ECONOMIC AND BUDGET ISSUE BRIEF

The Underfunding of State and Local Pension Plans

The recent financial crisis and economic recession have 

left many states and localities with extraordinary budgetary difficulties for the next few years, but structural shortfalls in their pension plans pose a problem that is likely to 

endure for much longer. This issue brief discusses alternative approaches to assessing the size of those shortfalls and 

the implications of those approaches for funding decisions:

B By any measure, nearly all state and local pension 

plans are underfunded, which means that the value of 

the plans’ assets is less than their accrued pension liabilities for current workers and retirees. 

B There are two leading approaches for valuing assets 

and liabilities, and the reported amount of underfunding varies significantly depending on which one is 

used.

B Decisions about how to address the underfunding 

can be informed by the choice between those two 

measurement approaches, but there is no necessary 

connection between the information provided by the 

two approaches and decisions about how much a 

plan’s sponsor should contribute each year. 

According to the Public Fund Survey of 126 state and 

local pension plans, which account for about 85 percent 

of pension assets and participants in state and local 

pension plans in the United States, those plans held 

roughly $2.6 trillion in financial assets in 2009 but had 

about $3.3 trillion in liabilities for future pension payments.1

 Thus, those assets covered less than 80 percent of 

liabilities, and unfunded liabilities (the amount by 

which liabilities exceed assets) amounted to roughly 

$0.7 trillion.2

 That share of liabilities covered by assets in 

2009 was the lowest percentage in the past 20 years (see 

Figure 1). By comparison, the amount of state and local 

governments’ debt that was outstanding at the end of 

2009 was $2.4 trillion.

That estimate of unfunded liabilities is calculated on the 

basis of actuarial guidelines currently followed by state 

and local governments. Another approach for measuring 

pension assets and liabilities, which more fully accounts 

for the costs that pension obligations pose for taxpayers, 

yields a much larger estimate of unfunded liabilities 

for those plans in 2009—between $2 trillion and 

$3 trillion.3

In any event, most state and local pension plans probably 

will have sufficient assets, earnings, and contributions to 

pay scheduled benefits for a number of years and thus 

will not need to address their funding shortfalls 

immediately. But they will probably have to do so eventually, and the longer they wait, the larger those shortfalls 

could become.4

 Most of the additional funding needed to 

cover pension liabilities is likely to take the form of 

higher government contributions and therefore will 

require higher taxes or reduced government services for 

residents. Additional funding for pension benefits already 

accrued is unlikely to come from current workers; state 

laws and court opinions indicate that efforts toward that

CBO A series of issue summaries from

the Congressional Budget Office

MAY 2011

1. Liabilities are measured as the present value of promised benefits. 

Present value is the value today of a series of payments made in the 

future, calculated by applying a discount rate to those payments. 

The lower the rate of discount, the higher the present value. 

2. See National Association of State Retirement Administrators, 

Public Fund Scorecard, available at www.publicfundsurvey.org/

publicfundsurvey/scorecard.asp (accessed March 22, 2011). The 

data do not include costs for retirees’ health care. 

3. See Alicia H. Munnell and others, Valuing Liabilities in State and 

Local Plans, Issue Brief 11 (Boston: Center for Retirement 

Research at Boston College, June 2010). For earlier estimates, see 

Robert Novy-Marx and Joshua D. Rauh, “The Liabilities and 

Risks of State-Sponsored Pension Plans,” Journal of Economic 

Perspectives, vol. 23, no. 4 (Fall 2009), pp. 191–210. 

4. For a listing of actions taken in 2010, see Ronald K. Snell, 

Pensions and Retirement Plan Enactments in 2010 State Legislatures

(National Conference of State Legislatures, November 23, 2010), 

available at www.ncsl.org/?TabId=20836.
2 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

Figure 1.

State and Local Governments’ Pension Assets as a Percentage of Liabilites, 

Calculated Using Guidelines Issued by GASB, 1990 to 2009

(Percent)

Source: Congressional Budget Office based on Alicia H. Munnell, Jean-Pierre Aubry, and Laura Quinby, The Funding of State and Local 

Pensions: 2009-2013, Issue Brief 10 (Boston: Center for Retirement Research at Boston College, April 2010).

