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Reason Foundation

Study: Public Pensions Nationwide Underfunded By $4.1 Trillion

Sal Rodriguez
September 5, 2013, 12:36pm

State Budget Solutions (SBS) has released a comprehensive review of state-level public employee pension plans in all 50 states and their funding levels.  Based on annual financial reports and actuarial valuations, the SBS examined “over 250 state-level defined benefit pension plans” with a combined $2.6 trillion in assets and evaluated their funding level based on a “fair-market valuation.” SBS determined that state-level public pension plans have a $4.1 trillion unfunded liability, nearly four times as large as the $1 trillion that pension systems officially report.

The SBS study is the latest report demonstrating how large the problem of underfunded public employee pension systems is and how flawed government accounting measures have understated the scope of the problem.

A defined benefit pension plan is a retirement plan based typically on a set formula, generally multiplying credited years of service by final average salary by a retirement factor (1-3%, generally) to yield the pension that a retired public employee will receive for life. Defined benefit pension plans are heavily dependant on employer and employee contributions, as well as careful investments, to sustain them long-term.

Most public pension systems assume a long-term investment return of around 8%. Based on such assumptions, state (and municipal) governments set contribution rates for government employers and employees. Higher investment return assumptions allow government agencies and employees to contribute less than may be necessary to fund pension systems. These rates also allow governments to assume a higher level of funding and a lower level of liabilities, thereby keeping contribution rates lower than may be necessary.

Based on the government-set investment assumptions, all state pension systems combined are 73% funded. In dollar amounts, state pension systems currently have $2.6 trillion in assets with obligations of $3.55 trillion. In other words, state pension systems are making $1 trillion more in promises than they can actually pay for.

As troubling as this shortfall is, the unfunded liability grows even further when alternative investment return assumptions are used.

While state pension systems generally assume around an 8% return on investments over 30-years, the SBS study assumes a drastically lower investment return of 3.225%, the 15-year Treasure bond yield as of August 21, 2013. Under this assumption, state-level public pension funding drops from 73% to 39%, meaning that the pension systems only have 39 cents for every dollar that they are promising in pension benefits.  With $2.6 trillion in assets up against $6.7 trillion in liabilities, the per capita unfunded liability works out to $13,145.

According to SBS, the most poorly funded systems are:

The five most well funded states are:

The SBS study is the most recent study to evaluate alternative investment assumptions and the consequent impact on unfunded liabilities.  While critics may charge that the 3.225% investment assumption is too low, the SBS study is hardly the first to consider the possibility that the 7-8% 30-year investment returns are far too high.

In fact, there is reason to believe that the 7-8% rates are unreasonably high. For one, the Moody’s has recently pushed for something similar to the SBS study, which is using assumptions more in line with long-term bond yields. The Government Accounting Standards Board similarly revised pension accounting standards and for investment assumptions outlined a “blended rate” to reflect “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,” according to a Boston College study based on the revised standards.  Applying the “blended rate” to state pension systems in 2010, the funding rate would have dropped from the then-76% funding level to 57%. Under this system,

Several others have been conducted challenging the prevailing investment assumptions:

What this all translates to, potentially, is a need for higher contributions to the pension system. Pragmatically, this can come in the form of higher contributions by public employees coupled with untold billions of dollars combined in annual increases to current funding. In other words even greater diversion of tax dollars that could be going to services could instead go towards making pensions sustainable.

Naturally, when one steps back and realizes that these programs are not sustainable, and that the amount of money necessary to keep them operating as such far exceeds any benefit pensions bring to society, considering common sense alternatives becomes an obviously viable option. One idea that comes to mind is switching to 401(k)-style retirement plans, something that the private sector largely shifted to decades ago.

The rising costs to taxpayers and the smoke-and-mirrors accounting practices that obscure the realities that pension systems are operating with threaten the long-term stability of government and, by extension, pensions. Taxpayers are being mislead as to the true cost of the tab they’ll be expected to pickup, and public employees are being sold retirement schemes that may not be around for them when it is there time to retire. Or even worse, governments and related pension systems may just go bankrupt and hurt everyone involved.

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