR’s approach appropriately recognizes that the trusts established to hold pension plan assets are for the exclusive benefit of the participants in each specific plan. In his approach, Rauh does not account for this cornerstone of pension law.

For example, assets in a public plan for teachers cannot be diverted for any other purpose of the state including paying retirement benefits to other public employees. This “exclusive benefit” is enshrined as a primary tenant of ERISA, the federal pension law, and states have followed it in their pension laws. The relevance of statewide numbers is questionable, especially for states with more than one plan, such as Oklahoma. Rauh estimates Oklahoma to have an exhaustion year of 2017 and places the state at the top of his published list (See Rauh data here), but Oklahoma has two distinct pensions, one for teachers and one for public employees, and these two plans have widely different exhaustion dates in the CRR analysis (See CRR data here). Most states have several separate plans with only a small number having only one plan.

The statewide approach that underlies Rauh’s calculations has also come under fire as an oversimplification of key plan features. Brian Murphy and David Kausch, actuaries at Gabriel Roeder Smith and Company, wrote of the underlying model Rauh developed with Robert Novy-Marx that was used to project the exhaustion years: “The analysis itself is a simplified approach to the very complicated task of projecting the funded status of 112 different systems with different populations, benefit structures, valuation assumptions, cost methods, and funding policies" (See GRS Memo here). The CRR analysis addressed this issue by using actual plan specific assumptions for the largest 14 plans and then fitting smaller plans into an appropriate set of standard assumptions (See CRR data here).

Rauh’s table entitled “When Might State Pension Plans Run Dry?” in the blog entry lists each state by the year its pension funds might be exhausted based on an assumed investment return of 8 percent, but there is no direct reference to the valuation date of the underlying plan assets. The blog links to his paper, “Are Public Pensions Sustainable?” which is dated December 31, 2009, and reflects plan asset values as of June 30, 2009 as the basis of his estimates (See Rauh data here). Subsequently, Rauh released a second chart with the same title in an undated paper modified by adding a subheading “Why the Federal Government Should Worry About State Pension Liabilities” and reflecting plan asset values as of September 30, 2009 (See Rauh data here).

A comparison of the state-by-state results in two Rauh charts uncovers numerous differences, many of which are substantial. Focusing on his revised statewide exhaustion dates, it appears that investment gains during these three months made a significant difference. In Rauh’s revised chart, five states will not run out of money under his termination assumptions, and ten additional states will not face his theoretical crisis until 2030 and beyond (See Rauh data here). Overall, exhaustion years remained the same for just five states and are projected for earlier years in six states, but by and large most states in the new chart displayed improvements that varied from modest to significant: 13 states gained a year or two; 16 states saw improvements of 3 to 7 years; and 10 states added between 8 years to nearly 7 decades of being able to pay benefits from existing plan assets, if you limit the horizon to the start of the next century. Rauh provides no explanation for the dramatic shift in results over the three months between June and September of 2009. In light of the upward trend in the stock market, results using the year end 2009 asset values as a starting point would be interesting, as well.

The CRR Looks at an Ongoing Plan Framework

Unlike Rauh, the CRR’s model estimates plan sustainability in individual exhaustion dates under both a termination and an ongoing framework. While a simple and direct comparison of the individual plan and state exhaustion calculations by CRR and Rauh is not possible for the majority of states, the CRR augments the exhaustion year information, conducting its analysis of the extent to which plans can make projected payments based on both terminated plan and ongoing plan scenarios. The CRR analysis reflects the value of plan assets on June 30, 2009. The CRR’s ongoing plan analysis is more consistent with the legal framework protecting participants in public pension plans.

Under the CRR’s termination scenario, existing pensions are considered to be an old plan and the normal cost contribution goes to fund only future benefits in a new plan. Old plans will at some point run out of money, and CRR determines when by projecting future investment earnings at two different interest rates - 6 percent and 8 percent. The paper finds that “the exhaustion date for the state-local sector as a whole is 2023 with returns of 6 percent and 2033 with returns of 8 percent” (See CRR report here). When state and local plans are treated as ongoing plans with the only contribution being the normal cost, the corresponding exhaustion dates are pushed back to 2025 and 2041, for the 6 percent and 8 percent return assumptions, respectively (See CRR data here). Of course, it is also important to remember the employees continue to make their required contributions to these ongoing public plans, often in substantial amounts of pay.