Notes: Liabilities include pension benefits paid to retired employees, benefits earned by active employees on the basis of their current salaries and years of service, and the effect of future salary increases on the value of pension benefits already earned by current workers. 

The data are for fiscal years, plotted biannually for 1990 to 2000 and annually after that.

GASB = Government Accounting Standards Board.

end could be successfully challenged in court in the 

majority of states.5

Decisions about the amount and timing of the additional 

funding for underfunded plans will depend on many factors, including competing budgetary priorities, views on 

intergenerational fairness, and the amount of risk that 

plans’ sponsors are prepared to take. If the financial condition of state and local pension plans worsened, the federal government might be asked to assist in the funding 

of such plans. If granted, such assistance would raise the 

federal deficit and debt, unless offset by higher taxes or 

lower spending in other areas. 

State and Local Pension Plans 

States and localities play a significant role in the nation’s 

retirement system, representing 19 percent of all contributions by employers for employee retirement plans and 

28 percent of total pension assets. According to the most 

recent data from the Census Bureau, in fiscal year 2008 

there were 2,550 state and local retirement systems, and 

about 90 percent of the participants in those plans were 

covered by 218 state-administered plans. State plans 

include many local government employees (primarily 

teachers). Local plans generally cover police personnel 

and firefighters as well as general municipal employees. 

About 70 percent of state and local employees are also 

covered by Social Security.

Pension plans of state and local governments generally are 

defined-benefit plans, in which retirement benefits are 

determined by formula on the basis of factors such as the 

employee’s recent salary and total years of service.6

 For 

example, a plan might offer a pension benefit equal to 

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

0

60

70

80

90

100

110

5. See Amy B. Monahan, “Public Pension Plan Reform: The Legal 

Framework,” Education Finance and Policy, vol. 5, no.4 (March 

2010), pp. 617–646. 

6. Most pension plans in the private sector are defined-contribution 

plans, in which employers commit to annual payments toward 

employees’ retirement savings but not to a particular amount of 

benefits. 
ECONOMIC AND BUDGET ISSUE BRIEF

THE UNDERFUNDING OF STATE AND LOCAL PENSION PLANS 3

1 percent of a worker’s recent salary for each year of service. In that case, an employee retiring after 40 years of 

work with recent earnings averaging $50,000 would get 

an annual pension of $20,000. For most employees, benefit payments increase over time with inflation because of 

cost-of-living adjustments. 

Retirement benefits paid by state and local pension plans 

are financed by contributions from governments and 

employees and by income from plans’ assets. Contribution rates for employers and employees are usually set as 

a percentage of salaries. During 2010, the 100 largest 

state and local pension plans, which account for almost 

90 percent of the assets of all state and local plans, collected about $117 billion in contributions ($81 billion 

from governments, or about 4 percent of total state and 

local spending, and $35 billion from employees) and paid 

out $183 billion in benefits.7

 Investment earnings 

amounted to $267 billion.

At the end of 2010, the largest 100 plans held assets of 

roughly $2.6 trillion (or 14 times the benefit payments 

made in that year); corporate stocks and international 

securities accounted for about half of the investments.8

Recent data indicate that the median annualized return 

on public pension plans with assets of more than $1 billion averaged 9 percent (roughly 6 percent after subtracting inflation) for the 25-year period extending through 

2010. In 2010, the median return for those plans was 

13 percent, compared with losses of 26 percent in 2008 

and gains of 20 percent in 2009.9

Most jurisdictions have guidelines or laws that call for 

additional contributions to their pension plans when 

assets are less than liabilities, but no federal laws or regulations govern how states and localities are to respond 

when plans are underfunded. Actuaries for the plans 

determine each year how much contributions would need 

to rise (above contributions for “normal costs”—those 

resulting from benefits accrued during the current year) 

in order to eliminate (amortize) the shortfall of assets relative to liabilities steadily over a period of time, generally 

15 to 30 years. However, payments by many states and 

localities have been lower than called for by their guidelines—especially in times of budgetary stress.10

Two Approaches to Measuring the 

Underfunding of Pension Plans

The approach used to measure pension plans’ liabilities 

and assets can significantly affect assessments of the adequacy of funding. Future obligations can be measured 

more or less broadly, and their current value is very sensitive to the discount rate that is used to cumulate the obligations.11 The two leading approaches—guidelines issued 

by the Government Accounting Standards Board 

(GASB), which is the organization that specifies the 

accounting practices generally followed by states and 

localities, and the fair-value method, which generates estimates of funding that are more comparable to those 

reported by the corporate sector—often give very different pictures of funding status, primarily because they use 

different discount rates. The GASB and fair-value 

approaches also differ in their treatment of assets, but 

that difference does not have a systematic effect on estimates of underfunding. 

