State and Local Government Retiree Benefits: Current Funded Status of Pension and Health Benefits
Published: 2008-01-29T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Pension and other retiree benefits for state and local government employees represent liabilities for state and local governments and ultimately a burden for state and local taxpayers. Since 1986, accounting standards have required state and local governments to report their unfunded pension liabilities. Recently, however, standards changed and now call for governments also to report retiree health liabilities. The extent of these liabilities nationwide is not yet known, but some predict they will be very large, possibly exceeding a trillion dollars in present value terms. The federal government has an interest in assuring that all Americans have a secure retirement, as reflected in the federal tax deferral for contributions to both public and private pension plans. Consequently, the GAO was asked to examine: 1) the key measures of the funded status of retiree benefits and 2) the current funded status of retiree benefits. GAO analyzed data on public pensions, reviewed current literature, and interviewed a range of experts on public retiree benefits, actuarial science, and accounting.
section_title: What GAO Found
paragraphs: Three key measures help to understand different aspects of the funded status of state and local government pension and other retiree benefits. First, governments' annual contributions indicate the extent to which governments are keeping up with the benefits as they are accumulating. Second, the funded ratio indicates the percentage of actuarially accrued benefit liabilities covered by the actuarial value of assets. Third, unfunded actuarial accrued liabilities indicate the excess, if any, of liabilities over assets in dollars. Governments have been reporting these three measures for pensions for years, but new accounting standards will also require governments to report the same for retiree health benefits. Because a variety of methods and actuarial assumptions are used to calculate the funded status, different plans cannot be easily compared. Currently, most state and local government pension plans have enough invested resources set aside to keep up with the benefits they are scheduled to pay over the next several decades, but governments offering retiree health benefits generally have large unfunded liabilities. Many experts consider a funded ratio of about 80 percent or better to be sound for government pensions. We found that 58 percent of 65 large pension plans were funded to that level in 2006, a decrease since 2000. Low funded ratios would eventually require the government employer to improve funding, for example, by reducing benefits or by increasing contributions. However, pension benefits are generally not at risk in the near term because current assets and new contributions may be sufficient to pay benefits for several years. Still, many governments have often contributed less than the amount needed to improve or maintain funded ratios. Low contributions raise concerns about the future funded status. For retiree health benefits, studies estimate that the total unfunded actuarial accrued liability for state and local governments lies between $600 billion and $1.6 trillion in present value terms. The unfunded liabilities are large because governments typically have not set aside any funds for the future payment of retiree health benefits as they have for pensions.

section_title: Letter
paragraphs: Nearly 20 million employees and 7 million retirees and dependents of state and  local governments—including school teachers, police, firefighters, and other  public servants— are promised pensions, and many are promised retiree health  benefits. Many of these benefits are guaranteed by state law or contract and  represent actuarial accrued liabilities for state and local governments and  ultimately the taxpayer. Typically, pension benefits are paid from a fund made  up of assets from employers’ and employees’ annual contributions and the  investment earnings from those contributions. Such a fund has an unfunded  liability when the actuarial value of assets is less than actuarial accrued  liabilities. Accounting standards have called for state and local governments to  report their unfunded pension liabilities since 1986. But accounting standards  have only recently been established that call for reporting the size of unfunded  retiree health liabilities. While few state and local governments have as yet  officially reported these unfunded liabilities, some studies have estimated that  they may exceed $1 trillion dollars nationwide in present value terms. Such  estimates raise concerns about the fiscal challenges that state and local  governments will face in the coming decades. As discussion of the unfunded  liabilities of state and local governments has increased, questions have been  raised by some about how to understand these amounts.
State and local retiree benefits are not subject, for the most part, to the federal  funding requirements that apply to pensions sponsored by private employers.  Nevertheless, the federal government has an interest in assuring that all  Americans have a secure retirement, as reflected in the federal tax deferral for  contributions to both public and private pension plans. Given the concerns  about unfunded liabilities for state and local retiree benefits, we are reporting  on: 1) the key measures of the funded status of retiree benefits and 2) the  current funded status of retiree benefits.
To address these objectives, we reviewed literature and interviewed a  range of experts and stakeholders, including national associations of state  and local officials, labor unions, bond raters, and actuarial and accounting  professionals, among others. To describe the funded status of state and  local pension plans, we analyzed self-reported data from the Public Fund  Survey (PFS) as well as surveys by the Public Pension Coordinating  Council (PPCC). This report represents one of two recent reports on state  and local government retiree benefits. The other report, State and Local  Government Retiree Benefits: Current Status of Benefit Structures,  Protections, and Fiscal Outlook for Funding Future Costs (GAO-07-1156),  provides a descriptive overview of such benefits.
