State and Local Government Pension Plans: Economic Downturn Spurs Efforts to Address Costs and Sustainability
Published: 2012-03-02T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Over 27 million employees and beneficiaries are covered by state and local government pension plans. However, the recent economic downturn and associated budget challenges confronting state and local governments pose some questions as to the sustainability of these plans, and what changes, if any, state and local governments are making to strengthen the financial condition of their pension plans. GAO was asked to examine
(1) recent trends in the financial condition of state and local government pension plans and
(2) strategies state and local governments are using to manage pension costs and the impacts of these strategies on plans, sponsors, employees, and retirees.
To address these topics, GAO analyzed various measures of sector-wide financial condition based on national-level data on pension funding from the U.S. Census Bureau and others, and reviewed information on recent state legislative changes affecting government pensions from annual reports prepared by the National Conference of State Legislatures (NCSL). GAO did not assess the soundness of individual plans, but did obtain documents and conduct interviews with pension and budget officials in eight states and eight localities, selected to illustrate the range of strategies being implemented to meet current and future pension funding requirement.
The Internal Revenue Service and Social Security Administration provided technical comments, which were incorporated, as appropriate.
section_title: What GAO Found
paragraphs: Despite the recent economic downturn, most large state and local government pension plans have assets sufficient to cover benefit payments to retirees for a decade or more. However, pension plans still face challenges over the long term due to the gap between assets and liabilities. In the past, some plan sponsors have not made adequate plan contributions or have granted unfunded benefit increases, and many suffered from investment losses during the economic downturn. The resulting gap between asset values and projected liabilities has led to steady increases in the actuarially required contribution levels needed to help sustain pension plans at the same time state and local governments face other fiscal pressures.
Since 2008, the combination of fiscal pressures and increasing contribution requirements has spurred many states and localities to take action to strengthen the financial condition of their plans for the long term, often packaging multiple changes together. GAOs tabulation of recent state legislative changes reported by NCSL and review of reforms in selected sites revealed the following:
Reducing benefits: 35 states have reduced pension benefits, mostly for future employees due to legal provisions protecting benefits for current employees and retirees. A few states, like Colorado, have reduced postretirement benefit increases for all members and beneficiaries of their pension plans.
Increasing member contributions: Half of the states have increased member contributions, thereby shifting a larger share of pension costs to employees.
Switching to a hybrid approach: Georgia, Michigan, and Utah recently implemented hybrid approaches, which incorporate a defined contribution plan component, shifting some investment risk to employees.
At the same time, some states and localities have also adjusted their funding practices to help manage pension contribution requirements in the short term by changing actuarial methods, deferring contributions, or issuing bonds, actions that may increase future pension costs. Going forward, growing budget pressures will continue to challenge state and local governments abilities to provide adequate contributions to help sustain their pension plans.

section_title: Letter
paragraphs: The recent economic downturn combined with continuing budget  challenges has heightened concerns about the financial condition of state  and local pension plans. Pension funding is a long-term endeavor, but  states and local governments often have annual balanced budget  requirements that can pit government contributions to pension plans  against other pressing funding needs. Although state and local retiree  benefits are not subject, for the most part, to federal laws governing  private sector retiree benefits, the federal government has an interest in  ensuring that all Americans have a secure retirement. This includes the  over 27 million people covered by state and local government pension   The federal government also has an interest in the challenging  plans.fiscal situation facing the state and local sectors because fiscal health  presents a national challenge shared by all levels of government. In light  of these concerns, you asked us to examine  1.  recent trends in the financial condition of state and local government  2.  strategies state and local governments are using to manage pension  costs and the impacts of these strategies on plans, sponsors,  employees, and retirees.
To describe trends in the financial condition of state and local pension  funds, we analyzed various measures of sector-wide financial condition  based on existing national-level data on pension funding. We analyzed  data from the U.S. Census Bureau’s surveys of state and local retirement  systems and from the Public Plans Database developed by the Boston  College Center for Retirement Research, which includes financial data on  126 large state and local defined benefit plans covering more than 85  percent of total state and local government pension assets and members.  To better understand the context for these trends, we reviewed existing  literature on state and local government pension plans and interviewed  national experts on state and local government pension issues.
To identify the prevalence of various strategies state and local  governments are using to manage pension costs, we analyzed national- level data on state legislative changes and use of bonds to finance their  plans. Specifically, to identify legislative changes, we analyzed annual  reports prepared by the National Conference of State Legislatures  (NCSL) summarizing selected state pension and retirement legislation  enacted from January 1, 2008, through June 30, 2011. We limited our  analysis of these NCSL reports to changes affecting broad categories of  employees, such as state employees, teachers, public safety personnel,  and local employees who are members of state-administered plans. In  some limited instances, to better understand a legislative change, we  reviewed supplemental documents such as pension plan documents and  summaries of the legislation prepared by plans, state legislative counsel,  or state agencies. We did not conduct an independent legal analysis to  verify the accuracy of the information pertaining to recently enacted  legislation contained in the NCSL reports. To identify bonds issued for the  purpose of financing public pension plans, we analyzed multiple sources  of bond data, including Mergent BondViewer and the Electronic Municipal   We supplemented these national-level data by  Market Access system.interviewing state and local pension and budget officials, and reviewing  financial and actuarial reports, from a small judgmental sample of plans  from eight states, and one locality within each of these states, that had  implemented pension modifications since 2008 (see table 1). This  judgmental sample was selected to provide examples of plans  experiencing a range of financial conditions and types of strategies  adopted by their sponsors. We based this selection on our analysis of  NCSL annual reports on pension legislation and suggestions from our  interviews with pension experts. We did not assess the financial  soundness of individual plans.
