by Gary Foreman

Only 3 states have set aside enough to meet their promised pensions. Is your pension and your retirement at risk?

You’ve worked hard and have been promised a pension from the state or local government or one of its agencies. You’ve always thought that it was secure, but now you hear about Detroit and their pension problems and you wonder about the security of your pension. Could an underfunded pension plan put your retirement at risk?

To help us understand the issue, we contacted David Payne, the Staff Economist for The Kiplinger Letter and a NABE-certified Business Economist. You can find his work on the Kiplinger website.

Q: How big is the problem of unfunded pensions? Are there many states that haven’t invested enough money to keep the pension promises they made to workers?

Mr. Payne: Almost all are partially funded (see Alicia Munnell and Jean-Pierre Aubry, “The Funding of State and Local Pensions, 2015-2020” and Pew Trust’s study, “State Pension Funding Gap”). Even assuming an optimistic rate of return, only three states have fully funded pension funds: Oregon, South Dakota, and Wisconsin. Eighteen states are below 70% funded, and three are below 45%, namely Illinois, Kentucky, and New Jersey. Only 14 states are improving their pension funding situation. The other 36 states are seeing their unfunded liabilities grow (See the net amortization column in Figure 1 of the Pew study. If the “% paid” number is below 100%, then unfunded liabilities are growing).

The states with the fastest growth in unfunded liabilities are New Jersey, Kentucky, Texas, and Pennsylvania, though Kentucky has cut the state budget significantly this year to devote more resources for pensions. Specific funds with less than 50% funding are Kentucky Emergency Response workers (22%), Chicago Police (27%), Illinois state (36%), Chicago municipal (37%), Illinois teachers (42%), Illinois universities (43%), Connecticut state (43%), Philadelphia municipal (45%), Indiana teachers (46%), and Arizona public safety (49%). Other states and cities with some problem funds include Alaska, Atlanta, Dallas, Massachusetts, Michigan, Missouri, New Jersey, New York City, Pennsylvania, Phoenix, Rhode Island, and Vermont.

The majority of public pension plans also have other lesser-known practices, which may also make the underfunding problem worse. Rules which allow contributions to be back-loaded 15 to 30 years out will create underfunding if early returns are poor. Rules which allow asset values to be smoothed over time don’t recognize the impact of poor early returns right away, increasing the risk of underfunding. And rules which allow amortization periods to be extended indefinitely could make the problem worse.

However, it’s important to emphasize that states are not going bankrupt and outright pension cuts to existing retirees would be a last resort. Most likely would be changes for new or current employees and cuts to both health care insurance for retirees and cost-of-living adjustments. (See page 3 of NASRA’s “Significant Reforms to State Retirement Systems”) It’s possible that the weight of pension funding on the ability to fund schools and social programs could create political movement to do something, especially as fewer non-public employees are covered by pensions and so may not be sympathetic, but this would likely happen in 5 to 10 years or whenever the next recession occurs (since that would put more pressure on budgets).

Although this is a couple years old, NASRA’s “Effects of Pension Plan Changes on Retirement Security” shows the effect of pension changes that have affected current workers.

Q: Understanding how much money should be invested today to pay retirement benefits years in the future can be a bit complicated. It’s easy for those managing the plans to bury people in numbers. Is there any easy way for the average person to know whether their plan is fully funded?

Mr. Payne: See the Munnell and Aubry appendix, which lists most public plans.

Q: If the pension manager assumes a high growth rate for the funds they’ve invested, it’s easier to hide an underfunded pension. Is it possible for workers to assume that any assumed growth rate above x% is overly optimistic and an indication that the plan is underfunded? And, if so, what would that rate be?

Mr. Payne: See page 5 of Munnell and Aubry and their tables 3 and 4. Public pensions currently hold about 70 percent of their assets in risky investments, including more than half of their assets in equities. “On average, plans assume a nominal return of 7.6 percent on their whole portfolios, which implies nominal stock returns of 9.6 percent. In contrast, many investment firms project much lower equity returns (see Table 3).” Table 4 shows that assuming a lower, more realistic, rate of 5.5% on equity investments would reduce funding ratios by about six percentage points by 2020.

A presentation of the Illinois Teachers Retirement System shows how funds are changing their asset mix to riskier investments, because of low interest rates.

Q: If someone finds that their pension plan is under-funded, what steps can they take to make sure that any benefits cutback won’t cripple their retirement lifestyle?

Mr. Payne: Always have a contingency plan in case benefits are cut 10% to 20%, the COLA is reduced, or the health insurance premium is increased. Again, cutbacks are not likely to take place until the next recession, which could be several years away.

Q: Who is responsible for making sure that state pension funds are properly funded and invested?

Mr. Payne: The executive directors of the individual funds control the investment. They make recommendations to the legislatures and encourage more funding. The legislatures don’t have to follow the recommendations, however. There is a measure of accountability from the bond rating agencies. If a state or city has too low a funding ratio, then their ability to repay further borrowing is considered diminished, and their credit rating is cut, making borrowing more expensive. For example, Illinois’ rating has been cut to Baa2, two steps above junk. Most states and cities want to avoid this and will try to stay at least in the 75% to 80% funded range. No state has yet threatened simply not to pay.

Q: Is there anything that state workers and retirees can do to make sure that their retirement plan is properly funded?

Mr. Payne: They could write legislators and support the efforts of the SLGE Association, but I think it would also be helpful if they promote the warnings of pension fund officials. For example, Richard Ingram, the Executive Director of the Illinois Teachers Retirement System was very blunt in his warnings. See https://trs.illinois.gov/press/2016/RateOfReturnIngram26May2016.pdf.

An excerpt: “TRS has never once in its history received an annual contribution from the state that was actuarially adequate… political science has always trumped actuarial science in Illinois. The proper policy would be to have the calculation of an actuarially based contribution required by the state. That would end the charade of people feeling good about paying an artificially low contribution each year. If the state can only afford some lower amount, then so be it, but at least everyone will know the real picture. … Between 60 and 70 percent of the cost of the benefit is designed to be borne by investment earnings over the life of the member. It is only when you don’t have money to invest that the cost becomes unbearable. Taxpayers have to pay for those lost earnings and that reality has been documented fully and writ large in Illinois. It is not plan design that has failed, it is politics. … Lower contributions now means higher, and often much higher, contributions over the long run. Putting off the pain does not change the reality of what it costs to properly fund the benefits. It only increases it.” (emphasis in original)

I spoke to Richard directly. Although the reduction in the assumed rate of future return to 7.0% was going to cost the legislature about $500 million next fiscal year, he was optimistic. He thinks it’s possible they may have to reduce the assumed rate of return to 6.5% or lower in the future.

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Reviewed October 2020

About the Author

Gary Foreman is the former owner and editor of the After50Finances.com website and newsletter. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com.