GASB Guidelines

Under the guidelines provided by GASB, actuaries compute liabilities by discounting future benefit payments 

using a discount rate based on the expected rate of return 

on the plans’ assets. (Currently, the median of pension 

plans’ assumptions for future returns on state and local 

7. Census Bureau, Finances of Selected State and Local Government pension assets is about 8.0 percent, or 4.5 percent after 

Employee Retirement Systems, Table 2, “Receipts, Benefits, and 

Withdrawal Payments of Major Public Employee Retirement 

Systems,” available at www.census.gov/govs/qpr/.

8. Census Bureau, Finances of Selected State and Local Government 

Employee Retirement Systems, Table 1, “Cash and Security 

Holdings of Major Public Employee Retirement Systems, by 

Type,” available at www.census.gov/govs/qpr/. 

9. National Association of State Retirement Administrators and the 

National Council on Teacher Retirement, Strong Investment Gains 

and Legislative Changes Speeding Public Pension Recovery, NASRA/

NCTR Issue Brief (April 2011).

10. Most of the shortfalls result from limits placed by state and local 

governments on the amount of such contributions. See Alicia H. 

Munnell and others, Why Don’t Some States and Localities Pay 

Their Required Pension Contributions? Issue Brief 7 (Boston: 

Center for Retirement Research at Boston College, May 2008).

11. Estimates of liabilities also depend to some extent on the factors 

that are included in calculating future benefits. In broad terms, 

actuarial methods differ in whether or not they take into account 

projected salary increases for current workers and their future 

years of service.
4 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

removing the effect of the median assumed rate of inflation.)12 That approach provides a measure of the amount 

that must be invested in assets earning the expected rate 

of return, on average, in order to cover future payments. 

The guidelines also allow the reported value of assets to 

be an average of the market value of assets over several 

years, so as to blunt the impact of a large swing in the 

value of equity holdings in a single year.13

According to the Public Fund Survey, the average funded 

ratio (that is, assets as a percentage of liabilities, or the 

percentage of liabilities that is funded by those assets) for 

the sample of 126 large plans was 78 percent in 2009; the 

value of the assets was about $0.7 trillion less than the 

value of the liabilities.14 Of those plans, 21 had funded 

ratios above 90 percent, and 26 were between 80 percent 

and 90 percent.15 At the other end of the spectrum, 

8 plans had funded ratios below 50 percent: the Illinois 

State Employees Retirement System (at 43 percent), the 

Connecticut State Employees Retirement System (at 

44 percent), the Illinois State Universities Retirement 

System (at 46 percent), the West Virginia Teachers 

Retirement System (at 47 percent), the Kentucky 

Employees’ Retirement System (at 47 percent), the Missouri Department of Transportation and Highway Patrol 

Employees Retirement System (at 47 percent), the Indiana State Teachers Retirement Fund (at 48 percent), and 

the Illinois Teachers Retirement System (at 48 percent).

Fair-Value Approach

The fair-value approach aims to measure the market value 

of an asset or liability:16

B For assets, the fair value is what an investor would be 

willing to pay for them—that is, the current market 

value (or an estimate when market values are unavailable); it is not the averaged, or smoothed, market values that are reported under GASB guidelines. 

B For pension liabilities, the fair value can be thought of 

as what a private insurance company operating in a 

competitive market would charge to assume responsibility for those obligations. 

