The Underfunding of State and Local Pension Plans

Report
May 4, 2011

Economic and Budget Issue Brief

The recent financial crisis and economic recession have left many states and localities with extraordinary budgetary difficulties for the next few years, but structural shortfalls in their pension plans pose a problem that is likely to endure for much longer. This issue brief discusses alternative approaches to assessing the size of those shortfalls and the implications of those approaches for funding decisions:

  • By any measure, nearly all state and local pension plans are underfunded, which means that the value of the plans' assets is less than their accrued pension liabilities for current workers and retirees.
  • There are two leading approaches for valuing assets and liabilities, and the reported amount of underfunding varies significantly depending on which one is used.
  • Decisions about how to address the underfunding can be informed by the choice between those two measurement approaches, but there is no necessary connection between the information provided by the two approaches and decisions about how much a plan's sponsor should contribute each year.

According to the Public Fund Survey of 126 state and local pension plans, which account for about 85 percent of pension assets and participants in state and local pension plans in the United States, those plans held roughly $2.6 trillion in financial assets in 2009 but had about $3.3 trillion in liabilities for future pension payments. Thus, those assets covered less than 80 percent of liabilities, and unfunded liabilities (the amount by which liabilities exceed assets) amounted to roughly $0.7 trillion. That share of liabilities covered by assets in 2009 was the lowest percentage in the past 20 years. By comparison, the amount of state and local governments' debt that was outstanding at the end of 2009 was $2.4 trillion.

That estimate of unfunded liabilities is calculated on the basis of actuarial guidelines currently followed by state and local governments. Another approach for measuring pension assets and liabilities, which more fully accounts for the costs that pension obligations pose for taxpayers, yields a much larger estimate of unfunded liabilities for those plans in 2009—between $2 trillion and $3 trillion.

In any event, most state and local pension plans probably will have sufficient assets, earnings, and contributions to pay scheduled benefits for a number of years and thus will not need to address their funding shortfalls immediately. But they will probably have to do so eventually, and the longer they wait, the larger those shortfalls could become. Most of the additional funding needed to cover pension liabilities is likely to take the form of higher government contributions and therefore will require higher taxes or reduced government services for residents. Additional funding for pension benefits already accrued is unlikely to come from current workers; state laws and court opinions indicate that efforts toward that end could be successfully challenged in court in the majority of states.

Decisions about the amount and timing of the additional funding for underfunded plans will depend on many factors, including competing budgetary priorities, views on intergenerational fairness, and the amount of risk that plans' sponsors are prepared to take. If the financial condition of state and local pension plans worsened, the federal government might be asked to assist in the funding of such plans. If granted, such assistance would raise the federal deficit and debt, unless offset by higher taxes or lower spending in other areas.