State Pension Funds: The Good and the Ugly
The economy is booming, tax cuts are looming and stock indexes are at record highs. But many public pension systems that provide retirement benefits to state and city employees and teachers are in trouble. Pension fund indebtedness has worsened in 43 of 50 states, according to Bloomberg Comprehensive Annual Reports, raising the prospect that future retirees may not receive all they have been promised.
This increase in pension indebtedness has occurred during an economic expansion of 100 months, third longest in U.S. history. U.S. economic growth has topped 3 percent during the last two quarters. The Dow Jones Industrial Average is up more than 19 percent in 2017.
Many pension systems have not kept pace. The median funding ratio – the percentage of assets states have for future payments to retirees – declined to 71.1 percent in 2016, the last year for which full data is available. Simply put, pension funds on average have on hand only 71 cents of each dollar needed to pay retirees. Economists and pension analysts worry that the next recession will compound the problems.
“Many states and cities are not prepared for the next economic downturn,” said Greg Mennis, director of the Public Sector Retirement Systems project at the Pew Charitable Trusts. Financial analyst John Mauldin, writing in Forbes, said that unfunded liabilities could triple in a prolonged recession.
Mennis singled out a handful of states that he said have fallen so far behind in contributions to their pension systems they have little hope of catching up. Worst off is New Jersey, which has only a 30.9 percent funding ratio and is one of three states that have accumulated less than 40 cents of their retirement dollars. The other two are Kentucky (31.4 percent) and Illinois (35.6 percent). Connecticut (44.1 percent) and Colorado (46 per cent) are other states with less than half of what they need to pay retirees.
The latter two states have tackled pension issues this year with mixed results. After a contentious legislative session Connecticut passed a two-year budget that made only minor changes in its pension system. The Constitution State would have to pay 35 percent of its tax revenue over 30 years in order to meet all its pension and retiree healthcare liabilities, according to a report by financial powerhouse JP Morgan.
Colorado has better prospects, if the legislature approves a new proposal by the Colorado Public Employees’ Retirement Association (PERA). The realistic PERA plan would slightly and gradually reduce payments to retirees while ratcheting up contributions from current employees and taxpayers. Its fate in the legislature is uncertain.
Colorado has also adopted “stress testing” procedures that among other things show how much pension funding would be needed during a recession. California and Washington have also used stress testing analysis for their state employee pension plans, and Connecticut, Hawaii and Virginia recently passed legislation requiring the disclosure of stress test results.
Not all states are struggling. The pension system in Wisconsin is fully funded (although that status is based on old pension accounting and reporting standards established by the Governmental Accounting Standards Board in 1994, GASB Statement No. 25, replaced by GASB Statement No. 67 in 2012) and the District of Columbia pension system is overfunded. New York, thanks to a reform bill passed by the legislature in 2012 and signed into law by Gov. Andrew Cuomo (D), improved notably and now funds 94.5 percent of its pension program. Pension systems in South Dakota and Tennessee (also based on GASB 25) are also more than 90 percent funded.
In addition, eight states are more than 80 percent funded. Ranked from highest funding to lowest, they are Nebraska, North Carolina, Idaho, Utah, Washington, Iowa, Delaware and Oregon.
Pension fund boards and managers persistently overestimate the income they are likely to receive from their investments. Mennis said that most funds expect a 7.5 percent return on their investments which is “a point higher than it should be.”
But reducing investment estimates requires participants in the pension system – current employees and local governments – to contribute more. The California Public Employees’ Retirement System (CalPERS), the largest U.S. pension system, last year lowered its annual forecast estimate from 7.5 percent to 7 percent last year in stages over three years. This modest adjustment was less than some CalPERS critics wanted but provoked a backlash from cities and counties that said they could not afford to spend more on employee retirement. California’s local governments are contributing $5.3 billion to CalPERS in the current fiscal year.
Pension managers are pulled in different directions on investment options. Should they invest in volatile equities with strong growth or supposedly safer bonds that have lagged far beyond the return of many stocks? Earlier this year their predicament was explained by Don Boyd, fiscal studies director at the Rockefeller Institute of Government. “Pension funds are in an extraordinarily difficult political situation,” he said. “If they protect their portfolios by moving assets into safer, lower-return investments they will have to drastically increase the cost for local governments. They are reluctant to do that.”
Finding the right balance isn’t easy for pension fund managers or, for that matter, state fiscal officials. Overall state revenues lagged in 2016, seven years after the Great Recession, growing only 2.2 percent. They improved only moderately in 2017, according to a report released last Thursday by the National Association of State Budget Officers (NASBO). Total state spending from all sources in fiscal 2017 reached nearly $2.0 trillion. The median growth level for state general fund spending was 3.0 percent.
The costs of Medicaid, the federal-state program that provides medical coverage for low-income people and the disabled, continued to climb, the report found. Medicaid accounted for 29 percent of all state spending compared to 20.5 percent in 2008 before the Affordable Care Act took effect. Medicaid consumes 16.8 percent of state funds and is second in state spending only to elementary and secondary education. State spending on higher education and transportation also increased in 2017, the report found.
In most reports on fiscal matters, the same states keep popping up as problems. A separate Pew study that examined accumulated state expenses and revenues from fiscal 2002 through fiscal 2016 found that New Jersey and Illinois were the only states with 15 consecutive deficits. Most states had more revenues than expenses over this 15-year period. Eleven states did not, “jeopardizing their long-term fiscal flexibility and pushing onto future taxpayers some of the past costs of operating government and providing services,” as the study put it.
The Pew study is helpful in charting the progress of states with long-time structural deficits. California, for instance, lurched from one budget crisis to another in the first decade of the century and was $25.5 billion in deficit in 2009, the last year of the Great Recession. After Jerry Brown (D) became governor in 2011 the Golden State raised taxes, tightened spending and emerged with a $10.6 billion surplus in fiscal 2016, using figures adjusted for inflation.
New York and Michigan are also among the 11 states with accumulated deficits that have shown notable improvement in recent years. The attainments of these states do not show a partisan pattern. Democrats control both the Legislature and governorship in California. Michigan has a Republican governor (Rick Snyder) and a GOP-controlled legislature. New York has a Democratic governor and a Democratic-controlled lower house but a Senate that more often than not has been controlled by Republicans either directly or in coalition with maverick Democrats.
States, in the well-worn phrase, are laboratories of democracy that offer alternative models of governance. These laboratories show how state government can work effectively – and also how government can falter through excessive partisanship or poor fiscal practices. As myriad analyses of pension liabilities and state spending demonstrate, good fiscal management can make a difference. Illinois, locked in partisan gridlock on pension reform (and other issues), is next door to Wisconsin, which fully funds its pension system. New York, with a solvent state government and reformed pension system, abuts New Jersey, the basket case of states on pension funding. Kentucky, with a similarly dysfunctional pension system, borders Tennessee, which has one of the nation’s best-managed and well-funded systems.
The performance of the successful states demonstrates that pension reform and effective fiscal management are obtainable goals – when politicians have the will to reach them.
