Do public employee pension programs threaten state and local government solvency and bond payments? Not likely.
Recently, the popular press has contained numerous stories alleging that public employee pension obligations will break the backs of state and local governments, threatening their ability to fund programs, and put pressure on bond payments. However, a peek into the technical world of public pension systems reveals a different picture. While reform is needed, the crisis is imaginary.
Consider the following charges:
Pension liabilities nearing $3 trillion will force state and local bankruptcies.
Facts: The problem is overstated by the use of aggregated statistics. The “trillion” number sounds large, but represents, in the aggregate, 50 states and thousands of local governments. Further, pension liabilities are long-term in nature – payable over 30 years or more. In fact, annual pension costs to states are estimated to be less than 4% of annual expenditures.
States and local governments have been remiss in not funding the pension promises they make.
Facts: Today’s underfunding is the result of the drop in investment values from the “Great Recession,” not a persistent failure to fund promised pensions adequately. In fact, prior to the recession, collectively state and local pensions were 100% fully funded. Pension experts consider public pension liabilities funded at the 70% level to be adequate, since long-term market gyrations will likely bring pension funding back to full at some point.
Pension liabilities and surpluses, at any point in time, are a snapshot of a long-term liability. That is why pension funding ratios are typically smoothed over a five-year period to give a more balanced reflection of a system’s true status. Many pension systems that were fully funded prior to 2008 became underfunded as a result of the market crash of 2008-2009. With an improving stock market (which has almost doubled) since the recession, the smoothing technique will bring many pension systems back to full funding once the perilous years of 2008-2009 eventually roll off the five-year moving average.
Pension systems generally use an 8% return rate – unrealistic in today’s markets.
Facts: The $3 trillion estimate overstates the unfunded liability since it usually assumes a “riskless” rate of return – based on much lower assumptions than actually experienced by pension fund investments. In fact, as of the date of this writing, the S&P 500 index shows a 12.5% return over the prior 52 weeks. Since most pension systems are heavily invested in equities, the historical return (excluding the recession) has often exceeded the questioned 8% return rate used to model pension fund performance.
State and local government pension funds are about to run out of money
Facts: According to the Federal Reserve (as quoted in Government Finance Review), public pensions’ combined value totaled $2.73 trillion as of the third quarter of 2010 – a substantial increase from the early 2009 level of $2.17 trillion, and has continued to increase since. Changes to contributions by both employers and employees have helped ameliorate disparities that have occurred due to market performance and the aging of baby boomers moving to retirement.
In fact, while most states have maintained well funded pension systems, there are a few (such as New Jersey and Illinois) that have severely unfunded pension liabilities. New Jersey, for example, was fully funded as recently as 2002, when it stopped making required contributions. Still, it is meeting current commitments and seeking a solution to its longer-run problems. Overall, since 2000, 21 states have increased employee contributions, 25 have changed eligibility or benefit formulas, 10 have reduced cost of living allowances, and 14 have modified their pension plans by adding defined contribution or hybrid plans. Through changes such as these, states have shown the resolve needed to ensure their pension plans remain solvent into the future.
Reform needed
Reform of public pension plans is clearly needed to bring them more in line with those offered in the private sector. Defined contribution plans are on the way and will play a greater part in public-employee benefits in the future. Police and fire pensions, which typically reward employees with higher benefits than general government employees, will need to resemble their non-uniformed colleagues. Clearly, those governmental units that have not funded their pension programs adequately will have to face the music.
Nevertheless, pension funding is a long-term liability and needs to be measured as such – not by a snapshot taken at any given point in time.