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STATE AND LOCAL PENSIONS

BROOKINGS INSTITUTION PRESS

Chapter One

Vallejo, California (2008), Prichard, Alabama (2010), and Central Falls, Rhode Island (2011) have filed for bankruptcy, with commentators citing pension promises to public employees as a major cause (see box). A Googling of the words "state," "pension," and "crisis" found more than a twentyfold increase between 2000 and 2011 (see figure 1-1). The Governmental Accounting Standards Board (GASB) has promulgated new standards that could dramatically change how pension liabilities and costs are reported. Many states have substantially reduced benefits for new employees and increased employee contributions across the board. Yet the majority of states should be able to recover from the devastating impact of the 2008 financial crisis. What is going on here? How did the states and localities facing serious problems get into trouble? How did the others avoid problems? And where problems exist, what changes should be made that would be both effective and fair?

This book tells the story of state and local pension plans over the past three decades. The late 1970s and early 1980s is a good place to start. In 1978, the first comprehensive survey of state and local plans, mandated by the Employee Retirement Income Security Act of 1974, awarded public plans a grade of D:

In the vast majority of public employee pension systems, plan participants, plan sponsors, and the general public are kept in the dark with regard to a realistic assessment of true pension costs. The high degree of pension cost blindness is due to the lack of actuarial valuations, the use of unrealistic actuarial assumptions, and the general absence of actuarial standards.

It was also a period when the author served as a member of the Massachusetts Retirement Law Commission and witnessed the "Wild West" up close. The then chair of the commission later pleaded guilty to state and federal charges that he engaged in a scheme to defraud the Massachusetts retirement systems.

From the perspective of the late 1970s and early 1980s, the management of state and local plans has improved dramatically. Plans began to put aside assets to pay for future benefits. Assets started to be managed professionally. Plan sponsors began to provide regular actuarial reports. And many public plan officials became subject to the same fiduciary standards that apply to the private sector. In fact, the preface to a 2001 comprehensive study of public plans from the prestigious Pension Research Council at the Wharton School of the University of Pennsylvania, of which the author is a member, awarded state and local plans at least an A–: "State and local plans in the United States have impressive levels of assets backing their liabilities, they provide reasonable replacement rates to retirees, and they invest in a manner not too different from that of private pension managers."

Two financial crises later—the bursting of the dot.com bubble in 2000 and the collapse of the entire equity market in 2008—it became clear that some state and local pensions were seriously underfunded. The ensuing recession, which decimated state and local budgets, precluded additional contributions to compensate fully for the drop in asset values. States and localities began to cut benefits for new employees, raise employee contributions, and, in some cases, shift to defined contribution or hybrid plans.

The economics profession followed with "I told you so." The issue, among the many complex questions surrounding the provision of pensions in the public sector, that economists pounced on was the rate used to discount obligations. Following the standards established by GASB, state and local plans have used the expected long-run rate of return on plan assets as the discount rate. But finance theory dictates that the appropriate rate should reflect the riskiness of the obligations; the expected long-run return backing those obligations is irrelevant. Using the economists' approach, unfunded liabilities turned out to be $2.1 trillion in 2008 rather than $507 billion. Divide the new figure by the number of residents and the problem looks insoluble.

Some problems could have been avoided by discounting obligations for reporting purposes by the appropriate rate. For example, California's plans would not have appeared overfunded in the 1990s, and the legislature might not have expanded benefits dramatically. And breaking the link between expected returns and the discount rate might have resulted in lower holdings of equities. But the discount rate is a narrow prism through which to view the hard questions public plan sponsors face.

At the other extreme, a number of governors identified public sector unions as the source of the problem. Wisconsin eliminated collective bargaining for public employees except police and firefighters. Michigan passed legislation that required each collective bargaining agreement to include a provision that allows an emergency manager appointed under the local government to reject, modify, or terminate the collective bargaining agreement. Oklahoma decided that municipal governments are no longer required to bargain, except with police and firefighters. And Ohio abolished the right to strike—a provision that was subsequently defeated by a referendum. Legislation to limit collective bargaining is currently under consideration in many other states.

