State public pension plans are underfunded by nearly $5.6 trillion nationwide, according to a new American Legislative Exchange Council (ALEC) study. Naturally, the level of pension funding and the size of liabilities vary widely across states. Given that, the new ALEC report provides useful comparisons based on three criteria:
- Funded ratio;
- Total unfunded liabilities; and
- Per capital unfunded liabilities.
In terms of funding ration, Wisconsin scores the best, at 63.4 percent funding, the only state with a ratio above 50 percent. Connecticut scores worst, at 22.8 percent.
Vermont has the nation’s smallest total pension obligation sum, at $8.7 billion; California the greatest, at $956 billion.
Of course, Vermont is a small state and California very large, which is why the per capital level of underfunding is important, as it reflects the long-term potential tax burden on each state resident—a major factor affecting each state’s business environment. On that score, Tennessee comes out on top, at $7,246 per resident. Only four other states have a per capita burden below $10,000: Indiana, Wisconsin, Nebraska, and North Carolina.
ALEC’s nationwide total might seem high, but that’s because a lot of state pension plans are lowballing their future obligations through the use of discount rates that are too high, which creates an unwarranted justification for states to make lower contributions to their employee pension plan.
One accounting trick is the use of high discount rates, the assumed rate of future investment returns on fund assets, when calculating pension liabilities. This report analyzed more than 280 state-administered pension plans, and found the simple, unweighted average discount rate to be 7.37 percent. While state funding is significant, on average, more than 70 percent of the total costs of pension benefits are paid for by the plan’s investment earnings.
According to public finance scholars Robert Novy-Marx and Joshua D. Rauh, “the states use discount rates that are unreasonably high.” As former Social Security Administration deputy commissioner Andrew Biggs and economist Kent Smetters have explained, “No matter how well a pension plan manages its investments, it cannot generate 8 percent returns with certainty.” Faced with unrealistically high expectations, state pension fund managers often embrace overly aggressive investment strategies, exposing taxpayers to additional risk.
In addition to expecting unrealistic investment returns, many state governments fail to make their annually required contributions (ARC). Pew Charitable Trusts, a nonpartisan think tank, defines the ARC as “the minimum standard set by government accounting rules.”6 Unfortunately, several states have reduced their annual contributions, failing to make full ARC payments, or they have skipped payments altogether.
According to a Pew Charitable Trusts report, only 21 states fully made their annual required contributions in 2013.
The authors of the ALEC report use a more conservative “risk-free” rate of 2.344 percent, based on an average of 10- and 20-year U.S. Treasury bond yields. Using that rate, the level of underfunding is greater than state pension plans themselves report.
The nationwide underfunding crisis is serious, but addressing it requires acknowledging its true extent.
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