In late 1992, about 13 million workers and retirees participated in state and local government pension plans. Eighty-seven percent of state and local full-time employees participated in defined benefit plans, while 9 percent participated in defined contribution plans. Some employees participated in both; 93 percent participated in one or the other. In a defined benefit plan, benefits are established by a formula that is generally based on such factors as years of employment, age at retirement, and salary level. Employers and employees in most state and local plans contribute to a fund from which these defined benefits will be paid. Actuaries calculate the size of the fund that will be needed to pay these benefits on the basis of projections of fund investment earnings, mortality, and other factors. If the fund’s assets are less than the projected liabilities, the plan is generally considered to be underfunded. Actuaries also calculate the contribution amount needed to cover the liability that accrues each year and to pay an installment on any unfunded liability. Thus, if a plan sponsor is making these actuarially required contributions, the plan can be underfunded yet still on track toward full funding. In contrast, a defined contribution plan, such as a 401(k) or 457 supplemental retirement account, sets the amount contributed to individual worker accounts. The balance in such an account at retirement, reflecting total contributions and investment earnings, determines the worker’s retirement benefit. Thus, by definition, such a plan cannot be underfunded in an actuarial sense. For private-sector pension plans, the Employee Retirement Income Security Act of 1974 (ERISA) ensures that most promised employee benefits will be paid. If a company goes out of business and leaves its defined benefit pension plan without adequate funds, the business no longer has earnings with which to make further contributions to cover its pension obligations. Among other things, ERISA insures pension benefits against insufficient funding; the Pension Benefit Guaranty Corporation (PBGC) assumes the liability and assets of terminated private pension plans and pays the retirement benefits, subject to certain limits. ERISA also requires that plan investments be diversified and funded on a sound actuarial basis and that plan fiduciaries adhere to certain standards of conduct. Further, ERISA establishes a framework for enforcing its provisions involving three federal agencies: the Department of Labor, the Internal Revenue Service, and the PBGC. ERISA does not apply, however, to state and local pension plans, nor does federal law impose funding requirements on them. Instead, state and local pension plans are created and governed by laws of their respective governments, which specify any funding or other requirements. These laws, their administration by state and local government agencies, and ultimately their enforcement by the courts provide any protections the beneficiaries may have. For example, in all 50 states, statutes include provisions for fiduciary standards; in about half of the states, these provisions are similar to ERISA’s. Also, about half restrict the types of investments that can be made. In addition, annual contributions to 56 percent of state and local pension plans are required to be actuarially based; for 40 percent of these plans, statutes set a specific contribution level, which in most cases is periodically adjusted to achieve actuarial balance, according to a state pension official. In addition, the plans are subject to review by state and local governmental audit agencies and legislative oversight committees. Moreover, the Governmental Accounting Standards Board (GASB) sets accounting and reporting standards for state and local governmental entities, including pension plans. Most state and local governments adhere to these standards. GASB will soon require the reporting of a 6-year funding and contribution history for pension plans and, for plan sponsors, the reporting of a measure of the difference between actuarially required and actual contributions. According to a PPCC analyst, such reporting should provide further impetus to improve funding and contributions. At times, perceptions arise that a state or local government is redirecting funds from a pension plan to meet other budgetary needs. For example, since 1992 California has attempted to delay its annual contributions of roughly $500 million by more than a year, costing its Public Employees’ Retirement System as much as $50 million per year in interest. In other states, such as New York and New Jersey, the legislatures have attempted to change certain actuarial assumptions to lower contributions. Also, several state legislatures have encouraged pension managers to invest some portion of plan assets in ways that will promote economic development as long as these investments are sound. Some critics raise concerns that such targeted investments often are not sound, citing certain bad investments that lost millions. For example, in 1990, Connecticut’s pension plan invested about $25 million in Colt Industries, which in 1992 declared bankruptcy; the pension plan lost $21 million. State and local government plans nevertheless operate in public view, and some plan fiduciaries and others have filed suits against plan sponsors. For