We conducted our work in Washington, D.C.; New York; and Connecticut  from July 2006 to January 2008 in accordance with generally accepted  government auditing standards.
subsections: section_title: Background
paragraphs: State and local governments will likely face daunting fiscal challenges in  the next few years, driven in large part by the growth in health-related  costs. Medicaid and health insurance for state and local employees and  retirees make up a large share of such costs. In contrast, our analysis  shows that state and local governments on average would need to increase  pension contribution rates to 9.3 percent of salaries—less than .5 percent  more than the 9.0 percent contribution rate in 2006 to achieve healthy  funding on an ongoing basis.
With few exceptions, defined benefit pension plans still provide the  primary pension benefit for most state and local workers. About  90 percent of full-time state and local employees participated in defined  benefit pension plans as of 1998. A defined benefit plan determines  benefit amounts by a formula that is generally based on such factors as  years of employment, age at retirement, and salary level. A few states  offer defined contribution or other types of plans as the primary  retirement instrument. In fiscal year 2006, state and local government  pension systems covered 18.4 million members and made periodic  payments to 7.3 million beneficiaries, paying out $151.7 billion in benefits.
Many state and local governments also offer retirees health care benefits— in addition to Medicare benefits provided by the federal government—the  costs of which have been growing rapidly. One study estimated that state  and local governments paid $20.7 billion in fiscal year 2004 for retiree  health benefits. For retirees who are under age 65 (that is, not yet  Medicare-eligible), many state and local employers provide access to  group health coverage with varying levels of employer contributions. As of  2006, 14 states did not contribute to the premium for this coverage, while  14 states picked up the entire cost, and the remainder fell somewhere in  between. For virtually all state and local retirees age 65 or older, Medicare  provides the primary coverage. Most state and local government  employers provide supplemental coverage for Medicare-eligible retirees  that covers prescription drugs.
subsections: section_title: Financing of State and Local Retiree Benefits
paragraphs: Both government employers and employees generally make contributions to  fund state and local pension benefits. States follow statutes specifying  contribution amounts or determine the contribution amount each legislative  session. However many state and local governments are statutorily required to  make yearly contributions based either on actuarial calculations or according  to a statutorily specified amount. For plans in which employees are covered by  Social Security, the median contribution rate in fiscal year 2006 was 8.5 percent  of payroll for employers and 5 percent of pay for employees, in addition to 6.2  percent of payroll from both employers and employees to Social Security. For  plans in which employees are not covered by Social Security, the median  contribution rate was 11.5 percent of payroll for employers and 8 percent of pay  for employees.
Actuaries estimate the amount that will be needed to pay future benefits.  The benefits that are attributable to past service are called the “actuarial  accrued liabilities.” (In this report, the actuarial accrued liabilities are  referred to as “liabilities.”) Actuaries calculate liabilities based on an  actuarial cost method and a number of assumptions including discount  rates and worker and retiree mortality. Actuaries also estimate the  “actuarial value of assets” that fund a plan (in this report, the actuarial  value of assets is referred to as “assets”). The excess of actuarial accrued  liabilities over the actuarial value of assets is referred to as the “unfunded  actuarial accrued liability” or “unfunded liability.” Under accounting  standards, such information is disclosed in financial statements. In  contrast, the liability that is recognized on the balance sheet is the  cumulative excess of annual benefit costs over contributions to the plan.  Certain amounts included in the actuarial accrued liability are not yet  recognized as annual benefit costs under accounting standards, as they are  amortized over several years.
In a typical defined benefit pension plan, employer and employee  contributions are made to a specific fund from which benefits will be paid.  The yearly contributions from employers and employees are invested in  the stock market, bonds, and other investments. Unlike most pension  plans, retiree health benefits have generally been financed on a pay-as-you- go basis. Pay-as-you-go financing means that state and local governments  have not set aside funds in a trust reserved for future retiree health costs.  Instead, governments pay for each year’s retiree health benefits from the  current year’s budget.
section_title: Oversight of State and Local Retiree Benefits
paragraphs: The federal government has an interest in the funded status of state and  local government retiree pensions and health care, even though it has not  imposed the same funding and reporting requirements as it has on private  sector pension plans. State and local government pension plans are not  covered by most of the substantive requirements, or the insurance  program operated by the Pension Benefit Guaranty Corporation (PBGC),  under the Employee Retirement Income Security Act of 1974 (ERISA),  which apply to most private employer benefit plans. Federal law generally  does not require state and local governments to prefund or report on the  funded status of pension plans or health care benefits. However, in order  to receive preferential tax treatment, state and local pensions must comply  with requirements of the Internal Revenue Code. In addition, the  retirement income security of all Americans is an ongoing concern of the  federal government.
All states have legal protections for their pensions. The majority of states  have constitutional provisions prescribing how pension trusts are to be  funded, protected, managed, or governed. The remaining states have  pension protections in their statutes or recognize legal protections under  common law. Legal protections usually apply to benefits for existing  workers or benefits that have already accrued; thus, state and local  governments generally can change the benefits for new hires. In contrast  to pensions, retiree health benefits generally do not have the same  constitutional or statutory protections. Instead, to the extent retiree health  benefits are legally protected, it is generally because they have been  collectively bargained and are subject to current labor contracts.
