The State Pensions Funding Gap: Challenges Persist by The Pew Charitable Trusts

New reporting standards may offer more guidance to policymakers

Overview

The nation’s state-run retirement systems had a $968 billion shortfall in 2013 between pension benefits that governments have promised to their workers and the funding available to meet those obligations-a $54 billion increase from the previous year.

This report focuses on the most recent comprehensive data and does not fully reflect the impact of recent strong investment returns. Because state retirement systems have historically accounted for investment losses and gains over time, the latest data still include losses from the 2008 Great Recession and do not fully incorporate the strong returns of recent years. As these returns are fully realized under new accounting standards, preliminary data from 2014 point to a reduction in unfunded liabilities for the majority of states. Many states have also benefited from reforms enacted since the financial crisis.

The State Pensions Funding Gap: Challenges Persist – Introduction

Nevertheless, reported pension debt is expected to remain over $900 billion for state plans, which increases to more than $1 trillion when combined with the shortfalls in local pension systems, and will stay at historically high levels as a percentage of U.S. gross domestic product. State and local policymakers cannot count on investment returns over the long term to close this gap and instead need to put in place funding policies that put them on track to pay down pension debt.

The actuarial required contribution, or ARC, that states have disclosed has been the common metric for assessing contribution adequacy, based on a minimum standard set by government accounting rules. Using plans’ own economic and demographic assumptions, the ARC calculation includes the expected cost of benefits earned for the current year and an amount to reduce some of the unfunded liability. In 2013, state pension contributions totaled $74 billion—$18 billion short of what was needed to meet the ARC—with only 24 states setting aside at least 95 percent of the ARC they determined for themselves. Overall, states that contributed at least 95 percent of the ARC from 2003 to 2013 had retirement systems that were 75 percent funded, while those that hadn’t were funded at 68 percent. But as we describe below, ARC does not always signal true fiscal health.

The Governmental Accounting Standards Board (GASB)—an independent organization recognized by governments, the accounting industry, and the capital markets as the official source of generally accepted accounting principles for state and local governments—has established standards that will provide new information on pension funds’ health for data from June 15, 2014, on.

State Public Pensions

Pension debt is continuing to increase in many states, despite reform efforts, because of missed contributions and the continued impact of investment losses.

State Pensions Funding Gap

State Pensions Funding Gap 1

Four states’ experiences

Four states illustrate the limitations of the ARC and why stronger measures of contribution policies may be useful. Alabama, Arizona, Tennessee, and West Virginia all contributed on average 100 percent or more of their ARC from 2003 to 2013. Tennessee and Arizona had nearly fully funded retirement systems in 2003, with 99 percent of their liabilities matched by assets. But 10 years later, while Tennessee’s pension plans remained well-funded at 94 percent, Arizona’s had steadily declined and was just 72 percent funded.

West Virginia and Alabama started from different points in 2003: West Virginia’s pension plan ranked last in the nation, while Alabama’s was in 20th place. But over the next decade, West Virginia improved its funding ratio from 40 percent to 67 percent and moved to the middle of the 50-state ranking. Meanwhile, Alabama’s ratio dropped from 93 percent to 66 percent, with 10 states outpacing it. (See Figure 1.)

State Pensions Funding Gap 1

Changes to pension funding ratios are the result of multiple factors, including investment returns, benefit or cost of living modifications, adjustments to actuarial assumptions, and contribution levels. However, the differing results in the four states that are used as examples here can in part be attributed to how they adopted minimum funding standards that allowed debts to grow over time. Many state plans have stretched out their schedules to pay down their pension debts to the maximum time-frame allowable under the ARC disclosure standard and refinance each year following a funding method called 30-year open amortization. This is similar to the negative amortization loans some homeowners used in the run-up to the financial crisis. Initial payments on those loans failed to pay down any principal, and homeowners fell deeper into debt as a result.

State Pensions Funding Gap

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