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

Letter

Background

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.

State And Local Government Pension Plans Typically Include A Defined Benefit Plan And A Supplemental Voluntary Savings Plan And Laws Protect Benefits

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.

Defined Benefit Plans Provide the Core Benefits for Most Retirees

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.

Laws Protecting Pensions Are often Anchored in State Constitutions and Local Charters

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.

Pensions Are Typically Managed as Trust Funds with Board Oversight

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.

Most Public Pensions Have Assets To Pay Benefits Over Several Decades, But Contributions Vary

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.

Most Public Pension Plans Have Enough Funds to Pay for Benefits over the Long- Term

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.

Some Pension Sponsors Do Not Contribute Enough to Improve Funding Status

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.

Conclusions

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.

Contacts and Acknowledgments

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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