Since the 1980s, the Governmental Accounting Standards Board (GASB)  has maintained standards for accounting and financial reporting for state  and local governments. GASB operates independently and has no  authority to enforce the use of its standards. Still, many state laws require  local governments to follow GASB standards, and bond raters do consider  whether GASB standards are followed. Also, to receive a “clean” audit  opinion under generally accepted accounting principles, state and local  governments are required to follow GASB standards. These standards  require reporting financial information on pensions, such as contributions  and the ratio of assets to liabilities. In contrast to pensions, the financial  status of retiree health care benefits has generally not been reported or  even estimated actuarially until recently. However, new GASB standards  (Statements 43 and 45) call for employers to quantify and report on the  size of retiree health care benefit liabilities. The new health care reporting  standards are being phased in over time to give more time to smaller state  and local government sponsors to generate estimates. Table 1 shows the  respective GASB 43 and 45 effective dates, as well as to what type of entity  each statement applies.
section_title: Key Measures of the Funded Status of Retiree Benefits Are Contributions, Funded Ratios, and Unfunded Liabilities of Individual Plans over Time
paragraphs: Understanding the financial health of pension plans can be confusing. To  help clarify, we found that three measures are key to understanding  pension plans’ funded status. GASB standards require reporting all three of  these measures. First, one can look at yearly contributions governments  are making to their plans. Actuaries calculate yearly contribution amounts  needed to maintain or improve the funded status of plans over time.  Comparing this amount to the amount governments actually contribute  indicates how well governments are keeping up with yearly funding needs.  Two other measures, funded ratios and unfunded liabilities, both suggest  the extent to which current assets can cover accrued benefits. These three  measures should be viewed together and over time to get a complete  picture of the funded status. The funded status measures of different plans  cannot be compared to one another easily because different governments  use different actuarial funding methods and assumptions to estimate them.
subsections: section_title: Three Measures, Viewed in Relation to One Another over Time, Describe Funded Status
paragraphs: Some officials we interviewed expressed confusion about how to  understand the funded status of public pension plans. State and local  governments report a significant amount of information on funding,  required by GASB standards. The media often report various measures of  the funded status without explaining the meaning of the terms or without  enough context. In addition, governments have been reporting these  funded status measures for pensions for years. However, the new  accounting rules will also call on governments to report the funded status  of retiree health benefits in a similar manner, even though many have not  made any contributions to build assets to cover liabilities.
We identified three key measures to help explain plans’ funded status:  contributions, funded ratios, and unfunded liabilities. According to experts  we interviewed, any single measure at a point in time may give a  dimension of a plan’s funded status, but it does not give a complete  picture. Instead, the measures should be reviewed collectively over time to  understand how the funded status is improving or worsening. For  example, a strong funded status means that, over time, the amount of  assets, along with future scheduled contributions, comes close to  matching a plan’s liabilities.
Comparing governments’ actual contributions to the “annual required  contribution” (ARC) helps in evaluating the funded status of each plan.  Each year, plan actuaries calculate a contribution amount that, if paid in  full, would normally maintain or improve the funded status. This amount  is referred to as the ARC, although the use of the word “required” can be  misleading because governments can choose to pay more or less than this  amount. If the actuarial assumptions are consistent with the plans’ future  experience, paying the full ARC each year provides reasonable assurance  that sufficient money is being set aside to cover currently accruing  benefits as well as a portion of any unfunded accrued benefits left over  from previous years, instead of leaving those costs for the future. In other  words, when a government consistently pays the ARC, the benefits  accrued by employees are paid for by the taxpayers who receive the  employees’ services. When the ARC is not paid in full each year, future  generations must make up for the costs of benefits that accrued to  employees in the past. In addition, the ARC can be compared to the  government’s yearly budget to understand the financial burden of the  benefits, according to officials. This comparison indicates how affordable  the plan is to the government in a given year. A high ARC relative to a  government’s budget may indicate that the costs of benefits are relatively  high or that payments have been deferred from previous years.
The funded ratio is the ratio of assets to liabilities. Liabilities are the  amount governments owe in benefits to current employees who have  already accrued benefits they will collect in the future. The funded ratio  indicates the extent to which a plan has enough funds set aside to pay  accrued benefits. If a plan has a funded ratio of 80 percent, the plan has  enough assets to pay for 80 percent of all accrued benefits. A rising funded  ratio over time indicates that the government is accumulating the assets  needed to make future payments for benefits accrued to date. A low or  declining funded ratio over time may raise concerns that the government  will not have the assets set aside to pay for benefits.
