After functioning for years as obscure, back-office operations of state and local government, retirement systems for employees of state and local governments have become the focus of increasing attention from both the media and policymakers.
Given the size and scope of the public pension community, this attention should come as no surprise. According to the U.S. Census Bureau, state and local governments employ 16 million workers–10 percent of the nation’s workforce–of whom nearly 90 percent have a defined benefit (DB) pension plan.
The nation’s state and local government retirement systems have combined assets of $2.66 trillion, and they distribute more than $130 billion annually to more than six million retired public workers and their beneficiaries. In 2004 (the latest year for which data are available), state and local governments contributed $61 billion to public pension plans. Public employees contributed another $31 billion, and public pension funds generated more than $300 billion in investment earnings.
The increased scrutiny of public pensions also reflects concerns brought about by other factors, including:
- public pension funding levels and costs;
- publicity surrounding corporate pension plan problems; and
- Social Security’s impending shortfall.
Concerns about DB plans have been met in some states by proposals to replace them with defined contribution (DC) plans. For example, Barry Poulson, a Colorado resident and scholar with Americans for Prosperity, an organization promoting limited government and free markets, says, “Reform of [Colorado’s pension system] should focus on designing a new defined contribution system for newly hired workers.” Poulson is pursuing a state ballot initiative to close the state DB plan to new entrants.
Three-Year Decline Hurt
A declining stock market in 2000, 2001, and 2002 marked the first time since the Great Depression that stock prices declined for three consecutive years. As a result, the combined value of public pension fund assets dropped by $360 billion, from $2.29 trillion at the end of 2000 to $1.93 trillion at the end of 2002. Pension plan funding levels also fell, from a peak of around 100 percent in 2001 to their current level of 87.5 percent. This means that for every dollar of liability pension funds have incurred to date, they have 87.5 cents in real assets.
With some exceptions, however, public pensions remain in reasonably good condition, thanks to diversified and professionally managed portfolios, an improving stock market, and a near cessation of benefit enhancements during the past few years. Assuming investment markets continue their return to historic norms, the current public pension funding level is projected to mark the low point and will begin to rise.
Most Reasonably Funded
Seventy percent of public pension plans are funded at 80 percent or higher, a threshold considered by many actuaries to indicate actuarial health. Of course, that leaves 30 percent funded at lower levels, with a higher unfunded liability to overcome.
Most plans with poor funding levels got that way through the chronic failure of legislatures (or city councils) to make required contributions.
Nationwide, taxpayer contributions make up one-fourth of all public pension revenue; investment earnings and worker contributions make up the rest. Generating investment earnings first requires contributions, and states and cities that failed to make required contributions have lost out on billions of dollars of potential earnings, thereby worsening their pension plan’s funding level.
Ending Pensions Has Costs
Some policymakers and interest groups have responded to declining pension funding levels by calling for an end to traditional defined benefit pension plans for public employees. Such an action, however, involves real costs:
- Terminating a pension plan under most circumstances not only yields little or no savings, but often will increase costs, at least for the first few years.
- Terminating a pension benefit impairs the ability of public employers to continue to attract and retain the skilled workers needed to perform essential public services. Two-thirds of all state and local government employees work either in education, public safety, corrections, or the judiciary. These are chiefly career-oriented positions, the type DB plans are designed to retain.
- DB plans are a helpful workforce management tool, promoting the orderly turnover of personnel and enabling employers to reduce or adjust the size and cost of their workforce.
Costs Fell, Now Rising
Although every public pension plan has its own contribution rates and requirements, the accompanying chart illustrates DB pension spending on a national level by state and local governments in the United States as a percentage of total payroll and as a percentage of total spending.
As the graph shows, during the mid-1990s state and local governments were spending approximately 10 percent of their payroll on contributions to pension benefits. That figure declined steadily for five years, until it began rising in 2002. (2005 figures are not yet available.)
A significant portion of the 2004 contribution was a result of a single bond issuance by the State of Illinois to pay down its pension liabilities. Excluding that issuance, the 2004 figures would have been 8.9 percent and 2.3 percent, respectively.
Rules Hurt Private Plans
Much of the decline in DB plan coverage for private-sector workers has been a result of federal regulations that complicate administering and funding a DB plan. Those regulations result in funding level volatility and uncertain contribution requirements. State and local government pension plans, however, are not subject to the federal regulations that vex corporate DB plans. Most of the problems experienced by corporate DB plans are not an issue with public pensions.
In light of Social Security’s impending problems, some analysts, applying Social Security’s problems to public pensions, have questioned the viability of state and local DB plans.
The two systems, however, are fundamentally different: While Social Security’s pay-as-you-go financing structure makes the program highly sensitive to demographic changes, public pension plans are primarily prefunded. As noted earlier, public pensions overall are funded at 87.5 percent, which is reasonably good.
Major Problems Remain
Underfunding in some states, however, has led to two major problems.
First, by skipping required contributions for years, states have forgone untold billions in investment revenue that otherwise would be available to fund pension benefits. Second, closing off DB plans will not necessarily improve the situation, and may well make it worse because (a) existing liabilities still must be paid, and (b) cutting off contributions from new workers shuts off an expected and important source of future revenue.
Since a state is going to pay for the retirement of these younger workers anyway, the best fiscal policy may well be to retain the DB plan, to take advantage of contributions from young workers, possibly coupled with a reduction in benefits for future workers to begin to reduce liability growth.
Keith Brainard ([email protected]) is research director at the National Association of State Retirement Administrators.