Meanwhile, Rauh’s exhaustion year projections, which assume no new contributions, go to fund past benefits and have earlier overall public sector plan exhaustion years for both the 6 percent and the 8 percent investment return assumptions: “if the returns only average 8 percent the existing funds will suffice through 2024. If the returns average 6 percent, they will run out before the end of 2022” (See Rauh data here). All of the exhaustion year figures are summarized in the following chart.

How Long Can Plans Pay Benefits without Receiving Full ARC Payments

Results from Rauh and the CRR Models for Public Pension Plans

 ROR  Rauh Day Rauh Why CRR
CRR
  Terminated  Terminated  Terminated Ongoing
 8% 2024
 2028  2033  2041
 6% 2022  2024  2023  2025

 

A state-by-state analysis is available here.

Looking at the full range of the data from these exhaustion year studies, there is significant variation in the estimates in the few situations when you compare at the state level, because there is only one statewide plan, such as in Florida. Rauh’s two calculations for Florida come to widely different results. His first chart shows Florida exhausting existing assets in his so-called “terminated” plan as 2033, but the revised analysis shows that Florida would not exhaust assets even as a “terminated” plan. The CRR agrees that Florida would not exhaust plan assets when it considers the pension as an ongoing plan assuming that normal cost contributions may be used to pay benefits under the current plan, but CRR calculates that retirement benefits could be paid until 2040, if as Rauh assumes, the plan can use only existing assets and projected earnings at 8 percent.

Clearly, the estimated plan exhaustion year results, both on an overall and a state/plan level, appear to be sensitive to the starting asset valuation date as well as to the assumptions, such as the nature of future contributions. Since the pension benefit protections in most states do not allow the freezing of benefits at current levels, CRR’s ongoing plan framework is the most relevant to actual operations of public pension plans. Importantly, ongoing plan trusts do not operate with an artificial firewall between existing assets and normal cost contributions made each year.

Moreover, assuming that future plan contributions will not exceed the normal cost ignores the actual funding behavior that the majority of plans have displayed historically. According to the data in the most recent Pew report, “The Widening Gap,” nearly two thirds of states contributed 90 percent or more of their ARC in FY 2009. In fact, 22 states contributed the full ARC (See Pew Center on the States study here). This commitment to pension funding occurred in a year, according to NASBO, when state general fund revenues fell by $54 billion (See NASBO summary here) and exerted significant pressure on short-term cash flows. Understating plan contributions serves to accelerate the predicted exhaustion years especially when nearly half of the states contributed their full ARC in FY2009 despite their severe revenue losses. Public plans that receive the full annual required contribution going forward will have sufficient assets to pay all of their promised benefits. Ignoring plan contributions distorts plan exhaustion year estimates.

Conclusion

Theoretical estimates of the number of years in which public pension plans can continue to pay existing benefits based on the investment of current assets represent a flawed, simplified way to view the sustainability of these pension plans. With some limited exceptions, states and localities do not face an immediate pension shortfall that would require sponsors to pay benefits from operating revenues even under dire termination assumptions.

When viewed under the more realistic ongoing plan analysis, and conservatively assuming that only normal costs are contributed, most plans have enough assets to pay benefits for at least 30 years (See CRR study here). State legislatures are appropriately using this wide breathing room to respond to the declining pension funding ratios with appropriate changes. Public plan sponsors and participants are not just relying on the investments in their plans to rebound in order to ensure sustainability. While the actions will vary, the most common solutions to the funding shortfall caused by the near collapse of the financial markets include increasing employee contribution rates and reducing benefit promises for new employees.

Each state is sovereign, with the power and the authority to make decisions to ensure long-term viability of its pension systems and to ensure that plan designs meets employer and employee needs into the future. States are nimble and react quickly as many have in the past few years by enacting plan design changes to meet funding goals. They should be left to fashion solutions such as those already under consideration. States and local governments will continue to monitor their progress in restoring greater funding to their public pension plans over the years to come, taking into account the actual investment experience and the changes adopted.

More than 8 out of 10 Americans think that Congress should make it easier for employers to offer a traditional pension and believe that all workers should have access to defined benefit pension plans. Placing new and unnecessary mandates on public plans does not move in that direction. Urging a wholesale shutdown of public pensions on the basis of these widely differing estimates based on very sensitive endpoints and under overly dire assumptions is not move in that direction. Urging a wholesale shutdown of public pensions on the basis of these widely differing estimates, based on very sensitive endpoints and dire assumptions, is not justified and could prove to be costly.

By Diane Oakley, NIRS Executive Director, May 5, 2011