Discipline Key to Well-Funded Public Plans

The issue brief looks at the varia­tion in funding among the 109 state-administered and 17 locally-administered plans in the Public Fund Survey and finds a strong relationship between plan size and funding status.

While a sizable num­ber of plans are not well funded, three quarters of the total assets are in well-funded plans. Other factors the report authors found that affect funding levels include funding practices, governance, the fiscal health of the state, and plan characteristics.

The report authors hypothesize that the funding status of pension plans depends on how long the government has been funding its pension costs, how much money the government and its employees are required to contribute and whether the government has been making its annual required contributions (ARCs) to plans.

A regression analysis of the 126 plans in the sample confirms that plans where fund­ing has been going on for a long time and where the plan sponsor makes the annual required contribution (ARC) have higher levels of funding. The analysis found that if the sponsor makes its full ARC payment, the funding ra­tio is 6.1% higher than in situations where the full ARC is not paid.

The report noted that several studies have explored the effect of governance on the funding status of public pension plans, and two variables that seemingly would be expected to have an important effect on the funding status of pension plans are the presence of employees and/or retirees on the board that governs the plan and the existence of an investment council.

However, the authors’ regression analysis showed that having employees and/or retirees on the board does not appear to affect the level of funding, while having a separate invest­ment council improves the funding status by 4.9%. Also, the mean funding level as of 2006 for plans in the sample that had no investment council was 82%, compared to 87% for plans that had an investment council.

As for the effect on plan funding of the fiscal health of the state, the hypothesis is that if a state is having fiscal problems, it may meet current non-pension obligations by not making the annual contribution to the pension plan.

The regression confirmed that the fiscal health of the state plays an important role in funding status, as it found states with high levels of debt to gross state product (GSP) are less well funded than those with lower levels. This fiscal ratio varies substantially (from 1.6% to 17.5%), and the results show that a one-standard-deviation change in the ratio between debt and GSP reduces funding levels by about 3.5%.

The authors hypothesized that three characteristics of plans would be expected to affect the funding ratio - plan size, whether the plan is administered at the state or local level, and the generosity of benefits.

Plan size and funding levels appear to be closely related, and the authors said possible reasons may be large plans use more sophisticated asset man­agement, are better disciplined because not funding could have a huge impact on taxpayers in the future, or are more in the political spotlight than smaller plans. The analysis found that the largest third of plans do appear to have a scale advantage with an average funding ratio that is almost 10% higher than small and medium plans.

The authors expected that state-administered plans may have higher funding levels than locally-administered plans, independent of size, because they would have access to better management and would be subject to greater public scrutiny. However, the regression results suggest that state administration has a nega­tive effect on funding, but the CRR notes that the coefficient is only marginally significant and points out that the sample includes only 30% of the assets of plans admin­istered at the local level compared to 90% of the assets in state-administered plans.

In the analysis of the effects of benefits levels on funding status the authors assume the more expensive the plan, the more difficult it is to fund, simply because the annual required contributions will be higher. In addition, high initial benefits make a plan expensive, and substantial cost-of-living increases also raise overall costs. They note that some previous studies have found a positive relationship between the level of benefits and low funding ratios.

The interesting result of the analysis is that plans that include teachers tend to be less funded. According to the report, one study found that teachers have longer tenures than general government employees and higher earn­ings, and these factors translate into larger pension liabilities. The authors' analysis showed that plans that include teachers have an average funding ratio that is 6.4% points less than plans that do not cover teachers.

The authors conclude that while the aggregate of public pension systems seems to be in good health, funding ratios vary substantially among plans due to funding practices, governance, general plan characteristics, and the overall fiscal health of the government. However, they point out that the key factor for better funding is whether the spon­sor has a funding plan and is sticking to it.

The CRR Issue Brief - Why Does Funding Status Vary Among State and Local Plans? - is here .