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Dallas Headquarters: Many state and local government pension plans’ liabilities are calculated
12770 Coit Road, Suite 800 using discount rates that are not commensurate with the risk they may pose
Dallas, TX 75251 to taxpayers. Accounting standards allow pension funds to calculate their
972.386.6272 liabilities using a discount rate comparable to the expected rate of return on
Fax: 972.386.0924 the funds’ assets. This typically high discount rate tends to reduce the size of
www.ncpa.org a pension plan’s accrued liabilities. However, pensioners have a durable legal
Washington Office: claim to receive their benefits and consequently, it is more appropriate to use a
601 Pennsylvania Avenue NW, lower discount rate in calculating the plans’ accrued liabilities.
Suite 900, South Building
Washington, DC 20004 Due to the use of high discount rates, the liabilities of state and local
202.220.3082 government pension plans are underestimated. For example, recent reports by
Fax: 202.220.3096 the Pew Center on the States and others indicate that assets will cover about
ISBN #1-56808-206-1 85 percent of the pension benefits owed to participants. But other studies that
www.ncpa.org/pub/st329.com adopted lower discount rates have found liabilities may actually be 75 percent
to 86 percent higher than reported. As a result, taxpayers’ role as insurer may
be much greater than anticipated.
In addition to pension benefits, state and local governments often also
provide other retirement benefits, especially postretirement health care
benefits. These nonpension postemployment benefits include such things as
health insurance, dental and vision insurance, and prescription drug plans.
Unlike pension plans, most of these nonpension benefit plans are completely
unfunded. That is, assets are not being set aside to fund the obligations. The
Unfunded Liabilities of State and Local Government
Employee Retirement Benefit Plans
Pew Center on the States reports that nonpension benefit ■■ Unfunded liabilities for health and other benefits are
unfunded liabilities across all states were about $537 $558 billion, compared to the reported $537 billion.
billion in 2008. Our estimates of the reported unfunded ■■ Thus, total unfunded liabilities for all benefit plans are an
liabilities of state and local governments for pensions and estimated $3.1 trillion — nearly three times higher than
other postemployment benefits total $1.03 trillion, but the plans report.
when these unfunded liabilities are recalculated using a To put these liabilities in context, state and local govern-
more appropriate discount rate, the total unfunded accrued ments’ reported unfunded obligations under pension and
liability is much higher. other benefit plans amounting to 7.1 percent of U.S. gross
We analyzed 153 state and local pension plans, repre- domestic product (GDP) in 2008. When adjusted using a
senting more than 85 percent of liabilities for state and local more appropriate discount rate, however, states’ unfunded
pensions and other benefits, and recalculated their liabilities obligations were 22 percent of U.S. GDP. All but 10 states
using a lower discount rate. Our calculations show: and the District of Columbia have total adjusted unfunded
liabilities above 15 percent of their state GDP, and four states
■■ Unfunded pension liabilities are approximately $2.5 — Alaska, Hawaii, New Jersey and Ohio — have adjusted
trillion, compared to the reported amount of $493 billion. unfunded liabilities above 35 percent of their state GDP.
Dr. Andrew J. Rettenmaier is the Executive Associate Director at the Private Enterprise
Research Center at Texas A&M University. His primary research areas are labor economics and
public policy economics with an emphasis on Medicare and Social Security. Dr. Rettenmaier and
the Center’s Director, Thomas R. Saving, presented their Medicare reform proposal to U.S. Sen-
ate Subcommittees and to the National Bipartisan Commission on the Future of Medicare. Their
proposal has also been featured in the Wall Street Journal, New England Journal of Medicine,
Houston Chronicle and Dallas Morning News.
Dr. Rettenmaier is the co-principal investigator on several research grants and also serves as
the editor of the Center’s two newsletters, PERCspectives on Policy and PERCspectives. He is
coauthor of a book on Medicare, The Economics of Medicare Reform (Kalamazoo, Mich.: W.E.
Upjohn Institute for Employment Research, 2000) and an editor of Medicare Reform: Issues and
Answers (University of Chicago Press, 1999). He is also coauthor of Diagnosis and Treatment
of Medicare (Washington, D.C.: American Enterprise Institute Press, 2007). Dr. Rettenmaier is a
senior fellow with the National Center for Policy Analysis.
2
Introduction magnitudes but were not reported in calculated. A discount rate is used
the governments’ financial state- to determine the current value of
Investors breathed a tentative ments. The GASB issued statements future obligations. A high discount
sigh of relief in recent months 43 and 45 requiring state and local rate tends to reduce the size of a
as they watched their retirement governments to report health care pension plan’s accrued liabilities.
accounts make up for lost ground. and other nonpension benefit liabili- Recent reports by state and local
Just a few months earlier, as they ties, though they are not required to government pension plans indicate
watched their 401(k)s weather prefund them. that their assets will cover about
dramatic stock market swings, 85 percent of the accrued pension
many may have wished they were benefits owed to participants.
covered by a defined benefit pen- However, using lower discount
sion plan from their employer (or rates, which are more appropri-
union). Such pension plans promise ate given the nature of pension
“Plans’ unfunded liabilities
a set lifetime retirement income, Insert callout
are larger here.
than reported.” liabilities, recent studies estimate
based on wages and longevity with that liabilities are 75 percent to
an employer, whereas the income 85 percent higher than reported.
