Federal Reserve Bank of Cleveland:
http://www.clevelandfed.org
John B. Carlson
Vice President
John Carlson is a vice president in the Research Department at the Federal
Reserve Bank of Cleveland. In addition to conducting economic research, he
oversees the departmentfs publications and its support functions. His research
interests include monetary policy, money demand, models of learning, and asset
pricing.
Public Pensions Under Stress
Public Finances: Shining Light on a Dark Corner
The financial crisis has made it all too clear that
regulators failed to see into the dark corners of the financial system. With
that in mind, the Federal Reserve Banks of Cleveland and Atlanta have formed a
Financial Monitoring Team to study pension funds and municipal finance with an
eye toward implications for the wider economy and financial system. What
concerns should we have? In this article and other articles from this spring
issue of Forefront, we explain where risks could be building and how
reforms might help forestall their impact on the broader economy and financial
system.
Since 2007, state and local governments have been caught in a perfect storm.
The confluence of the severe recession and the collapse of the housing bubble
dramatically slashed tax revenues. Although some revenue sources have rebounded
with the economy, the decline continues for others. Property values, a major
source of funding for local governments, remain especially depressed.
The toll has been particularly heavy on public pensions, whose troubles with
chronic underfunding predate the financial crisis. By one estimate, the nationfs
126 largest public pensions were underfunded by at least $800 billion in 2010.
By another, 54 percent of the countryfs state and local plans will have
exhausted their funds as early as 2034.
It now seems inevitable that sacrifices will be required from current
employees, employers, and in some cases, retirees. What remains unclear is the
extent to which changes in future investment returns and pension plan designs
can close the funding gap.
On that count, one key question is this: Without strong remedies, at what
point would pension plans run out of money, leaving financially impaired state
and local governments on the hook? That question is not quite settled.
The answer hinges on complex economic and legal questions. The potential
implications of adding financial stress to already overburdened state and local
governments are all too clear. Up to this point, the consequences of local
pension plan insolvencies—though they inflict hardship on citizens—have been
isolated enough not to become epidemic.
How it all shakes out depends on the success of future reform efforts, not to
mention the investment returns on pension-fund portfolios.
The Scope of the Problem
First, a little background on pensions: About 80 percent of public pensions
are defined-benefit plans, meaning that the planfs sponsor promises to
pay a specified income that is predetermined by years of service, final average
salary, and other factors. To fund the promised income, both the employee and
employer typically contribute to a pension trust. The trust invests these
payments in a portfolio of assets whose returns are expected to pay the lionfs
share of the benefit obligation.
Unfortunately, these expectations are not always met. Historically, public
pension plans have invested a large share of funds in stocks, which have offered
relatively high returns when averaged over long periods. Since the stock
marketfs peak in 2000, however, equity returns have been sharply lower than
expected. As a consequence, the value of assets held in public pension trusts
has not kept pace with the growing promises the plans have made, leaving them
substantially underfunded.
How far under is a matter of debate. According to the funding-status measure
prescribed by the Government Accounting Standards Board (GASB), the largest 126
pension plans were underfunded by around $800 billion in 2010. On the other
hand, some critics of GASBfs accounting methods estimate the aggregate pension
fund shortfall to be as much as $4 trillion. (See sidebar, gThe Widely Ranging
Estimates of Pension Underfunding.h)
Embedded in those aggregate estimates are individual plansf funding
ratios—the amount of assets held relative to the amount deemed necessary to pay
for a fundfs promised retirement packages. The funding ratio, however, does not
tell the whole story of a planfs sustainability. It does not take account of
potential supplemental contributions that could help restore a plan to fully
funded status over some reasonable period.
A recent study by the Center for Retirement Research argues that judging the
adequacy of pension funding requires more than looking at a snapshot of the
funding ratio. A key issue is whether the sponsor has a funding plan and is
sticking to it. Under GASB rules, plan sponsors must report an annual
required contribution (ARC). Effectively, this is the annual amount a plan
sponsor would have to pay to eliminate any shortfall over a period of 30
years.
Although public pension plansf annual reports must publish the percentage of
ARC payments they are making, not all states legally enforce such payments.
Since 2008, the average share of ARC paid has declined from 92 percent to 87
percent, according to the Center for Retirement Research, even though the same
payments as a percentage of payroll have actually increased.