We conducted this performance audit from December 2010 to March  2012 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: There are over 3,400 state and local pension systems in the United  States, according to the most recent Census Bureau Survey of State and  Local Public-Employee Retirement Systems. Most large plans are state  plans, and more state and local employees are covered by state- administered plans than by locally-administered plans (about 24 million  members and beneficiaries compared with about 3 million). However,  there are more local government employees than state government  employees (about 14 million compared with about 5 million), and while  local governments sometimes participate in plans administered by states,  the local governments generally retain responsibility for contributing the  employer’s share of funding to the plans for their employees. As a result,  local governments contribute more to pension plans each state fiscal  year, overall, than do state governments (see fig. 1).
Pension plans are generally characterized as either defined benefit or  defined contribution plans. Unlike in the private sector, defined benefit  plans provide primary pension benefits for most state and local  government workers. About 78 percent of state and local employees  participated in defined benefit plans in 2011, compared with only 18  percent of private sector employees. In a defined benefit plan, the  amount of the benefit payment is determined by a formula (in the public  sector, the formula is typically based on the retiree’s years of service and  final average salary, and is most often provided as a lifetime annuity).  However, unlike private sector employees with defined benefit plans,  state and local government employees generally contribute to their  defined benefit plans. A few states offer defined contribution or other  types of retirement plans as the primary retirement plan.contribution plan, the key determinants of the benefit amount are the  member’s and employer’s contribution rates, and the rate of return  achieved on the investments in an individual’s account over time.  Alternatively, some states have adopted hybrid approaches that combine  components of both defined benefit and defined contribution plans.
Also unlike in the private sector, many state and local employees are not  covered by Social Security. About 6.4 million, or over one-fourth, of state  and local government employees are not eligible to receive Social  Security benefits based on their government earnings and do not pay  Social Security taxes on earnings from their government occupations.a result, employer-provided pension benefits for non-covered employees  are generally higher than for employees covered by Social Security, and  employee and employer contributions are higher as well.
As  The federal government has not imposed the same funding and reporting  requirements on state and local pensions as it has on private sector  pension plans. State and local government pension plans are not  covered by most of the substantive requirements under the Employee  Retirement Income Security Act of 1974 (ERISA)—requirements which  apply to most private employer benefit plans. Nor are they insured by the  Pension Benefit Guaranty Corporation as private plans are. Federal law  generally does not require state and local governments to prefund or  report on the funded status of pension plans. However, in order for  participants to receive preferential tax treatment (that is, for employee  contributions and investment earnings to be tax-deferred), state and local  pensions must comply with certain requirements of the Internal Revenue  Code.
State and local governments also follow different standards than the  private sector for accounting and financial reporting. The Governmental  Accounting Standards Board (GASB), an independent organization, has  been recognized by governments, the accounting industry, and the capital  markets as the official source of generally accepted accounting principles  (GAAP) for U.S. state and local governments. GASB’s standards are not  federal laws or regulations and GASB does not have enforcement  authority. However, compliance with its standards is enforced through  laws of some individual states and the audit process, whereby auditors  render opinions on the fair presentation of state and local governments’  financial statements in conformity with GAAP. GASB’s standards require  reporting financial information on pensions, such as the annual pension  cost, contributions actually made to the plan, and the ratio of assets to  liabilities. In addition, actuarial standards of practice are promulgated by  the Actuarial Standards Board. These standards are designed to provide  practicing actuaries with a basis for assuring that their work will conform  to appropriate practices and to assure the public that actuaries are  professionally accountable (see app. II for information on recently  proposed changes to GASB and Actuarial Standards Board standards).
