State and Local Government Pension Plans: Current Structure and Funded Status
Published: 2008-07-10T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Millions of state and local government employees are promised pension benefits when they retire. Although these benefits are not subject, for the most part, to federal laws governing private sector benefits, there is a federal interest in ensuring that all American have a secure retirement, as reflected in the special tax treatment provided for private and public pension funds. Recently, new accounting standards have called for the reporting of liabilities for future retiree health benefits. It is unclear what actions state and local governments may take once the extent of these liabilities become clear but such anticipated fiscal and economic challenges have raised questions about the unfunded liabilities for state and local retiree benefits, including pension benefits. GAO was asked to report on (1) the current structure of state and local government pension plans and how pension benefits are protected and managed, and (2) the current funded status of state and local government pension plans. GAO spoke to a wide range of public experts and officials from various federal and nongovernmental entities, made several site visits and gathered detailed information about state benefits, and analyzed self-reported data on the funded status of state and local pension plans from the Public Fund Survey and Public Pension Coordinating Council.
section_title: What GAO Found
paragraphs: State and local entities typically provide pension plans with defined benefits and a supplemental defined contribution plan for voluntary savings. Most states still have traditional defined benefit plans as the primary retirement plans for their workers. However, a couple of states have adopted defined contribution and other plans as their primary plan. State and local entities typically offer tax-deferred supplemental voluntary plans to encourage workers to save. State statutes and local ordinances protect and manage pension benefit and often include explicit protections, such as provisions stating that pensions promised to public employees cannot be eliminated or diminished. In addition, state constitutions and/or statutes often require pension plans to be managed as trust funds and overseen by boards of trustees. Most state and local government pension plans have enough invested resources set aside to fund the benefits they are scheduled to pay over the next several decades. Many experts consider a funded ratio (actuarial value of assets divided by actuarial accrued liabilities) 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 when about 90 percent of plans were so funded. 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.

section_title: Letter
paragraphs: I am pleased to be here today as you consider the current structure and  funded status of state and local government pension plans. 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. Although state and local pension  plans are not subject, for the most part, to federal laws governing private  sector pension plans, there is a federal interest in ensuring that all  Americans have a secure retirement, an interest that is reflected in  preferential tax treatment for contributions and investment earnings  associated with qualified pension plans in both the public and private  sectors.
Many pension benefits 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 these  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. Recently, new government  accounting standards were issued, calling for the reporting of liabilities for  future retiree health liabilities. The extent of these liabilities nationwide is  not yet known, but some predict they will be very large, exceeding $1  trillion dollars nationwide in present value terms. It is unclear what  actions state and local governments may take once the future costs of  these liabilities become clear but such anticipated fiscal and economic  challenges have raised questions about the unfunded liabilities for state  and local retiree benefits, including pension plans.
My comments today are based on findings from our September 2007 report  entitled State and Local Government Retiree Benefits: Current Status of  Benefit Structures, Protections, and Fiscal Outlook for Funding Future  Costs and our January 2008 report entitled State and Local Government  Retiree Benefits: Current Funded Status of Pension and Health Benefits.  My remarks focus on (1) the current structure of state and local  government pension plans and how pension benefits are protected and  managed, and (2) the current funded status of state and local government  pension plans.
To determine the structure of state and local pension benefits and  protections, we spoke with experts, advocacy groups, and union officials  from various national organizations and associations, various federal  agencies, and nongovernmental entities that analyze government data and  conduct surveys on these topics. We also conducted site visits and  gathered detailed information about the benefits provided in three states,  California, Michigan, and Oregon. To illustrate a wide range of retiree  benefit system characteristics, in some instances we complemented  information gathered during our site visits with information gathered  about retiree benefits provided in other state and local jurisdictions. To  determine the current funded status of state and local government pension  plans, we analyzed self-reported data from the Public Fund Survey (PFS)  as well as surveys by the Public Pension Coordinating Council (PPCC).  We conducted our performance audits from July 2006 to January 2008 in  accordance with generally accepted government auditing standards, which  included an assessment of data reliability. 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 on our audit objectives.
