Update on the Funding of State and Local Pensions

A recent paper from the Center for Retirement Research at Boston College looks into the funded status of state and local pension plans and estimates their funded ratios from 2014 to 2017. The paper finds that despite recent strong stock performance, the funded status of those pension plans remained unchanged in 2013, and that even in an optimistic scenario, public plans’ funded ratio under the new Government Accounting Standards Board (GASB) standards using a combined discount rate will reach only 76.9 percent in 2017.

Based on a database covering 150 public pension plans, the paper finds that the funded ratio of public plans in 2013 was 72 percent, unchanged compared to the previous year in spite of a surge in stock market performance. The authors of the paper determined that no changes occurred because of the smoothing of plan assets that incorporated the market’s plunge in 2009. Another reason is that the California Public Employee Retirement System (CalPERS), one of the largest plans in the nation, changed it valuation assumptions, reducing its funded ratio from 83 percent in 2013 to 70 percent in 2013, causing a downward impact on the aggregate funded status. Since 2001, the funded ratio of public pensions has steadily declined from 103 percent to 72 percent. The paper also finds that in fiscal year 2013, almost half of the public plans (47 percent) had funded ratios ranging from 60 percent to 79 percent, and that about one fifth (18 percent) of them were only 40 percent-59 percent funded, based on those plans’ own valuations.

In the last five years, the annual required contribution (ARC) as a percent of payroll increased significantly, from about 12.5 percent in 2008 to 17.6 percent in 2013, thanks to the increasing unfunded liabilities that raised the amortization component of the ARC to cover debt payments for those benefits that have been underfunded for years. The percent of ARC paid decreased from 93 percent in 2008 to 81 percent in 2012, and picked up slightly to 83 percent in 2013.

The distribution of the discount rates to value public pension liabilities is highly skewed to the left, with the average rate being 7.7 percent. About 85 percent of the plans use a discount rate higher than 7.4 percent, which is unreasonably high and reflects both a misunderstanding of liability valuation and the outdated GASB standards. Financial economists have for a long time recommended using a riskless discount rate to value public pension liabilities to properly reflect the guarantee of pension benefits to plan participants. Using a discount rate of only 5 percent, the paper estimates that the aggregate funded ratio is only 50 percent, a far cry from the 72 percent figure based on the public plans’ own valuations. A 4 percent discount rate, which is close to the riskless rate, raises the unfunded liability to near $4 trillion, in line with the number reported by State Budget Solutions.

Public plans’ funded ratios may undergo some notable adjustments which began in 2014, when the new GASB standards are put in action. The new standards involve two major changes. First, assets will no longer be actuarially smoothed, but reported at current market value. According to the paper, this means that funded ratios are likely to improve in 2014 as market assets are expected to continue to outpace actuarial assets. But on the flip side, any large drop in market values will also be readily reflected in the reported pension assets and, accordingly, the funded ratios. The second major change is the use of a combined discount rate. Rather than using only the expected return on assets as the discount rate, plans will be required to employ a combined rate that “reflects the expected return for the portion of liabilities that are projected to be covered by plan assets and the return on high-grade municipal bonds for the portion that are to be covered by other resources”. In other words, highly unfunded pension plans will have to use a lower discount rate to value part of their liabilities.

While the change in the use of discount rate can be seen as an improvement of the GASB standards, the paper argues that most plan sponsors will claim that they will have enough assets to cover the obligations, and thus will continue using high discount rates to make their plans’ funded status look better than they really are. Therefore, only the weakest plans will adopt the combined rate. The paper concludes that the effect of the discount rate change “will be minimal”.

Using a set of economic assumptions, the paper provides projected funded ratios for 2014-2017. According to the projection, under the new GASB standards and assuming that many plans will adopt the combined discount rate, the aggregate funded ratio will be 76.9 percent in the optimistic scenario. The pessimistic scenario will push the ratio down to 67.5 percent. The range of the predicted ratio reflects the significant risk undertaken by public pension plans. As noted by the paper, “[P]ublic pensions currently hold more than half of their assets in equities and a total of about 70 percent in risky assets”. This imposes a substantial risk burden on taxpayers and government budgets, and only structural changes can remedy the risk profile and bring about long-term sustainability.