Some municipal bond analysts have reported concerns about state and  local governments’ creditworthiness in light of the recent economic  downturn and continuing pension obligations. In 2008 and 2010,  respectively, the Securities and Exchange Commission took enforcement  actions against the city of San Diego and the state of New Jersey for  misrepresenting the financial condition of their pension funds in  information provided to investors.
section_title: Plans Have Sufficient Assets to Pay Near- Term Benefits, but Growing Budget Pressures Will Challenge Their Sustainability
paragraphs: Although pension plans suffered significant investment losses from the  recent economic downturn, which was the most serious since the Great  Depression, most state and local government plans currently have assets  sufficient to cover their benefit commitments for a decade or more.  Nevertheless, most plans have experienced a growing gap between  actuarial assets and liabilities over the past decade, meaning that higher  contributions from government sponsors are needed to maintain funds on  an actuarially based path toward sustainability. In spite of budget  pressures through the recession, most plans continued to receive  prerecession contribution levels on an actuarial basis from their sponsors,  with most plans contributing their full actuarial level. However, there were  some notable exceptions, and these plans continued to receive lower  contribution payments. State and local governments experienced  declining revenues and growing expenses on other fronts, and growing  budget pressures will continue to challenge their ability to provide  adequate contributions to help sustain their pension funds.
subsections: section_title: Despite Investment Losses, Most Plans Hold Sufficient Assets to Pay Benefit Obligations for the Near Future
paragraphs: The recent economic downturn resulted in state and local pension plans  suffering significant investment losses. Positive investment returns are an  important source of funds for pension plans, and have historically  generated more than half of state and local pension fund increases.  However, rather than adding to plans’ assets, investments lost more than  $672 billion during fiscal years 2008 and 2009, based upon Census  Bureau figures for the sector (see fig. 2). Since 2009, improvements in  investment earnings have helped plans recover some of these losses, as  evidenced by more recent Census Bureau data on large plans. More  importantly, however, public pension plans have built up assets over  many years through prefunding (that is, employer and member  contributions) and through the accumulation of associated investment  returns.
Assessing the financial condition across all plans using actuarially  determined figures (such as a plan’s funded ratio) is challenging, in part,  because of the various methods and assumptions used by these plans  (see app. II). One alternative measure of financial condition across  pension plans, although not optimal when assessing the financial health  of a single plan, is the ratio of fund assets to annual expenditures. Fund  assets represent the dollar amount a plan has built up, while annual  expenditures ultimately determine how quickly assets are spent down.  Alternatively, when assessing the financial condition of an individual  defined benefit plan, various approaches are used, and looking at multiple  factors is especially useful in providing a more complete picture of a  plan’s financial condition. In addition to the level of funding (level of plan  assets relative to plan liabilities), assessments of a plan’s financial  viability by rating agencies and others may take into consideration the  influence of the plan sponsor, the plan’s underlying methods and  assumptions, and efforts to manage risk (see table 2).
As illustrated in figure 3, an analysis of historical Census Bureau data on  state and local government pensions shows that the ratio of fund assets  to annual expenditures fell during the stock market downturn related to  the oil crisis of the early 1970s, but eventually recovered and reached its  peak in 2000, driven by strong investment results throughout the 1990s.  Since that peak, both the market downturn in the early 2000s and  sustained economic weakness beginning in 2008 drove the ratio of  sector-wide assets relative to expenditures lower. Overall, these data  show that the aggregate ratio of fund assets to annual expenditures, as of  2009, is lower, but in line with historical norms dating back to 1957.
At the same time, data on individual plans indicate that this measure can  vary considerably across plans. As illustrated in figure 4, data on large  plans for fiscal year 2009 show that their fund assets relative to annual  expenditures varied widely, with ratios ranging from less than 5 to greater  than 20.
From the early years of prefunding of pension plans, sector-wide plan  contributions outpaced plan expenditures, but by the early 1990s,  expenditures began outpacing contributions. This trend was predictable.  As public plans matured, they began to have greater proportions of retirees  to active workers. As such, payments to retirees increased relative to plan  contributions and, as a result, in more recent years, sector-wide  expenditures have outpaced contributions. Nevertheless, given the asset  levels of most state and local government plans and the pace of  expenditures relative to contributions, most plans can be expected to cover  their commitments for the near future with their existing assets. For  example, even if these plans received no more contributions or investment  returns, most large plans would not exhaust their assets for a decade or  longer, since they hold assets at least 10 times their annual expenditures.
section_title: Plans Face a Growing Gap between Assets and Liabilities, Leading to Higher Contribution Requirements
paragraphs: While state and local pension plans have sufficient assets to meet their  obligations in the near future, an examination of actuarially determined  funded ratios among large plans shows a growing gap between their  assets and liabilities. This ratio is important since, on a plan-by-plan  basis, a plan’s funded ratio shows the plan’s funding progress and is part  of the basis for determining contribution levels necessary for fund  sustainability. As a result of recent market declines and other reasons— such as sponsors’ failure to keep pace with their actuarially required  contributions and benefit increases during the early 2000s—funded ratios  have trended lower. Data compiled on large plans indicate that the funded  ratios for these plans, in aggregate, have fallen over the past decade from  over 100 percent in fiscal year 2001 to 75.6 percent in fiscal year 2010.(See fig. 5.)
Several factors have contributed to the growing gap between plans’  actuarial assets and liabilities. For example, large pension funds generally  assumed investment returns ranging from 6 to 9 percent throughout the  2000s, including assuming returns of approximately 8 percent, on  average, in 2009, despite the declines in the stock market during this  time. Pension portfolios maintain other assets beside equities; however,  gains in these other asset classes did not make up the amounts lost by  negative equity performance over this period. It is important to note that  the period from 2008 to 2009 was an extraordinary low period for returns  on investments in the financial history of the United States.
