The Fiscal Health of State Pension Funds: Misunderstandings Regarding State Debt, Pensions, and Retiree Health Costs Create Unnecessary Alarm Misconceptions and Also Divert Attention from Needed Structural Reforms (excerpts) Â
By Iris J. Lav and Elizabeth McNichol
Center on Budget and Policy Priorities
January 20, 2011
[moderator: This report provides substantive documented information to refute anti state worker attempts to use the current fiscal crisis as an opportunity to eliminate defined benefit pensions.Â It also includes a section on the conservative call for states to be able to declare bankruptcy in order to enable cutting or eliminating guaranteed pension benefits that was the subject of a January 20 front page article in the New York Times and the previous postingâ€”â€œState Bankruptcy: A Right Wing Fantasy to Enable Confiscation of Employee Pensions.â€Â Â For the complete report including endnotes and informative charts and graphs please go to
A spate of recent articles regarding the fiscal situation of states and localities have lumped together their current fiscal problems, stemming largely from the recession, with longer-term issues relating to debt, pension obligations, and retiree health costs, to create the mistaken impression that drastic and immediate measures are needed to avoid an imminent fiscal meltdown.
The large operating deficits that most states are projecting for the 2012 fiscal year, which they have to close before the fiscal year begins (on July 1 in most states), are caused largely by the weak economy.Â State revenues have stabilized after record losses but remain 12 percent below pre-recession levels, and localities also are experiencing diminished revenues.Â At the same time that revenues have declined, the need for public services has increased due to the rise in poverty and unemployment.Â Over the past three years, states and localities have used a combination of reserve funds and federal stimulus funds, along with budget cuts and tax increases, to close these recession-induced deficits. While these deficits have caused severe problems and states and localities are struggling to maintain needed services, this is a cyclical problem that ultimately will ease as the economy recovers.
Unlike the projected operating deficits for fiscal year 2012, which require near-term solutions to meet states’ and localities’ balanced-budget requirements, longer-term issues related to bond indebtedness, pension obligations, and retiree health insurance â€“ discussed more fully below – can be addressed over the next several decades.Â It is not appropriate to add these longer-term costs to projected operating deficits.Â Nor
should the size and implications of these longer-term costs be exaggerated, as some recent discussions have done.Â Such mistakes can lead to inappropriate policy prescriptions.
Some observers claim that states and localities have $3 trillion in unfunded pension liabilities and that pension obligations are unmanageable, may cause localities to declare bankruptcy, and are a reason to enact a federal law allowing states to declare bankruptcy.Â Some also are calling for a federal law to force states and localities to change the way they calculate their pension liabilities (and possibly to change the way they fund those liabilities as well). Such claims overstate the fiscal problem, fail to acknowledge that severe problems are concentrated in a small number of states, and often promote extreme actions rather than more appropriate solutions.
State and local shortfalls in funding pensions for future retirees have gradually emerged over the last decade principally because of the two most recent recessions, which reduced the value of assets in those funds and made it difficult for some jurisdictions to find sufficient revenues to make required deposits into the trust funds.Â Before these two recessions, state and local pensions were, in the aggregate, funded at 100 percent of future liabilities.
A debate has begun over what assumptions public pension plans should use for the “discount rate,” which is the interest rate used to translate future benefit obligations into today’s dollars. The discount rate assumption affects the stated future liabilities and may affect the required annual contributions.Â The oft-cited $3 trillion estimate of unfunded liabilities calculates liabilities using what is known as the “riskless rate,” because the pension obligations themselves are guaranteed and virtually riskless to the recipients.Â In contrast, standard analyses based on accepted state and local accounting rules, which calculate liabilities using the historical return on plans’ assets, put the unfunded liability at about a quarter of that amount, a more manageable (although still troubling) $700 billion.
Economists generally support use of the riskless rate in valuing state and local pension liabilities because the constitutions and laws of most states prevent major changes in pension promises to current employees or retirees; they argue that definite promises should be valued as if invested in financial instruments with a guaranteed rate of return.Â However, state and local pension funds historically have invested in a diversified market basket of private securities and have received average rates of return much higher than the riskless rate.Â And economists generally are not arguing that the investment practices of state and local pension funds should change.
A key point to understand is that the two issues of how states and localities should value their pension liabilities and how much they should contribute to meet their pension obligations are not the same.Â The $3 trillion estimate of unfunded liabilities does not mean that states and localities should have to contribute that amount to their pension funds, since the funds very likely will earn higher rates of return over time than the Treasury bond rate, which will result in pension fund balances adequate to meet future obligations without adding the full $3 trillion to the funds.Â In fact, two of the leading economists who advocate valuing state pension fund assets at the riskless rate have observed, “the question of optimal funding levels is entirely separate from the valuation question.” Â The required contributions to state and local pension funds should reflect not just on an assessment of liabilities based on a riskless rate of return, but also the
expected rates of return on the funds’ investments, as well as other practical considerations.Â As a result, it is mistaken to portray the current pension fund shortfall as an unfunded liability so massive that it will lead to bankruptcy or other such consequences.