In summary, we found that state and local entities typically provide a  pension plan with defined benefits and a supplemental defined  contribution plan for voluntary savings. As of 2007, most states still have  traditional defined benefit plans as the primary retirement plans for their  workers. Only two states (Alaska and Michigan) and the District of  Columbia had adopted defined contribution plans as their primary plans  for general public employees.  Two other states (Indiana and Oregon) had  adopted primary plans with both defined benefit and defined contribution  components, while one state (Nebraska) had adopted a cash balance  defined benefit plan as its primary plan. State statutes and local  ordinances typically protect pension plan benefits, often including explicit  protections such as provisions stating that pensions promised to public  employees cannot be eliminated or diminished. State constitutions and/or  statutes often require pension plans to be managed as trust funds and  overseen by boards of trustees, which typically establish overall policies  for the operation and management of the pension plans, including  adopting actuarial assumptions for calculating liabilities, establishing  procedures for financial control and reporting, and setting investment  strategies. We also found that 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. Although many experts consider a  funded ratio of about 80 percent or better to be sound for government  pensions, the percentage of pension plans with funded ratios below 80  percent has increased in recent years. Available data show that 58 percent  of 65 large pension plans were funded to that level in 2006, a decrease  since 2000 when about 90 percent of plans were so funded. A few plans are  persistently and significantly underfunded, and 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. Finally, a number of  governments reported not contributing enough to reduce unfunded  liabilities. Low contributions raise concerns about the future funded  status, and may shift costs to future generations.
subsections: section_title: Background
paragraphs: Pension plans can generally be characterized as either defined benefit or  defined contribution plans. In a defined benefit plan, the amount of the  benefit payment is determined by a formula typically based on the retiree’s  years of service and final average salary, and is most often provided as a  lifetime annuity. For state and local government retirees, postretirement  cost-of-living adjustments (COLAs) are frequently provided in defined  benefit plans. But benefit payments are generally reduced for early  retirement, and in some cases payments may be offset for receipt of Social  Security. In a defined contribution plan, 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. The employee assumes the investment risk; the  account balance at the time of retirement is the total amount of funds  available, and unlike with defined benefit plans, there are generally no  COLAs. Until depleted, however, a defined contribution account balance  may continue to earn investment returns after retirement, and a retiree  could use the balance to purchase an inflation-protected annuity. Also,  defined contribution plans are more portable than defined benefit plans, as  employees own their accounts individually and can generally take their  balances with them when they leave government employment. There are  no reductions based on early retirement or for participation in Social  Security.
Both government employers and employees generally make contributions  to fund state and local pension benefits. 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 “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 simply 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.
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. 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 Americans is  an ongoing concern of the federal government.
Although ERISA imposes participation, vesting, and other requirements  directly upon employee pension plans offered by private sector employers,  governmental plans such as those provided by state and local governments  to their employees are excepted from these requirements. In addition,  ERISA established an insurance program for defined benefit plans under  which promised benefits are paid (up to a statutorily set amount) if an  employer cannot pay them—but this too does not apply to governmental  plans. However, for participants in governmental pension plans to receive  preferential tax treatment (that is, for plan contributions and investment  earnings to be tax-deferred), plans must be deemed “qualified” by the  Internal Revenue Service.
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 disclosing financial information on pensions, such as the amount  of contributions and the ratio of assets to liabilities.
Three measures are key to understanding pension 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 schedule contributions, comes close to matching  a plan’s liabilities.
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. Most  public pension plans use one of three “actuarial cost methods,” out of the  six GASB approves. Actuarial costs 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. In addition to the cost  methods, differences in assumptions used to calculate the funded status  can result in significant differences among plans that make comparison  difficult. Also differences in amortization periods make it difficult to  compare the funded status of different plans. 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.  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.
We reported recently that state and local governments will likely face  daunting fiscal challenges, driven in large part by the growth in health- related costs, such as Medicaid and health insurance for state and local  employees. Our report was based on simulations for the state and local  government sector that indicated that in the absence of policy changes,  large and growing fiscal challenges will likely emerge within a decade.  We found that, as is true for the federal sector, the growth in health-related  costs is a primary driver of these fiscal challenges.
section_title: State And Local Government Pension Plans Typically Include A Defined Benefit Plan And A Supplemental Voluntary Savings Plan And Laws Protect Benefits
paragraphs: State and local governments typically provide their employees with  retirement benefits that include a defined benefit plan and a supplemental  defined contribution plan for voluntary savings. However, the way each of  these components is structured and the level of benefits provided varies  widely--both across states, and within states based on such things as date  of hire, employee occupation, and local jurisdiction. Statutes and local  ordinances protect and manage pension plans and are often anchored by  provisions in state constitutions and local charters. State and local law  also typically requires that pensions be managed as trust funds and  overseen by boards.
subsections: section_title: Defined Benefit Plans Provide the Core Benefits for Most Retirees
paragraphs: Most state and local government workers are provided traditional pension  plans with defined benefits. About 90 percent of full-time state and local  employees participated in defined benefit plans as of 1998. 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. State and local government employees are  generally required to contribute a percentage of their salaries to their  defined benefit plans, unlike private sector employees, who generally  make no contribution when they participate in defined benefit plans.  According to a 50-state survey conducted by Workplace Economics, Inc.,  43 of 48 states with defined benefit plans reported that general state  employees were required to make contributions ranging from 1.25 to 10.5  percent of their salaries. Nevertheless, these contributions have no  influence on the amount of benefits paid because benefits are based solely  on the formula.
