Public pensions can be made and kept sustainable for the long haul by incorporating a new tool—sustainability valuation—into funding policies and practices, according to a study by the National Conference on Public Employee Retirement Systems (NCPERS).
The study by Michael Kahn, NCPERS director of research, suggests that pension systems can use sustainability valuation to monitor their fiscal status on a continuing basis, gaining insights that would enable them to identify fiscal adjustments needed to stabilize pensions for the long term.
Kahn says the study’s analysis confronts a fundamental error that critics of public pensions make. They frequently compare pension liabilities that are amortized over 30 years with one-year state and local economic capacity or revenues. This erroneous mismatch is then cited as justification for extreme measures, such as cutting benefits and shutting down pension plans, he notes.
This “is like a bank telling the borrower his or her 30-year mortgage is due at the end of this year,” Kahn says in the study report. “Were that the case, almost no one would be able to buy a house.”
The report notes that the prevailing theory of sustainability is that if the ratio between debt and economic capacity of a jurisdiction is stable over time, the debt is sustainable. It compares this to household finances. “If household debt is growing faster than income, we are in big trouble,” the report says. “But if income is rising in concert with debt, we are OK.”
In the study, Kahn uses personal income (PI) (which consists of all income, earned and unearned) as a measure of the economy. He explains that this is a better measure of the economy than, for example, gross domestic product (GDP) because PI is owned by residents of the state or locality and, according to the Advisory Commission on Intergovernmental Relations, PI is one of the key ways to measure tax capacity. Tax capacity refers to the amount of revenue a jurisdiction can raise beyond what it raises now.
The study found a realistic picture comparing 30-year unfunded liabilities with 30-year own-source revenues—the time horizon under which pension plan funding operates—shows unfunded pension liabilities “are a miniscule issue.”
When the ratio between debt and economic capacity is stable or declining, debt is sustainable. The study found that state and local outstanding debt is sustainable, especially since 2010.
“Despite the increase in the ratio between 2002 and 2010, the debt is more sustainable now than it was in 2002,” the report says. “For example, the debt was about 0.81% of PI in 2002, and in 2018, it was 0.78%.”
Looking at state-by-state trends in sustainability trends in outstanding debt, the study found pension debt is sustainable in all but five states.
Using Sustainability Valuation
Kahn says states and localities can enhance the sustainability of public pensions by adding a “sustainability valuation” on top of current pension funding practices such as actuarial valuation, stress testing, employers’ funding disciplines and sound investment strategies. “By ‘sustainability valuation’ we mean monitoring sustainability on an ongoing basis and making fiscal adjustments to keep the ratio between unfunded liabilities and economic capacity stable at, say, the average of the past two decades,” he says in the report.
The study involved a state-by-state level analysis, but Kahn says the sustainability analysis can be done for individual plans by using historical plan-level data and data on local economic capacity. Such plan-level analysis can include variables such as other post-retirement employee benefits liabilities, legacy experience and reasonableness of actuarial assumptions in the multivariate models.
The study report, “Enhancing Sustainability of Public Pensions,” is available here.
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