The Depressing State of Public Pension Funds

In recent years the financial health of the states has been a source of concern, especially in light of their growing pension liabilities. A recent paper by a couple of Northwestern University finance professors indicates that these concerns are well-founded.

Defined-benefit retirement plans, often called pension plans, in which employers promise to pay a specified amount for life to retired employees, have been declining in number for the last thirty years.  Only among government workers and the employees of large companies have pension plans remained as a significant part of the retirement income equation; the old “three-legged stool” retirement model of Social Security benefits, pension benefits, and personal savings does not exist for most of today’s workers.

My friend David Merkel, over at the alephblog, has written extensively about the troubling state of the states, noting recently that state financial data are a better indicator of the measure of the nation’s health than federal data.  As state finances come under closer scrutiny, one conspicuous source of concern has been their pension obligations.  A couple of professors at the Kellogg School of Management have been looking closely at the unfunded liabilities of state pension plans.  Joshua Rauh and Robert Novy-Marx presented a paper last month entitled “Policy Options for State Pension Systems and Their Impact on Plan Liabilities” that examines all state government-sponsored pension plans with more than $1 billion in assets.  These plans cover a total of 22.3 million current and former state employees.

Ruah and Novy-Marx began their analysis by correcting the overly-optimistic assumptions typically made by state pension systems about plan returns.  They concluded that the true level of unfunded pension liabilities for the 116 plans studied is about $3 trillion.

The study also examined the effect of changes that might be made by states in order to narrow their pension funding gaps.  These included raising the retirement age, eliminating overly-generous early retirement packages, and cutting cost-of-living adjustments (COLAs) to benefits.  Even using the most drastic combination of measures, they found that the gap between assets and liabilities could not be reduced below about $1.5 trillion.  This is because more than half of current plan liabilities are owed to people who are already retired.  Short of making serious cuts in the benefits of existing retirees, large unfunded liabilities would remain even if drastic changes were implemented.

The researchers concluded that thirty-one states could see their pension plans run dry by 2030.  Illinois, Louisiana, New Jersey, Connecticut, Indiana, Oklahoma and Hawaii are expected to exhaust their pension funds within ten years.  Since pension payments are a legal obligation, the collapse of a state’s pension fund would require meeting pension obligations through some other means: increased taxes, budget cuts, or perhaps Federal assistance.

In a few instances, states have begun recognizing that problems lie ahead.  Colorado and Minnesota recently reduced COLAs for their retirees, prompting legal challenges.  New Jersey’s governor is reportedly about to cut back state pension benefits and suspend COLAs for at least three years.  But for the most part, there seems to be little activity directed towards heading off looming state pension shortfalls.

The Northwestern study raises lots of questions.  The ones at the top of my mind are:

Which states have the worst pension liabilities?

Should current state workers count on getting their full pension benefits?

What implications might this have for investors in state municipal bonds?

I hope to pursue each of these questions in future posts.  Stay tuned.

About the author

Thomas Fisher, CFP®

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