Unions, like the discount rate, are too narrow a focus for understanding the complex situation facing state and local governments. Consider Illinois, a highly unionized state with generous benefits. Three of its four large state-administered plans are in terrible shape; one is much better off. Why? The answer lies largely in the fact that the sponsors of the plan for municipalities made their annual required contributions each year, whereas the state legislature failed to make the required contributions for the three other plans.

Thus, plans have a number of dimensions, including the generosity of benefits and the extent to which those benefits are funded. But more important, pension benefits are part of the compensation package used to attract and retain a skilled public sector workforce. The risk at this point is that state legislatures will cut benefits too much for new employees, so that public schools and universities, without compensating wage increases, will not be able to compete with the private sector for skilled workers. In order to make good decisions about public plans going forward, it is important to understand them in their full complexity and be able to answer a range of questions:

—How did states and localities get into their current situation?

—Why are some plans in trouble, others not?

—How do pension commitments affect state and local budgets?

—Are public sector workers appropriately compensated?

—Do defined contribution plans have a role in the public sector?

—How can public plans fairly distribute the pain in the case of unsustainable benefit promises?

The answers to these questions matter because public pensions have a significant economic effect on every state, city, and town in the nation: these plans hold about $2.8 trillion in assets, cover 15 million working members (about 11 percent of the nation's workforce), and provide regular benefits to 8 million annuitants.

Organization of the Book

This book offers a comprehensive overview of the health of state and local pension plans, outlines the major challenges they face, and proposes solutions that preserve their main strengths while promoting needed reforms. By adopting a broad perspective, the book captures the core issues that should drive the policy debate, rather than more narrow concerns that produce much heat, but little light.

The story of state and local pensions is big and complicated. It cannot be reduced to a single mantra such as discounting obligations by the riskless rate of return or limiting union power. It is a story of plan sponsors with unique histories, resources, and political cultures. The main theme is that many states and localities have provided reasonable benefits and set aside money to pre-fund their commitments, but a few have simply behaved irresponsibly. Whatever differences existed before 2008 were magnified by the financial crisis. However, even the good states face challenges: scaling back their investments in risky assets, maintaining adequate compensation to attract talented workers, and obtaining the flexibility to alter benefits for current workers.

Chapter 2 sets the stage by first discussing the recent history of state and local pensions, from the late 1970s to the present. During the 1980s, most plans dramatically improved their funding and investment practices. But they also increased their holdings of equities in the 1990s and engaged in benefit improvements and funding holidays during the bull market. As a result, they were thrown seriously off course by the twin economic crises of the 2000s. By 2010, the reported funded level for state and local plans was 76 percent; estimates for 2011 suggest a level of 75 percent. The chapter next provides a broad picture of the state and local plan universe, highlighting its breadth and diversity. The U.S. Census identifies 3,418 retirement systems that are sponsored by a government entity. State-administered plans, which often cover many local government workers as well as state employees, account for a tiny fraction of all plans but almost all of the participants and assets. While local plans are generally small, they hold more assets per active employee than state plans, likely because they cover police and firefighters who retire earlier and therefore have more expensive benefits. The final section discusses retiree health plans, the other major retirement benefit offered to state and local workers. Most of these plans are unfunded, so they represent a serious claim on future budgets. But due to their complexity and data constraints, retiree health merits a separate study and falls outside the scope of this book.

Chapter 3 covers the thorny issue of how best to account for the liabilities of public plans for reporting purposes and whether this choice should also influence investment and funding decisions. What may appear as an arcane issue has generated a white-hot debate among economists, actuaries, and practitioners. At issue is how best to measure future benefit promises made to current employees and the corresponding liability to the government.

As noted, most plans, following guidelines established by GASB, discount their obligations by the expected long-term return on the assets held in the pension fund, currently about 8 percent (although plans are beginning to lower their assumed rate of return). Economists argue that because pension benefits are guaranteed under most state laws, the appropriate discount factor is a riskless rate. The economists' approach would produce much higher liabilities than those currently reported by states and localities, and the unfunded liability would triple.

