Cypen & Cypen
Stephen H. Cypen, Esq., Editor
MISUNDERSTANDINGS REGARDING STATE DEBT, PENSIONS AND RETIREE HEALTH COSTS CREATE UNNECESSARY ALARM:
On January 20, 2011, Center on Budget and Policy Priorities issued “Misunderstandings Regarding State Debt, Pensions, and Retiree Health Costs Create Unnecessary Alarm – Misconceptions Also Divert Attention from Needed Structural Reforms.” One of the most comprehensive pieces we have seen, this scholarly paper contains 20 information-filled pages, all of which can be accessed at the following revised link http://www.cbpp.org/cms/index.cfm?fa=view&id=3372. The paper deals with bond indebtedness, pension/pension obligations, retiree health benefits/insurance, structural deficits, projected operating deficits and state/local debt. For purposes of this Special Supplement, we will only address the Summary and Pensions.
In sum, a spate of recent articles regarding the fiscal situation of states and localities has lumped together their current fiscal problems, stemming largely from the recession, with longer-term issues relating to debt, pension obligations and retiree health costs, to create the mistaken impression that drastic and immediate measures are needed to avoid an imminent fiscal meltdown. The large operating deficits that most states are projecting for the 2012 fiscal year, which they have to close before the fiscal year begins (on July 1 in most states), are caused largely by the weak economy. State revenues have stabilized after record losses but remain 12 percent below pre-recession levels, and localities also are experiencing diminishing revenues. At the same time that revenues have declined, the need for public services has increased due to the rise in poverty and unemployment. Over the past three years, states and localities have used a combination of reserve funds and federal stimulus funds, along with budget cuts and tax increases, to close these recession-induced deficits. While these deficits have caused severe problems, and states and localities are struggling to maintain needed services, the problem is a cyclical one that eventually will ease as the economy recovers. Unlike the projected operating deficits for fiscal year 2012, which require near-term solutions to meet states' and localities' balanced-budget requirements, longer-term issues related to bond indebtedness, pension obligations and retiree health insurance can be addressed over the next several decades. It is not appropriate to add these longer-term costs to projected operating deficits. Further, the size and implications of these longer-term costs should not be exaggerated, as some recent discussions have done. Such mistakes can lead to inappropriate policy prescriptions.
Now, specifically as to pensions, some who argue that states and localities are in a crisis claim that they have large amounts of “hidden” debt in form of underfunded pension funds. A figure of $3 Trillion in pension underfunding is sometimes cited; other estimates place the underfunding at levels as low as $700 Billion, or less than a quarter of the $3 Trillion figure. While some pension funds are indeed underfunded, there are a number of misconceptions about the extent and depth of the problem – and about states’ ability to resolve pension funding issues over time without disrupting their ability to continue public services.
States and localities currently make annual contributions to their pension trust funds equating an average of 3.8% of their general (operating) budgets. They began to make deposits to pre-fund their pension costs in the 1970s. Each year, they are supposed to deposit in a trust fund an amount that equals the present value of the future pensions their employees earned that year. (The present value is the amount that has to be invested today to grow to the desired amount in the year the employees are expected to retire.)
As of 2000, state and local pension obligations were fully funded on average, if obligations are discounted at 8 percent per year, which was the return on pension fund investments over the previous two decades. Since then, however, the nation has experienced two recessions, during which some states and localities have reduced or skipped pension trust fund deposits to help balance their budgets. In addition, the recessions have caused significant investment losses. By 2008, state and local pensions in aggregate were funded at 85 percent of their future liabilities; the other 15 percent is considered to be the "unfunded liability." The Center for Retirement Research at Boston College projects that, in the aggregate, state and local pensions were funded in 2010 at 77 percent of their future liabilities, a ratio projected to decline to 73 percent by 2013.
A drop to funding in the 70 percent range is a significant problem, although not an imminent crisis. Many experts argue that 80 percent funding is sufficient for public pensions because states and localities, as ongoing entities, can use tax revenues to make up a shortfall if necessary. A private company, in contrast, can go out of business, at which point the federal Pension Benefit Guaranty Corporation pays the company's employees their accrued benefits out of a combination of assets the company accumulated before it went out of business and the insurance premiums PBGC collects from private-sector employers with pension plans. (Federal law generally requires private companies to be 100 percent funded so the federal government does not have to make up any shortfall.)