Benefit increases were another important reason for the growing gap  between assets and liabilities over the past decade. These increases  were enacted early in the decade when the funded status of plans was  strong. For example, 11 states increased pension benefits in 2001  according to reports from the National Conference of State Legislatures.  Among the sites included in our review, Pennsylvania enacted legislation  in 2001 that increased the pension benefit multiplier from 2 to 2.5  percent—an increase of 25 percent. This higher benefit formula applied  to both new and currently employed pension plan members (covering  state employees and local public school employees). This was also the  case in California and Colorado where pension benefit increases in the  late 1990s and early in the 2000s helped drive liabilities higher.
Lower funded ratios generally mean higher annual contribution rates are  necessary to help sustain pension plans. Thus, as funded ratios trended  lower over the past decade, sponsor contribution rates trended higher.  For example, from 2002 to 2009, the median government sponsor  contribution rates among large plans rose as a percentage of payroll,  while employee contribution levels remained the same through this same  period (see table 3).
In spite of budget pressures through the 2007-2009 recession, most  government sponsors of large plans continued to contribute about the  same percentage of their annual required contribution (ARC) levels  determined to be needed to help sustain their fund assets. From 2005  until 2009, just under two-thirds of large plan sponsors continued to pay  at least 90 percent of their ARC payments.between what large plans would have received, in aggregate, if they  received their full ARC payments is significant. For example, in 2009,  large plans sponsors contributed approximately $63.9 billion in aggregate,  $10.7 billion less than if they had made their full ARC payments.
However, the gap in dollars  In addition, the distribution of plan sponsor contribution levels in 2010,  illustrated in figure 6, shows that about half the sponsors of large plans  contributed their full 100 percent or more of ARC payments, while others  contributed much less.
Going forward, among the eight selected states and eight selected local  jurisdictions we reviewed, several officials told us that they expected  significant increases in their employer contribution rates as a percentage  of payroll. For instance, officials from the Employees’ Retirement System  of Georgia expect their contribution rates to nearly double over the next 5  years (from 10.5 to 20 percent of payroll) to help maintain a sustainable  path for their defined benefit plans. Officials from the Utah Retirement  Systems expect rates to increase from approximately 13 to 20 percent of  payroll.
section_title: Plans Are Vulnerable to Pressures on State and Local Budgets
paragraphs: Fiscal pressures on state and local governments’ budgets add to the  challenges faced by plan sponsors and their ability to make adequate  contributions to their pension plans. The economic downturn and slow  recovery led to budget shortfalls in the state and local sectors because of  declining tax revenues and increased spending on economic safety net  programs such as health care and social services. According to survey  data from the National Association of State Budget Officers (NASBO),  from fiscal years 2009 through 2011, states reported solving nearly $230  billion in gaps between projected spending and revenue levels. Local  governments have also struggled with their budgets. For example, the  National League of Cities reported that if all city budgets were totaled  together, they would likely face a combined estimated shortfall of  anywhere from $56 billion to $83 billion from 2010 to 2012.
As a result, higher pension contributions have been needed at the same  time state and local governments have faced added pressures to balance  their budgets. Even in normal economic times, state and local  governments seek consistency in program spending areas, meaning that  large year-to-year increases in pension contribution levels can strain  budgets. Since some of these governments are subject to balanced  budget requirements, annual pension contributions, which averaged  around 4 percent of state and local budgets in fiscal year 2008, must  compete with other pressing needs, even though pension costs are  obligations that governments must eventually pay.
Although tax revenues are slowly recovering to pre-2008 levels, going  forward, long-term budget issues will likely continue to stress state and  local governments and their ability to fund their pension programs. GAO  has reported that state and local governments face fiscal challenges that  will grow over time, and with current policies in place, the sector’s fiscal  health is projected to decline steadily through 2060. driving this decline is the projected growth in health-related costs. For  example, GAO simulations show that the sector’s health-related costs will  be about 3.7 percent of gross domestic product in 2010, but grow to 8.3  percent by 2060.pension contribution rates, have spurred many states and localities to  take action to reduce pension costs and improve the future sustainability  of their plans.
section_title: States and Localities Have Made Changes to Reduce Costs and Improve Plan Sustainability
paragraphs: GAO, State and Local Governments' Fiscal Outlook: April 2011 Update, GAO-11-495SP  (Washington, D.C.: Apr. 6, 2011). sustainability long term (see fig. 7). Based on our tabulation of state  legislative changes reported annually by NCSL, we found that the  majority of states have modified their existing defined benefit systems to  reduce member benefits, lowering future liabilities. Half of states have  increased required member (that is, employee) contributions, shifting  costs to employees. Only a few states have adopted primary plans with  defined contribution components, which reduce plan sponsors’  investment risk by shifting it to employees. Some states and localities  have also taken action to lower pension contributions in the short term by  changing actuarial methods, and a few have issued pension bonds to  finance their contributions or to lower their costs by reducing the gap  between plan assets and liabilities. In general, we found that states and  localities often package several of these different pension changes  together. These packaged changes can have varying effects on employer  contributions, plan sustainability, and employees’ retirement security.