from defined contribution plans Consequently, the ratio of assets
— such as 401(k)s — depends to accrued benefit payouts is 37
on past contributions, the rate of percent to 45 percent, rather than 85
return on those contributions and Unlike the pension plans, health percent. Thus, the recognized role
future returns. Pension plans are care and other benefits are almost of taxpayers as insurers is much
perceived as safe, but the value of entirely unfunded. That is, assets larger under alternative estimates.
the benefits they promise depends are not being set aside to fund
on how well they are funded and, Pew Center Estimates. In
the obligations. Recent estimates February 2010, the Pew Center on
importantly, on how well they indicate that reported liabilities for
are insured. In the case of state the States published “The Trillion
health care and other benefits across Dollar Gap,” a report detailing
and local government pensions, all states are over $500 billion — an
taxpayers play the role of insurer. unfunded pension and other
amount that rivals the reported un- postemployment benefit obliga-
funded obligations of pension plans. tions by state. The study provides
Besides pensions, state and local
governments often provide other aggregate state-level data from
retirement benefits, primarily in Recent Estimates 231 pension plans and 159 health
the form of health care coverage. care and other benefit plans. In
These nonpension postemployment
of State and Local addition to measuring the liabilities,
benefits include such things as Government Pension and it reports the extent to which each
health insurance, dental and vision Other Postemployment state is meeting its required annual
insurance, and prescription drug Benefit Liabilities funding for the plans.
plans. Some government employers
According to the Pew study,
also offer life insurance. But most The GASB allows government
there is a “trillion dollar gap” in
of the costs are due to health care. pension plans to use the expected
funding state and local government
Previously, government entities rate of return on their assets to
employee retirement benefits:
only reported the annual cost of discount their accrued liabilities.
retiree nonpension benefits, but in Several recent studies have raised ■■ In 2008, total pension liabilities
2004 the Government Accounting concerns about the use of these amounted to about $2.77 trillion
Standards Board (GASB) addressed discount rates because they are and reported assets were approxi-
the concern that employees’ accrued typically high and may not reflect mately $2.31 trillion; thus, 84
benefits were reaching alarming the risks of the liabilities being percent of pension liabilities are
3
Unfunded Liabilities of State and Local Government
Employee Retirement Benefit Plans
4
75
86
40
40
40
75
75
FIGURE II
Comparison of Aggregate State and Local Pension
Liabilities Across Studies, 2008
(in trillions)
Percent Funded
Social Security $2.6
Social Security Discount $4.2 63.37%
DiscountFactor
Factor $1.5
Sources: Pew Center on the States, “The Trillion Dollar Gap: Underfunded States Retirement Systems and the Roads to Reform,” February 2010. Available at
http://downloads.pewcenteronthestates.org/The_Trillion_Dollar_Gap_final.pdf. Keith Brainard, “Public Fund Survey: Summary of Findings for FY
2008,” National Association of State Retirement Administrators, October 2009. Available at http://www.publicfundsurvey.org/publicfundsurvey/pdfs/
Summary_of_Findings_FY08.pdf. Andrew G. Biggs, “An Options Pricing Method for Calculating the Market Price of Public Sector Pension Liabilities,”
American Enterprise Institute, Working Paper No. 164, February 26, 2010. Robert Novy-Marx and Joshua D. Rauh, “Public Pension Promises: How Big
Are They and What Are They Worth?” Working Paper, December 2009. And authors’ calculations.
* The Public Fund Survey set of pension plans has been updated and ammended.
will cover accrued benefits and trillion, resulting in a funding ratio Based on the plans’ data, their total
found that the typical plan has a of 45 percent.8 Unfunded liabilities pension liabilities are $3.1 trillion
16 percent probability of covering equal about $3.1 trillion under and total pension assets are $2.6
expected payouts. Likening the Biggs’ calculations. trillion, for a funding ratio of 84
implied pension guarantees to a put percent. Their unfunded liabilities
option — the right of a holder to New Estimates of State are about $493 billion. Using
sell a certain amount of stock — he and Local Pension Plan other discount rates to calculate
recalculated the liabilities using an the liabilities requires estimating
option pricing method.7 Using this
Liabilities the future annual accrued benefit
method, and a nominal discount We analyzed a total of 153 plans, payments for each plan.
rate of 3.6 percent, he found that including the 125 plans examined The reported liabilities for each
liabilities rise to an estimated $5.6 in the 2008 Public Fund Survey.9 plan can be thought of as the pres-
5
Unfunded Liabilities of State and Local Government
Employee Retirement Benefit Plans
FIGURE III
Unfunded Pension Liabilities as a
Percentage of State GDP in 2008
(reported and calculated using real and nominal yield curves)
Increase with nominal
35 Increase with real
Reported
30
25
Percent of GDP
20
I
15 I
R
10
0
Montana
Oregon
Utah
Colorado
Missouri
New Jersey
Idaho
Maine
Nevada
Minnesota
Iowa
Massachusetts
New York
Texas
Washington
Florida
California
Kansas
Kentucky
Indiana
Nebraska
North Dakota
South Dakota
Tennessee
Oklahoma
Arizona
Georgia
Vermont
Connecticut
Hawaii
Michigan
Arkansas
Delaware
Illinois
Ohio
Virginia
Wisconsin
Mississippi
Alaska
Louisiana
North Carolina
South Carolina
West Virginia
Maryland
New Mexico
New Hampshire
Rhode Island
Pennsylvania
Wyoming
Alabama
-5
Sources: Keith Brainard, “Public Fund Survey: Summary of Findings for FY 2008,” National Association of State Retirement Administrators, October 2009.