Some states -- such as Illinois, New Jersey and Pennsylvania (and to a somewhat lesser extent, Colorado, Kentucky, Kansas and California) -- have skipped or reduced deposits to trust funds or expanded future pension benefits without providing commensurate funding. Over time, to reach adequate funding, these states may have to institute changes more difficult than potential solutions discussed below. These states, however, are not representative of states in general.
The issue whether states' discount-rate assumptions are reasonable is more complicated. The "discount rate" is the interest rate used to translate future benefit obligations into today's dollars. Discount rates are important, since 60 percent of pension trust fund revenues comes from trust fund earnings, and discount rates help determine how much money a state should put into the fund each year.
One school of thought argues that that it is appropriate to continue to use the actuarial method recommended by the Governmental Accounting Standards Board, which is to use as a discount the historical return on funds' assets -- about 8 percent. (State pension trust funds invest their assets in a diverse mix of stocks, bonds and other instruments until they are needed to pay for benefits.) Others argue that a much lower assumption is warranted: because pension obligations are guaranteed, they argue, the assumed growth of assets (the discount rate) should be similarly "riskless" and based on returns from the safest investments such as Treasury bonds -- around 4 percent or 5 percent.
The alarming reports that pension funds are about to run dry or that unfunded pension liabilities number in the trillions of dollars generally rely on these more conservative assumptions about the appropriate discount rate. For example, a recent Washington Post editorial said that "Public-employee pension funds are notorious for understating their liabilities through the use of vague projections and rosy investment return assumptions," and took note of a proposal by three members of Congress that would force pension funds to calculate their liabilities using a riskless discount rate.
While economists generally support use of a riskless rate in valuing state and local pension liabilities, they do not generally argue that investment practices of state and local pension funds should change. State and local pension funds historically have invested in a market basket of private securities, and have received rates of return much higher than the riskless one. The 8 percent discount rate that most funds now use reflects actual returns over the past 20 years.
Even if state and local pension liabilities were valued at the riskless rate, that would not mean that states and localities "owe" $3 Trillion to their pension funds. The issue of how states and localities value their pension liabilities and the issue of how much they have to contribute to meet their pension obligations are not the same. The $3 Trillion of unfunded liabilities is not equivalent to the amount that states and localities should contribute to their pension funds. It thus is mistaken to portray this liability as a huge one that will lead to bankruptcy or other similarly dire consequences.
Indeed, leading economists who advocate valuation at a riskless rate have observed, "the question of optimal funding levels ... is entirely separate from the valuation question." Required contributions to state and local pension funds should take account of expected rates of return on their investments, as well as other practical considerations.
While it may make sense to reconsider whether the typical 8 percent discount rate is the right one going forward, simply basing annual state contribution amounts to pension funds on return on riskless investments appears to go much farther than is necessary, for a number of reasons.
Pension funds invest for the long term, so a few years of below-average returns can be averaged out with years of higher returns. As noted, the 8 percent discount rate that most states assume reflects experience of the trust funds over the last 20 years (including the 2008 stock market decline); median returns for the last 25 years were even higher, at 9.3 percent. While rates of return on investments were much lower in the recent recession, it is generally assumed that they will rise in the future, even if they do not return to the very high rates of the late 1980s.
A business may be sold or go out of business at any time, so it is important to keep its pension plan 100 percent funded for benefits earned to date. Governments, in contrast, will be in continuing existence, so it makes sense to average or smooth expected investment returns over a long period. Smoothing also promotes intergenerational equity, enabling the state to contribute approximately the same amount for each cohort (assuming that it makes appropriate contributions each year).
The stated concern of some that basing required contributions on actual rates of return will lead pension managers to put funds in risky investments is overblown. Pension funds have a very long history and have been invested prudently except in very rare situations. Most states have other effective barriers to overly risky investing in place, including oversight boards, reporting requirements and regular actuarial reviews.