In 1998, all states had defined benefit plans as their primary pension plans  for their general state workers except for Michigan and Nebraska (and the  District of Columbia), which had defined contribution plans as their  primary plans, and Indiana, which combined both defined benefit and  defined contribution components in its primary plan. Almost a decade  later, we found that as of 2007, only one additional state (Alaska) had  adopted a defined contribution plan as its primary plan; one additional  state (Oregon) had adopted a combined plan, and Nebraska had replaced  its defined contribution plan with a cash balance defined benefit plan. (See  fig. 1.) Although still providing defined benefit plans as their primary plans  for general state employees, some states also offer defined contribution  plans (or hybrid defined benefit/defined contribution plans) as optional  alternatives to their primary plans. These states include Colorado, Florida,  Montana, Ohio, South Carolina, and Washington.
In states that have adopted defined contribution plans as their primary  plans, most employees continue to participate in defined benefit plans  because employees are allowed to continue their participation in their  previous plans (which is rare in the private sector). Thus, in contrast to  the private sector, which has moved increasingly away from defined  benefit plans over the past several decades, the overwhelming majority of  states continue to provide defined benefit plans for their general state  employees.
Most states have multiple pension plans providing benefits to different  groups of state and local government workers based on occupation (such  as police officer or teacher) and/or local jurisdiction. According to the  most recent Census data available, in fiscal year 2004-2005 there were a  total of 2,656 state and local government pension plans. We found that  defined benefit plans were still prevalent for most of these other state and  local employees as well. For example, a nationwide study conducted by  the National Education Association in 2006 found that of 99 large pension  plans serving teachers and other school employees, 79 were defined  benefit plans, 3 were defined contribution plans, and the remainder  offered a range of alternative, optional, or combined plan designs with  both defined benefit and defined contribution features.
In addition to primary pension plans (whether defined benefit or defined  contribution), data we gathered from various national organizations show  that each of the 50 states has also established a defined contribution plan  as a supplementary, voluntary option for tax-deferred retirement savings  for their general state employees.  Such plans appear to be common  among other employee groups as well. These supplementary defined  contribution plans are typically voluntary deferred compensation plans  under section 457(b) of the federal tax code.
While these defined contribution plans are fairly universally available,  state and local worker participation in the plans has been modest. In a  2006 nationwide survey conducted by the National Association of  Government Defined Contribution Administrators, the average  participation rate for all defined contribution plans was 21.6 percent.
One reason cited for low participation rates in these supplementary plans  is that, unlike in the private sector, it has been relatively rare for  employers to match workers’ contributions to these plans, but the number  of states offering a match has been increasing. According to a state  employee benefit survey of all 50 states conducted by Workplace  Economics, Inc., in 2006 12 states matched the employee’s contribution up  to a specified percent or dollar amount. Among our site visit states, none  made contributions to the supplementary savings plans for their general  state employees, and employee participation rates generally ranged  between 20 to 50 percent. In San Francisco, however, despite the lack of  an employer match, 75 percent of employees  had established 457(b) accounts. The executive director of the city’s  retirement system attributed this success to several factors, including   (1) that the plan had been in place for over 25 years, (2) that the plan  offers good investment options for employees to choose from, and (3) that  plan administrators have a strong outreach program. In the private sector,  a growing number of employers are attempting to increase participation  rates and retirement savings in defined contribution plans by  automatically enrolling workers and offering new types of investment  funds.
section_title: Laws Protecting Pensions Are often Anchored in State Constitutions and Local Charters
paragraphs: State and local laws generally provide the most direct source of any  specific legal protections for the pensions of state and local workers.  Provisions in state constitutions often protect pensions from being  eliminated or diminished. In addition, constitutional provisions often  specify how pension funds are to be managed, such as by mandating  certain funding requirements and/or requiring that the funds be overseen  by boards of trustees. Moreover, we found that at the sites we visited,  locally administered plans were generally governed by local laws.  However, state employees, as well as the vast majority of local employees,  are covered by state-administered plans.
