Promises, Promises (Spring 2008 Trust Magazine article)

  • April 30, 2008
  • By Sandra Salmans

The Pew Center on the States examines the rising cost of public-sector retirement benefits.

Retirement benefits for public employees—principally pensions and health care— may not be fodder for the six o'clock news. But they are critically important to all taxpayers.

Every dollar spent on such benefits is one dollar less for roads, schools, health care and the pantheon of other needs that put pressure on state budgets. States will spend a staggering $2.73 trillion on pensions, health care and other retirement benefits for their employees over the next three decades.

That is the conservative estimate of a report released recently by the Pew Center on the States. The first-of-its kind, 50-state analysis, Promises with a Price, found that over the next few decades the bill for pensions for state employees will amount to about $2.35 trillion, with an additional $381 billion for retiree health care and other post-employment benefits.

While the states on average had saved enough in fiscal 2006 to cover about 85 percent of their long-term pension costs—-a reasonable level of funding, according to the report—-this average can be misleading. About 19 of the states had set aside far less, with states such as Colorado, Connecticut, Illinois, Indiana and Massachusetts not even reaching the 75-percent level.

What's more, the states as a whole had put aside only 3 percent of the funds needed for promised retiree health care and other non-pension benefits. That means that states will need to come up with at least $731 billion within 30 years.

In fact, the actual number is likely substantially higher, because it does not include all retirement costs for teachers and local government employees, some of which are assumed by some states.

“This represents an enormous investment of taxpayer dollars, so Americans should be concerned about how states are managing this obligation,” says Susan Urahn, managing director of the Pew Center on the States. “Also, for government to be effective and efficient, states need to recruit and retain high-quality public employees, and they need to strike the right balance between controlling costs and making sure they're getting the best workers they can.”

“Even for states that are well funded right now, we feel this is a critical cautionary tale,” says Richard Greene, who wrote the report with Katherine Barrett; both are consultants to the Pew Center on the States. For one thing, the report points out, public pension funds have become more aggressive in their investments, so returns are likely to be considerably more volatile than they were in the past.

What's more, when states' funding levels are buoyed by good returns on their investments, as has been the case for some time, there's a powerful temptation to cut back on fiscally sound contribution levels. Says Greene, “We hope the study will help to keep states focused on the importance of properly funding these obligations year in and year out.”

In fact, the challenges states face today in meeting their bills are largely the result of short-sighted decisions in the past, says Urahn. Some states have had a buy-now, pay-later mentality about retiree benefits. In hard times, generous post-employment benefits became easy substitutes for salary increases because states could put off paying the bills. In good times, some states believe they can afford to expand benefits—even though these typically carry sizable long-term price tags. For many states, dramatically scaling back benefits has not been a practical option.

As the report explains, demographic trends suggest that the pressure on the states will only get worse. The number of retirees is increasing every year, and the public sector will face an escalating number of retirements sooner than the private sector because the average public employee is older. In addition, people are living longer, a trend that will put even greater demands on both pensions and retiree health-care benefits.

“Deferring funding is risky since workers can't be sure that future generations will be able or willing to set aside the cash needed to pay retirees, and taxpayers can't be sure what their future tax burden will be to pay for these benefits,” sums up Olivia S. Mitchell, Ph.D., executive director of the Pension Research Council and director of the Boettner Center for Pensions and Retirement Research, both at the Wharton School of the University of Pennsylvania, where she is a professor.

The report's key findings:

  • Funding is erratic. In the past decade, only about a third of the states have consistently contributed the full amount that their own actuaries said was necessary. In 2006, 20 states contributed less than 95 percent of the amount targeted, and 10 states contributed less than 80 percent.
  • The long-term price tag for retiree health-care and other benefits, such as dental care and life insurance, was about $381 billion at the end of fiscal 2006, and about 97 percent of that—a whopping $370 billion—was unfunded. Non-pension liabilities make up more than half of what states have not yet funded.
  • States that do not keep up with payments for either pensions or other post-employment benefits are engaged in a massive intergenerational shift of resources, as future generations are required to pay for the services delivered by past ones.