A discount rate that is too low would require a state to put money into the pension funds that it could be using instead to support public services, resupply reserve funds, invest in infrastructure or return to taxpayers in the form of tax cuts.
In addition, if the pension fund assumes a 4-or 5-percent discount rate and actually gets higher returns on its investments, funds will build up in the trust fund. When pension trusts have been overfunded in the past, it has led to problems such as employee demands for increases in pension benefits that later proved unsustainable. Overfunding also has led jurisdictions to skip payments that they subsequently found difficult to resume because programs were funded or taxes were cut permanently by the amount of the skipped pension contribution. A 2008 Government Accountability Office report said "... it can be politically unwise for a plan to be overfunded; that is, to have a funded ratio over 100 percent. The contributions made to funds with excess assets can become a target for lawmakers with other priorities or for those wishing to increase retiree benefits."
Nevertheless, improvements in pension plans' policies clearly are needed. There are a number of ways that most states with unfunded liabilities can improve their pension funding without causing major disruptions in their ability to provide services.
As previously noted, current employer contributions for public employee pensions average only 3.8 percent of state and local budgets, an amount that pales besides the states' largest expenses: education and health care. Pension contributions are smaller than amounts spent on transportation, corrections and many other services. If all states and localities were to fund their pensions based on the riskless rate, they would have to contribute approximately 9 percent of their budgets, on average. (This calculation uses 5 percent as the riskless rate.) A contribution amount this high would cut into states' and localities' ability to provide other public services; it arguably would not strike the appropriate balance between funding currently needed services and funding past pension liabilities.
If states and localities continue to use an 8 percent discount rate for calculating required contributions, a funding increase to 5 percent of their budgets would be required on average fully to fund their pensions. This level is not likely to be unduly burdensome after the economy recovers, and states could reduce it somewhat by adopting various pension reforms. (States should not begin to increase their contributions while the economy is still weak, because budget cuts this move would require could further slow the economy.)
States that have significantly underfunded their pensions, such as California, Illinois and New Jersey, would require higher contributions (7.3 percent, 8.7 percent and 7.9 percent of their respective budgets), even using the standard 8 percent discount rate. These states will have to consider more significant changes in their pension plans to bring their required contributions down to a more reasonable level.
More than 20 states have enacted changes to reduce pension costs in recent years, including raising length of service and age requirements for receiving a pension and reducing the factor that determines percent of salary that an employee receives as a pension payment for each year of service. While these types of changes generally can be applied only to newly-hired employees, they will help with a pension plan's longer-term funding.
Public-sector employees generally receive lower wages than their private-sector counterparts, and employee benefits such as pensions make up only part of the difference. If pensions are made less generous, current wages may have to increase so that the public sector can continue to attract high-quality employees.
In addition, all states and localities need to ensure that their employee pension provisions do not permit abuses, such as ability to inflate pay in the year or two before retirement in order to receive an outsized pension benefit. Reforms in this area are needed in a number of states. States also need to review their provisions for disability pensions to ensure that only employees who are appropriately qualified can retire on a disability pension. While these issues are not the major source of financial stress of pension systems, abuses are frequently publicized and undermine confidence in administration and fairness of public employee pensions.
In short, there are significant issues with public pensions, but they do not amount to a crisis. In part, pensions' funding status will improve as the economy and investment returns improve. Some states and localities already are taking actions to improve their pension funding; at an appropriate time when the economy is stronger, more states and localities can, if necessary, increase their pension trust fund contributions to put them on a path to funding their unfunded liabilities over the next few decades. A number of states also will need to institute various pension reforms. But for the reasons cited, evidence does not support the claim that states and localities are on the verge of bankruptcy because of massive unfunded pension liabilities. Well put.
Center on Budget and Policy Priorities is one of the nation’s premier policy organizations working at the federal and state levels on fiscal policy and public programs that affect low- and moderate-income families and individuals. The Center conducts research and analysis to help shape public debates over proposed budget and tax policies and to help ensure that policy makers consider the needs of low-income families and individuals in these debates.
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