While the funded ratio equals the ratio of assets to liabilities, unfunded  liabilities equal the difference between liabilities and assets in dollars.  Thus, unfunded liabilities indicate the amount of benefits accrued for  which no money is set aside. Assets may fall short of liabilities, for  example, when governments do not contribute the full ARC, when they  increase benefits retroactively, or when returns on investments are lower  than assumed. Additionally, because all these financial calculations  involve estimates of future payments, they are based on a number of  assumptions about the future. Unfunded liabilities can grow if actuaries’  assumptions do not hold true. For example, if beneficiaries live longer  than anticipated, they will receive more benefits than predicted, even if the  government has been paying the ARC consistently. Unfunded liabilities  will eventually require the government employer to increase revenue,  reduce benefits or other government spending, or do some combination of  these. Revenue increases could include higher taxes, returns on  investments, or employee contributions. Nevertheless, we found that  unfunded liabilities do not necessarily imply that pension benefits are at  risk in the near term. Current funds and new contributions may be  sufficient to pay benefits for several years, even when funded ratios are  relatively low.
As described in figure 1, unfunded liabilities are calculated as intermediate  steps in the process of calculating the ARC. After calculating the unfunded  liabilities, actuaries usually determine an amount to fund the unfunded  liabilities over several years or “amortize” the cost of the liability. That  amortized portion is added to the cost of benefits that employees accrued  in the current year to determine the ARC. If a government pays the ARC,  then a portion of the unfunded liabilities is paid off each year. When no  more unfunded liabilities exist, the funded ratio is 100 percent, and the  plan has “fully funded” all the benefits that its current employees have  accrued under the plan’s actuarial cost method. However, a fully funded  plan still requires yearly contributions to maintain full funding because as  employees perform additional service, they accrue additional benefits.
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section_title: Comparing the Funded Status of Different Plans Is Difficult
paragraphs: Under GASB reporting standards, the funded status of different pension  plans cannot be compared easily because governments use different  actuarial approaches such as different actuarial cost methods,  assumptions, amortization periods, and “smoothing” mechanisms.
subsections: section_title: Actuarial Cost Methods
paragraphs: Most public pension plans use one of three “actuarial cost methods,” out  of the six GASB approves. Actuarial cost methods differ in several ways.  First, each uses a different approach to calculate the “normal cost,” the  portion of future benefits that the cost method allocates to a specific year,  resulting in different funding patterns for each, as described in Table 2.
Actuarial cost methods are used to allocate the current value of future  benefits into amounts attributable to the past, to the current year, and to  future years, as shown in figure 2. The cost of future benefits that are  attributable to past years under the actuarial cost method is called the  actuarial accrued liability (AAL), while the cost of benefits accrued under  the cost method in the current year is known as the normal cost.
The funded status of plans using different cost methods differs because  each has a different approach to dividing up the value of future benefits.  Different cost methods are designed for plans to accrue liabilities at  different rates, so the normal cost and the AAL vary according to the cost  method. For example, under some cost methods, governments accrue  more liabilities in the early part of employees’ career rather than later. As a  result, two identical plans, using identical actuarial assumptions but  different cost methods, would report a different funded status.
In addition to the cost methods, differences in assumptions used to  calculate the funded status can result in significant differences among  plans that make comparisons difficult. One key assumption is the rate at  which governments assume their invested assets will grow. If governments  assume a high growth rate, their calculations will indicate that they do not  have to pay as much today, because the assets set aside will grow more  rapidly. In 2006, 70 percent of state and local government pension plans  assumed a return of 8.0 to 8.5 percent, while 30 percent assumed a lower  rate of return (7 percent at the lowest). If a plan’s assets fail to grow at the  assumed rate of return, then the shortfall becomes part of the unfunded  liabilities. However, in other years, assets may earn more than the  assumed rate of return, reducing unfunded liabilities.
Amortization Periods for Unfunded Liabilities  In addition to actuarial cost methods and assumptions, differences in  amortization periods make it difficult to compare the funded status of  different plans. Governments amortize unfunded liabilities to reduce the  volatility of contributions from year to year. Governments can choose  shorter or longer periods over which to amortize unfunded liabilities.  GASB standards allow governments to amortize unfunded liabilities over a  period of up to 30 years. State and local governments can amortize their  benefits because there is little chance that they will cease to exist.
section_title: Smoothing Periods
paragraphs: Finally, actuaries for many plans calculate the value of current assets  based on an average value of past years. As a result, if the value of assets  fluctuates significantly from year to year, the “smoothed” value of assets  changes less dramatically. GASB does not limit the number of years  governments may use to smooth the value of assets, but in 2006, most  governments averaged the value of current assets with those of the last  zero to 5 years. Comparing the funded status of plans that use different  smoothing periods can be confusing because the value of the different  plans’ assets reflects a different number of years. Given fluctuations in the  stock market from year to year, the reported value of assets for plans that  use different numbers of years for smoothing calculations could reflect  significantly different market returns.
