Public Pensions Need Sound Funding Policies

September 24, 2013 ( – Public pension plan need sound funding policies, research findings from the Center for State and Local Government Excellence show.

According to a new issue brief from the center, “How Sensitive is Public Pension Funding to Investment Returns?,” the aggregate funded ratio for state and local pension plans will most likely increase from 73% in 2012 to 81% in 2016. This analysis takes into account the variability of investment returns from year to year and provides a more complete picture of the risks of serious underfunding, the brief said.

The brief discusses:

  • Historical investment returns and the assumptions currently used by public plans;
  • A stochastic “Monte Carlo” framework, and explains why this model is more helpful than a deterministic model that uses constant rates of return; and
  • A projection of pension funding through 2042 (30 years from the most recent plan data) using stochastically generated real investment returns under alternative assumptions regarding how much of the Annual Required Contribution (ARC) plans pay and what amortization methods they use.

In projecting pension funding to 2042, the brief’s authors used a stochastic model. Under the baseline scenario, the 50th-percentile funded ratio never reaches full funding even if the assumed return materializes, but rather hovers a little below 80%.

This pattern reflects two problems, according to the brief’s authors. First, employers have been paying only 80% of the ARC. Rectifying the contribution shortfall improves the picture somewhat, but funding is still only 87% after 30 years and the risk of ending up below 60% remains substantial. The second problem is the combined effect of calculating the amortization payment as a percent of payrolls with an open 30-year amortization period.

The brief concluded that alternative funding arrangements yield better outcomes. However, plans that follow such approaches still face a significant risk of poor returns, even if the long-run average equals 4.45%, leading to less than full funding in 30 years.

The full brief can be downloaded here.