Of all the troublesome fiscal issues confronting states in recent years, the one most threatening to budgetary stability is the more than $1 trillion in unfunded liabilities accumulated in state and local public employee pension systems (see figure 3), plus at least $600 billion in obligations for postretirement health care.36 Even with the stock market’s robust gains in 2016 and 2017 helping to bolster retirement plan funding—and thus taking some financial pressure off policymakers—any significant market retrenchment will inevitably lead to more funding woes. That is of special concern to states ranking low in the Volcker Alliance’s assessment of how governments are dealing with legacy costs when they attempt to balance their budgets.
State and local governments have traditionally viewed promises of pension and other retiree benefits as a way to attract and retain employees for the long haul. Yet in weighing the need to fully fund retirement costs against the need to maintain general fund spending on roads, schools, universities, and public safety, states may end up taking shortcuts to achieve budgetary balance. When they decide not to pay the full amount that pension actuaries deem necessary to fund the promised retirement costs of current workers, along with liabilities run up for past underfunding, states push those costs—plus interest—onto future generations.
States and localities sometimes sell bonds to fund retirement costs, betting that any returns earned on the borrowed money will exceed interest payments to investors. The way that state and municipal governments calculate future pension liabilities also can affect the level of funding they provide. The discount rates used to estimate the present value of future liabilities typically reflect the high returns of past decades instead of the lower rates and returns prevailing in recent years. While the discount rates are based on estimates provided by a state retirement system’s actuaries, the Governmental Accounting Standards Board (GASB) obliges public pension plans whose assets are not expected to cover benefit payments to use a different rate on some liabilities that may be lower than the projected long-term rate of return. In the case of OPEB, states often set aside only minimal sums against their long-term liabilities and fund annual expenses on a pay-as-you-go basis.
These practices are so widespread across America that only eight states (Iowa, Idaho, Nebraska, Oklahoma, Oregon, South Dakota, Utah, and Wisconsin) received average grades of A from the Volcker Alliance on their legacy cost practices for fiscal 2015 through 2017.
The overall legacy cost grades were composed of separate grades for the way states handled pension and OPEB liabilities. The grades states received for pensions reflect their willingness to provide funding in line with actuaries’ recommendations, as well as the magnitude of any unfunded liabilities. The grades for OPEB reflect the ability to meet long-term costs by maintaining adequate funding or by keeping these retiree benefits low enough to obviate the need for long-term funding. (To maintain comparability among states regarding legacy costs, the Volcker Alliance relied on the approaches recommended by the GASB, even though some states use alternative approaches.)
We found that at various points over the three years studied, about twenty states contributed less to pension systems than the amount the plans’ actuaries recommended. Among those not making the full contribution for all three years were Hawaii, Illinois, Massachusetts, and New Jersey (although New Jersey municipalities, unlike the state itself, are obliged to contribute the full amount). The impact on state budgets of pension underfunding is evident. Before passing a budget in July 2017, Illinois went without one for more than two years as the legislature and governor fought over taxes and a menu of spending priorities limited by $119 billion in pension debt (as of June 30, 2016) and past-due vendor bills. A casualty of the long stalemate was the state’s credit rating, which Moody’s Investors Service downgraded to Baa3—one level above junk in June 2017.
Three states earning an A in the Reserve Funds category received D-minus grades from the Volcker Alliance for their handling of legacy costs. Hawaii, Texas, and Virginia all failed to make their full actuarially determined pension and OPEB contributions in all three years of the study. Under legislation passed in 2012, however, Virginia is scheduled to start making full contributions to pensions by fiscal 2019. Hawaii, meanwhile, is scheduled to begin making its full annual required contribution for OPEB in the same year under a law passed in 2013.
Some states have managed to keep up with their retirement funding obligations. The Nebraska Public Employees Retirement Board, which administers the state’s retirement plan, uses a conservative funding formula that led it to put $44 million into the plan’s fund in fiscal 2016, even though Nebraska’s actuaries had determined that slightly less than $30 million would be sufficient.
Unfunded pension liabilities tell only part of the story of states’ legacy costs. Unfunded OPEB liabilities also weigh on many states. In 2015, about four of five state government units offered OPEB to most employees not eligible for coverage under Medicare. About 70 percent provided a variety of retiree health benefits to former employees 65 and over, although who qualifies differs by state.
As with pensions, the amount states needed to fund these plans depended on a wide variety of issues relating to employee eligibility, the benefits offered, and actuaries’ assumptions. However, the significant difference between pension and OPEB liabilities is that the latter are often not subject to the same legal protections as pensions. This may allow states to improve the funding of retiree health plans by tightening eligibility requirements, reducing benefits, or increasing employees’ premium contributions.
Following are the two primary questions upon which the Volcker Alliance based its legacy cost evaluations:
- Was the contribution to the public employee pension fund effectively 100 percent of the actuarially required or determined amount? We assessed states’ pension-related performance by looking at their current pension funding ratio—a way to express the relationship of plan assets to promised obligations—as well as whether they made their full (or close to it) actuarially determined contribution (ADC) or actuarially required contribution (ARC) that year. The ADC or ARC, sometimes used interchangeably, denotes an amount that a retirement system’s actuaries have determined will adequately fund promised benefits accruing to current employees in a given year, as well as the cost of amortizing unfunded liabilities from past years.41 In fiscal 2016, sixteen states failed to make their full or close to full payment.
- Was the contribution to public employee OPEB effectively 100 percent of the ADC or ARC? A state received complete credit for making full or close to full ADC or ARC payments. Some states provide employees with little or no retiree health benefits, in which case there is little need for regular funding. The Volcker Alliance considered the contribution effectively 100 percent if the unfunded portion of the ADC or ARC was less than both $50 million and 0.5 percent of the budget. Eighteen states failed to meet that standard for OPEB contributions in every fiscal year studied.