section_title: Most Public Pensions Have Assets to Pay Benefits over Several Decades, Though Contributions Vary, While Unfunded Liabilities for Retiree Health Are Significant
paragraphs: More than half of public pension plans reported that they have put enough  assets aside in advance to pay for benefits over the next several decades,  while governments providing retiree health benefits generally have  significant unfunded liabilities. The percentage of pension plans with  funded ratios below 80 percent, a level viewed by many experts as sound,  has increased in recent years, and a few plans are persistently  underfunded. Although members of these plans may not be at risk of  losing benefits in the near term, the unfunded liabilities will have to be  made up in the future. In addition, a number of governments reported not  contributing enough to reduce unfunded liabilities, which can shift costs  to future generations. For state and local governments’ retiree health  benefits, studies have estimated unfunded liabilities nationwide to be  between $600 million and $1.6 trillion, although the amounts for individual  governments vary widely. Even though annual costs for retiree health  benefits are currently low compared to pensions, continuing to pay for  current benefits with current revenues can put stress on government  budgets because health care costs are increasing rapidly.
subsections: section_title: Most Public Pension Plans Have Enough Funds to Pay for Benefits over the Long- Term
paragraphs: Most public pension plans report having sufficient assets to pay for retiree  benefits over the next several decades. Many experts and officials to  whom we spoke consider a funded ratio of 80 percent to be sufficient for  public plans for a couple of reasons. First, it is unlikely that public  entities will go bankrupt as can happen with private sector employers, and  state and local governments can spread the costs of unfunded liabilities  over up to 30 years under current GASB standards. In addition, several  commented that it can be politically unwise for a plan to be overfunded;  that is, to have a funded ratio over 100 percent. The contributions made to  funds with “excess” assets can become a target for lawmakers with other  priorities or for those wishing to increase retiree benefits.
More than half of state and local governments’ plans reviewed by the  Public Fund Survey (PFS) had a funded ratio of 80 percent or better in  fiscal year 2006, but the percentage of plans with a funded ratio of 80  percent or better has decreased since 2000, as shown in figure 3. Our  analysis of the PFS data on 65 self-reported state and local government  pension plans showed that 38 (58 percent) had a funded ratio of 80 percent  or more, while 27 had a funded ratio of less than 80 percent. In the early  2000s, according to one study, the funded ratio of 114 state and local  government pension plans together reached about 100 percent; it has since  declined. In fiscal year 2006, the aggregate funded ratio was about 86  percent. Some officials attribute the decline in funded ratios since the late  1990s to the decline of the stock market, which reduced the value of  assets. This sharp decline would likely affect funded ratios for several  years because most plans use smoothing techniques to average out the  value of assets over several years. Our analysis of several factors affecting  the funded ratio showed that changes in investment returns had the most  significant impact on the funded ratio between 1988 and 2005, followed by  changes in liabilities.
Although most plans report being soundly funded in 2006, a few have been  persistently underfunded, and some plans have seen funded ratio declines  in recent years. We found that several plans in our data set had funded  ratios below 80 percent in each of the years for which data is available. Of  70 plans in our data set, 6 had funded ratios below 80 percent for 9 years  between 1994 and 2006. Two plans had funded ratios below 50 percent for  the same time period. In addition, of the 27 plans that had funded ratios  below 80 percent in 2006, 15 had lower funded ratios in 2006 than in 1994.  The sponsors of these plans may be at risk in the future of increased  budget pressures.
By themselves, lower funded ratios and unfunded liabilities do not  necessarily indicate that benefits for current plan members are at risk,  according to experts we interviewed. Unfunded liabilities are generally not  paid off in a single year, so it can be misleading to review total unfunded  liabilities without knowing the length of the period over which the  government plans to pay them off. Large unfunded liabilities may  represent a fiscal challenge, particularly if the period to pay them off is  short. But all unfunded liabilities shift the responsibility for paying for  benefits accrued in past years to the future.
section_title: Some Pension Sponsors Do Not Contribute Enough to Improve Funding Status
paragraphs: A number of governments reported not contributing enough to keep up  with yearly costs. Governments need to contribute the full ARC yearly to  maintain the funded ratio of a fully funded plan or improve the funded  ratio of a plan with unfunded liabilities. In fiscal year 2006, the sponsors of  46 percent of the 70 plans in our data set contributed less than 100 percent  of the ARC, as shown in figure 4, including 39 percent that contributed less  than 90 percent of the ARC. In fact, the percentage of governments  contributing less than the full ARC has risen in recent years. This  continues a trend in recent years of about half of governments making full  contributions.
In particular, some of the governments that did not contribute the full ARC  in multiple years were sponsors of plans with lower funded ratios. In 2006,  almost two-thirds of plans with funded ratios below 80 percent in 2006 did  not contribute the full ARC in multiple years. Of the 32 plans that in 2006  had funded ratios below 80 percent, 20 did not contribute the full ARC in  more than half of the 9 years for which data is available. In addition, 17 of  these governments did not contribute more than 90 percent of the full ARC  in more than half the years.
