How Population Changes Impact Public Pension Funds
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Commentary

How Population Changes Impact Public Pension Funds

States with declining populations need to make changes to their pension plans to avoid accruing even more public pension debt.

A recent Census Bureau report revealed major population shifts around the country and these geographic trends will have far-reaching political and financial effects on citizens and governments alike. Some state and local pension plans in areas losing taxpayers, for example, will face significant funding challenges while areas with population growth will likely have opportunities to improve the funding levels of their pension plans, thanks in part to these significant population shifts.

Population declines generally result in lower tax revenues for state and local governments. Government expenditures such as payroll, government employer pension contributions, and pension debt payments typically come from state and local governments’ general tax revenue streams. If a state or local government’s tax revenues decline, they typically have to make up the difference either by raising taxes, cutting government employee benefits, or cutting government-provided services. But, as governments reduce services or increases taxes, residents may respond with their feet by moving to other areas, which can then exacerbate their financial challenges.

Population declines affect government payrolls and public pension plans because fewer citizens should mean less demand for new government employees, like police officers and teachers. Payroll growth is a huge factor in projecting pension plan solvency. Most public pension plans base their annual contributions on their payrolls, so higher payroll growth numbers mean that a plan can expect higher contributions to the fund in the future. If a pension plan falls short of its payroll growth targets, it will most likely end up contributing less to the fund than what is needed, which means higher unfunded liabilities—debt—later on. 

To remove the risk of underfunding their public pension systems, state and local pension plans should lower their payroll growth assumptions. Doing so would reveal a more accurate accounting of what their true unfunded liabilities are.

Public pension plans should also consider switching debt payments from a percentage of payroll (level percent) to a fixed dollar amount (level dollar), similar to what Michigan did for its teacher and state police pension plans in 2019. This fixed dollar contribution method not only removes any speculation about debt payment schedules but can also save government employers significant long-term costs. 

Population shifts can also make pension reform more or less palatable for policymakers.  A major part of many pension reform efforts involves finding funding to address growing public pension debt. Relying on a growing base of taxpayers to help foot the pension bill no longer works when a state’s population is declining. In this scenario, a state can increase the financial burden on remaining citizens, expand debt payment schedules, or enact reforms that could negatively affect existing workers. But states like Texas and Florida that have growing populations are in a highly advantageous position because they will likely have a growing tax base to give them a cushion to pay down their current pension debt. These states should take this opportunity right now to change pension plans’ overly optimistic investment return assumptions to more realistic levels and ensure they have strong systems in place for paying down existing pension debt. 

States with declining populations are in a tougher spot so it is important that they make changes to their pension plans sooner rather than later to avoid accruing even more public pension debt. Reforms should involve serious adjustments to payroll growth forecasts and investment return assumptions. They should also consider how they can tackle existing pension debt sooner rather than later, to reduce interest payments and avoid backloading costs on future taxpayers.

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