What factors affect the underfunding of local pensions? Evidence from Indiana.

Author:Faulk, Dagney

    Underfunded local government pension plans place a burden on future taxpayers for public services performed in the past. Not surprisingly, unfunded pensions at the state and local level have become a critical public policy issue, so are worthy of closer scrutiny than they have thus far been afforded. Pension obligations were a significant factor in the re99cent bankruptcies of Vallejo, California, Central Falls, Rhode Island, and Detroit, Michigan (Dye and Gordon 2012, 3). Pension underfunding leads to lower credit ratings and thus, to higher borrowing costs. Pension underfunding masks the true cost of current services and encourages increased spending. It also violates interperiod equity by shifting current costs to future taxpayers, and it may decrease property values. Recent changes in governmental accounting standards may render pension funding shortfalls more visible, but will not necessarily lead to solutions. The purpose of this research is to identify factors contributing to pension underfunding among Indiana's local governments. The results will help local officials avoid pension funding crises and achieve healthy funding levels.

    This study extends the literature in the following ways. First, using data from Indiana we examine the determinants of underfunding of local pensions. Due to data constraints, most of the previous research has examined state pension programs. While important, this does not clearly outline the public policy dimension of underfunded local pension plans. Also, much of the analysis of pension plans has focused on the size, the actuarial certainty, the impact of underfunding on borrowing costs and the relationship between pension funding levels and the composition of debt. In this work, we examine factors that potentially contribute to underfunding of defined benefit plans. Recent changes in governmental accounting standards will increase pressure on local governments to more fully fund their pension plans, and our results will help them respond effectively.

    Our study's focus is the funded status of local public pension plans. We use data from Indiana to examine the determinants of underfunding. We find that economic and demographic factors such as per capita income and migration, along with fiscal factors such as the average tax levy and state aid, and broad interest group influences such as per capita retirement income are the major determinants of pension underfunding among local governments in Indiana.

    In the next sections we review the literature on defined benefit plans, the funding levels of public pension plans, effects of underfunded pensions and factors that influence underfunding. We then discuss the hypotheses that we tested related to local pension underfunding. Next, we discuss the data and empirical method used to test these hypotheses followed by a discussion of results. The final section offers conclusions and discusses implications and limitations.


    Pensions are compensation for work performed, and thus, shift a portion of labor costs from the present into the future. A defined benefit plan promises a certain level of monetary benefits to workers upon retirement, usually in proportion to their years of service and final wage or salary. The promise is independent of the resources actually set aside and held in trust to fund the future benefits, though employers usually make regular contributions to pension funds (Ippolito 1985, 612). A defined benefit plan is underfunded if the value of plan assets is less than the plan's actuarial accrued liability (Vermeer et al 2012, 47). Some public pension plans are so underfunded that it may precipitate a crisis for the government employer and for the retirees, who may not receive their promised benefits.

    While defined benefit plans are quickly disappearing from the private sector, about 80% of state and local government employees are covered by such plans (U.S. Government Accountability Office (GAO) 2012, 5; Dye and Gordon 2012, 4; Rich and Zhang 2014, 1). The United States has more than 3,400 state and local pension systems, covering about 27 million state and local workers and retirees (GAO 2012, 1). Local governments often participate in state-administered plans, yet contributions into state-administered plans often remain a local decision. Most public school teachers are covered by state-administered plans, but police and fire workers are more likely to be covered by local pension plans (Inman 1982, 51).