The argument is compelling that the obligations of public plans should be discounted by a riskless rate—for purposes of reporting. Such a change is not only theoretically correct, but would also deter plans from offering more generous benefits during periods when they appear to have "excess" assets and allow plans to reduce their holdings of risky assets without affecting their reported liabilities. And it would improve confidence in the stability of public plans among private sector observers.

The argument about the discount rate pertains to reporting; investing and calculating contributions are separate issues. Discounting obligations by a riskless rate does not imply that plans should hold only riskless assets. A number of considerations suggest that state and local plans should continue to invest in equities. If the returns on these equities resemble their long-run historical performance, then, for any given level of contributions, plans' unfunded liabilities would be paid off more quickly than if funds were invested in bonds.

Determining contributions is a trickier issue. Academic models suggest that the calculation should use the riskless rate. But contributing based on the riskless rate and investing in equities produces ever growing funding levels and declining contributions for each successive generation. These outcomes have political ramifications in the real world. Calculating contributions based on the expected rate of return is probably the least bad option and does not conflict with using the riskless rate for reporting purposes.

Building on chapter 2's discussion of the diverse pension universe and chapter 3's perspective on quantifying plan liabilities, chapter 4 analyzes the current funded status of plans to determine why some plans are in trouble while others are not. The discussion identifies the factors that lead plan sponsors to make their full annual required contribution (ARC) and the factors that, given the ARC payment, result in more or less funding. It then explores whether public employee unions have driven up plan costs, a concern expressed by many governors.

Three major conclusions emerge from the funding analysis. First, the notion that all public plans are in trouble is simply not correct. Before the two financial crises of the past decade, most plans were in reasonably good shape. And in the wake of the crisis, plan finances have begun to stabilize. Second, sponsors of seriously underfunded plans, such as those in Illinois, Kentucky, Louisiana, New Jersey, and Pennsylvania, have behaved badly. They have either failed to make their required contributions or used inaccurate assumptions so that their contribution requirements are not meaningful. An equally large number of states—Delaware, Florida, Georgia, Tennessee, and North Carolina—have done a good job of providing reasonable benefits, paying their required contributions, and accumulating assets. Third, it is impossible to identify a link between the poorly funded plans and the two factors others have highlighted as the source of the problem: (1) discounting obligations by the long-run expected return instead of the riskless rate; or (2) the collective bargaining activities of unions. The poorly funded plans did not come close to surmounting the lower hurdle associated with a high discount rate; raising the hurdle is unlikely to have improved their behavior. And union strength simply did not emerge as a significant factor in any of the empirical analyses. Pension funding is simply a story of fiscal discipline.

Chapter 5 puts the funding discussion in a broader perspective by assessing pension expenses as a share of state and local revenues. The important policy question is whether pension spending will squeeze out other priorities. The trade-offs here have become more challenging in recent years given both short-term fiscal pressures and more systemic factors driving up overall spending commitments. States and localities are still struggling to emerge from the budgetary strains that accompanied the financial crisis and Great Recession. Government revenues declined sharply as the economy deteriorated and took several years to begin to recover. At the same time, spending pressures resulting from the downturn have exacerbated structural budget challenges such as health care cost inflation.

Against this backdrop of ongoing fiscal challenges, it is particularly important to understand the burden that state and local pensions represent for their government sponsors. In 2009, overall pension contributions were about 4.6 percent of total state and local revenues. They will account for more in the future. How much more depends crucially on how much sponsors earn on plan assets. If they earn the expected return of 8 percent, pension spending will rise only modestly to 5.1 percent of revenue. If they earn only 6 percent, the share will grow to 9.5 percent. With a 4 percent return, pension contributions will account for 14.5 percent of revenue.

(Continues...)

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Excerpted from STATE AND LOCAL PENSIONS by Alicia H. Munnell Copyright © 2012 by THE BROOKINGS INSTITUTION. Excerpted by permission of BROOKINGS INSTITUTION PRESS. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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