Available at http://www.publicfundsurvey.org/publicfundsurvey/pdfs/Summary_of_Findings_FY08.pdf. And authors’ adjustments and calculations.
ent value of future annual benefit of service), mortality and job for each pension plan using an
payments based on accrued benefits tenure assumptions, cost of living estimate of the plan’s initial benefit
as of 2008. The studies mentioned assumptions and salary growth. payments in 2008, actuarial liability
previously also estimated future They used these data to produce a and investment return combined
annual benefit streams for each stream of annual benefits calibrated with estimates of annual accrued
of the plans they consider. For to yield the reported liability using Social Security benefits by age
example, to generate plan-specific the reported discount rate assump- group.11 The time path of annual
future accrued benefit series, tion.10 They then discounted the accrued Social Security benefits
Novy-Marx and Rauh collected plan-specific benefit series using are used as an initial proxy for
data on the plans’ benefit formulas, their two discount rate assumptions. the time path of workers’ accrued
composition of participants For our estimates, we identified pension benefits in the government
(including wages, ages and years an annual benefit payment series plans. Ultimately we derived a time
6
FIGURE IV
Composition of State and Local Pension Plans’ Assets
$3,500
Other
$3,000
Cash
$2,500
Millions
State/Local Securities
$2,000 Mortgages
$1,500 International Securities
$0 Corporate Stocks
March 2004
July 2004
November 2004
March 2005
July 2005
November 2005
March 2006
July 2006
November 2006
March 2007
July 2007
November 2007
March 2008
July 2008
November 2008
March 2009
July 2009
November 2009
Source: U.S. Census Bureau, Government Division Finances of Selected State and Local Government Employee Retirement Systems, Table 1.
series of annual benefit payments to nominal dollars) to produce an two nominal series are considered
that results in the reported liability index that begins at one in 2008. first for comparability with other
when discounted at the reported Each plan’s initial benefit payments estimates. The first series is the
rate of return on investments. were then indexed for future years. discount rate series from Table
The age composition was varied VI. F6 in the 2008 Social Security
Figure I presents the age
for each plan until the present value Trustees Report. This series is based
composition of accrued Social
of the indexed series calculated on the Trustees’ ultimate real
Security benefits based on the 2008
using the reported investment rate discount rate assumption of 2.9
Trustees Report — the same year as
of return equaled the reported percent and the ultimate inflation
the Public Fund Survey data.12 The
figure shows the age composition pension liability.13 The final series rate assumption of 2.8 percent per
for each pension plan was then year. The other discount factor
of the Social Security benefits
used to recalculate the liability series follows Novy-Marx and
that workers accrued as of 2008
with alternative discount rates. Rauh’s use of the term structure of
and the payout of those benefits
over time. It assumes there is no Using the Appropriate Discount the nominal yields on U.S. Treasury
change in law affecting the level Rate. The appropriate discount securities. Our term structure is
of benefits and it does not include rate depends on the nature of based on monthly averages from
additional benefits accruals. For the liability. We recalculated the July 2004 to August 2008.14
each pension plan we varied the age liabilities using four discount rate Figure II compares our aggregate
composition of the accrued Social series: two nominal rates and two estimates of the pension funds’ li-
Security benefits series (converted real (inflation-adjusted) rates. The abilities to the estimates in the other
7
Unfunded Liabilities of State and Local Government
Employee Retirement Benefit Plans
justment* FIGURE V
0
97
Unfunded Other Postemployment Benefit Liabilities
16 as a Percent of State GDP
59
0
0 14
47 With Adjustment*
0 12 As Reported
0
Percent of GDP
0 10
84
0 8
0
0 6
0
0 4
0
13
2
0
89
0
0
Montana
Oregon
Utah
Colorado
Missouri
New Jersey
Idaho
Maine
Nevada
Minnesota
Iowa
Massachusetts
New York
Texas
Washington
California
Florida
Kansas
Kentucky
Indiana
North Dakota
South Dakota
Tennessee
Nebraska**
Oklahoma
Arizona
Georgia
Vermont
Connecticut
Hawaii
Michigan
Wisconsin
Illinois
Arkansas
Delaware
Ohio
Virginia
Mississippi
Alaska
Louisiana
North Carolina
South Carolina
West Virginia
Maryland
New Mexico
New Hampshire
Rhode Island
Pennsylvania
Wyoming
Alabama
0
0
0
0
45
* Plans using discount rates of 7 percent or higher were recalculated using discount factor based on the nominal Treasury yield curve.
0 ** Nebraska does not report other postemployment benefit liabilities.
0 Sources: States’ and plans’ comprehensive annual financial reports for reported unfunded liabilities and authors’ recalculation of liabilities for the subset of plans
with reported discount rates of 7 percent or higher.
0
0
0
studies, including the Pew study discount rate of 8 percent) produces increase using the option pricing
0
and the Public Fund Survey. Our a liability that is a third larger. method and a nominal discount rate
0
estimate of the total liability based of 3.6 percent).