In the case of state and local pension plans, the discount 

rate for future benefit payments using the fair-value 

approach is lower—and, therefore, the estimated present 

value of those payments is higher—than under the GASB 

approach. Under the fair-value approach, future cash 

flows are discounted at a rate that reflects their risk characteristics. Hence, for pension liabilities, the discount rate 

reflects the fact that the cash flows associated with 

accrued liabilities are fixed and carry little risk; it is very 

unlikely that the liabilities will not be honored.17 (By 

contrast, under the GASB approach, the discount rate 

used for liabilities reflects the greater risk associated with 

pension funds’ assets.) Under the fair-value approach, one 

way to approximate the discount rate applied to future 

12. An assumed rate of inflation lower than the median assumption of 

3.5 percent reported in the Public Fund Survey would tend to 

lower the expected nominal rate of return on assets and thus 

increase the present discounted value of pension obligations. 

However, it would also reduce the nominal growth of wages and 

benefit accruals and would result in lower projected cost-of-living 

adjustments to benefit payments.

13. In June 2010, GASB expressed preliminary views on potential 

changes to its guidelines for accounting and reporting issues. For 

assets, reported values would be current market values; assets 

would no longer be valued using prices that are averaged over several years. For liabilities, the discount rate would be a weighted 

average of expected returns on a portfolio and the rate of an index 

for high-quality municipal bonds, with the weights determined by 

how many years of benefits were funded and unfunded. The 

municipal bond rate would get more weight when there were relatively more unfunded years. The approach is roughly equivalent to 

using expected returns on assets to discount liabilities covered by 

those assets and using a municipal bond rate to discount liabilities 

that would be paid after the assets were exhausted. 

14. See National Association of State Retirement Administrators, 

Public Fund Survey, www.publicfundsurvey.org/publicfundsurvey/

memberslogin.asp. Updated data are available upon registering at 

this Web site. For 74 of the plans, the data are for fiscal year 2009; 

for 51 of the plans, for fiscal year 2010; and for one of the plans, 

for fiscal year 2008.

15. The tally does not include six plans that use accounting methods 

that do not produce measures of unfunded liabilities and, by definition, imply funding ratios of 100 percent. 

16. See Financial Accounting Standards Board, Fair Value Measurement, Statement No. 157 (September 2006), p. 2.

17. See Jeffrey R. Brown and David W. Wilcox, “Discounting State 

and Local Pension Liabilities,” American Economic Review, vol. 99, 

no. 2 (May 2009), pp, 538–542.
ECONOMIC AND BUDGET ISSUE BRIEF

THE UNDERFUNDING OF STATE AND LOCAL PENSION PLANS 5

Table 1.

State and Local Governments’ 

Unfunded Pension Liabilities Under 

Alternative Discount Rates, 2009

(Trillions of dollars)

Source: Congressional Budget Office based on Alicia H. Munnell 

and others, Valuing Liabilities in State and Local Plans,

Issue Brief 11 (Boston: Center for Retirement Research at 

Boston College, June 2010).

Note: Unfunded liabilities are the current value of promised 

benefits minus assets in 2009. Liabilities include pension 

benefits paid to retired employees, benefits earned by active 

employees on the basis of their current salaries and years of 

service, and the effect of future salary increases on the value 

of pension benefits already earned by current workers.

benefit payments is by using the interest rate on municipal securities (adjusted to remove the effect of tax deductibility): In 2010, the discount rate would have been about 

half as large as the median discount rate of 8 percent 

under the GASB guidelines. (For additional discussion of 

discount rates, see Box 1 on page 6.) 

A study published last year that examined the sensitivity 

of estimates of underfunding to discount rates for pension plans in the Public Fund Survey illustrates the 

large difference between the GASB and fair-value 

approaches.18 Unfunded liabilities in 2009 amount 

to about $0.7 trillion when liabilities are discounted at 

8 percent but total $2.2 trillion when liabilities are discounted at 5 percent and $2.9 trillion when they are 

discounted at 4 percent (see Table 1). Those unfunded 

liabilities, as calculated on a fair-value basis, indicate 

funded ratios of roughly 55 percent and less than 50 percent, respectively. 

The Visibility of Costs

The GASB and fair-value approaches differ in what they 

tell a plan’s managers, its participants, and the public 

about the costs of a pension system, including the cost of 

the risk to taxpayers that the rate of return on risky pension assets may not meet expectations. By using the 

expected rate of return on assets as the discount rate for 

converting future benefit payments into today’s dollars, 

the GASB approach essentially assumes that those returns 

are as certain as benefit payments, at least in the long run. 

