Public pensions across the country continue to battle with funding ratios. According to a new study released this month by Boston College’s Center for Retirement Research, the national funded average for state and local pension funds slipped to 75 percent.
The continued decline in funding ratios comes despite improvements in the stock market, increased revenues to state and local governments, new contributions from employees, and decreased benefits to new hires. It is a result, in part, of the five-year actuarial smoothing used by many pension systems to minimize the impact that year-over-year fluctuations in the market have on funding ratios.
Despite smoothing, the Center for Retirement Research at Boston College estimates that the 126 pension plans in the study had an actuarial value of assets equaled $2.7 trillion versus $3.6 trillion in liabilities.
The study showed in 2010, state and local pensions had $2.3 trillion in market assets, a number which is estimated to have jumped to $2.6 trillion this year. That’s an 11.5 percent increase. However, the estimated assets for 2011 are only slightly above the 2006 levels – the year that it replaces in the five-year smoothing model.
Nearly half of all pension funds are between 60 and 79 percent funded, while 17.5 percent are less than 60 percent funded. Illinois SERS and Kentucky ERS are only 35.6 percent funded.
The funding ratio depends upon the commonly used discount rate of 8 percent. However, should alternative discount rates be used, the 2011 pension liability would increase exponentially. At 6 percent, pensions would be 57 percent funded; at 5 percent, funding decreases to 50 percent; and at 4 percent, pensions would be funded at just 42.2 percent.
The 8 percent discount rate follows the GASB’s standards for long-term yields. However, “for reporting purposes, future streams of payment should be discounted at a rate that reflects their risks.” In the case of public pensions, the risk is a question of what payments are required – including cost of living adjustments and core benefits. In other words, the largest portion of public pensions is guaranteed, and therefore liabilities should be reported at a risk-free interest rate – for reporting purposes.
That was a position presented in another study by Boston College’s CRR titled “Valuing Liabilities in State and Local Pensions,” published in 2010. There, the authors said that “discounting pension funds’ liabilities by the expected returns on their portfolios overstates their funded status, measures that ignore the surplus return could understate their funded status.
“Nevertheless, a clear understanding of the status of a pension fund requires calculating the present value of liabilities using the riskless rate.”
In combating the unfunded liability, annual required contributions have continued their decade long increase, now topping 15.7 percent. The last decrease in the ARC came in 2002, when the rate fell to 6.1 percent. Corresponding decreases in payment rates have largely accompanied the increases in ARC. In 2011, just 79 percent of the required payments are expected to be made – that’s the lowest rate in the scope of the study.
When analyzing the out-years, the CRR brief took three approaches to quantifying expected liability gaps – an optimistic rate that calls for 8 percent annual growth, a middle rate of 5 percent growth, and a pessimistic rate of 3 percent annual growth. Under the best scenarios, pensions could be 98 percent funded by 2015; worst case is a funding ratio of just 74 percent.