Introduction and summary
At the turn of the century, many U.S. public pension funds faced a "perfect storm," brought about by the confluence of unfavorable demographics, low interest rates that increased the present value of liabilities, declining investment returns from the stock market, and swelling ranks of pension benefit claimants. As state and local governments try to address these challenges and plan for the future, some analysts have begun to question whether traditional notions of defined benefit pension plans (where the retiree is guaranteed a monthly income for life) can be sustained. Many private sector firms have abandoned these traditional pensions in favor of defined contribution plans, whereby individuals are responsible for ensuring that their retirement plans are adequate to meet their retirement needs.
Pension strains are coming at a particularly inopportune time for state and local governments. The 2001 recession showed that some state and local finances are on shaky ground; that is, a relatively mild recession had an unexpectedly large impact on some states' and localities' tax revenues. On the spending side of the equation, states and localities are increasingly devoting larger shares of their resources to expenditures, such as health care (Medicaid in particular) and elementary and secondary education. When expenditure growth in these areas is coupled with higher spending for corrections and public safety, little is left over for other government services. Pension obligations compound this problem, since they are usually legally protected by "nonimpairment" clauses that essentially guarantee future payouts regardless of the financial condition of the government. As such, in a fiscal crisis, a state or local government may have no other option than to raise taxes or cut other programs to meet their required pension obligation. Finally, other retirement costs are looming for state and local governments, particularly in the form of retiree health care costs, as reported in costs for other post-employment benefits, or OPEB (see box 1, pp. 8-9).
In this article, I discuss the current condition of state and local pension plans and strategies to improve pension performance. I review the academic literature on optimal pension plan design. Then, I describe strategies used by state and local governments to meet pension obligations. Finally, I offer some thoughts on the possible future directions for state and local pension funds.
The nature of the problem
Estimates for the aggregate unfunded balance--actuarial liabilities in excess of assets--for U.S. state and local pensions range from $200 billion (1) to as high as $700 billion. (2) Estimates of actuarial pension balances are by nature imprecise and often controversial (see box 2, p. 10). Actuarial estimates change as interest rates and investment returns change and as the demographics of future and current pensioners are revised. Further, the appropriate actuarial funded ratio or fund balance is highly related to the economic and fiscal conditions in the state or locality. As currently defined, the funded ratio of a pension plan is the ratio of accumulated assets to the present value of the cost of benefits that have been earned. Lower funding levels can be perfectly acceptable in jurisdictions with high expected revenue growth.
The trend in aggregate pension assets and liabilities through fiscal year 2005 (FY2005) continues to show that funds are still working off the effects of the bursting of the stock market bubble at the turn of the century. As figure 1 demonstrates, actuarial liabilities have grown considerably, while actuarial assets have been recovering more slowly.
Still, while estimates of billions of dollars in deficits speak to the magnitude of the problem facing the public pension systems, they fail to show that many public pensions are in fact adequately funded and positioned to meet their benefit obligations. …