While the states have been required for some time to report their long-term pension liabilities, data on other postemployment benefits have not been widely available. Under a new rule of the Governmental Accounting Standards Board, however, states are required to disclose their liabilities for non-pension benefits, and those numbers will be released between December 2008 and March 2009.

But because states had to begin their calculations—some for the first time—Pew assembled a team that included Barrett and Greene as well as Lori Grange and Kil Huh, senior officer and project manager, respectively, for the Pew Center on the States, and others to report on the extent of the liabilities and funding in all 50 states. Barrett and Greene produced a related report on Philadelphia (see In Philadelphia, a "Quiet Crisis").

“I think a lot of state officials were horrified by what they found,” says Barrett. “Actually, we were kind of gratified when we heard that they were alarmed—that seemed like a good sign that they were aware of the magnitude of the issue.”

The situation is quite different from that in the private sector, where defined benefit pensions have become the exception to the rule. Increasingly, companies have abandoned them in favor of 401(k) plans, or defined contribution plans, to which employees contribute a percentage of their pay. The report found that 90 percent of public sector employees have pensions, compared with 20 percent of private sector employees; furthermore, the public sector retiree's median pension in 2005 was $17,640, compared with $7,692 for the private sector worker.

A similar gap between the private and public sectors was found in retiree health benefits. According to the study, 82 percent of workers for state and local governments with more than 200 employees received retiree health benefits of some kind, compared to 33 percent of workers for large private- sector employers.

Stephen D'Arcy, Ph.D., professor of finance and the John C. Brogan Faculty Scholar of Risk Management and Insurance at the University of Illinois, says he was “astounded” by the public sector number. “People should know about this, they should care about this, and they should elect legislators who are willing to address this problem,” he adds. “These have been major hidden costs, and the fact that this information is being revealed will have an impact.”

The report found that, while there are no quick and easy solutions, states can take steps to reduce their liabilities. In some cases, states may owe so much that they feel compelled to restructure benefits to cut costs. In general, states have more flexibility to make changes to retiree health-care benefits than to pensions. Some possibilities:

  • States are raising the retirement age and closing loopholes within pension systems that allow employees to inflate the amount they collect after retirement.
  • For non-pension benefits, states are increasing premiums and copays and raising the number of years of employment required for lifetime or fully subsidized benefits, among other reforms. As in the private sector, they are also experimenting with more efficient approaches to managing health care costs, such as requiring retirees to join a Medicare Advantage Plan (which augments the original Medicare's benefits at additional cost), promoting wellness programs and other preventive measures, and joining with localities to bundle their plans under a single administrative umbrella.
  • At least 13 states, including Alabama, Delaware, Georgia and West Virginia, have set up irrevocable trusts to pay for retiree health care in the years to come. These trusts, which require that all the money that goes in is used in a predetermined way, protect funds from being raided for other purposes.
  • At least five states, including Ohio, Oregon and Washington, offer hybrid pension plans that combine elements of both defined benefit and defined contribution plans. In Alaska andMichigan, certain employees are no longer promised a set benefit when they retire. Instead, they make annual contributions to a savings plan, to which the state government also contributes.

Although it addresses issues typically well below the radar, Promises with a Price attracted a remarkable amount of media coverage, from national press to reports by local newspapers on the situation in their own states. And experts hailed the report as raising the curtain on an area of state budgets that has too long been kept in the dark.

“It's nice to have confirmation that there's a big problem here,” says Alicia H. Munnell, Ph.D., the Peter F. Drucker Professor of Management Sciences and director of the Center for Retirement Research at Boston College. “The numbers will spur action, both in funding and assessing the feasibility of incurring these costs. It will make government entities take a serious look at benefits and either fund them or pare back the benefits for new hires.”

“As the Pew Center on the States developed this report, it became increasingly difficult to avoid the cliché ‘a ticking time bomb,'” says Urahn. “Yet that's precisely what this is. And it joins a whole host of other fiscally explosive issues that the states are confronting, including corrections and infrastructure needs. While there are few easy solutions available, it's clear that just hiding from these bills that are coming due is the least desirable approach.”

For the full study and fact sheets for each state, go to the press release, Pew Study Finds States Face $2.73 Trillion Bill for Retiree Benefits.

Sandra Salmans is senior writer at Trust.