Expanding the time period for calculating final average salaries generally reduces  pension benefits by averaging in lower employee salaries. to current retirees. In the case of Colorado, the state recently reduced  postretirement COLAs for future, current, and retired members.  According to plan documents, most plan members, who are not  covered by Social Security, had previously been guaranteed an  annual postretirement COLA of 3.5 percent, but the recent legislation  eliminated the COLA for 2010 and capped future COLAs at 2  percent.
As discussed later, Illinois took the more unusual step of taking advance credit for  benefit reductions that apply only to new employees. reduce pension liabilities and consequently lower actuarially required  sponsor contributions. From the employee perspective, these changes  can mean that those in the new tier or plan will realize lower future  benefits than their coworkers who continue to participate in the old plan.  This could affect employee recruitment and retention over the long term,  but some pension officials we spoke with expected any short-term  impacts to be minimal.
Among the pension plans included in our review, we found that six states  and two localities had reduced the benefits in some of their largest  defined benefit plans. For example, in 2011, Denver, Colorado, reduced  retirement benefits for new members of the Denver Employees  Retirement Plan hired after July 1, 2011. Denver reversed previous  benefit enhancements enacted over prior decades by increasing the  period used for calculating final average salary (the basis for benefit  calculations) and raising the minimum retirement age from 55 to 60,  among other changes. Over the next 30 years, these changes are  expected to reduce the city’s pension contributions by 1.65 percent of  payroll. According to plan documents, the changes enacted are expected  to reduce pension benefits for new employees and will require some  members to work longer to receive full pension benefits. Nevertheless,  city officials do not expect any of the recent changes to significantly affect  employee recruitment and retention.
subsections: section_title: Half the States Have Raised Member Contributions, Shifting Costs to Plan Members
paragraphs: Twenty-five states have taken action since 2008 to increase member  contributions, shifting pension costs to employees, according to NCSL  reports. States generally have more leeway to adjust member contribution  rates as compared with pension benefits for existing members. As a  result, more states have increased contributions for some active  employees rather than limiting the increases to future employees. Some  states are also requiring members to contribute to their pensions for the  first time. Among the states we reviewed, Virginia and Missouri recently  required some new plan members to contribute to the retirement plan (5  percent in Virginia and 4 percent in Missouri), whereas members did not  previously contribute.
Increases in member contributions reduce the actuarially required  amounts plan sponsors need to contribute to their pension systems. As a  result, these changes often do not affect the amount of revenue flowing  into pension systems, but rather represent a shifting of pension cost from  employers to plan members. Member contributions are a relatively stable  source of pension revenue, since they are less susceptible to market  conditions than investment returns, and less susceptible to budgetary and  political pressures than employer contributions. However, member  contributions are susceptible to declines in the size of the workforce and  are often refunded to employees if they separate from their employer  before becoming eligible to receive benefits.
Among the jurisdictions included in our review, we found that four states  and one locality had increased the member contributions in some of their  largest defined benefit plans. For example, in the case of Norfolk,  Virginia, the city began requiring new members to contribute 5 percent to  the Employees’ Retirement System in 2010, whereas current members  do not contribute. As a result of this change, the city’s employer  contributions will decline as more contributing members join the system.  City officials said that new employees had already contributed over  $140,000 to the system in the first year. This increase in member  contributions will reduce employee compensation and could affect  recruitment and retention, particularly since the change will be  immediately reflected in lower paychecks. However, city officials did not  expect the changes to have a significant impact on employee recruitment  and retention, since the Virginia Retirement System had recently  implemented similar changes for state employees.
section_title: Three States Recently Adopted Hybrid Approaches, Reducing Risk for Plan Sponsors
paragraphs: Although a majority of states have continued to use traditional defined  benefit plans as their primary pension system, our analysis of NCSL  annual reports on recent pension legislation found that, since 2008, three  states—Georgia, Michigan, and Utah—have implemented hybrid  approaches as primary plans for large groups of employees, shifting  some investment risk to new employees. Two of the eight localities we  reviewed have also switched to hybrid approaches since 2008: Cobb  County, Georgia, and Bountiful, Utah (which participates in Utah’s state- administered retirement system). Unlike in a defined benefit plan, which  provides benefits based on a set formula,component of a hybrid approach, the key determinants of the benefit  amount are the employee’s and employer’s contribution rates, and the  rate of return achieved on the amounts contributed to an individual’s  account over time.
