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Pew's latest pension report understates unfunded liabilities, but still shows growing pension problem

by Cory Eucalitto | April 4, 2014

"The Fiscal Health of State Pension Funds: Funding Gap Continues to Grow," is the Pew Center on the States' latest annual update of state unfunded liabilities. This report, using data from fiscal year 2012, finds that combined state defined benefit pension plans have $914 billion in unfunded liabilities and a 72 percent funded ratio. While Pew's report relies directly on state-reported numbers that understate the size of unfunded liabilities, it nonetheless shows tremendous growth in unfunded liabilities since 2008, driven largely by both the failure of states to adequately fund their retirement promises and investment returns short of optimistic assumptions.

Importantly, Pew's pension funding figures are dramatically different from those reported by State Budget Solutions in "Promises Made, Promises Broken - The Betrayal of Pensioners and Taxpayers." SBS found a $4.1 trillion unfunded liability for state-administered defined benefit plans, and a combined 39 percent funded ratio.

The table below shows state-by-state unfunded liabilities according to both Pew and SBS, along with the percentage of fiscal year 2012 Annual Required Contributions made. For the sake of comparison, SBS uses only those pension plans listed in Loop Capital Markets' "Eleventh Annual Public Pension Funding Review."

The difference in figures lies in the discount rate used. Public plans discount their liabilities according to their assumed investment return, typically between 7 and 8 percent. State Budget Solutions, on the other hand, calculated liabilities using 3.225 percent, based on the 15-year treasury yield at the time of calculation.

SBS relies on a "risk-free" calculation, as do many financial economists, because liabilities ought to be discounted at a rate based on their status as largely legally guaranteed benefits. Therefore, the risk that they will not have to be paid is quite low. Using such a rate provides the best guarantee of future funding for earned pension benefits.

Despite the discount rate differences, Pew's report still shows a rapidly deteriorating funding situation across the country. Pew found that combined unfunded liabilities have grown to $914 billion from just $452 billion in 2008. 

A major contributing factor to this increase is that many state governments routinely skip parts of their Annual Required Contributions. In all, state governments paid just 77 percent of their required contributions in 2012. New Jersey (39 percent), Pennsylvania (43 percent), North Dakota (53 percent), and Ohio (57 percent) were some of the worst offenders.

This may be politically expedient, such as when near-term budget pressures reduce the incentives for leaders to set aside money for the future. But each skipped contribution must necessarily be satisfied in the future, along with any unrealized investment returns.

These skipped contributions, along with the use of assumptions that reduce the apparent size of unfunded liabilities, are just some of the ways that politics can undermine public employee retirement security. When it comes to reducing unfunded liabilities, and eventually making them a thing of the past, the surest pension reform option involves closing defined benefit plans and instituting defined contribution alternatives. Properly structured, and with a responsible plan to pay down existing liabilities, such reforms would provide true retirement security to public employees, protect vital funding for services that help keep communities safe and strong, and keep politicians out of pension funding. 

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