By contrast, the fair-value approach views the returns on 

assets as more uncertain than the benefit payments, even 

in the long run; under that approach, the rate of return 

on assets is not suitable for discounting pension benefits. 

By accounting for the different risks associated with 

investment returns and benefit payments, the fair-value 

approach provides a more complete and transparent measure of the costs of pension obligations.19

Some proponents of the GASB approach argue that, 

although rates of return on assets in some periods may be 

lower than those necessary to cover future obligations, 

those periods will tend to be offset by others in which the 

returns will be higher, so the historical average return is 

fairly certain. They believe that sponsors of plans can wait 

out the periods of losses or low returns and still pay full 

benefits by allowing the fund balances to temporarily 

decline because governments do not have the finite planning horizons that individuals do. Consequently, under 

this view, it is appropriate to use an average expected 

return when informing the public about the financial 

condition of public-sector pension funds.20

However, even over very long periods, higher returns 

on risky investments are not a sure thing.21 Although a 

strategy of investing in relatively risky assets produces 

18. See Alicia H. Munnell and others, Valuing Liabilities in State and 

Local Plans. Those estimates incorporate projected increases in salaries but not projected increases in years of service. The sensitivity 

of the size of unfunded liabilities to alternative discount rates also 

is shown in Robert Novy-Marx and Joshua D. Rauh, “The Liabilities and Risks of State-Sponsored Pension Plans.”

Discount Rate Amount Unfunded

4 Percent 2.9

5 Percent 2.2

6 Percent 1.6

8 Percent 0.7

19. The fair-value approach also gives a more complete picture of the 

costs of changes in policy, to the extent that such changes would 

affect pension benefits (and possibly wages) for current employees. 

See Joshua Rauh and Robert Novy-Marx, “Policy Options for 

State Pension Systems and Their Impact on Plan Liabilities,” 

Working Paper No. 16453 (Cambridge, Mass.: National Bureau 

of Economic Research, October 2010).

20. For example, see Dean Baker, The Origins and Severity of the Public 

Pension Crisis (Washington, D.C.: Center for Economic and Policy Research, February 2011). 

21. See Lubos Pastor and Robert F. Stambaugh, Are Stocks Really Less 

Volatile in the Long Run? Working Paper No. 14757 (Cambridge, 

Mass.: National Bureau of Economic Research, February 2009).
6 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

Continued

higher returns on average, compared with a strategy of 

investing in relatively safe assets, there is no certainty of 

obtaining higher returns for a particular portfolio or over 

any given period of time. Those potential higher returns 

would be obtained by imposing added risk on taxpayers—particularly the risk of experiencing severe losses 

during protracted economic downturns—which represents an equal and offsetting cost.22 Such long-run risk, 

which investors view as costly, is reflected in the premium 

that investors require to bear it.23 Fair-value measures 

account for that cost.

Box 1.

Selecting Discount Rates for Measuring Pension Plans’ Liabilities

A market valuation of any future cash flows, which is 

the basis of the notion of fair value, depends on the 

risks associated with those cash flows. For example, 

the market value of a corporate bond is the present 

discounted value of the bond’s expected principal and 

interest payments. The discount rate for those 

expected flows is the bond’s expected rate of return, 

which reflects the time value of money and the market’s assessment of the various risks of owning that 

bond, including the risk that the company will fail 

to make all of the payments on the bond.1

 By using 

the expected return on a pension plan’s assets to discount future payments to beneficiaries, the guidelines 

issued by the Government Accounting Standards 

Board (GASB) implicitly reflect an assumption that 

the risk to workers that states and localities will fail to 

pay future retirement benefits is the same as the risk 

that expected returns on the plan’s assets will not be 

realized. 

In fact, because the risk to future payments to beneficiaries is generally much less than the risk to the 

returns on typical assets held by pension plans, standard financial principles of valuation suggest that 

future benefit payments be discounted at a lower rate 

than under GASB’s guidelines. Under the legal 

framework in most jurisdictions, the accrued benefits 

of current workers and retirees are obligations of the 

government and, therefore, like most municipal 

bonds, have a low likelihood of not being paid. 