Defined contribution and hybrid approaches reduce the impact of market  volatility on plan funding and employer contributions, but are riskier for  plan members. Whereas under a defined benefit system, employer  contributions generally rise and fall depending in part on investment  returns, plan sponsors of a defined contribution system contribute a set  amount regardless of investment returns. This reduces the risk facing the  pension system as well as the state or locality sponsoring the plan.  However, switching to a defined contribution plan can involve additional  short-term costs for plan sponsors, since contributions from new  employees go toward their own private accounts rather than paying off  existing unfunded liabilities of the defined benefit plan once it is closed to  new employees. From the member’s perspective, building up retirement  savings in defined contribution plans rests on factors that are, to some  degree, outside of the control of the individual worker. Most notable  among these is the market return on plan assets, which, among other  factors, determines future retirement benefits. On the one hand, this  exposure to market risk increases members’ financial uncertainty, since  retirement benefits rise and fall based on investment returns. On the other  hand, defined contribution plans are often viewed as more portable than  defined benefit plans, as employees own their accounts individually and  can generally take their balances with them—including both member and  employer contributions—when they leave government employment, as  long as they are vested. In contrast, employees in defined benefit plans  can generally take their member contributions, if any, with them if they  leave government employment, but not the employer’s contributions.
A 401(k) plan is a type of defined contribution plan that permits employees to defer a  portion of their pay to a qualified tax-deferred plan. State and local government defined  contribution plans are typically 457(b) plans. The Tax Reform Act of 1986 prohibited state  and local governments from establishing any new 401(k) plans after May 6, 1986, but  existing plans were allowed to continue. Pub. L. No. 99-514, § 1116(b)(3), 100 Stat. 2085,  2455.
401(k) component of the hybrid approach were contributing only the  default 1 percent, according to plan officials. At this level, employees may  struggle to build adequate retirement savings. Plan officials said they  have tried to encourage members to contribute more to their 401(k) plans,  but these efforts have not been successful.
section_title: Some States and Localities Have Adjusted Pension Funding Practices, Potentially Increasing Future Costs
paragraphs: To address rising actuarially required pension contribution levels and  budget pressures, some states and localities have taken actions to limit  employer contributions in the short term or refinance their contributions.  These strategies included changing actuarial methods or issuing pension  bonds to supplement other sources of financing for pension plans. Such  strategies help plan sponsors manage their contributions in the near term,  but may increase their future costs. Fewer nationwide data are available  on the use of these strategies; however, we were able to document their  use across several of our selected pension plans.
Some state and local governments have limited or deferred their pension  contributions in the short term by making actuarial changes. It is difficult  to determine the recent prevalence of these changes nationwide;  however, five of the eight states and one of the localities we reviewed had  implemented actuarial changes to reduce their pension contributions  since 2008. The changes included expanding amortization periods (the number of years allotted to pay off unfunded liabilities) and adjusting  smoothing techniques (methods for reducing the effect of market volatility  on pension contributions by averaging asset values over multiple years).  For example, Utah reported that it increased the amortization for the  state’s retirement system from 20 years to 25 years to extend the length  of time for paying down unfunded pension liabilities. Alternatively, Illinois  reported that it recently required all Illinois state retirement systems to  switch from a market valuation with no smoothing to a 5-year smoothing  method for calculating actuarial assets and employer contributions to  lessen the immediate impact of fiscal year 2009 investment losses on  contributions.
Some state and local governments, while not formally changing their  underlying actuarial methods, have simply deferred or capped their  pension contributions. Two states and one locality we reviewed limited  contributions in the short term by capping increases in employer  contributions or by simply postponing otherwise scheduled contributions.  Capping increases in contributions allowed these states and this locality  to temporarily suppress the increases that would otherwise have been  required given 2008 investment losses and other factors. In the case of  the Pennsylvania, the state addressed an expected 19 percent increase  in actuarially required contributions to the State Employees’ Retirement  System by capping annual increases at 3 percent for 2012, 3.5 percent  for 2013, and 4.5 percent thereafter. Similarly, the Illinois Municipal  Retirement Fund allowed local plan sponsors to cap contribution  increases at 10 percent starting in 2010.
Although adjusting plan funding produced some short-term savings for  state and local budgets, it also increased the unfunded liabilities of the  pension system and will necessitate larger contributions in the future. In  the case of Philadelphia, the city used its authority under state law to  partially defer pension payments by $150 million in fiscal year 2010 and  $90 million in 2011. While these deferrals helped the city reduce its  contributions in the short term, state law requires that the money be  repaid with interest by fiscal year 2014. The city has adopted a temporary  1 percent increase in the sales tax to help cover these future costs.
Issuing pension obligation bonds (POB) is another funding strategy,  although relatively few states and localities have used it, as it can expose  plan sponsors to additional market risk. POBs are taxable general  obligation bonds that provide a one-time cash infusion into the pension  system. They convert a current pension obligation into a long-term, fixed  obligation of the government issuing the bond. POBs are issued for  generally one of two purposes: either to provide temporary budget relief  by financing a plan sponsor’s actuarially required contribution for a single  year, or as part of a longer-term strategy for paying off a plan’s unfunded  liability. Using POBs to pay off all or a portion of a plan’s unfunded liability  potentially reduces future actuarially required pension contributions, but  requires plan sponsors to make annual debt service payments on the  POBs instead.
