Are state and local pension funds really in crisis?

California state worker Albert Jagow (L) goes over his retirement options with Calpers Retirement Program Specialist JeanAnn Kirkpatrick at the Calpers regional office in Sacramento, California October 21, 2009. Calpers, the largest U.S. public pension fund, manages retirement benefits for more than 1.6 million people, with assets comparable in value to the entire GDP of Israel. The Calpers investment portfolio had a historic drop in value, going from a peak of $250 billion in the fall of 2007 to $167 billion in March 2009, a loss of about a third during that period. It is now around $200 billion. REUTERS/Max Whittaker   (UNITED STATES) - WASE5AM11ZS01

State and local government pension funds are important economic institutions: They hold nearly $4 trillion in assets; their annual benefit payments to beneficiaries are equal to about 1.5 percent of U.S. GDP; and more than 10 million people rely on these payments to sustain themselves in retirement. Louise Sheiner, the Robert S. Kerr Senior Fellow in Economic Studies and policy director of the Hutchins Center at Brookings, along with Byron F. Lutz , assistant director and chief of the fiscal analysis section of the Federal Reserve Board, and Jamie Lenney, an economist at the Bank of England, present a paper, “The Sustainability of State and Local Government Pensions: A Public Finance Approach,”at the Municipal Finance Conference held at Brookings on July 15 and 16, 2019.

In the Q&A below, Louise Sheiner explains their findings and the significance for policymakers.

Q: One often hears and reads about a “crisis” in state and local pension plans and anxiety about trillions of dollars in “unfunded liabilities” that exceed the plans’ assets. Your bottom line is quite different. Why?

A: Much analysis of state and local pension plans focuses on valuing the plans’ liabilities—benefits promised to retirees—and comparing those obligations to the plans’ assets (their portfolios of stocks, bonds and other investments). The gap between the present value of those liabilities and assets, known as “unfunded pension liabilities,” is often a huge and scary number, the size of which depends on the discount rate used to calculate the liabilities and the rate of return used to project growth in assets. In most cases, the implicit assumption behind these analyses is that pension plans should reduce this gap to zero –that is, they should set aside enough money today to cover (or prefund) all the pension benefits they’ve promised to pay.

We take a different perspective, gauging the fiscal sustainability of a sample of 40 state and local pension plans by looking at their cash flows over time and determining when (or if) they will require outside funding to meet their obligations. We then estimate the increased funding that would stabilize the pension plans in the long run—that is, keep their obligations stable measured against the size of the economy. The way we look at it, an unfunded pension liability is similar to a government having debt, and a government’s debt is sustainable so long as its size relative to the economy isn’t continuously increasing.

The message from these exercises is that for most (but certainly not all) plans, there is no imminent crisis in the sense that the plans are likely to exhaust their assets within the next two decades. That said, many plans are not stable and adjustments—in the form of higher contributions or, perhaps, reduced benefits—will be necessary. The question we try to answer is how large is that adjustment and how urgent is it?

What are the advantages of this approach compared to those that other analysts have used?

A: First, it provides a clear answer to the pressing policy questions of whether public pensions are likely to spark a fiscal crisis; failure to achieve full prefunding should not spark a crisis. Second, this approach is consistent with the history of these pension funds; they have always operated short of full prefunding. Third, prefunding is not necessarily welfare enhancing. In other words, current and future taxpayers and pension beneficiaries may not be made better off by putting a lot of money into pension funds today to eliminate unfunded liabilities. For instance, state and local governments have been ramping up pension plan contributions substantially in recent years, and often spending less on education and infrastructure as a consequence—with potential negative consequences for future economic growth.

Ok. So, using your approach, how big a problem do state and local pension funds face?

A: This, of course, depends on what one assumes about the rate of return on pension funds’ investments. At a 1.5 percent real rate of return, the increased funding required across all the state and local pension plans we examine would be about 14 percent of payroll. At a 3.5 percent real rate of return, it would be about 5 percent of payroll. And at a 5.5 percent real rate of return, future contributions could actually fall below current contributions – reflecting the fact that plans are currently making efforts to reduce their unfunded liabilities that exceed what we estimate is required to stabilize pension debt as a percentage of GDP. This required increase in funding to stabilize pension debt under these asset returns might be stressful, but would fall well short of what most observers would call a crisis.

In contrast, the increased funding required to reach full prefunding if one assumes a 1.5 percent real return on assets or a 3.5 percent real return would constitute a fiscal crisis for many state and local governments.

Q: Isn’t it hard – perhaps misleading – to generalize across state and local pension plans when some are so much stronger financially than others?

A: There is substantial heterogeneity across states and localities. The 40 plans we examined cover a broad range of financial strength. For instance, our sample includes the Oklahoma Police and the New York Teacher’s plans, both of which are essentially fully pre-funded (using the plans chosen actuarial assumptions, including discount rate). It also includes the Illinois State Retirement System and the New Jersey Teachers’ plan, which have a ratio of assets to liabilities of roughly 35% and 40%, respectively. Our sample also includes many typical plans such as the Georgia Teachers and the San Diego County plans, both of which have funding ratios around 75 percent.

Q: Isn’t it prudent to act sooner rather than later to fund public pension plans so we don’t burden future generations with keeping the promises our generation made?

A: Under a risk free 1.5 percent asset return assumption, there is little advantage to beginning the stabilization process now versus a decade or two in the future; neither the level at which debt stabilizes as a share of the economy nor the contribution increase needed to achieve stabilization increase much when the start of the stabilization process is pushed a bit further into the future. If interest rates are assumed to be higher, then there is a somewhat greater benefit to acting sooner, but the problem is smaller, so less action is needed.

Q: You mentioned that states have ramped up their pension contributions in recent years. What else have they done to shore up their finances?

Governments have been chipping away at the generosity of their employee pension plans. Seventeen out of the forty plans we examine have made their cost-of-living-adjustments ( COLAs) less generous since 2007, which is holding down the growth in benefit costs for current and future retirees. Other plans have been made less generous for newly hired workers, by changing the formula used to calculate benefits, by requiring more years of service before workers are entitled to pensions, and by raising the retirement age. We find that, even though the number of retirees in these plans is rapidly increasing relative to the size of the workforce as the baby boomers retire, benefit costs as a share of GDP are increasing only slightly over the next two decades, and then begin to fall as a result of these reforms.