The pension system for state workers in New Jersey is so underfunded that it could run out of money in 12 years. Pennsylvania and Connecticut have taken steps to stabilize their systems, such as increasing state contributions, but policymakers face the prospect of high pension costs for years to come. And Colorado could deplete its retirement fund assets by 2044 because the state lacks policies to manage volatile financial markets.
These gloomy projections are among those in a first-of-its-kind simulation of state pension system funding conducted by The Pew Charitable Trusts. A new study, "Assessing the Risk of Fiscal Distress for Public Pensions: State Stress Test Analysis," presents findings about the largest public employee plans in 10 states: Colorado, Connecticut, Kentucky, New Jersey, North Carolina, Ohio, Pennsylvania, South Carolina, Virginia, and Wisconsin. The John F. Kennedy School of Government at Harvard University published the report on May 23, 2018.
Not all of the 10 states assessed by Pew are in bad shape. North Carolina and Wisconsin, both hard hit by the Great Recession of 2007-09, fully fund their retirement systems by following well-designed contribution policies that are adjusted depending on economic conditions. Every state in the study has enacted reforms since the Great Recession and should expect declines in costs over time as savings are realized from those changes.
The analysis shows the advantages of nonpartisan, evidence-based financial stress testing to inform policymakers about the impact of economic uncertainty on a state's ability to pay benefits to retirees. The Pew model incorporates a range of scenarios for economic projections and investment returns, which can give policymakers a better sense of potential liabilities and costs.
The findings could bolster efforts by state policymakers to strengthen their retirement system finances, which along with Medicaid are the top spending pressures facing states today. Pew recently pegged the cumulative gap between state pension fund assets and liabilities at $1.4 trillion. Money used to close that shortfall represents dollars not available for other priorities such as education or public safety.
Warning that state retirement system finances and government budgets could face greater risk of rising costs in the next economic downturn than in any previous recession, Pew's analysis concludes that state legislators should require pension stress test reporting to quantify the estimated impact of lower returns on pension balance sheets and state finances.
The median return assumption was 7.5 percent for public pension plans in 2016, but many analysts expect returns to be a full percentage point lower over the next two decades. Some say there is about a 1 in 4 chance that returns may not rise above 5 percent in that period. Although many states have lowered their assumed rates of return, fund investment targets still exceed industry estimates at a time when state reporting does not adequately account for economic uncertainty and market risk.
Seven states—California, Colorado, Connecticut, Hawaii, New Jersey, Virginia, and Washington—recently moved to require pension plan stress testing. Pew evaluated the plans in four of those states.
Pew's model is patterned after requirements for financial institutions in the 2010 Dodd-Frank Wall Street reform legislation. Using multiple economic scenarios and rates of return can show what states and employees would need to contribute over time to fully fund their retirement systems.
One scenario, for example, applies a fixed 5 percent rate of return, while another assumes an initial investment loss of 20 percent, followed by low returns over many years. State tax revenue projections are factored in to measure the impact of economic downturns on state budgets. The model also can account for the possibility that policymakers will underfund required pension contributions.
Though Pew tested 10 states, the findings can apply to all. Among the general conclusions, the analysis shows that:
Greg Mennis is director of The Pew Charitable Trusts' project on public sector retirement systems, and Stephen C. Fehr is a senior officer with Pew's project on state and local fiscal health.