Modernizing State Pension Plans

Ensuring the Fiscal Survival of State Pension Plans

This is another commentary in Civic Way’s series on reconstructing American government, more specifically state government. The author, Bob Melville, is the founder of Civic Way, a nonprofit dedicated to good government, and a management consultant with over 45 years of experience improving public agencies across the US. Our earlier commentary on the need to revamp Federalism provides a great framework for understanding our thinking about state government. We also suggest our commentary on restructuring state government.

Highlights

• While state government needs wholesale restructuring, it also can benefit from other reforms, including public pension plan reforms

• There are 297 state and 5,232 local pension entities administering defined benefit, defined contribution and hybrid plans for about 21 million members, but state plans account for 90 percent of total members and 82 percent of total assets

• There are several metrics for identifying well-run pension plans, but arguably the most useful measure is the funding ratio (e.g., 90 percent during normal times or 100 percent during bull markets)

• In FY17, state pension plans had $4.13 trillion in obligations and $2.85 trillion in assets—a funding gap of $1.28 trillion (a 69 percent aggregate funded ratio unlikely to improve in the aftermath of the pandemic)

• Many states have pension crises (5 states are less than 1/2 funded and another 15 are less than 2/3 funded) and the gap between strong and weak state pension plans is widening

• States have already enacted many pension plan reforms and continue to consider appropriate changes to benefits and contributions, but they must get serious about consolidating state and local pension plans

Introduction

State government won’t realize its potential without structural reforms. Until such time we find the wisdom and courage to enact such measures (or demand them), there remain several non-structural opportunities for improvement. In our last commentary, we recommended public benefit program reforms. This commentary presents another such opportunity—state pension plan reform.

Despite claims to the contrary, the pandemic’s impact on state government will be devastating. Sure, some initial state government stimulus needs may have been inflated and a few states, like California and Virginia, have exceeded expectations. Still 42 states have suffered revenue losses. Some states, especially those with large service, tourism and energy sectors, have been hammered. And, despite the encouraging vaccine news, the long-term fiscal projections for states are disturbing. Moody's Analytics, for instance, projects $224 billion in total state government deficits through FY22.

The new federal stimulus package contains no direct aid for state and local governments, but that is no excuse for accepting the status quo. About 1.3 million state and local government workers have lost their jobs (750,000 jobs were lost during the Great Recession) and more job losses are likely. And state government constituents are hurting even more. State governments owe it to their constituents to do everything they can to improve their operations, pursue reforms and face the future. Delay is not a responsible option.

Understanding State and Local Pension Funds

State and local pension plans have nearly 21 million members or participants. Active, former and retired public employees. Teachers, police officer, firefighters, sanitation workers and clerks. Ultimately, all dependent on the income due them from public pension plans. 

There are three kinds of pension plans: defined benefit, defined contribution and hybrid plans. Defined benefit plans, the most common type, guarantee a specified lifetime annuity without regard to employee contributions. Defined contribution plans fix the contribution amounts, but do not guarantee benefits. Hybrid plans include aspects of both types (defined benefits and contributions). Under defined benefit plans, governments carry the risk and, during economic downturns, assume more liabilities precisely when they can least afford them.

The US has 5,529 state and local pension plans, of which 5,232 are local. That translates to an average of 102 locally-administered plans per state (including DC), but actual state numbers vary considerably. In 2017, six states had no local plans and eight states had over 100. Five states—Pennsylvania (1,594), Illinois (651), Minnesota (567), Florida (476) and Indiana (238)—accounted for over 2/3 of all local plans. Even some small states had large numbers of public pension funds (e.g., Arkansas with 151 and Montana with 92).

There are 297 state plans, but they are dominated by a relatively small number of large plans. The 30 largest state pension funds, while representing only 10 percent of total state plans, account for over 90 percent of combined state pension plan assets. As of 2017, Florida and Hawaii had one state-administered plan each, while Massachusetts had 14 plans (the most of any state). The opportunity for consolidation remains in many states.

According to the National Association of State Retirement Administrators, state-administered plans dwarf local plans. State plans account for 90 percent of total pension plan members and 82 percent of total pension fund assets. Many local government employees are covered by state plans (nearly 60 percent of local government pension contributions go to state-administered plans). Despite the importance of federal regulations, state government retains the paramount role in overseeing state and local pension plans.

Defining a Well-Run Pension Plan

American politicians often complain about public pension plans. But they offer little guidance on how to distinguish healthy public pension plans from the rest. They claim that state and local pension plans are unworthy of fiscal aid, but fail to tell us which plans they deem worthy. Instead, they sound the alarms about reckless state and local spending and bailouts. 

What constitutes a well-managed public pension fund? As it turns out, there are some quantitative and qualitative indicators of what constitutes a well-run, healthy pension plan.

One measure is the funding ratio, the market value of a plan’s assets divided by its accrued liabilities (e.g., payouts to retirees). Generally, the funding ratio should be at least 90 percent (or 100 percent during bull markets). Another metric is the equity risk premium (i.e., the difference between US bond yields and the plan’s assumed return). There are other quantitative measures as well.

There are many qualitative indicators of a well-run pension fund, such as the following:

• Strong, independent and active pension board oversight

• Professional plan management and efficient operations

• Mandatory plan participation as a condition of employment

• Periodic competitive assessments and adjustments of employee benefits

• An unwavering commitment to making actuarially-determined contributions

• Regular independent audits and actuarial assessments 

• Routine use of modern risk management tools to maintain desired funding ratios 

• Diversified, professionally-managed portfolio with reasonable risk and costs

A well-run pension plan continually strives to employ best management practices. One example of such a practice is empowering pension plan officials to make periodic risk-sharing adjustments (e.g., benefits or contributions) in response to audits or actuarial studies without additional legislative action.