We analyzed data on state and local government bond issuances  nationwide and found that other than the states of Illinois and  Connecticut, and the Chicago Transit Authority, most state and local  governments have not issued sizable POBs over the past 6 years (see  fig. 8). This type of pension funding has been limited, with only 25 or  fewer POB issuances in each of the last 6 years. The total amount of  POBs issued in a single year has not exceeded more than 1 percent of  total assets in state and local pension plans.
These transactions involve significant risks for government entities  because investment returns on the bond proceeds can be volatile and  lower than the interest rate on the bonds. In these cases, POBs can leave  plan sponsors worse off than they were before, juggling debt service  payments on the POBs in addition to their annual pension contributions.  In a recent brief, the Center for State and Local Government Excellence  reported that by mid-2009, most POBs issued since 1992 were a net  drain on government revenues. In light of these concerns, officials in  Pennsylvania noted that the state had enacted legislation in 2010  prohibiting the use of POBs.
Two of the pension systems included in our review—Illinois and Sonoma  County, California—have issued POBs since 2008. Illinois, which is  discussed at length below, has been the largest single issuer in recent  years, issuing over $7 billion in POBs since 2010. In the case of Sonoma  County, California, the county issued $289 million of POBs in 2010 with  maturities ranging up to 19 years. County officials explained that the  POBs were financially advantageous because they had an average  interest rate of just under 6 percent, which is lower than the 8 percent  expected return on the pension fund investments at the time the bonds  were issued. The difference between the POB interest rates and the  assumed rate of return is projected to save the county $93 million in  contributions over the life of the bonds. significantly. The POBs could increase the county’s future expenses if  actual investment returns fall below 6 percent. Over the prior 10-year  period ending in 2010, the retirement system’s average investment rate of  return was 4.1 percent, but returns over the prior 20-year period have  been significantly higher at 8.4 percent.
section_title: States and Localities Often Combine Strategies
paragraphs: States and localities often packaged multiple pension changes together.  For example, our analysis of the NCSL reports revealed that 23 states  have both increased employee contributions and reduced member  benefits. Each change made, and the interplay among the changes,  contributes to various impacts on plan sponsors, pension sustainability,  and plan members. The following examples demonstrate some of the  ways states have packaged these changes, and the varying impacts that  are expected as a result.
The county pension system subsequently lowered its assumed rate of return to 7.75  percent. This action, along with any future actuarial changes, would affect the expected  savings from the POBs.
subsections: section_title: Reducing Benefits and Increasing Contributions for New Members
paragraphs: Missouri is an example of a state that packaged increases in member  contributions with reductions in benefits to narrow the gap between plan  assets and liabilities. For new general members of the Missouri State  Employees Retirement System and the Missouri Department of  Transportation and Highway Patrol Employees’ Retirement System, the  state increased the normal retirement age from 62 to 67, expanded the  vesting period from 5 to 10 years, and required members to contribute 4  percent of pay to the pension system, although current members do not  contribute. These changes are expected to lower the state’s contributions  to the system over the long run by more than 5 percent of payroll, but the  initial savings are much smaller. In fiscal year 2012, the benefit and  contribution changes are expected to reduce the state’s contribution to its  largest plan by less than 1 percent of payroll, since there will be only a  small number of newly hired members in the system. However, by fiscal  year 2018, employees covered under the reduced benefit structure are  expected to account for over half of payroll, further reducing the state’s  annual contributions. Plan officials said these changes could pose issues  for recruitment and retention, although the influence of retirement plan  details will vary based on individual circumstances.  They also noted that  the changes could affect employee morale, since new employees will  have to work longer to qualify for benefits and the required pension  contributions will reduce their compensation.
In the case of Pennsylvania, the state passed a package of pension  changes in 2010 that offset a short-term funding cap with long-term  benefit reductions to limit the impact on the plan’s funded status. For the  State Employees’ Retirement System, the most significant funding  change was a statutory cap on employer contribution rate increases. The  legislation addressed an expected 19 percent increase in actuarially  required contributions by capping any increases at 3 percent for fiscal  year 2011/2012, 3.5 percent for fiscal year 2012/2013, and 4.5 percent  thereafter. In the short term, the caps effectively reduced the state’s  expected contributions over the next 4 years by $2.5 billion. But in the  long term, the caps, along with other actuarial changes, are expected to  increase the state’s pension contributions to the system by $7 billion over  the next 32 years. To help offset the additional long-term costs,  Pennsylvania enacted pension legislation calling for various benefit  reductions for future employees. For example, the state reduced the  benefit multiplier for future employees from 2.5 to 2 percent (with an  option for members to maintain the 2.5 multiplier by paying a higher  member contribution rate); increased the normal retirement age from 60  to 65; and expanded the vesting period from 5 to 10 years. These benefit  reductions will reduce future liabilities and are expected to lower the  state’s pension costs by almost $8.5 billion over the next 32 years, for an  estimated net savings of $1.5 billion over the cost of the caps and other  funding adjustments. Both pension and budget officials said these  changes will help the state better manage rising pension contributions in  the short term, but the overall savings from the legislative package are  relatively modest over the long term. Meanwhile, the changes will require  new employees to work longer for lower benefits and will leave more  employees with no benefit at all. Plan officials said it is too early to tell if  this will affect employee recruitment and retention.