States and localities devote an average of 3.8 percent of their operating budgets to pension funding. Â In most states, a modest increase in funding and/or sensible changes to pension eligibility and benefits should be sufficient to remedy underfunding.Â (The $700 billion figure implies an increase on average from 3.8 percent of budgets to 5 percent of budgets, if no other changes are made to reduce pension costs. )Â However, in some states that have grossly underfunded their pensions in past years and/or granted retroactive benefits without funding them – Illinois, New Jersey, Pennsylvania, Colorado, Kentucky, Kansas, and California, for example – additional measures are very likely to be necessary.
States and localities have managed to build up their pension trust funds in the past without outside intervention.Â They began pre-funding their pension plans in the 1970s, and between 1980 and 2007 accumulated more than $3 trillion in assets.Â There is reason to assume that they can and will do so again, once revenues and markets fully recover. States and localities have the next 30 years in which to remedy any pension shortfalls.Â As Alicia Munnell, an expert on these matters who directs the Center for Retirement Research at Boston College, has explained, “even after the worst market crash in decades, state and local plans do not face an immediate liquidity crisis; most plans will be able to cover benefit payments for the next 15-20 years.” Â States and localities do not need to increase contributions immediately, and generally should not do so while the economy is still weak and they are struggling to provide basic services.
Should States Be Allowed to Declare Bankruptcy?
Various pundits have suggested enacting federal legislation that would allow states to declare bankruptcy, potentially enabling them to default on their bonds, pay their vendors less than they are owed, and abrogate or modify union contracts.Â Such a provision could do considerable damage, and the necessity for it has not been proven.
States have a strong track record of repaying their bonds.Â In most states, bonds are considered to have the first call on revenues; debt service will be paid before any public services are funded.Â (In California, education has the first call on revenues because of the provisions of a ballot initiative, but bonds are right behind.)
There are no modern instances of a state defaulting on its general obligation debt.Â One has to reach back to the period before and during the Civil War, when several states defaulted, or the single state that defaulted during the Great Depression (Arkansas), to find examples.
It would be unwise to encourage states to abrogate their responsibilities by enacting a bankruptcy statute. States have adequate tools and means to meet their obligations.Â The potential for bankruptcy would just increase the political difficulty of using these other tools to balance their budgets, delaying the enactment of appropriate solutions.Â In addition, it could push up the cost of borrowing for all states, undermining efforts to invest in infrastructure.
The severity and consequences of these operating deficits should not be minimized.Â Throughout the country, residents are losing services on which they depend – sometimes on which their very life depends, as in the refusal of Arizona’s Medicaid program to fund organ transplants.Â But these deficits are cyclical and temporary; they will diminish as the economy improves. Â They should not be confused with the longer-term structural budget problems that a number of states have. 
Some who argue that states and localities are in a crisis claim that they have large amounts of “hidden” debt in the form of underfunded pension funds.Â A figure of $3 trillion in pension underfunding is sometimes cited; other estimates place the underfunding at levels as low as about $700 billion, or less than a quarter of the $3 trillion figure.Â While some pension funds are indeed underfunded, there are a number of misconceptions about the extent and depth of the problem – and about states’ ability to resolve pension funding issues over time without disrupting their ability to continue public services.
States and localities currently make annual contributions to their pension trust funds equaling an average of 3.8 percent of their general (operating) budgets.Â They began to make deposits to pre-fund their pension costs in the 1970s.Â Each year, they are supposed to deposit in a trust fund an amount that equals the present value of the future pensions their employees earned that year.Â (The present value is the amount that has to be invested today to grow to the desired amount in the year the employees are expected to retire.)
As of 2000, state and local pension obligations were fully funded on average, if obligations are discounted at 8 percent per year, which was the return on pension fund investments over the previous two decades.Â (See Figures 3 and 4.) Since then, however, the nation has experienced two recessions, during which some states and localities have reduced or skipped pension trust fund deposits to help balance their budgets.Â In addition, the recessions have caused significant investment losses.Â By 2008, state and local pensions in aggregate were funded at 85 percent of their future liabilities; the other 15 percent is considered to be the “unfunded liability.”Â The Center for Retirement Research at Boston College projects that, in the aggregate, state
and local pensions were funded in 2010 at 77 percent of their future liabilities, a ratio projected to decline to 73 percent by 2013.