Protections for pensions in state constitutions are the strongest form of  legal protection states can provide because constitutions—which set out  the system of fundamental laws for the governance of each state— preempt state statutes and are difficult to change. Furthermore, changing a  state constitution usually requires broad public support. For example,  often a supermajority (such as three-fifths) of a state’s legislature may  need to first approve proposed constitutional changes and typically if a  change passes the legislature, voters must also approve it.
The majority of states have some form of constitutional protection for  their pensions. According to AARP data compiled in 2000, 31 states have a  total of 93 constitutional provisions explicitly protecting pensions. (The  other 19 states all have pension protections in their statutes or recognize  legal protections under common law.) These constitutional pension  provisions prescribe some combination of how pension trusts are to be  funded, protected, managed, or governed. (See table 1.)
In nine states, constitutional provisions take the form of a specific  guarantee of the right to a benefit. In two of the states we visited, the state  constitution provided protection for pension benefits. In California, for  example, the state constitution provides that public plan assets are trust  funds to be used only for providing pension benefits to plan participants.  In Michigan, the state constitution provides that public pension benefits  are contractual obligations that cannot be diminished or impaired and  must be funded annually.
The basic features of pension plans—such as eligibility, contributions, and  types of benefits—are often spelled out in state or local statute. State- administered plans are generally governed by state laws. For example, in  California, the formulas used to calculate pension benefit levels for  employees participating in the California Public Employees’ Retirement  System (CalPERS) are provided in state law. Similarly, in Oregon,  pension benefit formulas for state and local employees participating in the  Oregon Public Employees Retirement System (OPERS) plans are provided  in state statute. In addition, we found that at the sites we visited locally  administered plans were generally governed by local laws. For example, in  San Francisco, contribution rates for employees participating in the San  Francisco City and County Employees’ Retirement System are spelled out  in the city charter.
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 by creating a series of new tiers or plans  that apply to employees hired only after the date of the change. For  example, the Oregon legislature changed the pension benefit for  employees hired on or after January 1, 1996, and again for employees hired  on or after August 29, 2003, each time increasing the retirement age for the  new group of employees.
For some state and local workers whose benefit provisions are not laid out  in detail in state or local statutes, specific provisions are left to be  negotiated between employers and unions. For example, in California,  according to state officials, various benefit formula options for local  employees are laid out in state statutes, but the specific provisions  adopted are generally determined through collective bargaining between  the more than 1,500 different local public employers and rank-and-file  bargaining units. In all three states we visited, unions also lobby the state  legislature on behalf of their members. For example, in Michigan,  according to officials from the Department of Management and Budget,  unions marshal support for or against a proposal by taking such actions as  initiating letter-writing campaigns to support or oppose legislative  measures.
subsections: section_title: Pensions Are Typically Managed as Trust Funds with Board Oversight
paragraphs: In accordance with state constitution and/or statute, the assets of state  and local government pension plans are typically managed as trusts and  overseen by boards of trustees to ensure that the assets are used for the  sole purpose of meeting retirement system obligations and that the plans  are in compliance with the federal tax code. Boards of trustees, of  varying size and composition, often serve the purpose of establishing the  overall policies for the operation and management of the pension plans,  which can include adopting actuarial assumptions, establishing  procedures for financial control and reporting, and setting investment  strategy. On the basis of our analysis of data from the National Education  Association, the National Association of State Retirement Administrators  (NASRA), and reports and publications from selected states, we found that  46 states had boards overseeing the administration of their pension plans  for general state employees. These boards ranged in size from 5 to 19  members, with various combinations of those elected by plan members,  those appointed by a state official, and those who serve automatically  based on their office in state government (known as ex officio members).  (See fig. 2.)
Different types of members bring different perspectives to bear, and can  help to balance competing demands on retirement system resources. For  example, board members who are elected by active and retired members  of the retirement system, or who are union members, generally help to  ensure that members’ benefits are protected. Board members who are  appointed sometimes are required to have some type of technical  knowledge, such as investment expertise. Finally, ex officio board  members generally represent the financial concerns of the state  government.
Some pension boards do not have each of these perspectives represented.  For example, boards governing the primary public employee pension plans  in all three states we visited had various compositions and responsibilities.  (See table 2.) At the local level, in Detroit, Michigan, a majority of the  board of Detroit’s General Retirement System is composed of members of  the system. According to officials from the General Retirement System,  this is thought to protect pension plan assets from being used for purposes  other than providing benefits to members of the retirement system.  Regarding responsibilities, the board administers the General Retirement  System and, as specified in local city ordinances, is responsible for the  system’s proper operation and investment strategy.