Moreover, because state and local pension payments 

are based on wages, they are less risky than would be 

the case if they were based on measures more closely 

related to the stock market, for example. Under an 

assumption that the risk of a state or local government’s defaulting on its obligations to pensioners is 

the same as the risk of its defaulting on its debt, the 

appropriate discount rate for obligations already 

accrued would be approximately the interest rate on 

state and local debt, adjusted for the fact that it is taxexempt and pension benefits are not.2

 With that 

1. In addition to the risk of default, risks posed by inflation and 

a lack of liquidity should be taken into account when selecting an appropriate discount rate. So should “market risk,” 

which is the risk that losses will be greatest during times of 

economic stress (when such losses are more burdensome). 

Creditors require a risk premium—an expected return in 

excess of a risk-free rate—as compensation for assuming such 

risks.

2. However, a factor that tends to lower the risk of default on 

pension plans’ obligations relative to that risk for general 

obligation bonds is that the pension plans’ obligations have 

more collateral backing them than do state and municipal 

bonds. (In 1975, for example, New York City defaulted on its 

debt but continued to make its pension payments.) For jurisdictions with relatively poor credit ratings, the interest rates 

on municipal bonds would be relatively high, and relatively 

high discount rates would be appropriate; however, applying 

higher rates would lower the discounted value of liabilities, 

thus effectively rewarding those jurisdictions for having bad 

credit ratings. 

22. Even if those losses would not immediately result in higher taxes 

or reduced government services, the losses from a reduction in the 

market value of assets are equivalent to borrowing from the pension plan, and that debt eventually would need to be repaid. 

23. See Zvi Bodie, On the Risk of Stocks in the Long Run. Working 

Paper No. 95-013 (Cambridge, Mass.: Harvard Business School, 

December 1994), available at the Social Science Research 

Network, http://ssrn.com/abstract=5771.
ECONOMIC AND BUDGET ISSUE BRIEF

THE UNDERFUNDING OF STATE AND LOCAL PENSION PLANS 7

In addition, by not smoothing asset values over time, the 

fair-value approach provides a clearer view of the fluctuations that can occur in long-term funding needs when 

risky assets are used to finance fixed pension obligations. 

By making the mismatch in risk between assets and liabilities more transparent, the fair-value approach also may 

discourage risk taking on the part of fund managers.

Implications for Funding Pension 

Plans

State and local governments are experiencing extraordinary budgetary pressures as the result of the recent financial crisis and economic recession, and for some jurisdictions the need to address the underfunding of their 

pension plans adds to those pressures. By indicating a 

larger amount of underfunding, adopting a fair-value 

approach in reporting pension plans’ finances could 

indicate a need for a significant increase in funding, 

which would further strain government budgets—despite 

the fact that, on average, a much smaller increase in funding might turn out to be sufficient to cover pension plans’ 

liabilities. Moving to a fair-value approach could also 

increase the volatility in reported underfunding and, 

therefore, in funding requirements, making budgeting for 

the required contributions more difficult.24

Box 1. Continued

Selecting Discount Rates for Measuring Pension Plans’ Liabilities

adjustment, the appropriate nominal discount rate in 

2010 would have been about 4 percent, or approximately half the discount rate used by most state and 

local pension plans.3

 Four years earlier, in 2006, that 

rate would have been higher (about 5 percent). 

The appropriate discount rate for future benefit payments can be affected by the way that pension systems project future obligations for benefits because 

different projection methods can indicate differences 

about the risk to those payments. Most systems use a 

broader measure than current accruals as the basis for 

obligations—one that includes employees’ future 

years of service and sometimes includes projected salary increases. One consideration is that the future 

benefits not yet accrued by current employees are less 

certain than those already accrued. Recently, in some 

states, the formulas determining future benefits for 

current employees have been modified (for instance, 

in Colorado, Minnesota, and South Dakota). 

