The Underfunding of State and Local Pension Plans

May 4, 2011

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.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. 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, unfunded liabilities (the amount by which liabilities exceed assets) amounted to roughly $0.7 trillion; in other words, assets covered less than 80 percent of liabilities. That share was the lowest percentage in the past 20 years.

Estimating the value of a plans liabilities is not straightforward, however. The benefit payments that it is obligated to make span many years and depend on a variety of factors, including the duration of peoples employment, their salary in years near retirement, how long participants live, and the magnitude of any required cost-of-living adjustments In addition, an estimate of liabilities requires the conversion of a projected stream of benefits over many years into a single number, their present value, through the use of a discount rate.

Today, CBO released an issue brief that discusses two approaches to calculating the present value of a plans liabilities. That brief notes the following:

  • The reported amount of underfunding varies significantly depending on the approach used to calculate assets and liabilities. The estimate of unfunded liabilities cited above$0.7 trillionis calculated on the basis of actuarial guidelines currently followed by state and local governments. Under those guidelines, actuaries compute liabilities by discounting future benefit payments using a discount rate based on the expected rate of return on the plans assets.
  • An alternative method, the so-called fair-value approach, aims to measure the market value of assets and liabilities. It more fully accounts for the costs that pension obligations pose for taxpayers by discounting future cash flows at a rate that reflects their risk characteristics. Because the future cash flows associated with accrued pension liabilities carry are fixed and carry little risk, the discount rate used under this approach is lower than that under actuarial guidelines. That approach yields a much larger estimate of unfunded liabilities for those plans in 2009between $2 trillion and $3 trillion.
  • 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 plans sponsor should contribute each year.

Estimates on the basis of the actuarial guidelines and those that follow the fair-value approach differ in what they tell a plans managers, its participants, and the public about the costs of a pension system, including the cost of the risk to taxpayers that the rate of return on risky pension assets may not meet expectations. The actuarial guidelines essentially assume that future returns on assets are as certain as benefit payments, at least in the long run; by contrast, the fair-value approach views the returns on assets as more uncertain than the benefit payments, even in the long run. By accounting for the different risks associated with investment returns and benefit payments, the fair-value approach provides a more complete and transparent measure of the costs of pension obligations.

Adopting a fair-value approach does pose challenges. It could trigger a significant increase in funding requirements, further straining government budgetsdespite the fact that, on average, a much smaller increase in funding might turn out to be sufficient to cover pension plans liabilities. Moving to a fair-value approach could also increase the volatility in reported underfunding and make budgeting for the required contributions more difficult.

To address such issues, jurisdictions could adopt the fair-value approach for reporting purposes and use a different basis to determine their annual contributions to their pension plans. Ultimately, judgments about the amount and timing of additional funding that should be provided for underfunded plans depend on many factors, including competing budget priorities, views about intergenerational fairness, and the amount of risk the sponsors are prepared to take that they (and their taxpayers) might have to bear substantial costs at some point in the future in order to pay promised benefits.

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 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.

This brief was prepared by Frank Russek of the Macroeconomic Analysis Division.