The Looming Pension Fund Debacle

Many federal legislators have resisted more pandemic-related aid for state government due to their concerns about state government, especially public pension funds. While their opposition to state government aid is misguided, they are right about the need for public pension fund reform. 

At first glance, reports of a public pension crisis can seem overblown. State and local pension plans have thus far defied the direst forecasts during the pandemic. They have neither imploded nor devoured state budgets. Some pension officials have even touted the fiscal fitness of their pension funds, referring to them as “fully funded.” Given the strong stock market, such boasts are hollow. A sub-100 percent funding ratio is a dubious indicator of full funding during a bull market. A closer look is merited.

Most state pension plans pose a risk to state government finances. In FY17, according to the Pew Charitable Trusts, state pension plans had $4.13 trillion in obligations and $2.85 trillion in assets, an aggregate funding gap of $1.28 trillion. This represented a 69 percent aggregate funded ratio, well below full funding. And, with the pandemic, it is highly unlikely that the aggregate funding ratio will improve, not without substantial changes to benefits, employee contributions or government contributions (the average government contribution is about 5 percent of direct general spending).

Some states face severe pension funding gaps. The fiscal health of state pension funds varies widely, ranging from Kentucky’s 34 percent funded ratio to Wisconsin’s 103 percent funded ratio. Five states—Colorado, Connecticut, Kentucky, Illinois and New Jersey—are less than half-funded, and another 15 are less than two-thirds funded. Only eight states have funding ratios of at least 90 percent—Idaho, Nebraska, New York, North Carolina, South Dakota, Tennessee, Utah and Wisconsin. Having over 5,500 public pension funds can obscure troubling trends, mask a pending crisis and even contribute to long-term solvency risks. 

The Great Recession dealt a serious blow to public pension funds. The stock market collapse slashed state and local pension fund asset values from $3.15 trillion in 2007 to $2.17 trillion in 2009. And, since the Great Recession, the gap between the best- and worst-funded state pension plans has actually widened. By FY17, the eight states with the strongest plans had an average 95 percent funding ratio. In contrast, from FY07 to FY17, the 20 states with the weakest plans saw their average funding ratio slip steadily from 76 to 56 percent. In addition, as bond yields declined from 1992 to 2016, the average equity risk premium increased from less than 1 percent to over 4 percent.

The pandemic found state pension funds in worse financial shape than before the Great Recession and the future looks ominous. If revenues continue to fall, states will struggle to make pension contributions and maintain funding ratios. States that underfund pension plans will experience significantly higher debt levels and pension plan operating costs. Poor policy decisions and indifferent management also could put future benefits at risk for generations to come. The pressures to allocate more general taxes to unfunded pension benefit obligations will mount.

Reforming State Pension Plans

The Great Recession’s global stock market crash spurred substantial public pension plan reforms. Most state governments have taken steps to improve the financial condition and operations of their public pension plans. Since the Great Recession, while virtually every state retained its traditional pension plan, nearly all states have implemented changes designed to restore the fiscal health of their pension plans. 

Several states partially transitioned from defined benefit to defined contribution plan for new employees. Eight states launched hybrid plans and two states created cash balance plans. Some states adjusted employee and employer contribution levels (member contribution rates were increased in 40 plans in 39 states), some adjusted benefits and changed vesting periods. Most shifted at least some risks from the employer to the employee. Such initiatives should be expanded and accelerated.

In pursuing further reforms, state officials must strike a balance among potentially competing objectives—providing retirement security for long-time employees, recruiting and retaining high-quality workers, maintaining the fiscal health of the pension funds and making the best use of public moneys. This ideal is critical in assessing the feasibility of the potential reforms summarized below.

States must get serious about consolidating state and local pension plans. States with too many state plans, like Massachusetts, should merge those plans. Similarly, states with too many local plans (e.g., Arkansas, Florida, Illinois, Indiana, Minnesota and Pennsylvania) should consolidate as many local plans as possible. Small states should establish multi-state pension plans to spread costs and risks. Fewer, stronger public pension plans should be accompanied by stronger board oversight, more professional management, healthier portfolios and more agile risk-sharing tools.

States should continue to explore prudent ideas for restructuring public pension funds and rebalancing risks between employers and employees. Continue the migration from defined-benefit plans to defined-contribution plans. Explore hybrid or cash benefit plans for new employees that offer greater portability to employees in exchange for reduced governmental risk. Give employees a bigger voice in designing and overseeing retiree medical benefit programs like Retiree Medical Trusts (RMTs).

States should continue to adjust benefits and contributions to balance the risks borne by employers and employees. Retirement benefits should be competitive, but not overly generous, and calibrated to time worked (e.g., partial benefits for part-time workers). Benefits should be periodically reviewed and, as appropriate, the benefit formula should be tweaked (e.g., vesting period, age and service requirements, cost-of-living adjustments and retirement multiplier). Employee contributions should be increased as appropriate.

No Pain, No Gain

Public pension plan reforms must be tailored to each state’s circumstances and reconcile the competing objectives and needs of various stakeholders. There are many obstacles to change—statutory and regulatory hurdles, employee union resistance and litigation. Still, while difficult to implement, pension reforms can yield many important long-term benefits for states. Improved efficiency. Lower operating costs. Prevented or mitigated risk. Restrained liabilities. More portable employee benefits. More successful employee recruitment.

Our failure to reform state pension plans will have serious long-term fiscal consequences for state governments, especially in states with poorly-structured and funded plans. State officials will be forced to allocate more general funds to public pension funds. Since most voters will likely resist tax increases, states will have to shift funds from the top program priorities of our state governments—education, health care and infrastructure. Ultimately, unless they improve the fiscal health of their pension plans, state governments will be far less able to invest in future capacity and far less equipped to manage future crises.