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

Letter

Background

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.

Plans Have Sufficient Assets to Pay Near- Term Benefits, but Growing Budget Pressures Will Challenge Their Sustainability

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.

Despite Investment Losses, Most Plans Hold Sufficient Assets to Pay Benefit Obligations for the Near Future

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.

Plans Face a Growing Gap between Assets and Liabilities, Leading to Higher Contribution Requirements

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.

Plans Are Vulnerable to Pressures on State and Local Budgets

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.

States and Localities Have Made Changes to Reduce Costs and Improve Plan Sustainability

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.

Half the States Have Raised Member Contributions, Shifting Costs to Plan Members

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.

Three States Recently Adopted Hybrid Approaches, Reducing Risk for Plan Sponsors

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.

Some States and Localities Have Adjusted Pension Funding Practices, Potentially Increasing Future Costs

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.

States and Localities Often Combine Strategies

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.

Reducing Benefits and Increasing Contributions for New Members

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.

Concluding Observations

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.

Agency Comments

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.

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