A drop to funding in the 70 percent range is a significant problem, although not an imminent crisis. Many experts argue that 80 percent funding is sufficient for public pensions because states and localities, as ongoing entities, can use tax revenues to make up a shortfall if necessary. Â A private company, in contrast, can go out of business, at which point the federal Pension Benefit Guarantee Corporation (PBGC) pays the company’s employees their accrued benefits out of a combination of the assets the company accumulated before it went out of business and the insurance
premiums the PBGC collects from private-sector employers with pension plans. Â (Federal law generally requires private companies to be 100 percent funded so the federal government does not have to make up any shortfall. )
Some states – such as Illinois, New Jersey, and Pennsylvania (and to a somewhat lesser extent Colorado, Kentucky, Kansas, and California) – have skipped or reduced deposits to trust funds and/or expanded future pension benefits without providing the commensurate funding.Â Over time, to reach adequate funding, these states may have to institute changes more difficult than the potential solutions discussed below.Â These states, however, are not representative of states in general.
The issue of whether states’ discount-rate assumptions are reasonable is more complicated.Â The “discount rate” is the interest rate used to translate future benefit obligations into today’s dollars. Discount rates are important, since 60 percent of pension trust fund revenues come from trust fund earnings (see Figure 5), and discount rates help determine how much money a state should put into the fund each year.
One school of thought argues that it is appropriate to continue to use the actuarial method recommended by the Governmental Accounting Standards Board (GASB), which is to use as a discount the historical return on funds’ assets – about 8 percent.Â (State pension trust funds invest their assets in a diverse mix of stocks, bonds, and other instruments until they are needed to pay for benefits.)Â Others, most prominently Joshua Rauh at Northwestern University and Robert Novy-Marx at the University of Rochester, argue that a much lower assumption is warranted:Â because pension obligations are guaranteed, they argue, the assumed growth of assets (the discount rate) should be similarly “riskless” and based on the returns from the safest investments such as Treasury bonds – around 4 percent or 5 percent.
The alarming reports that pension funds are about to run dry or that unfunded pension liabilities number in the trillions of dollars generally rely on these more conservative assumptions about the appropriate discount rate.Â For example, a recent Washington Post editorial said that “Public-employee pension funds are notorious for understating their liabilities through the use of vague projections and rosy investment return
assumptions” and took note of a proposal by three members of Congress – Paul Ryan, Darrell Issa, and Devin Nunes – that would force pension funds to calculate their liabilities using a riskless discount rate. 
While economists generally support use of a riskless rate in valuing state and local pension liabilities, they do not generally argue that the investment practices of state and local pension funds should change.Â State and local pension funds historically have invested in a market basket of private securities and have received rates of return much higher than the riskless rate.Â As Figure 4 shows, the 8 percent discount rate that most funds now use reflects actual returns over the past 20 years.
Even if state and local pension liabilities were valued at the riskless rate, that would not mean that states and localities “owe” $3 trillion to their pension funds. The issue of how states and localities value their pension liabilities and the issue of how much they have to contribute to meet their pension obligations are not the same.Â The $3 trillion of unfunded liabilities is not equivalent to the amount that states and localities
should contribute to their pension funds.Â It thus is mistaken to portray this as a huge liability that will lead to bankruptcy or other similarly dire consequences.
Indeed, Novy-Marx and Rauh, the leading economists advocating valuation at a riskless rate, have observed, “. the question of optimal funding levels . is entirely separate from the valuation question.” Â The required contributions to state and local pension funds should take account of expected rates of return on their investments, as well as other practical considerations.
While it may make sense to reconsider whether the typical 8 percent discount rate is the right one going forward, simply basing annual state contribution amounts to pension funds on the return to riskless investments appears to go much farther than is necessary for a number of reasons:
Pension funds invest for the long term, so a few years of below-average returns can be averaged out with years of higher returns.Â As noted, the 8 percent discount rate that most states assume reflects the experience of the trust funds over the last 20 years (including the 2008 stock market decline); median returns for the last 25 years were even higher, at 9.3 percent.Â While the rates of return on investments were much lower in the recent recession, it is generally assumed that they will rise in the future, even if they do not return to the very high rates of the late 1980s. A business may be sold or go out of business at any time, so it is important to keep its pension plan 100 percent funded for benefits earned to date.Â Governments, in contrast, will be in continuing existence, so it makes sense to average or “smooth” expected investment returns over a long period.Â This also promotes intergenerational equity, enabling the state to contribute approximately the same amount for each cohort (assuming that it makes appropriate contributions each year).