13 on the nominal Social Security Using the discount factor based
19 discount factor is $4.2 trillion, with on the yield curve, our estimate of We also estimated the liabilities
0 a net unfunded liability of $1.5 tril- the total liability is $5.2 trillion, using real (inflation-adjusted)
0 lion. The funding ratio of assets to or 66 percent larger than the actu- discount rates and real estimates of
02 liabilities is 63 percent. Recall that arial estimates in the plans’ annual future pension payments. The use
0 the liabilities were recalculated for reports. The net unfunded liability of real discount rates is based on
0 the plans in the Public Fund Survey, is $2.5 trillion. This increase in the the observation that the discount
63 for which the reported aggregate total liability relative to the reported rates used by the individual pen-
0 liability was $3.1 trillion. Thus the liability is in the range of the in- sion plans assume higher inflation
0 lower nominal discount rate of ap- crease estimated by Novy-Marx and rates than the Social Security
28 proximately 5.8 percent (compared Rauh (75 percent increase using the Trustees assume. The nominal
0 to the modal, or most frequent, yield curve) and Biggs (86 percent discount rates in our previous
0
06 8
0
estimate were also higher than the unfunded pension liabilities and benefits, it is important to recognize
implied inflation rate based on a each state’s gross domestic product how the stock market decline since
comparison of the nominal Treasury (GDP) in 2008. The unfunded 2008 affects pensions’ unfunded
yields and the yields on Treasury liabilities by state are the sums liabilities. The liabilities, assets and
Inflation-Protected Securities. The across all plans in the state from the resulting unfunded liabilities
most frequent nominal discount the updated Public Fund Survey.15 are based on 2008 estimates, with
rate among the pension plans is The three unfunded liabilities are most estimated by June 2008. The
8 percent and the most frequent the reported unfunded actuarial dramatic drop in the stock market
inflation assumption is 3.5 percent. accrued liability, the unfunded during the latter part of 2008 that
Thus, the most frequent real rate of liability based on the yield curve continued through the beginning
return is in the range of 4.5 percent. derived from the Treasury of 2009 increases the unfunded
However, the nominal Treasury Inflation-Protected Securities and liabilities reported for 2009. Figure
yields relative to the yields on Trea- the unfunded liability based on IV depicts Census Bureau data on
sury Inflation-Protected Securities the nominal yield curve. The last the aggregate assets in state and
indicate that the implied real inter- estimate is most comparable to the local retirement plans:
est rate for the period from 2004 estimates by Novy-Marx and Rauh ■■ Total assets in June 2008 were
to 2008 was less than 2 percent, and Biggs, and is reflected by the $2.8 trillion, but fell 25 percent to
and the anticipated inflation rate total height of each bar. $2.1 trillion by March 2009.
was about 2.35 percent. Because Reporting the estimates based ■■ By June 2009 total assets in-
the inflation rate anticipated by the on the real discount factors paired creased back to $2.2 trillion, or a
pension plans is higher than the rate with the real accrued benefit series 22 percent decline over the year.
implied by the relative yields on the along with the estimates based on
Treasury Inflation-Protected Securi- ■■ If the 22 percent decline in aggre-
the nominal discount factors paired
ties, the nominal Treasuries and gate assets were recognized for
with the nominal accrued benefits
the inflation rate assumed by the 2009 the reported funding ratio
series shows how the alternative
Trustees, the recalculated liabilities would decline from 85 percent to
inflation rate expectations affect
are higher than they would be if the 65 percent, assuming no change
the calculation. The states with the
inflation estimates were the same. in the liabilities.
top five unfunded liabilities by this
The recalculated aggregate measure are Ohio, New Mexico, When the liabilities are calcu-
pension liability based on the real Oregon, Mississippi and Alaska. lated using the nominal Treasury
Social Security discount factor is Ohio, New Mexico and Mississippi yield, the funding ratio in 2008 was
$3.9 trillion; it is $4.5 trillion based were also in the top five states by 65 percent. If the decline for 2009 is
on the yield curve from the Trea- this metric in Novy-Marx and recognized, then the funding level
sury Inflation-Protected Securities. Rauh and Biggs. However, when declines to 40 percent. Finally, the
While not as high as the liabilities ranked by the reported unfunded figure indicates that total pension
using the nominal returns, these two liability as a percent of GDP only assets rose to about $2.5 trillion
estimates indicate that the unfunded Mississippi appears in the top five by December 2009, or about 13
liability is $1.2 trillion (based on the in all four lists. This illustrates percent below the June 2008 level.
