Reducing the Funding Gap for State Pensions

In “Policy Options for State Pension Systems and Their Impact on Plan Liabilities (NBER Working Paper No. 16453),” co-authors Joshua Rauh and Robert Novy-Marx examined 116 state-sponsored pension plans, including those with more than $1 billion of assets, to estimate the extent of unfunded pension liabilities and how that issue might be addressed.

The authors noted that the principles of financial economics suggest using a much more conservative discount rate than 8% rate typically used. “This means discounting either with a taxable state-specific municipal yield curve, which credits states for the possibility they could default on pension payments, or with a Treasury yield curve, which presents the benefit payments as default-free,” said Rauh and Novy-Marx.

According to the paper, the states estimate their unfunded liabilities at just less than $1 trillion. That gap increases to $1.3 trillion using the municipal yield curve and to $2.5 trillion using the Treasury curve. The authors focus on the narrowest measure of liabilities, which is liabilities frozen as of June 2009, not accounting for future work by existing employees, new hires or future pay increases.

These funding gaps are not only large but difficult to fill, even with relatively dramatic policy fixes, Rauh and Novy-Marx said. Steps such as eliminating generous early retirement benefits or raising the retirement age by a year would reduce liabilities by no more than 2% to 5%. Reducing cost of living adjustments (COLAs) by a percentage point would have a somewhat stronger effect, they said, reducing total liabilities by 9% to 11%.

But even eliminating COLAs completely, or changing the Social Security retirement age, would leave state pension plans with $1.5 trillion less than they need based on the Treasury discounting method, according to Rauh and Novy-Marx.

The paper cites several examples of states taking steps to address gap-related issues. While states such as Minnesota and Colorado have reduced their COLAs, they have encountered legal challenges as a result, said Rauh and Novy-Marx. Rhode Island has increased the plan retirement age for employees who are not yet eligible for retirement benefits. So has Iowa, but only for nonvested employees. In addition, Iowa has doubled its actuarial reductions, from 3% to 6% per year, effectively making early retirement less generous. Vermont has implemented actuarially fair early retirement, where early retirement penalties are assessed on workers below a certain age and service threshold.

The paper concluded that, while these measures may have modest effects on reducing unfunded liabilities, a large share of the unfunded liabilities will remain.

Information about how to purchase the working paper can be found here.