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The Economic Consequences Of Pension Underfunding

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The Economic Consequences Of Pension Underfunding: Evidence From The Retirement Systems Of Alabama

Daniel J. Smith
Troy University – Manuel H. Johnson Center for Political Economy

John A. Dove
Troy University – Manuel H. Johnson Center for Political Economy

June 14, 2016


There is a strong consensus among economists and public pension experts that many public pensions are substantially underfunded and that absent fundamental reform many state and local governments will have to resort to some mixture of tax increases, budget cuts, and/or bailouts. While many nation-wide empirical studies have evaluated the growth in unfunded pension liabilities, few academic case studies have been done for individual public pension systems to analyze specifically how these unfunded liabilities have accumulated and to formulate concrete avenues for reform. Therefore, this paper provides a cases study of the Retirement Systems of Alabama. We find that Alabama is similarly situated relative to a number of other public pension systems in the U.S. when it comes to issues with accounting standards, transparency and oversight, and the use of economically targeted investments. Based on this work, we offer recommendations for reforming public pensions.

The Economic Consequences Of Pension Underfunding: Evidence From The Retirement Systems Of Alabama – Introduction

Research on the economic and fiscal effects of state and local public pensions has grown over time, with a significant increase in interest resulting from the financial crisis of 2008 (Congressional Budget Office 2011). Much of this research indicates that underfunded public pensions represent a potential threat to the fiscal solvency of many state and local governments (Barth et al. 2016; Novy-Marx and Rauh 2009, 2014; Kiewiet 2010; Ricketts and Walker 2012). For instance, a survey of leading policy economists found that nearly every economist agreed that some U.S. states will be forced to make drastic changes to their pension, tax, or spending policies to meet understated, unfunded pension liabilities (U.S. State Budgets, 2012). Further, Kiewiet and McCubbins (2013) describe the impending pension crisis as a “new fiscal ice age” that will increasingly consume the budgets of state and local governments.

While many national studies have been conducted on state and local public pension systems (Biggs 2012; Brown and Wilcox 2009; Russek 2011; Elliott 2010; Kieweit 2010; Mitchell and Smith 1994; Novy-Marx and Rauh 2014; Rauh 2010), along with policy studies revolving around problems associated with reforming public pensions (see Pew (2015) for a review of the issues), there have been far fewer academic case studies that provide an in-depth analysis of any individual pension system.

An individual case study, providing a rich analysis of a particular public pension system would be valuable for two reasons. First, each public pension system faces a unique political, economic, demographic, and financial landscape. While aggregate studies of state and local pensions are important for identifying systematic trends and offering general reforms, they do, by their nature, abstract away from historical, political, economic, financial, and demographic contexts that are important for a full understanding of an individual pension system. This could be especially important when it comes to informing policymakers and making concrete recommendations for reform. Second, contextualized case studies, especially of a representative public pension system, can be used to corroborate the existing empirical literature as well as to inform future investigations.

Therefore, this paper provides an in-depth case study of Alabama’s public pension system. The Retirement Systems of Alabama (RSA) is an appropriate and representative public pension system for a case study on public pensions for three reasons. First, in terms of the RSA’s funded health, as measured by its funded ratio, the RSA ranks in the middle of the pack among the 50 U.S. states (The Pew Charitable Trusts 2015). Second, despite making its annual required contribution each year, the RSA’s funded ratio has fallen in the state rankings from 20th in 2003 to 30th in 2013. This makes it a particularly interesting public pension system to analyze (The Pew Charitable Trusts 2015). Finally, the RSA’s funding status as a percentage of tax revenue ranks it as the 5th worst in the nation (Novy-Marx and Rauh 2009, 198). This means, that, despite ranking in the middle of the pack in terms of funded health, that the RSA will likely require major reforms before many other states.

Pension Underfunding

Additionally, as will be discussed, Alabama is also representative of many other state and local pension systems on a number of important margins. First, like many state and local pensions, the financial crisis of 2008 led to a significant increase in its unfunded liabilities. This in turn has forced the pension system to increase its risk exposure in order to compensate for those loses, which, without particular reforms, leaves the state at risk of greater fiscal burdens in the future.

Second, and related to the previous point, legally permissible accounting standards indicate a much stronger financial position for the retirement system than would be the case if accounting standards recommended by economic and financial experts were to be employed. This has the effect of masking more fundamental and structural problems that most public pensions, including the RSA, face. Finally, the RSA also devotes sizeable portions of its portfolio toward economically targeted investments (ETIs). The literature, however, has shown that returns on these investments tend to be lower and are, in many instances, politically motivated (Romano 1993; Mitchell 1993). The evidence also suggests that public pensions tend to be poor managers when they take a controlling interest in a company (Karpoff, Malatesta, and Walkling 1996; Wahal 1996; Wohlstetter 1993). We show that Alabama’s experience with ETIs has been no different, as these investments have been made in order to justify increased public support and to spur economic development and job growth at the expense of investment returns, contributing to the system’s underfunding.

Based upon our findings, we make several recommendations for public pension systems. First, public pension systems, such as the RSA, require a much greater degree of transparency and reporting. Second, private placement investments, especially those intended to encourage in-state economic growth at the expense of investment returns, should be curtailed or eliminated. Third, major reforms, such as transitioning to defined contribution, individual retirement accounts, may ultimately be necessary to curb the growth of unfunded pension liabilities.

Section 2 provides a brief overview of the retirement systems of Alabama. Section 3 gives a thorough evaluation of the funded health of the RSA. Section 4 lays out an analysis of how the RSA has reacted to declining funded health by adopting more risk exposure and pursuing goals with investments beyond achieving investment returns. Section 5 includes more generalizable results and potential policy options for reforming public pension systems. Section 6 concludes.

Pension Underfunding

Pension Underfunding

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