Pension costs are a challenge for local governments all over the country. The actuarial funded ratio, or the ratio of actuarial value of assets to actuarial accrued liability, for U.S. public pension plans dropped from approximately 90 percent at the beginning of the century to approximately 70 percent in 2012, where it has remained. (1) The effect of this sustained underfunding is that local governments' pension contributions, both as a percentage of payroll and total revenue, have been steadily increasing, rising to 17.4 percent and 3.2 percent, respectively, as of 2018. (2) (Exhibit 1 shows the long-term trend.) These numbers are based on nationwide averages, so some individual local governments are experiencing even more difficult conditions than the numbers suggest.
The pension underfunding problem represents a collective action problem of the kind addressed by GFOA's Financial Foundations for Thriving Communities (gfoa.org/financialfoundations). A local government budget is a collective action problem because a local government must reach a financially sustainable budget over the long term, despite the incentives that all stakeholders have to get as much as possible from the budget for themselves each year. A pension plan presents an even more challenging dynamic. Both public employees and elected officials have an incentive to increase pension benefits and underfund the liabilities. The people who have the strongest interest in responsibly managing today's pension plans are future officials, employees, and taxpayers, and they don't have a voice in today's decisions.
This article is about the experience of the Town of Queen Creek, Arizona, a community of about 50,000 that solved its pension problem and, in the process, transformed the entire state of Arizona. We'll explain how Queen Creek's solution reflects many of the strategies described in the Financial Foundations Framework.
THE PROBLEM AND THE SOLUTION
Queen Creek had multiple pension plans that were cause for concern. The town had accumulated a great deal of what amounted to debt for services rendered by public employees in years past. This debt is known as an unfunded pension liability. Queen Creek was also paying what amounted to interest in the form of higher contribution rates. Because Queen Creek was using today's tax dollars to pay the "debt" costs for services rendered years ago, current taxpayers were not getting full value for the money they contributed to the town government --which, according to the Financial Foundations Framework, leads to two problems. First, people won't see the value in contributing to the collective resource that is local government because they aren't getting benefits back commensurate with their contributions. This might lead them to resist making contributions (e.g., paying taxes) in the future. Second, people feel unfairly treated because their resources are being used to pay for something that benefits other people (past residents, past employees, past officials). When people feel unfairly treated, they are more likely to leave (e.g., move out of the community) or fight back.
The public pension problem would not just make it more difficult for Queen Creek to balance its budget --it could drive a wedge between elected officials, staff, and the public, making it difficult for them to work together for a thriving community.
The solution began in June 2015, when the town council adopted a pension funding policy. We'll examine the policy details later in this article, but its critical feature was to commit the town to fully funding its pension plans. Queen Creek was determined to reach 100 percent funding within a few years of adopting the policy and would reach its goal by directing budget surpluses to fund the liability. The town was frugal with its expenditures and was growing in population, so it could expect its revenues to grow as well.
The policy first addressed the pension plan for firefighters, which is part of a statewide system for public safety personnel (the Arizona Public Safety Personnel Retirement System). The system is set up so that each participating employer's plan is administered separately, which means that Queen Creek has its own employer contribution rate and unfunded liability. This made it easy for people to understand what the town's responsibility was for the pension costs. In fiscal 2015 to 2016, the town's annually required contribution rate was equal to 15.7 percent of the total payroll of the town employees who were covered by this pension plan ("covered payroll"). The plan was 65 percent...