In the case of Illinois, the state combined use of POBs, actuarial changes,  and benefit reductions to manage the state’s pension costs. The state  issued $3.5 billion of POBs in 2010 and $3.7 billion in 2011 with  maturities up to 8 years and used the proceeds to fund the state’s annual  contributions to various pension systems. An Illinois budget official  explained that issuing the POBs helped the state avoid making additional  spending cuts to other portions of the state’s budget. Alternatively, given  the state’s budgetary challenges, some pension officials said that if the  state had not issued the POBs, it is more likely that it would have not paid  its full required pension contributions.
Use of POBs will be costly to Illinois, since the state will face annual debt  service payments of about $1 billion over the next 9 years. However, the  state increased individual and corporate taxes in 2010 and state budget  officials told us the state plans to use the additional revenue to fund these  debt service payments as well as other budgetary priorities. Whether the  state’s statutorily required contributions are funded through POBs or  general revenue does not directly affect the financial condition of the  pension system. However, some pension officials were concerned that  the debt service payments on the POBs would reduce available funding  for future pension contributions.
Illinois has also lowered employer contributions to the state’s pension  systems in the short term by adjusting actuarial methods. In 2009, the  state required its pension systems to switch from a market value (no  smoothing) to a 5-year smoothing method for calculating actuarial assets  and employer contributions. Plan officials explained that the change was  intended to reduce the state’s contributions and dampen the impact of  fiscal year 2009 market losses for the short term. As a result of the  change, the state’s actuarially calculated contribution to the State  Employees’ Retirement System of Illinois was reduced by $100 million in  the first year, according to plan officials. However, plan actuaries noted  that this strategy only defers contributions when plan assets experience a  loss, as they did in fiscal year 2009. Future contributions will be higher  than they would have been previously once the fiscal year 2009 market  losses are fully recognized.
In addition to the use of POBs and actuarial changes, Illinois also reduced  benefits for new employees and applied the future savings to reduce  employer contributions in the short term. For example, the state raised  new employees’ normal retirement age to 67, capped final average salaries used for pension purposes, and reduced annual COLAs.According to plan officials, these changes are expected to reduce the  State Employees’ Retirement System’s future liabilities by a third. State  budget officials said the projected total estimated savings for the state  over the next 35 years will be about $220 billion. Since the changes apply  only to new employees, the savings will slowly accrue over the next 35  years. Nevertheless, the state took advanced credit for these future  benefit reductions, further reducing contributions in the short term.  According to plan actuaries, by taking this advance credit, the state also  increased unfunded liabilities in the short term, adversely affecting its  retirement systems.
section_title: Concluding Observations
paragraphs: State and local governments continue to experience the lingering effects  of investment losses and budget pressures in the wake of the recent  economic downturn. Although most large state and local government  pension plans still maintain substantial assets, sufficient to cover their  pension obligations for a decade or more, heightened concerns over the  long-term sustainability of the plans has spurred many states and  localities to implement a variety of reforms, including reductions in  benefits and increases in member contributions.
Despite these efforts, continued vigilance is needed to help ensure that  states and localities can continue to meet their pension obligations.  Several factors will ultimately affect the sustainability of state and local  pension plans over the long term. Important among them are whether  government sponsors maintain adequate contributions toward these  plans, and whether investment returns meet sponsors’ long-term  assumptions. Going forward, growing budget pressures will continue to  challenge state and local governments’ abilities to provide adequate  contributions to help sustain their pension plans and ensure a secure  retirement for current and future employees.
section_title: Agency Comments
paragraphs: We provided officials from the Internal Revenue Service and the Social  Security Administration with a draft of this report. They provided technical  comments that we incorporated, as appropriate. In addition, we provided  officials from the states and cities we reviewed with portions of the draft  report that addressed aspects of the pension funds in their jurisdictions.  We incorporated their technical comments, as appropriate, as well.
We are sending copies of this report to relevant congressional  committees, the Commissioners of the Internal Revenue Service and the  Social Security Administration, and other interested parties. In addition,  this report will be available at no charge on GAO’s website at  http://www.gao.gov.
If you have any questions concerning this report, please contact Barbara  D. Bovbjerg at (202) 512-7215 or Stanley J. Czerwinski at (202) 512- 6806. Contact points for our Office of Congressional Relations and Public  Affairs may be found on the last page of this report. GAO staff who made  major contributions to this report are listed in appendix III.