Promises Made, Promises Broken - The Betrayal of Pensioners and Taxpayers

by Cory Eucalitto, State Budget Solutions, September 3, 2013

Comprehensive research into the funded status of state level defined benefit public pension plans reveals that public employee retirement promises are underfunded by $4.1 trillion. Combined, state public pension plans are just 39 percent funded.

States facing a particularly large unfunded liability at a per capita level and as a percentage of their annual gross state product include Illinois, Ohio, New Jersey, Oregon, Connecticut, Nevada, New Mexico, Hawaii, and Alaska.

As this report demonstrates, unfunded public pension liabilities present a unique threat to state government finances. While many have tried to turn a blind eye to the pension crisis, the problem is simply too big to ignore.

Evolving Perspectives

Both the Governmental Accounting Standards Board and Moody's Investors Services have recently made changes to the way they approach public pensions from their respective vantage points. The impetus for those changes was the routine undervaluing of plan liabilities.

With their rejection of an unsatisfactory approach to calculating public pension liabilities, GASB and Moody's have joined a chorus of financial economists and other observers warning that pension funding practices are dangerous for both taxpayers and public employees alike. Despite this progress, many discordant perspectives remain on the true size of these funding gaps.

The table below, the State Budget Solutions 50 State Pension Table, shows each state's total assets, total market-valued liability, overall funded ratio, and unfunded liability. The second table, the Per Capita table, shows unfunded liabilities by state per capita and as a percentage of gross state product. Click here for access to the full, sortable spreadsheet.

Figures were drawn from state Fiscal Year 2012 Comprehensive Annual Financial Reports, as well as the Comprehensive Annual Financial Reports and actuarial valuations published by individual plans. In each case, figures were from the most up-to-date valuation available at the time of research. Plans were compiled based on the United States Census Bureau's Annual Survey of Public Pensions and state-level financial reports.

Breaking Down the Numbers

Flawed funding practices have put public pension systems across the country in peril, but some states are in better shape than others. An unfunded liability dollar amount alone does not tell the whole story. Larger states will, naturally, have a larger unfunded liability than smaller ones.

A funded ratio presents a plan's assets as a percentage of liabilities, or the amount of money owed in benefits. The funded ratio is used as one of the primary measurements of a pension plan's overall funding health. It provides an additional layer of context that an unfunded liability alone does not. For example, California has a larger unfunded liability than Kansas, but based on what the state currently knows it will owe to retirees versus the amount of money they actually have, the funded ratio tells us that Kansas is in worse shape than California, with Kansas' plans being 29% funded and those of the Golden State being 42% funded.

By this measure, the five most poorly funded states are Illinois (24%), Connecticut (25%), Kentucky (27%), and Kansas (29%), along with Mississippi, New Hampshire, and Alaska tied at 30% funded.

At the other end of the spectrum, Wisconsin, the most well funded state in the country, has just a 57% funded ratio, followed by North Carolina (54%), South Dakota (52%), Tennessee (50%) and Washington (49%).

The unfunded liability of all plans in this study, $4.1 trillion, works out to $13,145 per capita.

The states with the largest unfunded liability per person are Alaska ($32,425), Ohio ($24,893), Illinois ($22,294), Connecticut ($21,378) and New Mexico ($20,530). On the other hand, the states with the smallest unfunded liability per person are Tennessee ($5,676), Indiana ($6,581), North Carolina ($6,874), Nebraska ($7,212) and Arizona ($7,688).

An examination of unfunded liabilities as a percentage of each state's gross state product reveals a list similar to that shown on a per capita basis. Ohio (56%), New Mexico (53%), Mississippi (48%), Alaska (46%) and Illinois (41%) have the five largest ratios of unfunded liabilities to 2012 Gross State Product according to the Bureau of Economic Analysis. Delaware, Tennessee, Nebraska (13%), Indiana (14%), North Carolina (15%), North Dakota (16%), and South Dakota, Washington, and Texas (17%) had the lowest ratios.

By combining the rankings of per capita unfunded liabilities and unfunded liabilities as a percentage of annual gross state product, it is possible to identify which states stand out on both scales. Nine states are present in the top ten of both lists, showing large unfunded liabilities compared to their populations and economic output. Those states are Illinois, Ohio, New Jersey, Oregon, Connecticut, Nevada, New Mexico, Hawaii, and Alaska.

A Market-Valued Approach

This fair-market valuation shows the tremendous impact that the choice of a discount rate has on funding health. It demonstrates the extent to which current funding practices undervalue the retirement promises made to public employees. According to official reporting, the overall funded ratio of state plans included in this report is 73 percent - a far cry from the 39 percent level that a fair-market valuation has revealed.

The size of a pension plan's liability is based greatly on the discount rate used in a valuation. Public pension plans discount liabilities in order to determine how much must be paid into the fund today to guarantee funding for benefits that will be paid in the future. The process involves starting with the amount of money that is projected will be owed and subtracting interest each year to arrive at a present value.

Current public sector practices involve discounting a liability according to the assumed investment returns of plan assets, typically around 8 percent. Yet with discount rates tied to expected investment performance, plan sponsors can easily take on greater risk in order to make liabilities appear smaller. This reduces the resources required today to pay for the promises of tomorrow.

Accurately accounting for a pension system's liability requires incorporating the nearly certain nature of benefits. That is, once promised, the chances that benefits will not have to be paid are extremely low.

A fair-market valuation does away with optimistic investment return assumptions and instead uses a rate that reflects the risk of the liability itself. One common approach, taken here, is to discount liabilities according to the yield of a 15-year Treasury bond.

Method

This report includes data from over 250 state-level defined benefit pension plans holding nearly $2.6 trillion in assets. Figures were drawn from state Fiscal Year 2012 Comprehensive Annual Financial Reports, as well as the Comprehensive Annual Financial Reports and actuarial valuations published by individual plans. In each case, figures were from the most up-to-date valuation available at the time of research. Plans were compiled based on the United States Census Bureau's Annual Survey of Public Pensions and state-level financial reports. Plan liabilities were discounted according to the 15-year Treasury bond yield as of August 21, 2013. That rate was 3.225 percent.

The formula for calculating the market value of a liability requires first finding the future value of the liability. That formula, in which "r" represents a plan's assumed interest rate, is FV = AAL x (1+r)^15. The second step is to discount the future value to arrive at the present value of the market valued liability. That formula is PV = FV / (1+r)^15, in which "r" represents the risk free discount rate.

Click here for access to the full spreadsheet.

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