Setting the record straight about public pensions.

• Author: Snell, Leigh

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State and local governments have recently come under substantial criticism about the condition of their pension plans. Critics maintain that the vast majority of public pension plans are significantly underfunded and seem to see this as the main cause for the current financial crisis in which state and local governments find themselves, along with the nation's difficulties in achieving a robust economic recovery. Indeed, some academics, as well as federal and state politicians, are claiming that state pension funds are running out of money. They are raising the specter of a large-scale federal bailout and calling for pension reform.

Is there really a public pension crisis of this magnitude? And what can--and should--be done to address legitimate concerns about the sustainability of the pension benefits of public workers? Before any productive discussion can occur, it is necessary to agree on some basic facts, distinguish reality from hyperbole, and set the record straight. (See "Addressing the Media Misconceptions about Public Sector Pensions and Bankruptcy" in this issue of Government Finance Review, which more fully develops some of the points touched on in this article.)

NOT RUNNING OUT OF MONEY

Are State and Local Government Pension Plans About to Run Out of Money? No, they are not. In fact, according to the Federal Reserve Flow of Funds, the combined value of public pensions was $2.73 trillion as of the 3rd quarter of 2010--the highest level in two years. This represents an increase of more than half a trillion dollars since a low of $2.17 trillion at the end of the 1st quarter of 2009, and marks the fourth consecutive year-over-year quarterly increase.

Furthermore, at the same time asset values have been increasing, pension plans and their sponsors have been aggressively addressing long-term pension costs. Over the last several years, nearly two-thirds of states have made changes to benefit levels and/or contribution rate structures, often raising contributions for employees, employers, or both, and reducing benefits, in some cases for existing plan participants. Many more local governments have made similar adjustments. Indeed, more state and local governments adopted significant changes to their retirement plans in 2010 to restore or preserve their long-term financial sustainability than in any other year in recent history. (1)

WHAT DECREASED FUNDING LEVELS MEAN

But Aren't Public Pension Funding Levels Dropping? Despite the significant dollar gains in the value of their assets, it is true that the funding levels of many--but not all--state and local government pension plans are nevertheless still declining. This is in part because the value of global equities decreased significantly in 2008-2009. Since most well-diversified pension portfolios place a significant portion of their holdings in such investments, there was a corresponding decline in their asset values. In addition, nearly all public pension plans phase in their investment gains and losses over several years through an approved accounting process called smoothing, so the full extent of this market drop will continue to be incorporated into funding levels over several years. Accordingly, public pension funding has generally declined. However, the aggregate public pension funding level is still at approximately 80 percent for fiscal 2009. (2) a level that is believed by many experts and government officials to be acceptable for public plans, according to the U.S. Government Accountability Office. (3)

Overall, this funding level may continue to drop by as much as another 10 percentage points before bottoming out in fiscal 2013, as the smoothed market gains of 2009-2010 begin to offset the smoothed market losses of 2008-2009. (4) For some plans, though, funding ratios are already improving as the result of plan modifications and actual investment gains that have substantially exceeded actuarially assumed rates of return.

If Most Pension Plans are Becoming Increasingly Underfunded, Aren't They Bound to Eventually Run Out of Money? Asset values are increasing substantially, but funding levels are declining, a seeming contradiction that can make it sound like government pension plans are inevitably going to run out of money. But judging the adequacy of funding requires more than a snapshot of the ratio of assets to liabilities. That is, a funding level is simply the actuarial value of a plan's assets divided by the value of its liabilities at a specific moment in time. In effect, this actuarial funding ratio represents a single day's view of a funding amortization process that averages approximately 25 years for most public pension plans, (5) during which unfunded liabilities are paid off--one out of approximately 9,125 days.

Another way of looking at it is as one frame from a movie that is more than 9,000 frames long: Important for what it is, but hardly telling the entire story. Being technically under-funded is not necessarily a sign that a plan is about to run out of money. The key issue, experts agree, is whether a plan sponsor has a funding plan and is sticking to it.

A plan that has a funding ratio of 101 percent on one day and then, on that same day one year later, drops to 99 percent has technically gone from being overfunded to underfunded. The difference may sound dramatic and troublesome, but in reality, the plan has actually seen little real change in its funding condition.

Nevertheless, some critics of public pensions are using these underfunded percentages to support their arguments that states are about to run out of pension money in as few as six years. This is simply not true, and the research used to support these claims is seriously flawed. It is based on asset values from the end of a 12-month period when the S&P 500 had a return of -26.2 percent, (6) and prior to many of the increases that have taken place since then; the assumption that, going forward, state and local governments will contribute nothing to amortize their past pension liabilities; and the idea that public pension funds will generate rates of return on their investments as if they were...