State and local government pension representatives told us that  governments may not contribute the full ARC each year for a number of  reasons. First, when state and local governments are under fiscal pressure,  they may have to make difficult choices about paying for competing  interests. State and local governments will likely face increasing fiscal  challenges in the next several years as the cost of health care continues to  rise. In light of this stress, the ability of some governments to continue to  pay the ARC may be questioned. Second, changes in the value of assets  can affect governments’ expectations about how much they will have to  contribute. Because a high proportion of plan assets are invested in the  stock market, the decline in the early 2000s decreased funded ratios and  increased the unfunded liabilities of many plans. Such a marked decline in  asset values was not typical in the experience of public pension funds,  according to one expert. Reflecting the need to keep up with the increase  in unfunded liabilities, ARCs increased, challenging many governments to  make full contributions after they had grown accustomed to lower ARCs  in the late 1990s. Moreover, some plans have contribution rates that are  fixed by constitution, statute, or practice and do not change in response to  changes in the ARC. Even when the contribution rate is not fixed, the  political process may take time to recognize and act on the need for  increased contributions. Nonetheless, many states have been increasing  their contribution rates in recent years, according to information compiled  by the National Conference of State Legislatures. Third, some  governments may not contribute the full ARC because they are not  committed to pre-funding their pension plans and instead have other  priorities, regardless of fiscal conditions.
When a government contributes less than the full ARC, the funded ratio  can decline and unfunded liabilities can rise, if all other assumptions are  met about the change in assets and liabilities. Increased unfunded  liabilities will require larger contributions in the future to keep pace with  the liabilities that accrue each year and to make up for liabilities that  accrued in the past. As a result, costs are shifted from current to future  generations.
section_title: Unfunded Retiree Health Liabilities Are Large for Many State and Local Governments
paragraphs: Our review of studies estimating the total retiree health benefits for all  state and local governments showed that liabilities are between $600  billion and $1.6 trillion. The studies noted that, like many private  employers, few governments have set aside any assets to pay for these  obligations. The projected unfunded liabilities do not have to be paid all at  once, but can be paid over many years. Some governments do not pay for  any retiree health benefits and therefore do not have any unfunded  liabilities. Others may have large unfunded liabilities. For example,  California has estimated its unfunded retiree health benefits liabilities at  $70 billion, while the state of Utah estimates $749 million.
Estimates of unfunded liabilities for retiree health benefits are subject to  change substantially because projecting future costs of health care is  difficult. Compared to the future payments for pension benefits, payments  for health care benefits are significantly more unpredictable. Pension  calculations generally use salaries as a base for calculations and result in a  predictable benefit amount per year. But the cost of providing health care  benefits varies with the changing cost of health care as well as with each  individual’s usage. In addition, state and local governments usually have  the ability to reduce or eliminate benefits.
Unfunded liabilities for retiree health benefits are high because unlike  pension plans, nearly all state and local government retiree health benefits  have been financed on a pay-as-you-go basis. In other words, most  governments have not set aside funds in a trust dedicated for future retiree  health benefit payments. As a result, governments do not pay a yearly  ARC, but rather pay for retiree health benefits as they become due from  annual funds. However, the new GASB accounting standards will require  state and local governments to report their funding status on an accrual  basis. In other words, for the first time, most governments will begin to  calculate and report their funding status in a manner similar to the way  they report pensions’ funding status, whether or not they are prefunded.
Officials told us that state and local governments have not prefunded  retiree health benefits for several reasons. First, for many governments,  retiree health benefits began as an extension of employee health care  benefits, which are usually paid for from general funds. Governments did  not view retiree health as a separate stream of payments. Second, retiree  health benefits were established at a time when health care costs were  more affordable, so paying for the benefits as a yearly expense was less  burdensome. Third, the inflation rate for health care is less predictable  than for pensions, so calculating the current funding status is difficult.  Fourth, given that specific retiree health benefits are generally not  guaranteed by law, employers are freer to modify benefits; as a result,  state and local governments are reluctant to commit funds to an obligation  that may be reduced or eliminated in the future. Finally, changes in  national health care policy and health insurance markets can affect what  benefits state and local governments cover, so state and local governments  may have resisted locking in their commitment to pay for future retiree  health benefits by prefunding, and instead preferred to finance on a pay- as-you-go basis.
