State and local government pension benefits are paid not from general operating revenues, but from trust funds to which public retirees and their employers contributed while they were working. On a nationwide basis, pension contributions made by state and local governments account for roughly three percent of total spending (see Figure 1). Current pension spending levels, however, vary widely and are sufficient for some entities and insufficient for others.
In the wake of the 2008-09 market decline, nearly every state and many cities have taken steps to improve the financial condition of their retirement plans and to reduce costs. Although some lawmakers have considered closing existing pension plans to new hires, most determined that this would increase—rather than reduce—costs,i particularly in the near-term. Instead, states and cities have made changes to the pension plan by adjusting employee and employer contribution levels, restructuring benefits, or both. Generally, adjustments to pension plan costs have been proportionate to the plan’s funding condition and the degree of change needed.ii
Three Percent Nationwide
Based on the most recent information provided by the U.S. Census Bureau, approximately three percent of all state and local government spending is used to fund pension benefits for employees of state and local government.iii As shown in Figure 2, pension costs since 1980 have been reliably stable, declining from around four percent to three percent in 2010.
Source: U.S. Census Bureau
Because not all state and local government revenue is discretionary, the actual effect of pension costs on state and city budgets is likely to be higher—to varying degrees—than calculated. In addition, some states and cities do not contribute the amount determined actuarially to adequately fund the plan.
Although pensions are not the state-local budget-drain that some claim they are, as shown in Table 1, spending levels for states and cities do vary from the national average, from less than one percent to more than four percent. Some municipalities have reported higher pension costs as a percentage of their budget. One study estimates that total required spending on pensions could consume as much as 13 percent of one state’s budget,iv due partly to past failures to adequately fund pension costs and assuming a relatively low five percent investment return. The chronic failure by some pension plan sponsors to pay required contributions results in greater future contributions to make-up the difference.
Most of the variation in pension spending levels is attributable to three factors: different levels of effort by states and cities to make pension contributions; differences in benefit levels; and variations in the size of unfunded pension liabilities. As a percentage of total spending, pension costs for cities are higher than states by about 50 percent. This is due in part to the types of services delivered at the local level and the resulting larger share of municipal budgets that is committed to salaries. As with states, pension costs for municipalities can vary widely.
Cost and Financing Factors
Public pensions are financed through a combination of contributions from public employers (state and local agencies) and public employees, and the investment returns on those contributions.v Since 1982, investment earnings have accounted for approximately 60 percent of all public pension revenue; employer contributions, 28 percent; and employee contributions, 12 percent.
Because the vast majority of public employees are required to contribute toward the cost of their pension benefit—typically four to eight percent of pay—most state and local government retirement plans are mandatory savings programs. In recent years, many states have increased required employee contributions. On a national basis, in fiscal year 2009, employee contributions accounted for 31 percent of all public pension plan contributions, with employer contributions making up the remaining 69 percent (see NASRA Issue Brief: Employee Contributions to Public Pension Funds, January 2013).
A variety of state and local laws and policies guide governmental pension funding practices. Most require employers to contribute what is known as the Annual Required Contribution (ARC), which is the amount needed to finance benefits being accrued each year, plus the cost to amortize unfunded liabilities from past years, minus required employee contributions.
The average ARC received in recent years has been around 90 percent. Beneath this average ARC experience lies diversity: approximately 60 percent of plans in the Public Fund Survey consistently receive 90 percent or more of their ARC.vi This means that although a majority of plans have been receiving their required funding, many plans have not been adequately funded, which will result in higher future costs.
Leading national public sector associations recently established a Pension Funding Task Force, which earlier this year released its report Pension Funding: A Guide for Elected Officials urging policymakers to follow recommended guidelines for an actuarially determined contribution to government retirement systems.
Social Security Coverage
Twenty-five to thirty percent of state and local governments and their employees make contributions to their retirement plan instead of to Social Security. This is the case for most to substantially all of the state and local government workforce in seven states, 40 percent of the nation’s public school teachers, and a majority of firefighters and police officers. Pension benefits—and costs—for those who do not participate in Social Security are usually higher than for those who do participate in order to compensate for the absence of Social Security benefits. This higher cost should be considered in the context of the 12.4 percent of payroll, or an estimated $31.2 billion annually,vii these employers and employees would otherwise be paying into Social Security.