Most state budgets have been under too much stress to make full ARC payments
voluntarily. Without mandatory ARC payments, the funding status of many pensions
will continue to deteriorate unless reforms increase employee contributions or
reduce benefits.
Estimating Plan Exhaustion Dates
The question then becomes how much time a plan has before it runs out of
money—the fundfs exhaustion date. A pension plan with a 60 percent funding
ratio, for example, may not run out of funds for 12 years. This stretch of time
would give this planfs administrators some breathing room to implement necessary
reforms.
How much breathing room do the more severely underfunded plans have? One
study estimated exhaustion dates for the 126 largest pension plans, assuming the
plans are ongoing. Simply put, this means that employers and employees continue
to make contributions while benefits are paid out of the trust fund. Of course,
the exhaustion date also depends on investment returns on assets. The study
considered funding situations for returns of both 6 percent and 8 percent. Its
results show that although several plans will become insolvent in the next
decade, most would have some time to work out their difficulties (see
figure above).
Other estimates paint a bleaker picture. Joshua Rauh, Northwestern University
professor, finds that seven states would run out of money by 2020, and 30 more
would run out in the following decade, even assuming 8 percent investment
returns. Unlike the study mentioned earlier, Rauh assumes that employers make
only enough contributions to the pension funds to pay for the present value of
newly accrued benefits, and no more. On the other hand, a recent GAO study
concludes that Rauhfs projected exhaustion dates are not a realistic estimate of
when the funds might actually run out of money.
The Urgency of Pension Reform
If there is any hope that future investment returns will offset losses
following the financial crisis, it is slim indeed. Most plan sponsors recognize
this and have supported reforms that increase new employeesf contributions and
reduce their future benefits. Between 2008 and 2011, the National Conference of
State Legislatures counted 40 states that have implemented pension reforms.
But most of these changes have only a limited effect on plan funding. Until
recently, few states have attempted to alter benefits or contribution levels of
vested employees or retirees, which could have a far greater positive impact on
pension funding. Although some state legislatures have passed reforms that were
upheld in the courts, the fate of other efforts remains to be decided by the
courts. (See related article, gNavigating
the Legal Landscape for Public Pension Reform.h)
When funding ratios fall, the amount of cash generated by interest and
dividends from investments declines relative to the amount needed to pay
benefits. Without sufficient contributions to offset the lower cash flow from
investments, the process becomes self-reinforcing—that is, assets must be sold
to pay benefits, further reducing the cash generated by investments. This
becomes especially problematic when the funding ratio falls below 50
percent.
For example, the Rhode Island Employee Retirement System recently recognized
that its funding process could not be sustained without urgent action. In late
2011, the state legislature responded with sweeping pension reforms that passed
by an overwhelming bipartisan majority. Under the new law, current employeesf
benefits will be frozen, modified, or even reduced, and retireesf cost-of-living
adjustments will be suspended until the funding ratio improves enough to satisfy
sustainability conditions. Whether these actions will be sufficient remains to
be seen, especially since they will probably be challenged in the courts.
Is a Liquidity Crisis Imminent?
At this point, it seems unlikely that any major pension fund will run out of
cash in the next few years, barring a general worsening of economic and
financial conditions. Indeed, increased public attention on the underfunding
problem has motivated pension plan sponsors to work with state legislators to
implement substantive reforms.
But we are not out of the woods yet. Many funds will require significant
reforms to reduce underfunding levels, with painful new contributions from
employers and employees. Over the long term, a stronger, steadier economy would
help a lot by supporting higher asset returns. Meanwhile, an imminent collapse
of several large funds, accompanied by a shock to the financial system, remains
improbable—though not impossible.
Over the longer term, the current low-interest-rate environment may be cause
for concern. Fund managers will struggle to achieve 8 percent yields without
shifting their portfolio composition toward higher-yielding assets, which are
inherently riskier. Managersf greach for yield,h if practiced widely, would make
pension plan sustainability particularly vulnerable to another negative shock to
equity prices.
Another concern is that some statesf legal protections may be too strong to
give reforms enough time and flexibility to put plans on sustainable paths. In
that case, states would ultimately be on the hook for covering pension benefits
out of general revenues. This scenario, by creating crisis conditions in those
states, could stress economic conditions more generally. But we have by no means
reached that point yet.