real Social Security discount factor) the sensitivity of the outcomes
to $1.9 trillion (based on the Trea- to alternative discount rate New Estimates of
sury Inflation-Protected Securities assumptions, and therefore the
importance of providing a variety
Nonpension
yield curve), or more than 2.5 times
the reported aggregate unfunded of estimates in public reports. Postemployment Benefit
liability of $493 billion. Effect of the Stock Market
Liabilities
Figure III depicts the relation- Decline on Unfunded Liabilities. In 2004, the GASB issued two
ship between three measures of Before turning to the nonpension statements addressing the concern
9
Unfunded Liabilities of State and Local Government
Employee Benefits
her Postemployment Retirement Benefit Plans
146306
1.45433
359198 FIGURE VI
778686
289875 Unfunded Pension and Other Postemployment Benefits
558722 Liabilities as Percent of State GDP
2.03614 25 (as reported)
750081 Other Postemployment Benefits
323066
4.60609 Pensions
20
3.76572
Percent of GDP
928963
303644 15
173428
298448
258288 10
453527
644457
594741 5
390129
003014
0.43592 0
384634
Montana
Oregon
Utah
Colorado
Missouri
New Jersey
Idaho
Maine
Nevada
Minnesota
Iowa
Massachusetts
New York
Texas
Washington
California
Florida
Kansas
Kentucky
Indiana
Nebraska
North Dakota
South Dakota
Tennessee
Oklahoma
Arizona
Georgia
Vermont
Connecticut
Hawaii
Michigan
Illinois
Arkansas
Delaware
Ohio
Virginia
Wisconsin
Mississippi
Alaska
Louisiana
North Carolina
South Carolina
West Virginia
Maryland
New Mexico
New Hampshire
Rhode Island
Pennsylvania
Wyoming
Alabama
621037
199342 -5
760887
0
1.68479
Sources: Pensions are from Keith Brainard, “Public Fund Survey: Summary of Findings for FY 2008,” National Association of State Retirement Administra-
264645 tors, October 2009. Available at http://www.publicfundsurvey.org/publicfundsurvey/pdfs/Summary_of_Findings_FY08.pdf. And authors’ adjustments.
0.66459 Other postemployment benfits are from states’ and plans’ comprehensive annual financial reports.
687063
440353 that government obligations for calculating the necessary annual ernments must publish a schedule of
182053 retiree health benefits and other contributions to ensure that the funding progress and a schedule of
0.16342 postemployment benefits were large promised funds will be available for employer contributions in an annual
335434 and, for the most part, unfunded. retirees in the future. 16
report. These new requirements
245821 provide a more complete picture of
Reporting requirements for gov- The GASB now requires govern- the full magnitude of nonpension
377538
ernment pension plans have existed ments to report several different benefit obligations, and allow for
938907
since 1994, but until 2004 there values, including the actuarial comparisons across state and local
665822
were no comparable standards for accrued liability, the actuarial value governments.17
523583
reporting funding for other retiree of assets, the unfunded actuarial ac-
205633
benefits. Because most govern- crued liability, the annual required Estimated Liabilities for
692508
mental entities report only annual contribution and the net obligation. Retiree Health Benefits and Other
982964
cash outlays for these benefits, the Governments may choose among Retiree Benefits. The Pew Center
610328 full cost was substantially underre- six different actuarial methods to study identified $587 billion in total
347771 ported. The new GASB statements calculate these values, but must retiree nonpension benefit liabilities
916567 provide guidelines for determining report the method used and any and $555 billion in unfunded li-
449052 governments’ full obligations and other actuarial assumptions. Gov- abilities, given that only $32 billion
907221
711229
10
492778
in assets are set aside. In addition future liabilities at a higher rate of 5.25 percent, but is only $14.2
to nationwide aggregates, the results in a smaller present value billion (or 34 percent lower) when
study gives funding levels by state. estimate, as seen in the case of an 8 percent rate is applied.20
This provides the opportunity for pension fund accounting. The As discussed, there has been a
cross-state comparisons to deter- GASB provides guidelines for the good deal of debate among experts
mine which states’ programs are selection of a discount rate which regarding the proper discount rate
particularly well-funded and which reflects the assumed rate of return in determining accrued pension
states have the greatest unfunded on investments. The choice of rates liabilities. The rationale for using
obligations. The Pew study shows is largely determined by the way a lower discount rate more in line
that 20 states’ health benefits are in which the plan is funded. Most with the government borrowing rate
completely unfunded. Most of the retiree health plans are funded on a to calculate pension liabilities is that
remaining states’ funding levels pay-as-you-go basis, meaning there those liabilities are legally binding.
range from 0.01 percent to 50 is no trust accruing assets to fund Retirees may not have as durable a
percent. Only two states — Alaska future benefits. These plans must claim to health benefits, but those
and Arizona — have funding ratios use a much lower discount rate — benefits pose extra risks to taxpay-
above 50 percent. usually 4 percent or 4.5 percent ers in the form of greater uncer-
— than plans that are prefunded. tainty about the size of future health
The Pew study provides a Prefunded plans with dedicated
comprehensive view of funding at care costs. This uncertainty suggests
trusts for future payments may use that a lower rate is also appropri-
the state level; however, it would a higher rate equal to the return on
also be useful to examine funding ate in calculating retiree health
those investments. Discount rates benefits, which is consistent with
at a more disaggregated level. associated with prefunded plans
Most states’ totals are aggregated the prevalent use of the 4 percent
are typically around 8 percent. and 4.5 percent nominal discount
from several different reporting As noted, state and local pension
sources. For example, a single rates for the pay-as-you go plans.
plans, all of which have related trust
state might have different plans funds, are usually discounted at the If actuaries used a lower discount
for teachers, judges, state police higher rate of about 8 percent. rate for all plans, regardless of fund-
and other state employees. The ing method, the liabilities for health
state would report liabilities and The difference in the overall benefits that are partially prefunded
costs for each of the plans. estimated liability when using the would be much larger than current
low rate versus the high rate is estimates. However, since the
Individual reports were obtained
substantial. For example, consider majority of health benefit plans are
for all of the available plans listed
the state of New Hampshire, which funded on a pay-as-you-go-basis,
in the Pew study and liabilities
reports its total liabilities for retiree the change in discount rates to
were documented for each of these
health care benefits under a variety match the government borrowing
groups, as well as state totals.
of different assumptions. The net rate makes a much smaller impact
In most cases, state totals match
actuarial accrued liability using a on the total liability than for pen-
closely with the Pew numbers.18
prefunded plan with an 8.5 percent sion plans.