Whether those actions will stand depends on the outcomes of current challenges in the courts.4

 Also, 

uncertainty about the legislated growth of future salaries introduces risk about the level of benefits tied to 

those salaries, especially for younger workers, whose 

benefits are mostly not yet accrued. For measures of 

future benefit payments that involve such uncertainties, the principle of using a discount rate that reflects 

the risk to the payments suggests using a slightly 

higher discount rate than the rate on tax-adjusted 

municipal bonds but still one that is considerably less 

3. On average in 2010, the interest rate on a tax-exempt 10-year than the expected returns on pension plans’ ass

AAA-rated municipal bond was roughly 3.0 percent, down 

from 3.9 percent four years earlier. For additional discussion 

of using taxable rather than tax-exempt municipal bond 

rates, see Robert Novy-Marx and Joshua D. Rauh, “The 

Liabilities and Risks of State-Sponsored Pension Plans,” 

Journal of Economic Perspectives, vol. 23, no. 4 (Fall 2009), 

pp. 191–210.

4. Justus v. Colorado, 2010-CV-1598 (Colo. Dist. Ct. 

February 26, 2010); Swanson v. Minnesota, 62-CV-10-05285 

(Minn. Dist. Ct. May 17, 2010); and Tice et al. v. South 

Dakota et al., Civ. No. 10-225 (6th Cir. S.D. June 15, 2010).

24. Such volatility, it has been argued, could lead to fewer and fewer 

defined-benefit pension plans. See Norman L. Jones, Brian B. 

Murphy, and Paul Zorn, “Actuarial Methods and Public Pension 

Funding Objectives: An Empirical Examination” (paper presented 

at the Public Pension Finance Symposium, Chicago, Illinois, 

May 18–19, 2009). 
8 CONGRESSIONAL BUDGET OFFICE

ECONOMIC AND BUDGET ISSUE BRIEF

However, there is no necessary connection between the 

information provided by the fair-value approach and the 

determination of a sponsor’s annual contributions to the 

plan, which could be calculated on a different basis. For 

instance, to take into account the higher expected returns 

on riskier portfolios, annual contributions could continue 

to be based on the GASB guidelines for measuring liabilities, and volatility in annual contributions could be 

reduced by basing contributions on shortfalls averaged 

over several years.25 If adequately funded, such a strategy 

would offer a significant likelihood that a plan’s assets 

would be sufficient to cover its liabilities, but that strategy 

would be accompanied by the risk of a significant shortfall that could burden future taxpayers.

Reducing Underfunding 

Underfunding can be reduced either by decreasing pension plans’ liabilities or by increasing their assets. Reducing liabilities essentially means lowering the present value 

of lifetime benefits (though not by just raising the discount rate). Some states have begun to offer less generous 

packages to new employees. In some cases, new employees will be required to make larger contributions, accept 

less favorable benefit formulas (possibly supplemented by 

moving to coverage under the Social Security system), 

shift partly to defined-contribution plans, or work more 

years before becoming vested.26 Those changes, however, 

will not reduce the underfunding that currently exists 

because it derives from promises to current and former 

employees, not from potential promises to future 

employees. A few states have proposed or taken actions 

that would affect current workers (and possibly retirees) 

as well as prospective employees; for instance, Colorado, 

Minnesota, and South Dakota have changed formulas for 

cost-of-living adjustments. Those actions are being challenged in court. 

Increasing plans’ assets requires raising contributions 

from current workers, raising government contributions, 

or earning more on investments. The legal framework 

that governs state pension plans—the constitutional and 

statutory provisions and the legal precedents that are 

applicable—suggests that, in most states, increases in 

contributions to address underfunding will probably be 

borne by employers, not employees.27 Larger government 

contributions, in turn, will need to be financed either by 

raising taxes or by reducing other spending by state and 

local governments (including employees’ salaries). Alternatively, managers of pension plans can seek faster growth 

in their assets through higher expected returns by increasing the share of risky assets in their portfolios. Whether 

that strategy is good public policy has been the subject of 

debate.28 

Some jurisdictions have sought to raise pension plans’ 

revenues by borrowing to invest in equities. For instance, 

some jurisdictions have sold pension obligation bonds 

and invested the proceeds in equities and other risky 

securities. Such a transaction is expected to generate 

future income, because it involves investing in assets that 

have expected returns in excess of the interest rate paid on 

the bonds underlying pension plans’ obligations.29 However, the transaction does not alter the value of pension 

plans’ assets, because it simply exchanges safe claims (the 

bonds) for risky ones (equities and other securities) of

25. Volatility also could be reduced by shifting assets away from risky 

equities and toward bonds that posed low risk and that had promised cash flows similar to those of the projected obligations.

