State Pension Gap Continues to Grow

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The damage done by the Great Recession to state public pension systems is now clearer than ever: The most recent available figures, for fiscal year 2009, show that the gap between what states had set aside to pay for employee retirement benefits and the amount they had promised the workers had grown to $1.26 trillion, or 26 percent in one year, according to a report released today.

 The report by the Pew Center on the States ( Stateline 's parent organization) covered the worst budget year of the recession, one that included the Wall Street financial crisis in September, 2008. The report found that during the period from July 1, 2008, to June 30, 2009, state public pension plans had accumulated nearly $3.6 trillion in pension and retiree health care cost obligations but had set aside only $2.34 trillion to pay for them.

The $1.26 trillion difference between liabilities and assets in 2009 marks a substantial deterioration from the $1 trillion gap that Pew found in 2008. It is a conservative estimate. Some analysts believe the disparity in funding could be as high as $3 trillion, although those estimates are based on different assumptions and projections. The Pew Center on the States, which uses the most recently available annual financial reports and actuarial valuations, makes its calculations based on states' own assumptions about the average gains their investments will achieve.

The report confirmed the depth of the beating suffered by public pension funds in the months following the Wall Street collapse. Those funds lost a median 19.1 percent in market value in fiscal 2009. And although most have regained much of their asset value since then, they are behind expectations because they had assumed they would be earning a steady 8 percent a year. ( Story continues below the graphic
  

Another key finding: The percentage of state pension liabilities that are funded dropped from 84 percent in fiscal 2008 to 78 percent in fiscal year 2009. Most analysts, including the U.S. Government Accountability Office, recommend a funding level of 80 percent or higher. Pew found 31 states below this threshold in 2009, up from 22 states a year earlier. The pattern of lower funding levels continued in fiscal 2010 among the 16 states that have already completed annual financial reports for that year, according to the report.

 New York, which requires lawmakers to pay the state's public pension bills in full, had a funding level of 101 percent in 2009, leading all states. Illinois and West Virginia, which have struggled for years to finance their public pension systems, were funded at slightly above 50 percent, making them the shakiest performers.

 In its report on 2008 public pension funding, released early last year, the Pew Center on the States found that over half of the $1 trillion shortfall came from unfunded retiree health care and other benefits, with the rest from public pension liabilities. That pattern reversed itself in fiscal 2009 for the first time since states began reporting these liabilities in fiscal 2006. Of the $1.26 trillion gap in 2009, Pew said, public pensions accounted for $660 billion.

But the retiree health care funding gap was striking for a different reason: States reported only $31 billion in assets to pay for $638 billion in liabilities. Nineteen states failed to set aside any money for this long-term bill, instead paying retiree health care costs as expenses incur.

 Susan K. Urahn, managing director of the Pew Center on the States, says the bills for retirement benefits and health care are competing with other spending pressures in states. "The larger the unfunded gap, the higher the cost to taxpayers today and for many years to come," she says. "And the pain is certainly greater for states that have a history of kicking the can down the road on funding these promises."

Wave of cuts

The focus on public-sector pension funding shortfalls has spurred a wave of benefit cuts in nearly every state since 2009. Most of the cuts apply to newly hired state employees. They include increasing the percentage of their pay that goes towards pensions, raising their minimum retirement age and changing the formula under which retirement benefits are calculated, to reduce the amount of their checks. States also have moved to boost contributions from employers — the taxpayer-funded public agencies where employees work.

These cuts usually do not produce near-term savings since they do not apply to workers who have reached or are approaching retirement. States generally are prohibited by law from changing benefits for current workers. But three — Colorado, Minnesota and South Dakota — are testing that restriction by freezing or lowering the annual cost of living adjustment for current retiree benefits. Retirees in the three states have filed lawsuits seeking to overturn the benefit cut but judges have not yet decided those closely watched cases. If any of the three states prevail, it could cause other states to limit cost of living adjustments. 

States also are weighing major structural changes to their public pension systems. Many are shifting from the decades-old defined benefit plan, which provides a fixed retirement benefit, to a defined contribution plan, which is similar to the 401(k) arrangement used by most private sector employers. Republican governors elected in November in Alabama, Florida, Iowa, Nevada, Pennsylvania, Tennessee and Wisconsin, as well as the independent governor of Rhode Island, have said they would favor switching to a defined contribution plan. 

None of those states has approved the switch, pointing out the difficulty of changing benefit systems. Kentucky and Nevada lawmakers commissioned studies that concluded replacing the current defined benefit system would initially be expensive to implement but would begin saving the state money after several years.

Currently, Alaska and Michigan are the only two states with a defined contribution plan; some Alaska lawmakers have proposed changing back because they say the pension liability keeps growing instead of shrinking as was initially promised. Other states, notably Utah in 2010, have offered a plan for new hires that gives them a choice between a defined contribution or a hybrid of defined benefit and defined contribution. None of the new options are as generous as the defined benefit for current workers. 

States also are examining the financial underpinning of their pension funds. In addition to employee and employer (taxpayer) contributions, state public pension funds are financed from investment gains. Most of the plans assume an average 8 percent gain over an extended period of time, but many actuaries and other pension analysts say that rate should be lowered to a more realistic figure that reflects current and projected future market performance.

These sorts of changes were recently made in Rhode Island (from 8.25 percent to 7.5 percent), New York (from 8 percent to 7.5 percent) Alaska (from 8.25 percent to 8 percent) and Illinois (from 8.5 percent to 7.75 percent). But last month, California's pension board rejected a similar move for the same reason other state pension managers are skittish: Lowering the projected rate of return increases pension liabilities and in turn employee and employer contributions.

According to the Pew report, the combined state shortfall for their long-term pension obligations could be as high as $1.8 trillion if they were based on investment rate assumptions similar to corporate plans, or $2.4 trillion using a discount rate based on a 30-year Treasury bond.

Editor's note: This article has been corrected to reflect the fact that pension systems in 22 states (not 21) fell below the 80 percent funding threshold in 2008. It also has been corrected to reflect the fact that the overall amount of retiree health liabilities in 2009 is $638 billion (not $635 billion).