Investments and Other Parts of the Financing Equation
The largest portion of public pension funding comes from investment earnings, which illustrates the major role this revenue source plays in determining pension costs (see NASRA Issue Brief: Public Pension Plan Investment Return Assumptions, March 2013). Other factors that affect pension costs include expectations for wage and general inflation, rates of worker retirement and attrition, and rates of mortality. Expectations for these and other economic and actuarial events typically are based on long timeframes, such as 20 to 50 years.
Although the market decline of 2008-09 lowered public pension fund asset values, macro-economic events also affect the cost of the plan. These events include such changes as retirement rates, attrition (such as hiring freezes), and wage growth (including salary cuts/layoffs). Additionally, legislatures in over 40 states have made changes to pension benefits and/or financing structures, in some cases reducing plan costs and long-term obligations.
On average, retirement programs remain a small part of state and local government spending, although required costs, benefit levels, funding levels, and funding adequacy vary widely. Over $210 billion is distributed annually from these trusts to retirees and their beneficiaries, which serves as a source of economic stimulus to virtually every city and town in the nation.viii
Changes to benefit levels and required employee contributions adopted by states and cities have been diverse, dependent in part on such factors as the legal authority to make changes to benefits or required employee contribution rates, and the plan’s financial condition prior to the 2008-09 market decline. Generally, states and cities with a history of paying their required pension contributions are in better condition and have needed more minor adjustments to benefits or financing arrangements compared to those with a history of not adequately making their contributions.
Republished with the permission of NASRA
National Governors Association, National Governors Association, National Conference of State Legislatures, The Council of State Governments, National Association of Counties, National League of Cities, The U.S. Conference of Mayors, International City/County Management Association, National Council on Teacher Retirement, National Association of State Auditors, Comptrollers and Treasurers, Government Finance Officers Association, and National Association of State Retirement Administrators, “Pension Funding: A Guide for Elected Officials,” 2013, http://wikipension.com/images/9/95/1303PensionFundingGuideBrief.pdf
Center for Retirement Research at Boston College, “The Impact of Public Pensions on State and Local Budgets,” October 2010, http://crr.bc.edu/briefs/the_impact_of_public_pensions_on_state_and_local_budgets.html
Center on Budget Priorities and Policies, “Misunderstandings Regarding State Debt, Pensions, and Retiree Health Costs Create Unnecessary Alarm,” January 2011, http://www.cbpp.org/cms/index.cfm?fa=view&id=3372
National Association of State Retirement Administrators, Issue Brief: Public Pension Plan Investment Return Assumptions, Updated March 2013, http://www.nasra.org/resources/InvReturnAssumption_Final.pdf
National Association of State Retirement Administrators, Issue Brief: Employee Contributions to Public Pension Funds, January 2013, http://wikipension.com/images/8/8e/Issuebrief130102.pdf
Keith Brainard, Research Director here.
Alex Brown, Research Associate here.
National Association of State Retirement Administrators
i Wikipension, “Costs of Switching from a DB to a DC Plan,” http://www.wikipension.com/index.php?title=Studies_and_reports#State_Studies
ii Center for Retirement Research at Boston College, “State and Local Pension Costs: Pre-Crisis, Post-Crisis, and Post-Reform,” February 2013
iii A similar study conducted by the Center for Retirement at Boston College calculated the cost of pensions to be 3.8 percent, using a calculation that excluded capital spending
iv Center for Retirement Research at Boston College, “The Impact of Public Pensions on State & Local Budgets,” supra
v U.S. Census Bureau, http://www.census.gov/govs/retire/2009ret02.html – State and local government retirement system sources of revenue
vi Public Fund Survey, http://www.publicfundsurvey.org/
vii Author’s calculation based on 30 percent of state and local government employees not participating in Social Security
viii Pensionomics: Measuring the Economic Impact of State and Local Pension Plans, National Institute on Retirement Security, February 2009; see also “Economic Effects of Public Pensions,” http://www.nasra.org/resources/economic.htm