Why should anyone other than a municipal analyst care about state and local pensions, OPEB (Other Post Employment Benefits) and ARCs (Annually Required Contributions)? We should all care, and care deeply as these problems directly impact the services provided by our city, county, and state governmental services.
The funding gap between state pension system assets and future benefits promised to workers reached $1.4 TRILLION in 2016. Underfunded public pensions have become one of the largest fiscal challenges for state and local governments. As the underfunded gap grows, so does the amount of the governmental budget that must be allocated to pension and OPEB funding. These increased costs deplete funds necessary to pay for the important governmental services we count on, such as roads, healthcare, public safety, and education. These impacts are already being felt around the country.
Here are a couple of recent headlines that exemplify concerns:
“Kentucky Makes Changes to Free Pension from Funding ‘Death Spiral’”
“Cash-Hungry Cities Seek Buyers for Sewer Systems to Pay Pensions”
I will walk you through an abbreviated history, the problems that have impacted the systems, and a few possible solutions.
History, or How Did We Get Here?
Historically, government employees were paid less than their private counterparts. In exchange, they received a more stable job and great retirement benefits: pensions, vacation, healthcare, sick-time, overtime, etc. These benefits were typically more generous than private companies.
Pensions are promises of future payments to retirees. Many governmental retirees also receive generous OPEBs such as governmental funded healthcare. The municipality, or employer, bears the risk of funding the plan through contributions and investment returns. This is in stark contrast to the model that most private companies utilize, which pushes the investment risk onto the plan participants (employees), usually through a 401(k)-type plan.
The public pension funding plans worked reasonably well when investment returns were higher and healthcare costs were lower. It is important to note that states and local governments don’t have to pay out the ENTIRETY of this debt is one fell swoop, municipalities need to be able to pay the existing retirees what is owed this year and think about how much they need to put aside today to fund future benefits.
Municipalities rely on actuaries to determine future cost of benefits, future numbers of employees drawing on these benefits, and what type of return is necessary to meet these costs. The annual required contribution (ARC) is calculated from these projections. Because public employers don’t have to pay the entire liability at the same time, plans are considered fully funded at 80% of the calculated future liability.
In 2000, most state pension programs were fully funded and paying close to the full ARCs. Investment returns had been fairly robust in the years prior, and it was generally assumed that investments would return an average of about 12% for perpetuity. A high rate of return benefits the municipalities, as the higher the assumed investment return, the less money that public entities will have to pay in on their ARC. If the investment return is lower, then the contributions must be higher to offset the lack of return.
Problems
“We will outperform the stock market this year and every year in the future!” aka Unrealistic Investment Return Expectations:
The funding issues came to light when the markets experienced a string of bad investment return years: in 2000 the S&P 500 was down 9.1%, down 11.9% in 2001, and down 22.1% in 2002. Some municipalities started lowering their expected investment rates to a range between 8 & 9%. Then we experienced the doozy, remember 2008? The S&P 500 was down 37.0% that year.
Fast forward to now. A 60% equity/40% bond portfolio has returned a little over 6% the last 20 years*. Most plans have slowly dropped their expected investment return rates and are now operating on an assumption of around a 7% return. Since they were slow to respond they are now behind because of previous years’ unachieved return assumptions.
Tax Revenue Collection Dropped During the Recession:
Looking again at 2008, not only were investment returns negative, but unemployment was high and tax revenue dropped precipitously.
This exacerbated an already huge problem for governments. The negative investment returns implied that a higher annual required contribution should have been demanded. Unfortunately, state and local tax offices collected much less revenue during this time-frame – leaving a substantial gap in what should have been required for pension funding and what local municipalities were able to contribute. Also, the need for state and local services was high (i.e. unemployment, housing assistance etc.). How could they fund their ARC payments and keep office doors open? Many municipalities chose NOT to fully fund their ARCs (a practice known as a “pension holiday”), crossing their fingers and hoping for a better revenue picture and future investment returns to make up for the lack.
Lack of Political Will:
It is difficult to enforce full compliance in towns or cities who are barely scraping by: few politicians want to be known for cutting school funding or street repairs to boost up funding for a complicated issue that voters don’t generally understand.
Potential Solutions
There are several solutions that political leaders and local governments can employ to strengthen pension funding, but none of them are easy:
- Strengthening funding policies: making laws at the state level that require local governments to pay their full ARC
- Gradually reducing expected investment returns to more reasonable levels
- Increasing employee contributions and shifting some of the funding responsibilities (similar to the private company 401(k) model)
- Changing benefit designs for new employees
- Reducing benefits for current employees and retirees (met with mixed success)
- OPEB benefit reduction (paid medical, how benefits are calculated, etc.)
In the Pacific Northwest, our municipal governments are paying attention to the issues. The Pew Research Center shows that Oregon’s state pension plan was funded at 83% and Washington was funded at 90%. This compares favorably to the overall funding ratio of 71% for all states. By contrast, Illinois is funded at 38% and Kentucky is funded at 33%.
The high costs of the pension funding gap impact all of us. It can impact our individual pocketbooks with higher taxes. It may affect the quality of services provided, such as the number of children in a school room or bridge repairs. It may impact governmental ability to support non-profits, reducing the essential services they provide to our communities. And it may also impact the ability of municipalities to repay municipal bond debt.
At Becker Capital Management, municipal pension issues are one of the factors that we employ in our municipal bond analysis. We believe that the tax-exempt benefits of owning quality municipal bonds is an important investment strategy. We watch funding levels and avoid municipalities that have large funding gaps and will continue to closely monitor this ongoing issue.
*Source: Bloomberg. Calculated using the 20-year average 60/40 blend of annual total returns of the S&P500 and Bloomberg Barclays Intermediate US Gov’t/Credit indices, for the year ending 2018.