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States' Pension, Health Care Funding Shortfalls Top $1 Trillion

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In fiscal year 2009, states overpromised at least $1.26 trillion in retirement and retiree health care benefits to public employees, according to a study released Tuesday by the Pew Center on the States, a 26% increase in one year.

Pew's report, "The Widening Gap," found pension plans make up more than half of the shortfall. With liabilities of nearly $3 trillion, and just $2.28 trillion in state coffers, there's a gap of $660 billion in state pension funded status. States have saved less than 5% of the funds needed to cover non-pension liabilities.

The shortfall is a result of "precipitous revenue declines" in fiscal year 2009, according to the report. State actuaries recommended states contribute nearly $115 billion to fund long-term obligations, but states only met 64% of that commitment.

"There are no quick fixes to the pension funding challenge," Steve Fehr, project director and senior staff writer for Pew Center on the States told AdvisorOne, "but we are seeing policy makers in a number of states deal with the problem head on."

For example, in 2010, Fehr said, 19 states were able to reduce their long-term bill by cutting benefits levels for new employees and requiring workers to contribute more of their paychecks to pension and health care funds.

"The immediate savings from these reforms are relatively small compared to the size of current budget shortfalls," according to Fehr, "but in the long run the savings are significant. Missouri’s policy changes, for example, are projected to save $660 million over the next decade. One Missouri change was to raise the retirement age from 65 to 67."

The $1.26 trillion figure, high as it is, could be a conservative estimate, according to Pew. Most states use an 8% discount rate to calculate pension liabilities, but "there is significant debate among policy makers and experts" about whether that figure is appropriate. Pew found that between 1990 and 2009, states' median investment return was 8.1%, but for 2000 to 2009, if fell dramatically to 3.9%.

"Given recent economic events," Fehr said, "some states are considering discount rate changes, and at least four have recently lowered their rates. Those states are Alaska, Illinois, New York, Rhode Island and Pennsylvania."

Depending on how states liabilities are calculated, the shortfall could be between $1.8 trillion, assuming the 5.22% discount rate used on corporate pensions, and $2.4 trillion, using the Treasury bond's 4.38% discount rate, Pew found.

Fehr added that Pew does not recommend a discount rate, affirming that each state needs to answer that question for itself. However, he said, "we do want policymakers and taxpayers to understand several potential consequences of lowering the discount rate. Most immediately, a state would see the amount of its annual required contribution increase to compensate for the reduced expectations for investment gains."

As an example, Fehr pointed to objections from California state agencies to a recent proposed cut in the discount rate. "It would have meant that each agency needed to spend more now on retirement contributions, leaving fewer dollars for public services."

"A longer-term risk," he added, "is that, if the discount rate is set too low and states’ investment returns greatly exceed expectations, policy makers may be tempted to increase employees’ benefits without considering the full cost – a practice that was a large factor leading to the $1.26 trillion dollar gap."

The Government Accountability Office recommends states have at least 80% of their pension liabilities funded, but in 2009, 31 states were below this threshold. In 2008, 21 states had funding levels under 80%. Overall, pension funded status fell six percentage points in 2009 to 78%.

Since states began reporting liabilities in fiscal year 2006, this is the first time pension funding shortfalls have been greater than those of retiree health care and non-pension shortfalls.

While the pension shortfall surpassed that of health care and non-pension liabilities, the situation for those obligations has worsened since fiscal year 2008. Back then, states had a shortfall of $555 billion; in 2009, that figure increased to $604 billion.

Just five states made full contributions in 2009 – Alaska, Arizona, North Dakota, Utah and Washington – while overall, states made only 36% of the contribution necessary to make the $47 billion obligation. Fully 19 states have set aside nothing to pay for retiree health care and non-pension obligations. Only two states – Oregon and Arizona – had more than 50% of these obligations funded.

Data for fiscal year 2010 are available for just 16 states, but the picture so far is mixed. The average funding level for those states fell from 77% to 75% in 2010. Idaho, Minnesota and Vermont enjoyed an increase of between 2% and 5% in pension funding levels. Iowa and Tennessee experienced no change in funding levels, but the remaining 11 states suffered declines of between 1% and 9%.

Pew attributed the variance to two factors: differences in when states recognize investment gains; and, states' "smoothing policies," which spread investment returns out over time to avoid significant changes in year-over-year funding levels and required contributions.

Employees who are near or already in retirement generally won't be hurt by states' shortfalls in funding levels, Fehr said. "Most of the changes that states have enacted reducing benefits apply to employees hired in the future. State and federal law protects current employees and retirees who are or will receive public pension retirement benefits."

However, Fehr cautioned that Colorado, Minnesota and South Dakota attempted last year to freeze or reduce the annual cost of living adjustment for current retirees.

"Retirees in each of those states challenged the state action in court, and we are waiting for the judges’ decisions. If any of the judges uphold the state action, other states may try similar reductions for current retirees."