Funding Public Pensions

The Problem: Underfunded Pension Systems

The Problem: Underfunded Pension Systems

Across the nation, public pensions are in crisis, and have been so for a long time. Funding pension costs is a political issue in cities, counties, and states from California, to Illinois, to Rhode Island. The rising expense of public employee pensions has become a political hot button justifying cuts to education and other necessary government investments, causing acrimonious debate, court cases, protest marches, and more. All the recent incidents of municipal bankruptcies have been blamed, at least in part, on pension obligations. Most famously, this was the case in Detroit, Michigan, but has also been true in the cities of Stockton and Vallejo in California, Prichard, Alabama, and Central Falls, Rhode Island. 

The city of Chicago is currently feeling some of the warning tremors. According to its own estimates, the city’s various pension funds have only half the funds in hand needed to pay its pensions. This leaves a $26.8 billion difference between the assets and the present value of the debt to all the current and future retirees in the system.1 This difference, known as the “unfunded liability,” was cited as the primary reason that Moody’s, the bond-rating firm, downgraded Chicago’s bond rating to “junk” status in May of 2015.2

The other common measure of a pension system’s health is the ratio between the assets and the future liabilities, known as the “funding ratio.” Chicago’s funding ratio hovers around 50 percent, but the condition of the pension funds managed by the state of Illinois is even worse, showing a 39 percent funding ratio, with $111 billion worth of unfunded liability.3

 This infographic includes a diagram showcasing the pension funding ratio.

Funding ratio calculation for CalPERS, 2014. “Total assets” is the value of the pension fund today, and “Estimated total liability” is the estimate of the future liability of the current employees whom are owed a pension. This is an estimate over several decades, so there are a lot of assumptions built in, and a great deal of uncertainty.

These are just the cases that make the headlines. In thousands of other governments across the country, pension contribution increases are a constant source of fiscal stress, resulting in cuts to schools, infrastructure, and increases in taxation. Despite the stress of added payments, the problem is not going away. America’s public pension systems are, on average, only 74 percent funded as of 2014, with only $3.6 trillion in assets on hand to pay $4.8 trillion in liabilities, an unfunded liability of $1.2 trillion.4 These governments have only a fraction of the assets on hand to make all the pension payments they have promised to their members. Retirement benefits, state and municipal budgets, and taxpayers are jeopardized. It is a crisis all around.

And yet, is it really true? A close look at the Detroit bankruptcy shows that it really had far more to do with the politics of Michigan’s suburbs and the Governor Rick Snyder’s feelings about the city than it did with the mathematical reality of the city finances.5 The narrative of runaway pension obligations sinking an ailing city’s finances is simply not supported by the facts, which had much more to do with a sudden loss of state support and ill-advised interest-rate swaps.6 Longterm debt due decades in the future cannot cause insolvency today even if it is a sign of trouble to come. Insolvency is the result of being unable to pay current obligations; long-term debt is just a threat.

Detroit’s long-term debt of $18 billion was the headline number for the bankruptcy proceedings, but the pension system accounted for less than 20 percent of that, and that was only using very conservative assumptions about the discount rate and demographics. The actual cash-flow issue that triggered the bankruptcy was a $198 million shortfall in fiscal year 2014, a number easily explained by a $194 million decline in revenue—the largest component of which was changes in state policy that cut revenue sharing by $56.5 million—and $547 million in termination fees from swaps deals. The cost of running the city’s pension systems had actually declined in the previous two years. Detroit’s pension contribution in 2013 was $78.3 million, a slight drop from the 2012 contribution of $86.1 million, though still above the $65 million average payment of the previous five years.7 Obviously the city’s willingness to enter into the swaps was a symptom of financial pressure, and it is certainly true that the pension system was among the sources of that pressure. But as we will see, the pressure was applied by the pension accounting rules in place, much more than the mathematical reality of the payments to be made.

Cases of other cities used to illustrate the pension crisis provide equally misleading stories contradicted by a closer look. Stockton, California, seems to have been sunk not by pension costs, but by the foreclosure crisis, by some expensive city investments like a sports arena and hotel that did not pay off, and by an ill-advised gamble.8 The purpose of the gamble was to reduce pension liability, but it was this gamble that went wrong, not the pensions.9

Central Falls saw its crisis precipitated by devastating cuts in state aid in 2009 and 2010, and a balloon payment worth 40 percent of the city’s annual budget due in 2010 from a 1990 bond.10 Prichard, a poor town near Mobile, Alabama, could hardly have been sunk by its pension costs, since they had not been paid in years. During its first round of bankruptcy in 1999, Prichard officials “admitted that it had not made payments into its employees’ pension fund for years and had withheld taxes from employees’ pay checks, but had not submitted the withholdings to the state and federal governments.”11

Obviously, these cities were all stressed fiscally, but how and why did it come to be that public employee pensions were argued to be primary causes, when this was not the case? Part of the reason is that the pension funds in these cities were known to be underfunded by the accounting standards used to evaluate them, and those standards use normative language and measures to describe the situation. 

A pension plan is “underfunded” and the government deemed not “fiscally sound” if it does not have the assets currently on hand to pay all of the future liabilities, clearly implying big problems ahead.12 The unfunded liability provides a convenient measure of the degree of the problem, and since the liabilities of any pension system are typically large compared to the size of the budget, the unfunded part of that liability often seems immense. For example, the Illinois annual budget is in the $55–60 billion range, an uncomfortable comparison with its pension funds’ liability of almost twice as much. Nationally, pension liabilities are in the trillions, even if the precise number of trillions is heavily contingent on analyst assumptions.13

Unfortunately, the widely-used measures of pension assets and liabilities are more complicated, less complete, and less reliable than they are typically presented to be. Where the measurements are accurate, they are commonly misinterpreted. They ignore important sources of system strength and create perverse incentives to system managers. They serve not only to exaggerate the problems facing pension funds, but also provide a poor guide to addressing those problems. Certainly the current funding situation of most pension plans could be improved and certainly there exist pension systems that really are in danger of collapse. However, might there be needless damage done by constantly predicting impending collapse for so many others?