What Discount Rate Should Be discount rate is $1.33 billion. The Only 22 percent of the health and
Used to Calculate Retiree Health comparable liability associated with other benefit plans use a discount
Benefit Liabilities? As we have a pay-as-you-go plan and 4.5 per- rate of 7 percent or higher. The
seen, a key variable in assessing the cent discount rate is $2.56 billion, liabilities for this set of plans were
present value of actuarial liability almost twice the original amount.19 recalculated using a procedure
is the discount rate. The choice Similarly, the reported unfunded similar to the one described earlier
of the discount rate significantly liability for the Teachers Retirement for pension plans.21 Health benefit
influences the size of the overall System of Texas is $21.6 billion unfunded liabilities based on the
liability. All else equal, discounting based on the current discount rate nominal Treasury yield curve are
11
Unfunded Liabilities of State and Local Government
BenefitEmployee
AdjustmentRetirement Benefit Plans
FIGURE VII
Unfunded Pension and Other Postemployment Benefit
Liabilities as a Percent of State GDP in 2008
(as reported and adjusted)
Other Postemployment Benefit Adjustment
Other Postemployment Benefit Unfunded Actuarial Accrued Liability
45 Pension Adjustment
Pension Unfunded Actuarial Accrued Liability
40
35
30
Percent of GDP
25
20
15
10
5
0
Tennessee
Massachusetts
Missouri
Texas
Minnesota
Utah
Connecticut
Montana
Maine
Idaho
Kentucky
Maryland
Mississippi
New Jersey
Nebraska
Vermont
Oregon
Ohio
Wisconsin
Colorado
Indiana
Kansas
Washington
Iowa
Michigan
Arizona
Georgia
New Mexico
Pennsylvania
Arkansas
Hawaii
New York
Rhode Island
Delaware
Louisiana
California
Illinois
South Carolina
Nevada
New Hampshire
North Carolina
Oklahoma
Wyoming
Alaska
Florida
South Dakota
Alabama
North Dakota
Virginia
West Virginia
-5
Sources: Pensions are from Keith Brainard, “Public Fund Survey: Summary of Findings for FY 2008,” National Association of State Retirement Administrators,
October 2009. Available at http://www.publicfundsurvey.org/publicfundsurvey/pdfs/Summary_of_Findings_FY08.pdf. And authors’ adjustments and
calculations. Other postemployment benfits are from states’ and plans’ comprehensive annual financial reports and authors’ recalculation of liabilites
for subset of plans with reported discount rates of 7 percent or higher.
$558 billion, compared to reported ■■ Eight states report unfunded Combining Unfunded Pension
health benefit unfunded liabilities liabilities in excess of 8 percent and Nonpension Liabilities.
of $537 billion. Figure V illustrates of GDP — Alabama, Alaska, Figure VI presents the reported
how these unfunded liabilities, as Connecticut, Delaware, unfunded pension and nonpension
a percentage of state GDP, would Hawaii, Michigan, New benefit liabilities for state and local
change if the discount factor based Jersey and West Virginia. governments as percentages of the
on the nominal Treasury yield states’ GDPs.23 Before adjusting the
curve were used for those plans.22 discount rate:
■■ However, when the liabilities of
Notably:
the plans using a discount rate of ■■ Seven states — Alaska,
■■ Half of the states have reported 7 percent or higher are recalcu- Connecticut, Hawaii, Illinois,
health benefit unfunded liabilities lated, Kentucky also exceeds the Kentucky, New Jersey and
of less than 2 percent of GDP. 8 percent of GDP threshold. West Virginia — have total
12
unfunded pension and non- were 7.1 percent of GDP in 2008. Under any reasonable assump-
pension benefit liabilities Thus, the unadjusted unfunded tions, the fundamental result
above 15 percent of GDP. liabilities associated with state and remains: There is a substantial
local governments’ commitments difference between promised retire-
■■ Nine states have reported unfund-
to pay retirement benefits to former ment benefits and the assets set
ed liabilities less than 2 percent
employees are about equal to the aside to satisfy those obligations.
of their GDP — Florida, Idaho,
states’ official debt, but the adjusted What should state and local govern-
Iowa, Massachusetts, Nebraska,
unfunded liabilities are almost ments do about it? One possibility
North Dakota, South Dakota,
three times the debt. The appendix is to make up the difference and
Tennessee and Wisconsin.24
table shows unfunded liabilities in use taxpayers’ money to fulfill the
■■ Across all states, the combined dollar amounts by state as reported liabilities. Alternatively, employer
reported unfunded liabilities are and based on our estimates. Total and employee contribution rates
equal to 7.2 percent of GDP. unfunded liabilities for all benefit could be increased to help shrink
Figure VII depicts the reported plans are $3.1 trillion based on future unfunded liabilities.
and adjusted unfunded pension our estimates, compared to $1.03
trillion as reported — a difference State and local governments
and nonpension benefit liabilities
of more than $2 trillion. could also begin to change the
by state as a percent of GDP. The
standards of their postemployment
rankings of states before and after
health benefits for new workers.