Although the unfunded liabilities for retiree health benefits are generally  much higher than for pensions, their current annual payments are  considerably lower. According to our analysis presented in our recent  report on this topic, in 2006, the aggregate state and local contribution  rate for pensions was about 9 percent of salaries, and the pay-as-you-go  expense for retiree health benefits was about 2 percent of salaries.  However, if retiree health continues to be financed on a pay-as-you-go  basis, the pay-as-you-go amount is estimated to more than double to  5 percent of salaries by 2050 to keep up with the growth in health costs,  adding to budgetary stress. Pay-as-you-go financing also leaves less  budgetary flexibility because state and local governments must pay the full  costs of each year’s benefits. In contrast, under pre-funding, benefits are  paid from a fund that already exists, so government contributions can be  reduced when fiscal pressures are great. As a result, governments may  face even greater pressure to reduce benefits or shift the costs of benefits  to beneficiaries, for example, by restricting eligibility, reducing coverage,  or increasing premiums. Still, pre-funding retiree health benefits would  require significantly higher contributions in the short term than pay-as- you-go financing would require.
section_title: Concluding Observations
paragraphs: Understanding the funded status of state and local government retiree  benefits requires examining, on a plan-by-plan basis, whether funding  levels are improving over time and whether governments are making the  contributions recommended by the plan’s actuary each year. The variety of  actuarial funding methods and assumptions makes it difficult to compare  funded status across different pension plans. However, funded status  information is not intended to help compare plans, but rather to determine  contributions that will achieve full funding over time and to assess a given  plan’s funded status over time.
The funded status of state and local government pensions overall is  reasonably sound, though recent deterioration underscores the  importance of keeping up with contributions, especially in light of  anticipated fiscal and economic challenges. Since the stock market  downturn in the early 2000s, the funded ratios of some governments have  declined. Governments can gradually recover from these losses. However,  the failure of some to consistently make the annual required contributions  undermines that progress and is cause for concern, particularly as state  and local governments will likely face increasing fiscal pressure in the  coming decades. While unfunded liabilities do not generally put benefits at  risk in the near-term, they do shift costs and risks to the future.
In the case of retiree health benefits, pay-as-you-go financing has been the  norm up to the present day. The initial estimates of the unfunded liabilities  will be daunting. But that is a natural consequence of pay-as-you-go  financing. Just as the unfunded liabilities did not accumulate overnight, it  may be unrealistic to expect them to be paid for overnight. Rather, state  and local governments need to find strategies for dealing with unfunded  liabilities, and such strategies will take time, will require difficult choices,  and could be affected by changes in national health policy.
section_title: Agency Comments
paragraphs: We provided officials from the Internal Revenue Service, GASB staff, and  other external reviewers knowledgeable about the subject area a copy of  this report for their review. They provided us with technical comments  that we incorporated, where appropriate.
As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies of this report to relevant  congressional committees, the Acting Commissioner of Internal Revenue,  and other interested parties. Copies will also be made available to others  upon request. In addition, the report will be available at no charge on the  GAO Web site at http://www.gao.gov. Please contact me at (202) 512-7215,  if you have any questions about this report. Other major contributors  include Tamara Cross, Assistant Director; Ken Stockbridge; Anna Bonelli;  Temeca Simpson; Amy Abramowitz; Joseph Applebaum; Rick Krashevski;  Jeremy Schwartz; Walter Vance; Charles Willson; and Craig Winslow.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: The objectives of this report were to examine 1) the key measures of the  funded status of retiree benefits and 2) the current funded status of state  and local pension and retiree health benefits.
To describe the key measures of the funded status of retiree benefits, we  interviewed experts on state and local government pension and retiree  health benefits such as national organizations, bond rating agencies, and  representatives from one local government retiree benefit system. We also  spoke with experts on actuarial science such as the Actuarial Standards  Board, the American Academy of Actuaries, and independent actuaries.  We spoke to staff of the Governmental Accounting Standards Board to  understand accounting practices and principles. We also reviewed  actuarial literature and attended conferences. In addition, we conducted  the following analysis:    To understand the impact of various economic factors on the funding  ratio of public pension plans, we developed a simple model of the  determinants of the funding ratio and conducted “counterfactuals”  holding rates of return on investments constant. To do this, we used  the following data sources:  funding ratio data from the Public Fund Survey (PFS) for years 2001 to  2005 and the Survey of State and Local Pensions for years 1988 to 2000;    market value of pension assets from the Federal Reserve’s Flow of    contributions and benefits data from the Bureau of Economic  Analysis’s National Income and Product Accounts database; and    data on returns on pension fund portfolios by analyzing market data.
Our methodology and data sources for this analysis include some  limitations. First, annual data are not available in the Survey of State  and Local Pensions for 5 years during the period. For those years,  values were imputed by using the average growth between the two  closest values. In addition, the funding ratios are available on a fiscal  year basis and were subsequently adjusted to a calendar year period.  Second, assumptions may not be representative of all pension plans,  such as the assumptions based on smoothing functions and the real  expected returns on investments. Last, counterfactuals do not include  policy adjustments that may occur because of different rates of return.
