Unfunded pension liabilities are worse than we thought
State Budget Solutions just released a new report analyzing the funding status of pension systems across the country. The news is far from good. The report, which incorporates data from more than 250 pension plans in all 50 states, estimates pension funding levels far more realistically than the plan administrators themselves do.
The standard method, employed by almost all state and local governments, is based on an optimistic assumed rate of return on the plan’s investments—typically 7-8% annually. Before the financial crisis, meeting these figures seemed reasonable enough. But once the market downturn began, pension systems became unable to meet their return targets; on top of this, the gains they had made before the downturn were largely erased. Nonetheless, pension administrators continue to use these rosy growth projections in order to lend their plans at least the appearance of financial stability.
And even using administrators’ preferred projections, the outlook for pension systems looks worrisome. In the best case scenario, the 250+ plans that State Budget Solutions analyzed would be 72.5% funded, with $1 trillion in unfunded liabilities.
But State Budget Solutions applies a more realistic rate of return, based on fair market valuation of the assets held by the plans rather than the seemingly arbitrary rates used by the plans themselves. SBS used the average 15-year Treasury bond yield over 2013 (2.734%) as an assumed rate of return. With this approach, the combined 250 plans are underfunded by a whopping $4.7 trillion, and are funded at a meager 36%.
There is significant variance on a state-by-state level. The best-funded system in the country, Wisconsin, is only two-thirds funded. Illinois, unsurprisingly, performs the worst overall: it has the second-highest unfunded liability in the country ($330 billion), the worst funding ratio (22%), and the second worst unfunded liability per capita ($25,000 for every resident of the state).
If the standard return assumptions used by pension administrators are too optimistic, perhaps State Budget Solutions’ 2.734% is too pessimistic. After all, pension systems are, for better or worse, exposed to much more than T-bonds. They invest in office buildings, hedge funds, and a variety of other assets. The returns on these (riskier) investments may well exceed 2.734%, but of course, they may also fall significantly below 0% per year. The SBS report might overstate its point to some degree, but the point nonetheless is well taken. Pension administrators dramatically underestimate the funding challenges they face. And in the midst of a tenuous and fragile economic recovery, rosy growth outlooks seem almost as disconnected from reality as they did in 2008.
Ultimately, pension administrators grapple with enormous and contractually-bound liabilities; it is their responsibility to base their projections on cautious estimates rather than the assumption of best-case scenario economic performance year after year. When administrators assume conservative returns, being wrong is good news, and if pension systems could use anything right now, it’s good news.