adjusting are highly correlated: Conclusion
While governments are contractual-
■■ Seven of the top 10 highest Many state and local govern- ly bound to fulfill the coverage they
unfunded liability states in the ments calculate their plans’ have already promised to current
reported rankings are also in the liabilities using discount rates that workers and retirees, they could
top 10 in the adjusted rankings. are not commensurate with the alter guidelines for new employees.
risks they carry for taxpayers. As a For example, raising the age at
■■ At the lower end of the distribu-
result, those liabilities are greatly which workers become eligible
tion, six states with the lowest 10
underestimated. The sensitivity of for retiree health care coverage or
unfunded liabilities as a percent
the final liability estimates to the increasing the premiums of health
of GDP in the reported rankings
choice of discount rates emphasizes plan members would reduce future
remain in the lowest 10 based on
the necessity of transparency in accruals and obligations.
the adjusted rankings.
governments’ financial statements.
■■ All but 10 of the states and the It is a simple matter for actuaries An additional option is to begin
District of Columbia have total who prepare government reports to to replace defined benefit pension
adjusted unfunded liabilities recalculate the promised benefits plans with defined contribution
above 15 percent of GDP and under a different discount rate plans, such as 401(k)s. States could
four states — Alaska, Hawaii, assumption and include these honor what current employees
New Jersey and Ohio — have estimates along with the original have already paid into their defined
total adjusted liabilities above 35 ones. Several states and local benefit plans, but then switch to
percent of GDP. governments already do a good job 401(k) plans after a certain date
■■ Across all states and the District of presenting alternative estimates or for newly hired workers. In
of Columbia the adjusted unfund- under different assumptions. New addition to relieving taxpayers from
ed liabilities are approximately Hampshire, for example, reports the burden of insuring pensions,
22 percent of U.S. GDP. [See the other postemployment benefit individual defined contribution
table.] liabilities under both high and low plans are portable across employers
discount rate assumptions corre- and would allow employees more
To put these liabilities in context, sponding with a prefunded plan and freedom in switching from one job
states’ official debt obligations a pay-as-you-go plan, respectively. to another.
13
Unfunded Liabilities of State and Local Government
Employee Retirement Benefit Plans
TABLE I:
Adjusted Unfunded Benefit Liabilities as Percent of Gross Domestic Product (in millions)
APPENDIX TABLE I:
State and Local Government Employees’ Unfunded Retirement Benefit Liabilities (in millions)
17
Unfunded Liabilities of State and Local Government
Employee Retirement Benefit Plans
18
Endnotes
1.
Pew Center on the States, “The Trillion Dollar Gap: Underfunded State Retirement Systems and the Roads to Reform,”
February 2010. Available at http://downloads.pewcenteronthestates.org/The_Trillion_Dollar_Gap_final.pdf.
2.
Keith Brainard, “Public Fund Survey: Summary of Findings for FY 2008,” National Association of State Retirement
Administrators, October 2009. Available at http://www.publicfundsurvey.org/publicfundsurvey/pdfs/Summary_of_Find-
ings_FY08.pdf.
3.
Jeffrey R. Brown and David W. Wilcox, “Discounting State and Local Pension Liabilities,” American Economic Review:
Papers and Proceedings, Vol. 99, No. 2, May 2009, page 542.
4.
As mentioned earlier, the GASB allows pension plans to discount future accrued benefits to the present using the rate of
return expected on the plans’ assets. However, as Novy-Marx and Rauh note, “Discounting liabilities at an expected rate
of return on the assets in the plan runs counter to the entire logic of financial economics: financial streams of payments
should be discounted at a rate that reflects their risk.” They later comment, “The way the liabilities are funded is irrelevant
to their value.” Robert Novy-Marx and Joshua D. Rauh, “Public Pension Promises: How Big Are They and What Are They
Worth?” Working Paper, December 2009, pages 2 and 18. Available at http://ssrn.com/abstract=1352608.
5.
The U.S. Treasury securities’ yield curve reflects the relationship between interest rates and the term to maturity of govern-
ment bonds.
6.
Biggs uses data from the Public Fund Survey supplemented with additional background data from the Center for Retire-
ment Research at Boston College. Andrew G. Biggs, “An Options Pricing Method for Calculating the Market Price of
Public Sector Pension Liabilities,” American Enterprise Institute, Working Paper No. 164, February 26, 2010.
7.
The option pricing method basically values the guarantee to pay the accrued benefits and takes into account the variation in
asset returns, the time to maturity, the present value of assets and the future value of the accrued benefits to be paid.
8.
The option pricing method does not rely on a time series of future accrued benefit payments, but rather future liabilities
enter the option pricing model as a single number equal to the capitalized value of the current liability 15 years in the
future. The capitalized value is determined using the plan-specific discount rate. However, Biggs first simulates the
likelihood that each plan’s funding will be sufficient to pay accrued benefits. For this exercise he estimates the series of
annual accrued benefit payments for each plan. The annual payments are estimated using a profile that identifies annual
accrued pension payments as a percent of the accrued liability. The profile used to translate the accrued liability into an
annual series of benefit payments is derived from Aaron Meder and Renato Staub, “Linking Pension Liabilities to Assets,”
UBS Global Asset Management Working Paper, 2006.
