Research from The PEW Charitable Trusts (PEW) has evaluated what policies and factors could be inhibiting certain states from reducing their public pension system funding gaps.
A $1.28 trillion funding gap exists in public pension funds cumulatively across all 50 states, according to a June 2019 report by PEW titled “The State Pension Funding Gap: 2017.” States have assets of only $2.9 trillion to offset pension obligations of $4.1 trillion.
A pension funding gap is the difference between galaxiaestates a state retirement system’s assets and liabilities. Every state funding gap grew following the Great Recession (2007 to 2009) and to this day, many states continue to struggle in funding their pension systems. Moreover, the states that had the best-funded pension systems before the recession hit have recovered, while the states with the lowest-funded pension systems continue to struggle.
Funding levels are the assets needed for a state to fully fund their pension liabilities. The average funding level for all states in 2017 was 69 percent. Before the Great Recession hit, the average funding level was 86 percent. Further, one of the lowest-funded states, Kentucky, only had 34 percent funding in 2017. Only Idaho, Nebraska, New York, North Carolina, South Dakota, Tennessee, Utah, and Wisconsin were at least 90 percent funded in 2017.
States with well-funded pension systems, such as Wisconsin, Tennessee, and South Dakota, have two policies that they and other states with well-funded pension systems follow. These states:
Consistently make full actuarial contributions no matter the market conditions; and
Follow risk management policies which can account for bad investments and other risks.
States with the lowest-funded pension systems-New Jersey, Kentucky, and Illinois-are inconsistent in paying the full actuarial contributions necessary to cover the cost of benefits for retirees. Moreover, these poorly-funded states continue to increase employer contributions and take money that could be allocated towards other public priorities to try to reduce their funding gaps but to no avail.
States may find it helpful to look at two measures described below-the net amortization rate and the operating cash flow ratio-in order to assess whether their pension system funding policies are adequate.
Pension Plan Net Amortization Measures
Net amortization measures whether the total contributions to a pension system will be sufficient to reduce liabilities if all expectations are met that year, including expected investment returns, as defined by PEW research. For example, New Jersey, one of the lowest-funded states, has failed to meet minimum actuarial funding standards since 2000. New Jersey’s average net amortization between 2015-17 was -25 percent, meaning New Jersey would have needed additional contributions amounting to 25 percent of payroll from 2015 to 2017 in order to break even and not increase their pension debt.
On average, states that adhere to their contribution and plan assumptions come out with positive net amortization and in turn can slowly reduce pension debt.
Pension Plan Operating Cash Flow Ratio Measures
An operating cash flow ratio measures the difference between cash coming in to the pension system (mostly through employer and employee contributions) and cash flowing out of the pension system in the form of benefit payments. The difference between cash coming in and out would then be divided by the value of plan assets and in turn would provide a benchmark for the rate of return required to keep plan assets from declining. For most states, this ratio is often a negative percentage showing how dependent states are on investments for their funding and how sensitive pension systems are to market fluctuations. A warning sign of fiscal distress may come from states with a consistent -5 percent cash flow ratio. This means that asset levels for these states will fall if investments fall below 5 percent.
A Framework for State Pension Funding Policies
If a state looks at both their net amortization and their operating cash flow ratio and realizes that their pension fund policies may need to be reworked, Wisconsin, Tennessee, and South Dakota can provide a helpful framework.
Wisconsin’s funding level in 2017 was 103 percent. Wisconsin consistently makes full actuarial contributions and also follows their risk management policies, as do all states with well-funded systems. Further, Wisconsin has employers, employees, and retirees all share the cost of poor investment returns as well as benefit from strong investment returns. Moreover, they also manipulate employer and employee contributions equally to fluctuate with market conditions. Last, Wisconsin sets the Cost of Living Adjustments (COLAs) at a 5 percent return assumption which is below the long-term average of 7.2 percent to provide a safeguard for pension funding if needed.
Like Wisconsin, Tennessee also makes full actuarial contributions and follows their risk management policies. Tennessee also offers a risk-managed hybrid benefit system for new state employees and teachers. The risk-managed hybrid benefit system gives the employee a fixed benefit and gives the employer a defined contribution plan but the employees final benefit will depend on the investment performance. This system distributes risk between both the employer and employee.
As a third example, South Dakota sets their contribution rates through statutes. Although statutes cannot account for a fluctuating market, South Dakota’s COLAs remain below the level that plan actuaries calculate is required to maintain full funding. They do this to account for possible bad investments or other funding changes.
All states have changed their pension funding policies since the Great Recession. States that are still struggling with under-funded systems may find helpful guidance in how Wisconsin, Tennessee, and South Dakota handle market fluctuations and other risks.