example, according to pension officials and trade publications, in the California case, a superior court judge ordered the state to make the delayed contribution with accrued interest; the case is pending on appeal. Similarly, New York’s highest court ruled that the New York law changing the actuarial methodology for the public employees’ retirement system violated the New York State Constitution, and the state has agreed to a payment schedule that will make full restitution of missed contributions by 1999. As of this writing, the other cases involving New York and New Jersey are still pending in their respective courts. Regarding targeted pension investments, while some such investments do not earn competitive returns, others do. Although incidents of insolvency or termination of state and local pension plans are rare, underfunding of such plans may present governments with difficult budget decisions in the future. If the actuarial value of a pension plan’s liabilities exceeds its assets, a plan may still have enough funds to pay benefits for many years. If such underfunding persists, however, eventually—perhaps years in the future—the plan may lack enough funds to pay benefits. At that time, the sponsoring government will need to have made additional contributions to the pension fund. Or, a government may change the law to reduce benefits or postpone benefit increases that offset inflation, depending on the law that created the plan and the state constitution or municipal charter that governs lawmaking. Thus, the ability of state and local governments with underfunded plans to meet their pension obligations at some future date will depend on balancing competing budgetary demands and possibly on the willingness of their taxpayers to meet the cost. Moreover, if pension benefits are not fully funded, the fiscal burden of providing for them can grow quickly as a share of the budget under various circumstances. Benefit costs can increase rapidly if the number of retirees surges. Also, government revenues can grow slowly if the tax base decreases or tax rates are cut, even though promised benefits have already been determined for years to come. In fact, the ratio of active workers to retirees is declining in the state and local sector, which means that the cost of paying benefits for previous years’ employees is growing relative to the cost of paying current employees. If benefits are not fully funded, the relative fiscal burden of providing for them will grow as well. Also, the prospect of such budgetary pressures can significantly affect the sponsoring government’s bond ratings. In addition to concerns that full benefits might not be paid as promised or that the fiscal burden of doing so might be excessive, underfunding of state and local plans implies that the cost of government has been partially shifted from one generation of taxpayers to another. This year’s cost of government includes the cost of pension benefits that employees earn with this year’s work. Underfunding can arise when pension contributions do not fully cover the cost of pension benefits that workers earn in a given year. Underfunding can also arise for other reasons, however, such as pension plan investments’ not earning as high a return as projected. Actuarially required contributions include an installment on the amount needed to amortize the underfunded amount. Thus, undercontributing arises when the sponsoring government is not paying enough either to cover the pension liability incurred this year or to amortize this year’s share of the unfunded liability or both. A number of federal pension plans also have unfunded liabilities;however, arrangements have been made to fund the liabilities in the future. More importantly, the funding status of federal pension plans does not have the same implications as that of state and local plans. Unlike state and local pension assets, the vast majority of federal pension assets must by law be invested in nonmarketable U.S. Treasury securities. In effect, federal pension assets largely represent government promises to pay benefits, rather than investments that can be converted to cash. When the Treasury pays benefits now or in the future, it must obtain the money either from tax revenues or borrowing, regardless of the plans’ technical funding status. Although underfunding of state and local pensions has decreased considerably since the mid-1970s, underfunded plans remain. The unfunded liabilities of all state and local government pension funds then totaled $150 to $175 billion, according to the U.S. House of Representatives Pension Task Force; adjusting for inflation, this equals about $400 billion in 1992 dollars. In 1992, unfunded liabilities totaled roughly $200 billion, according to our estimate from the PPCC sample. Thus, the unfunded liability has decreased by about half in constant dollars. Also, in the mid-1970s, the funding ratio was roughly 50 percent. The 1992 funding ratio for plans in the PPCC sample was 82 percent (see table 1). (The funding ratio is the proportion of pension liability covered by the value of plan assets.) Funding ratios vary widely, however. Of the plans that were underfunded in 1992, 38 percent were less than 80-percent funded (see fig. 1). For underfunded plans alone in the PPCC sample, total assets equaled 77 percent of liabilities.