To describe the funded status of state and local governments’ pensions, in  addition to a literature review, we analyzed pension funding data provided  by the National Association of State Retirement Administrators (NASRA).  The data come from two different databases. The first database is the PFS  and is sponsored by NASRA and the National Council on Teacher  Retirement (NCTR). Data from years 2001 to 2006 were available. PFS data  are gathered by reviewing publicly available financial documents from the  state and local government plans. The second database is called the  PENDAT database and was sponsored by the Public Pension Coordinating  Council. PENDAT data are available in fiscal years 1992, 1994, 1996, 1998,  and 2000. PENDAT data were collected via a survey sent to the  administrators of a sample of plans nationwide.
The PFS and PENDAT databases do not include all of the same entries.
We matched individual entries from PENDAT to PFS, resulting in a  sample with between 63 and 71 plans that had data across each of the  available years from 1994 to 2006. In fiscal year 2005, these plans  represented 58 percent of plan assets nationwide, and 72 percent of  state and local government pension plan members.
We reviewed the PFS and PENDAT data and found them to be reliable  for our purposes. To do this, we reviewed all entries of key data points  in the PFS data using publicly available sources from the state and  local government plan sponsors and made adjustments to the data as  needed. The corrections made to the PFS data were not material. To  review the PENDAT database, we reviewed the methodology used to  collect the data and verified the data of 23 percent of entries using  external sources. The corrections were not found to be material.
The information contained in the PFS and PENDAT databases have  limitations: 1) surveys, including PENDAT, are subject to several kinds  of error such as the failure to include all members of the population in  the sample, nonresponse error, and data processing error; 2) the  funding ratio and other funding indicators represent the financial status  for the fiscal year with the most recent actuarial valuation, and thus do  not all represent the same fiscal year’s financial status; 3) the plans  included in the analysis are not necessarily representative of all state  and local government pension plans nationwide; and 4) data for every  plan is not available in each year.
To obtain information on the funded status of retiree health benefits, we  interviewed experts on retiree health benefits funding from national  organizations, bond rating agencies, and one local government retiree  benefits system. We also reviewed studies conducted by various  organizations estimating the funded status. These organizations each  obtained information about retiree health benefits liabilities from a  number of different state and local governments and then extrapolated  these figures to generate a nationwide estimate of all state and local  governments. We reviewed the following studies:    Credit Suisse, You Dropped a Bomb on Me, GASB, 2007. Limitations of  this study include: only states in the analysis, not local jurisdictions, are  included; assumes that those government entities for which Credit  Suisse was able to find estimates of future retiree health benefit  obligations were representative of governments overall in terms of age  distribution and funding levels; and does not consider the variation in  actuarial assumptions and methods between the different plans.
Cato Institute, Unfunded State and Local Health Costs: $1.4 Trillion,  2006. Limitations of this study include: includes states only in the  analysis, not local jurisdictions; assumes that those government entities  for which Cato was able to find estimates of future retiree health  benefit obligations were representative of governments overall in terms  of age distribution and funding levels; does not consider the variation  in actuarial assumptions and methods between the different plans; it is  not clear how many employees were covered by the sample because  there were so many localities; and figures on the percentage of  employees covered by health care plans in state and local government  jurisdictions may not be precise.
OPEB for Public Entities: GASB 45 and Other Challenges, JP Morgan,  2005. Limitations of this study include: assumes that those government  entities for which they were able to find estimates of future retiree  health benefit obligations were representative of governments overall  in terms of age distribution and funding levels; and does not consider  the variation in assumptions and methods between the different plans.
We conducted our work in Washington, D.C.; New York; and Connecticut,  from July 2006 to January 2008 in accordance with generally accepted  government auditing standards.
section_title: Related GAO Products
paragraphs: State and Local Government Retiree Benefits: Current Status of Benefit  Structures, Protections, and Fiscal Outlook for Funding Future Costs.  GAO-07-1156. Washington, D.C.: September 24, 2007.
State and Local Governments: Persistent Fiscal Challenges Will Likely  Emerge within the Next Decade. GAO-07-1080SP. Washington, D.C.: July  18, 2007.
Retiree Health Benefits: Majority of Sponsors Continued to Offer  Prescription Drug Coverage and Chose the Retiree Drug Subsidy.   GAO-07-572. Washington, D.C.: May 31, 2007.
Employer-Sponsored Health and Retirement Benefits: Efforts to Control  Employer Costs and the Implications for Workers. GAO-07-355.  Washington, D.C.: March 30, 2007.
State Pension Plans: Similarities and Differences Between Federal and  State Designs. GAO/GGD-99-45. Washington, D.C.: March 19, 1999.
Public Pensions: Section 457 Plans Pose Greater Risk than Other  Supplemental Plans. GAO/HEHS-96-38. Washington, D.C.: April 30, 1996.
Public Pensions: State and Local Government Contributions to  Underfunded Plans. GAO/HEHS-96-56. Washington, D.C.: March 14, 1996.