According to a new report from the American Legislative Exchange Council (ALEC), unfunded state pension liabilities are the highest they’ve ever been at $8.28 trillion. According to ALEC, California alone has over $1.5 trillion in risk-free unfunded liabilities. ALEC reports:
Unfunded state pension liabilities total $8.28 trillion or just under $25,000 for every man, woman and child in the United States. This is an unprecedented amount in the history of this report, but most of the change is the result of a decrease in the risk-free discount rate, caused by the decrease in U.S. Treasury note yields. State governments are obligated, often by contract and state constitutional law, to make these pension payments regardless of economic conditions. As these pension payments continue to grow, revenue that could have gone towards tax relief or essential services like public safety and education is spent paying off these liabilities instead.
Unfunded liabilities have increased by $2.45 trillion in this year’s report due to several factors:
This study uses a risk-free discount rate, expressed as a percent, to determine the value of liabilities that pension plans must pay in the future. The “riskfree” aspect of our discount rate calculation follows the reality that states cannot default on their pension promises. This risk-free discount rate is based upon the yields of the 10-year and 20-year U.S. Treasury bonds, which means the rate changes each year. With the financial reporting data from 2021, the risk-free discount rate lowered from 2.34% to 1.13%, in part due to historically low interest rates driving down treasury note yields and drastically increasing the present value of liabilities. It is reasonable to expect that as interest rates rise in response to inflation, treasury yields will increase, increasing the risk-free discount rate and returning unfunded liability amounts closer to previous report estimates.
To account for unexpected fluctuations in the risk-free discount rate, this report also measures liability values with a fixed discount rate of 4.5% to account for these changes in the riskfree discount rate. Using the ALEC fixed discount rate of 4.5%, unfunded liabilities total just over $2 trillion.
FY 2020 saw a slight increase in the number of retirees and a slight decrease in the number of active members contributing to pension systems.
Most state pension plans are structured as defined benefit plans, where an employee receives a fixed payout at retirement based on a calculation of the employee’s final average salary, the number of years worked and a benefit multiplier. Pension plans pay these benefits to millions of public workers across the country. These plans accrue assets through employee contributions, employer contributions (tax revenue) and by taking on debt to pay pension promises. Several states, however, have defined contribution options, such as a 401(k) or other individual retirement account options.
States are obligated to pay pension promises, often by state constitution or statute. There are important reforms that can prevent unfunded liabilities from growing in the future. By offering new employees sustainable plans, such as hybrid and defined contribution plans—similar to how 401(k) plans work in the private sector—states can prevent the rapid growth of unfunded liabilities. Pension reforms that move in the direction of defined contribution systems give public workers greater flexibility with their retirement contributions, plus the ability to take their retirement savings with them to new jobs.
Your Survival Guy has written in the past (see here, here, here, and here) about how the overly optimistic assumptions used by state pension fund managers to avoid putting even more taxpayer into the funds are making the funds themselves weak. ALEC writes that “poor assumptions make poor pensions.” They explain:
State government balance sheets are experiencing increased pressure from growing pension liabilities. This pressure is becoming more apparent with improved financial reporting. The Governmental Accounting Standards Board (GASB) statements 67 and 68 went into effect in FY 2014 and 2015, respectively. These changes were discussed extensively in Unaccountable and Unaffordable, 2019.1 As summarized by Eileen Norcross and Sheila Weinberg,
“The implementation of GASB 67 and 68 was intended to improve the accuracy and transparency of pension reporting for US public sector plans. To date, the standards have had a mixed effect. State and local governments are now required to report the unfunded pension liability as part of their overall fiscal position, providing a more accurate assessment of fiscal health. The underlying assumptions used to measure pension obligations continue to need improvement.”2
Most pension plans use historical trends to estimate future conditions of assets and liabilities.3 Past returns, however, are no guarantee of future performance. As state pension plans invest their funds in increasingly risky assets, the gap between expected rates of return and actual rates of return widens, with results falling far short of expectations. When investment returns fail to meet expectations, taxpayers and plan members must make up the difference through increased contributions.
To reflect terminology used in most pension plans, this report refers to the fiduciary net position (FNP) when discussing the value of assets and the total pension liability (TPL) to discuss the value of liabilities. Even with market rebounds in the fall of 2020, actual investment returns still fell short of most plan assumed rates of return. As this report shows, pension plans cannot invest their way out of the unfunded liabilities.
Action Line: If your state is promising more than it can deliver to its retired employees, you will see problems creeping up. See ALEC’s entire report here. If your state is promising more than it can deliver, maybe it’s time you looked for a better America. Click here to sign up for my free monthly Survive & Thrive letter, and I’ll help you find the America that’s right for you.
E.J. Smith - Your Survival Guy
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