Pension boards of trustees typically serve as pension plan fiduciaries, and  as fiduciaries, they usually have significant independence in terms of how  they manage the funds. Boards make policy decisions within the  framework of the plan’s enabling statutes, which may include adopting  actuarial assumptions, establishing procedures for financial control and  reporting, and setting investment policy. In the course of managing  pension trusts, boards generally obtain the services of independent  advisors, actuaries, or investment professionals.
Also, some states’ pension plans have investment boards in addition to, or  instead of, general oversight boards. For example, three of the four states  without general oversight boards have investment boards responsible for  setting investment policy. While public employees may have a broad  mandate to serve all citizens, board members generally have a fiduciary  duty to act solely in the interests of plan participants and beneficiaries.  One study of approximately 250 pension plans at the state and local level  found that plans with boards overseeing them were associated with  greater funding than those without boards.
When state pension plans do not have a general oversight board, these  responsibilities tend to be handled directly by legislators and/or senior  executive officials. For example, in the state of Washington, the pension  plan for general state employees is overseen by the Pension Funding  Council—a six-member body whose membership, by statute, includes four  state legislators. The council adopts changes to economic assumptions  and contribution rates for state retirement systems by majority vote. In  Florida, the Florida Retirement System is not overseen by a separate  independent board; instead, the pension plan is the responsibility of the  State Board of Administration, composed of the governor, the chief  financial officer of the state, and the state attorney general.  In New York, the state comptroller, an elected official, serves as sole  trustee and administrative head of the New York State and Local  Employees’ Retirement System.
section_title: Most Public Pensions Have Assets To Pay Benefits Over Several Decades, But Contributions Vary
paragraphs: Currently, most state and local government pension plans have enough  invested resources set aside to pay for the benefits they are scheduled to  pay over the next several decades. Many experts consider a funded ratio of  about 80 percent or better to be sound for state and local government  pensions. While most plans’ funding may be sound, a few plans have  persistently reported low funded ratios, which will eventually require the  government employer to improve funding, for example, by reducing  benefits or by increasing contributions. Even for many plans with lower  funded ratios, 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 need to improve or maintain funded ratios. Low contributions  raise concerns about the future funded status, and may shift costs to  future generations.
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 out of business or cease operations as can happen with  private sector employers, and state and local governments can spread the  costs of unfunded liabilities over a period of 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 (42 percent) 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.
Unfunded liabilities will eventually require the government employer to  increase revenue, reduce benefits or other government spending, or do  some combination of these. Revenue increase 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  rations are relatively low.
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 annual required  contribution (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. 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  prefunding their pension plans and instead have other priorities.
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: Conclusions
paragraphs: The funded status of state and local government pensions overall is  reasonably sound, though recent deterioration underscores the  importance of keeping up with contributions. Since the stock market  downturn in the early 2000s, the funded ratios of some governments have  declined. Although governments can gradually recover from these losses,  the failure of some to consistently make the annual required contributions  undermines that progress and is cause for concern. This is especially  important as state and local governments face increasing fiscal pressure in  the coming decades.
The ability to maintain current levels of public sector retiree benefits will  depend, in large part, on the nature and extent of the fiscal challenges  these governments face in the years ahead. As state and local governments  begin to comply with GASB accounting and reporting standards,  information about the future costs of retiree health benefits will become  more transparent. In light of the initial estimates of the cost of future  retiree health benefits, state and local governments will likely have to find  new strategies for dealing with their unfunded liabilities. Although public  sector workers have thus far been relatively shielded from many of the  changes that have occurred in private sector defined benefit commitments,  these protections could undergo revision under the pressure of overall  future fiscal commitments.
We are continuing our work on state and local government retiree  benefits. We have two engagements underway; the first study will examine  the various approaches these governments are taking to address their  retiree health care liabilities, while the second examines the ways state  and local governments allocate the assets in their pension and retiree  health care funds. We are pleased that this committee is interested in our  work and look forward to working with you in the future.
That concludes my testimony: I would be pleased to respond to any  questions the committee has.
section_title: Contacts and Acknowledgments
paragraphs: For further information regarding this testimony, please contact Barbara  D. Bovbjerg, Director, Education, Workforce, and Income Security Issues  at (202) 512-7215 or bovbjergb@gao.gov.  Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this statement.  Individuals making key contributions to this testimony  include Tamara Cross (Assistant Director), Bill Keller (Assistant Director),  Anna Bonelli, Margie Shields, Joe Applebaum, and Craig Winslow.
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