9.
Our analysis begins with the state and local plans identified by Keith Brainard in “Public Fund Survey: Summary of
Findings for FY 2008.” The survey identifies the actuarial value of the plans’ assets, liabilities and unfunded liabilities.
In the cases in which the valuation date reported in the Public Fund Survey was prior to 2008, we update the data using
information from the states’ or the plans’ comprehensive annual financial reports. We also add several plans in the process
of our data collection, yielding a total of 153 total plans.
10.
Robert Novy-Marx and Joshua D. Rauh, “Public Pension Promises: How Big Are They and What Are They Worth?”
Working Paper, December 2009, pages 2 and 18. Available at http://ssrn.com/abstract=1352608.
11.
The initial benefit payments are estimated from the 2006 State and Local Pension data file available from the Center for
Retirement Research (CRR) at Boston College. See “State and Local Pension Data,” Boston College Center for Retirement
Research. Available at http://crr.bc.edu/frequently_requested_data/state_and_local _pension_data_4.html. The ratio of
benefit payments to accrued liabilities for each plan in the 2006 Center for Retirement Research file is applied to the 2008
19
Unfunded Liabilities of State and Local Government
Employee Retirement Benefit Plans
accrued liabilities to impute benefit payments for 2008. Where data is missing, the average ratio is used and in some cases
the actual benefit payments from the comprehensive annual financial reports are used. These data are also the source for
the investment return. When the discount rate is missing, the average discount rate is used. The actuarial liability is from
the 2008 Public Fund Survey except for the cases we update to 2008.
Andrew J. Rettenmaier and Thomas R. Saving, “Thinking About Tomorrow,” National Center for Policy Analysis, Policy
12.
Report No. 317, December 2008, Figure VII and associated discussion. See the 2008 Social Security Trustees Report for
the underlying assumptions used to produce the annual estimates. The Social Security accrued benefit series is similar to
the series Biggs used, however, our methodology derives a series that is calibrated to the plans’ initial benefit payments and
ultimately yields present values equal to the plans’ reported liabilities.
The series reported in Figure I are used to produce two groups: the “young” who are 35 to 54 years of age and the “old”
13.
who are 55 years of age and above. We produce an annual spending series by adding the two series together, but vary the
proportion of young each time. The series is indexed to its initial value in 2008 and then multiplied by the 2008 benefit
payments for the plan being calibrated. The present value of the series is calculated and the process is repeated until the
present value approximates the reported present value. For several pension plans in which the initial benefit payments were
either large or small relative to the accrued liability the composition of the “old” and “young” series was modified.
The nominal term structure is based on the average monthly yields on 1, 2, 3, 5, 7, 10, 20 and 30-year constant maturity
14.
Treasury securities. The averages are based on monthly data from July 2004 to August 2008 with the exception of a start
date of February 2006 for the 30 year bonds. The start date was chosen for compatibility with the start of the Treasury
Inflation-Protected Securities series.
See Robert Novy-Marx and Joshua D. Rauh, “Public Pension Promises: How Big Are They and What Are They Worth?”
15.
Table IV and Andrew G. Biggs, “An Options Pricing Method for Calculating the Market Price of Public Sector Pension
Liabilities,” for similar presentations.
Statement 43 addresses financial reporting for the benefit plans, and Statement 45 addresses both accounting practices and
16.
The requirements were implemented in three phases based on a government’s total annual revenue, starting with Statement
17.
43: Governments with revenue less than $10 million were required to implement Statement 43 in 2007. Governments with
revenue between $10 million and $100 million were required to implement it in 2006. Governments with annual revenue
exceeding $100 million were required to implement the standard in 2005. The effective dates for Statement 45 followed
the same pattern but began one year later.
Several cases in which the totals are not an exact match are caused by a difference in the year of the report. We try to
18.
obtain data from fiscal year 2008 where available; some of the data from the Pew study is one year earlier.
The Segal Group, Inc., “State of New Hampshire: Actuarial Valuation and Review of Other Postemployment Benefits
19.
Gabriel Roeder Smith & Company, “TRS-Care Retiree Health Plan, Teachers Retirement System of Texas,” November 5,
20.
Initial benefit payments for the subset of plans with reported discount rates of 7 percent or higher were collected from
21.
the states’ or plans’ annual reports. Future benefit flows were imputed using an index derived from estimates of accrued
Medicare benefits (see Andrew J. Rettenmaier and Thomas R. Saving, “Thinking About Tomorrow,” Figure XII). As with
20
the estimation of the pension plans’ future benefit series, the age composition of the index was varied until the present value
of the imputed benefit series using the reported discount rate yielded the reported other postemployment benefit liability.
The present value of this series was then computed using the discount factors based on the nominal Treasury bonds’ yield
curve.
Denominating the liabilities by state GDP places the liabilities within the context of the states’ economies. However,
22.
denominating the unfunded liabilities by the present value of the states’ expected GDP over the duration of the liability
would provide a better indication of the states’ abilities to cope with the liabilities.
Note that combining the pension and other postemployment benefit liabilities in this way excludes some plans, particularly
23.
Nebraska’s comprehensive financial report notes that the state has no other postemployment benefit obligations once an
24.
21
Unfunded Liabilities of State and Local Government
Employee Retirement Benefit Plans
22
About the NCPA
23
About the NCPA