26. Often workers have to remain employed for some minimum 

number of years before they become vested, which means that 

they have a right to receive benefits under the plan.

27. Nevertheless, some states and localities with relatively weak protections for pensions may be able to raise contribution rates for 

current employees for future benefits not yet earned. Another possibility would be to slow the growth of employees’ pay, but that 

step would not affect estimates of state and local pension plans’ 

liabilities unless actuarial assumptions about the projected growth 

in salaries were also adjusted downward. Moreover, benefits paid 

to people who have already retired would not be altered as a result. 

28. See Lawrence N. Bader and Jeremy Gold, “The Case Against 

Stock in Public Pension Funds,” Financial Analysts Journal, 

vol. 63, no. 1 (January/February 2007), pp. 55–62. See also 

Deborah J. Lucas and Stephen P. Zeldes, “How Should Public 

Pension Plans Invest?” American Economic Review Papers and 

Proceedings, vol. 99, no. 2 (May 2009), pp. 527–532. 

29. Another rationale for using pension obligation bonds is to postpone raising taxes or cutting services—to avoid such actions 

during a recession, for instance. That step also has the effect of 

shifting some of the burden of paying for pensions onto later 

generations.
ECONOMIC AND BUDGET ISSUE BRIEF

THE UNDERFUNDING OF STATE AND LOCAL PENSION PLANS 9

equal market value.30 Although the average return is 

higher on the risky investments, there is a significant risk 

that returns could fall below the cost of servicing the 

additional debt from the bonds. Because those bonds are 

ultimately backed by tax revenues, future taxpayers bear 

the risk of losses.

Although the amount of underfunding of state and local 

pensions is substantial, it is not necessarily in the best 

interests of taxpayers for states and localities to completely prefund their pension liabilities. Ultimately, judgments about the amount and timing of additional funding that should be provided for underfunded plans 

depend on many factors, including competing budget 

priorities, views about intergenerational fairness, and the 

amount of risk the sponsors are prepared to take that they 

(and their taxpayers) might have to bear substantial costs 

at some point in the future in order to pay promised benefits.31 It is generally agreed that the costs—including 

pension costs—of current services provided by state and 

local governments should be borne by those who benefit 

from those services and not shifted to future generations 

of taxpayers, as has already occurred because of underfunding by previous taxpayers.32 However, the services 

provided by school teachers, for example, might be justifiably financed, at least in part, by future taxes on people 

who are now students.33 Despite those considerations, 

employee compensation packages currently may be substantially distorted by political pressures to favor deferred 

compensation—to raise pension benefits and postpone 

the associated costs to taxpayers until some future time.34

32. An important issue is how costs shifted by previous taxpayers 

should be distributed between current and future taxpayers. The 

shifting of costs from one generation to another is mitigated to the 

extent that underfunding pension plans lowers current property 

values, as residents move to other places to avoid anticipated 

increases in taxes or reductions in public services. 

33. However, in a mobile society, the people paying future taxes in a 

particular state may not be the students there today. 

34. The optimal level of funding also may change over the course of 

the business cycle. In particular, because a stable tax rate is considered less distortionary than one that frequently changes, underfunding may be preferable to full funding in times of economic 

downturns because the underfunding would avoid the need to 

raise tax rates in bad times.

30. Because of federal restrictions to prevent tax arbitrage (that is, 

investment strategies that attempt to profit by exploiting the price 

differences between tax-free and taxable bonds), pension obligation bonds are not exempt from federal taxes. 

31. For contrasting views emphasizing lower and higher funding levels, respectively, see Henning Bohn, Should Public Retirement 

Plans be Fully Funded? Working Paper No. 16409 (Cambridge, 

Mass.: National Bureau of Economic Research, September 2010) 

and Stephen P. C’Arcy, James H. Dulebohn, and Pyungsuk Oh, 

“Optimal Funding of State Employee Pension Systems,” Journal of 

Risk and Insurance, vol. 66, no. 3 (September 1999), pp. 345–380.

This brief was prepared by Frank Russek. It and other 

CBO publications are available at the agency’s Web site 

(www.cbo.gov).

Douglas W. Elmendorf

Director