Policy Analysis | July 2015
Public Pension Trends & Developments
The Southern Legislative Conference (SLC) has intensely focused on public pensions and the entire retirement architecture of the United States for more than 15 years. Some of the strategies adopted by dozens of states to bolster their public pension plans include: increasing employee contributions; limiting COLA increases (a strategy complicated by recent court decisions); increasing age and vesting limits; trimming benefits; and issuing pension obligation bonds.
In the wake of the 2008-09 market decline and Great Recession, nearly every state and many cities have taken steps to improve the financial condition of their retirement plans and to reduce costs. Although some lawmakers have considered closing existing pension plans to new hires, most determined that this would increase – rather than reduce – costs, particularly in the near-term. Based on the most recent information provided by the U.S. Census Bureau, 3.9 percent of all state and local government spending is used to fund pension benefits for employees of state and local government. Pension costs have remained within a narrow range over a 30-year period, declining from a high point of 5 percent to a low of 2.3 percent in FY02, and reaching 3.9 percent in FY12. State and local governments contributed, in aggregate, an estimated $109 billion to pension funds in FY13, a figure equal to 3.9 percent of projected state and local direct general spending for that year. This February 2015 National Association of State Retirement Administrators Issue Brief, entitled 'State and Local Government Spending on Public Employee Retirement Systems,'provides more details on these trends.
After its creation in the 1990s, the annual required contribution (ARC) quickly became recognized as the unofficial measuring stick of the effort states and local governments are making to fund their pension plans. A government that has paid the ARC in full has made an appropriation to the pension trust to cover the benefits accrued that year and to pay down a portion of any liabilities that were not pre-funded in previous years. Failing to meet its ARC is one of the primary reasons for a public pension plan to be in a financially perilous position. This March 2015 NASRA publication, entitled 'The Annual Required Contribution Experience of State Retirement Plans, FY 01 to FY 13,' contains additional information on the topic.
The Center for Retirement Research at Boston College is one of the nation's top research institutes studying state and local government pension plans. In February 2013, the Center issued a report entitled 'State and Local Pension Costs: Pre-Crisis, Post-Crisis, and Post-Reform.' The publication notes that in the aftermath of the Great Recession, states responded to their pension challenges by enacting a mix of revenue increases and benefit cuts. The paper poses a number of salient questions: First, whether plans stick with the reforms, or instead, expand benefits again when the economy improves is an open question. Second, the projections presented in this study assume that plans consistently make their annual required contribution, a degree of fiscal discipline that has been lacking in some jurisdictions. Third, retiree health plans represent an additional and growing claim on state-local budgets, given the rising number of retirees and healthcare cost inflation. Finally, plan finances are sensitive to the performance of the stock market, so lower-than-expected returns going forward could raise costs.
Another June 2015 publication from the Center for Retirement Research is entitled The Funding of State and Local Pensions: 2014-2018 As the publication notes, a strong stock market and the elimination of 2009 from the smoothing process led to a sharp increase in actuarial assets and to the first improvement in the funded status of public sector plans since the financial crisis. What happens from here depends very much on the performance of the stock market. In 2018, assuming plans achieve their expected return, they should be 81 percent funded. If returns are lower, as predicted by many investment firms, funding will stabilize at about 77 percent.
A March 2015 publication prepared by the Municipal Securities Research Division of Wells Fargo Securities, entitled 'State Revenues and Public Pensions,' contains valuable information. This publication reflects on how the states have become much more dependent on the financial markets' performance since 2000. This Wells Fargo publication also concludes that:
- State revenue has become more volatile, turning budget making into something of an aerobic activity. Much of this is due to fluctuation in capital gains taxes (and taxes on other investment income). Tax policy changes (at the federal as well as state level) also influence the timing when investors choose to take gains.
- Public pension plans, operating in a tough earnings environment since 2000, have increased the riskiness of their investments in an effort to achieve earnings targets. The reach for yield is an understandable effort to limit the damage to state and local budgets but, nevertheless, intensifies exposure to financial markets' volatility.