    Determining the funded status of a plan is not a straight-forward proposition. Complex, actuarial assumptions are used to calculate required contributions to pension plans as well as the funded status (ratio of plan assets to projected pension obligations) at any point in time. The net pension liability is the difference between accumulated assets and the actuarially determined liability (Mortimer and Henderson 2014, 431). Critics charge that in the past, the Governmental Accounting Standards Board (GASB) contributed to confusion over funding status through poorly-conceived accounting standards. For instance, GASB previously allowed a choice of six different actuarial methods for projecting future obligations and allowed use of overly-optimistic rates for discounting future liabilities (GASB 2012, 45; Dye and Gordon 2012, 5). The new GASB pension accounting standard, Statement No. 68: Accounting and Financial Reporting for Pensions (1), became effective for fiscal years beginning after June 15, 2014; it requires use of a single actuarial method and a more conservative, composite discount rate. Moreover, it requires governments to report the net pension liability of defined benefit plans on the face of the balance sheet, thus ending the off-balance sheet treatment of these liabilities (Rich and Zhang 2014, 5; GAO 2012, 47: GASB 2012, 9).

    The funded status of a defined benefit plan is affected by several factors. These include the investment return on plan assets; the level of annual contributions; deviations from actuarial assumptions (e.g. workers living longer than expected); an increase or decrease in promised benefits; and the choice of the discount rate to discount future liabilities (Munnell et al, 2015). While the new GASB standard will improve pension reporting, assessing the funded status of a pension plan remains an exercise in professional judgment; no single benchmark will indicate a healthy or unhealthy plan. The "80%" criterion, referring to plans where assets held in trust equal at least 80% of actuarially projected obligations, has been widely cited but recently debunked as a single, reliable measure of a healthy plan. The American Academy of Actuaries (AAA) and the Government Finance Officers Association (GFOA) argue that all pension plans should be managed to achieve a funding status of 100% or greater over a reasonable period of time (AAA 2012, 1-2; GFOA 2015). (2) Additional factors, such as the contribution record or the size of actuarially required contributions in relation to total revenues or total payroll, should be considered along with funded ratios when assessing the health of a plan (AAA 2012, 3).

    Recent practice (prior to implementation of GASB Statement 68) reveals considerable variation in choice of actuarial methods and discount rates, and pension obligations are easily manipulated by the choice of discount rate (3) (Marks et al 1988, 160). Governments vary significantly in their financial skills and level of disclosure (Farmer 2015, 57), and many governments do not follow GASB standards (Khumawala et al, 2014).


    While there is considerable variation among plans, many public pension plans are seriously underfunded (Collins & Rettenmaier 2010, 9; Dye and Gordon 2012, 8-9; Farmer 2015, 57). Some plans are so underfunded that to bring them to a fully funded status would require more than 100% of current payroll (Dye and Gordon 2012, 8). The Pew Center on the States estimates that state pension plans have a combined shortfall of $757 billion and local plans have a combined shortfall of $9 billion (Lambert 2013). Dye and Gordon report that "A significant fraction of local governments are in trouble" (2012, 9). Rauh concludes that based on current estimates, pension fund assets may be exhausted within 15 years (2011). Kelley analyzed self-reported data for the 126 state and local plans found in the Public Pensions Database (4) and finds the average state has about $1,280 in unfunded liabilities per capita (2014, 29-30). The GAO (2012, 7) is less alarming but still cautionary; it finds that most state and local plans can cover their commitments "for a decade or more" but that higher contributions are required if these plans are to remain sustainable.

    The higher the discount rate, the lower the present value of future obligations. In the past, plan administrators typically chose discount rates around 7% to 8% (Novy-Marx and Rauh 2011, 54). Recently, scholars have recalculated projected pension obligations using discount rates similar to those required under GASB 68 and the result is a deterioration in funded status. Collins and Rettenmaier (2010, 451) recalculated the liabilities of 153 state and local pension plans and found their unfunded pension liabilities to be $2.5 trillion rather than $493 billion as reported under previous assumptions; average funded ratios decreased from 73.4% to 56.3%. The journal Governing analyzed 80 state and local pension plans and found that under the new GASB guidelines, the average increase in projected liabilities was only nine per cent but for some plans the increase was as high 55% (Farmer and Maciag, 2015). Mortimer and Henderson studied 48 major, state-administered defined benefit plans; for their sample, the average funded ratio decreased from 73.4% to 56.3% under the new guidelines (2014, 439).

    Some analysts argue that discount rates should be based on U.S....

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