The stated concern of some that basing required contributions on actual rates of return will lead pension managers to put funds in risky investments is overblown.Â Pension funds have a long history and have been invested prudently except in rare situations.Â Most states have other effective barriers to overly risky investing in place (although these could be strengthened), including oversight boards, reporting requirements, and regular actuarial reviews. A discount rate that is too low would require a state to put money into the pension funds that it could be using instead to support public services, resupply reserve funds, invest in infrastructure, or return to taxpayers in the form of tax cuts.
In addition, if the pension fund assumes a 4 or 5 percent discount rate and actually gets higher returns on its investments, funds will build up in the trust fund.Â When pension trusts have been overfunded in the past this has led to problems such as employee demands for increases in pension benefits that later proved unsustainable.Â Overfunding also has led jurisdictions to skip payments that they subsequently found difficult to resume because programs were funded or taxes were cut permanently by the amount of the skipped pension contribution.Â The 2008 GAO report noted experts that
said: “. it can be politically unwise for a plan to be overfunded; that is, to have a funded ratio over 100 percent. The contributions made to funds with “excess” assets can become a target for lawmakers with other priorities or for those wishing to increase retiree benefits.” 
Nevertheless, improvements in pension plans’ policies clearly are needed.Â There are a number of ways that most states with unfunded liabilities can improve their pension funding without causing major disruptions in their ability to provide public services.
As noted, current employer contributions for public employee pensions average only 3.8 percent of state and local budgets, an amount that pales beside states’ largest expenses – education and health care.Â Pension contributions are smaller than the amounts spent on transportation, corrections, and many other services. If all states and localities were to fund their pensions based on the “riskless” rate, Boston College researchers calculate that they would have to contribute approximately 9 percent of their budgets, on average. (This calculation uses 5 percent as the riskless rate.)Â A contribution amount this high would cut into states’ and localities’ ability to provide other public services; it arguably would not strike the appropriate balance between funding currently needed services and funding past pension liabilities.
If states and localities continue to use an 8 percent discount rate for calculating required contributions, a funding increase to 5 percent of their budgets would be required on average to fully fund their pensions.Â This level is not likely to be unduly burdensome after the economy recovers, and states could reduce it somewhat by adopting various pension reforms.Â (States should not begin to increase their contributions while the economy is still weak, because the budget cuts this move would require would further slow the economy.)
States that have significantly underfunded their pensions, such as alifornia, Illinois, and New Jersey, would require higher contributions (7.3 percent, 8.7 percent, and 7.9 percent of their respective budgets), even using the standard 8 percent discount rate.Â These states will have to consider more significant changes to their pension plans to bring their required contributions down to a more reasonable level. 
More than 20 states have enacted changes to reduce pension costs in recent years, including raising the length of service and age requirements for receiving a pension and reducing the factor that determines the percent of salary that an employee receives as a pension payment for each year of service.Â It is difficult to defend a system where public employees can retire at age 55 with a pension after 25 or 30 years of service,
particularly if their work is not physically arduous, while the age for receiving full Social Security benefits is set to increase to 67.Â While these types of changes generally can be applied only to newly hired employees, they will help with a pension plan’s longer-term funding.Â Another option that could have a more immediate effect would be to increase the contribution that employees make toward their pensions, as a number
of states have done, particularly in places where employee contributions are particularly low.
Public-sector employees generally receive lower wages than their private-sector counterparts, and employee benefits such as pensions make up only part of the difference.Â If pensions (and/or retiree health benefits, discussed below) are made less generous, current wages may have to increase so that the public sector can continue to attract high-quality employees. Given the difficulty that some jurisdictions have in funding deferred compensation, this may be a reasonable trade-off.
In addition, all states and localities need to ensure that their employee pension provisions do not permit abuses, such as the ability to inflate pay in the year or two before retirement in order to receive an outsized pension benefit.Â Reforms in this area are needed in a number of states.Â States also need to review their provisions for disability pensions to ensure that only employees who are appropriately qualified can retire on a disability pension.Â While these issues are not the major source of financial stress of pension systems, abuses are frequently publicized and undermine confidence in the administration and fairness of public employee pensions.
In short, there are significant issues with public pensions, but they do not amount to a crisis.Â In part, pensions’ funding status will improve as the economy and investment returns improve.Â Some states and localities already are taking actions to improve their pension funding; at an appropriate time when the economy is stronger, more states and localities can, if necessary, increase their pension trust fund contributions to put them on a path to funding their unfunded liabilities over the next few decades.Â A number of states also will need to institute various pension reforms.Â But for the reasons cited above, the evidence does not support the claim that states and localities are on the verge of bankruptcy because of massive unfunded pension liabilities.