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What to Do About Underfunded Pension Plans


State and local governments sponsor nearly 4,000 pension plans that cover almost 20 million retirees, employees and former employees who have not yet claimed benefits. The majority of full-time state and local government employees participate in a defined benefit (DB) pension plan in which pension benefits are typically determined by a formula based on the employee’s salary history and years of service. For example, if a plan offered annual payouts equal to 2% of a worker’s final salary times the number of years of service and the worker had a final salary of $80,000 after 30 years of service, the pension benefit would equal $48,000 per year for the rest of the worker’s life and, typically, would provide for survivor benefits.

Estimates of unfunded municipal pension liabilities are approximately $1 trillion, based on current accounting rules, while other estimates, using risk-adjusted interest rates, peg the amount at between $3 trillion and $4 trillion.

Public pension benefits payments come from dedicated trust funds, not from governments’ general operating budgets. From 1985 through 2014, fund balances were created from the combination of employee contributions (11%), government (employer) contributions (25%) and the investment returns (64%). Government employer pension contributions were 4.1% of state and local direct general expenditures, ranging across states from 1.6% to 8%.

The Governmental Accounting Standards Board (GASB) via Statement 67 created a measurement technique designed to target the contribution amounts to keep the pension plans on a sustainable path. The tool was designed to measure the present value of newly accrued benefits during a given year plus an amount that would be sufficient to amortize existing unfunded liabilities throughout the next 30 years. For state and local pension plans, these measures have risen steadily over the past 15 years, from 6.7% of payroll in 2001 to 18.6% by 2015. Reasons for the increase include:

  • Asset values dropped during the 2008 recession.
  • Some municipalities did not consistently make the contributions indicated by the tool.  

An underfunded pension plan does not indicate that it is failing to meet current obligations. However, after all of these interesting facts are known, the question remains – What steps should be considered to prevent potential insolvency?

Approach to Solving the Problem
No one solution will solve this problem, so a combination of alternatives is needed. Ultimately, raising taxes and realigning government spending will be considered and enacted. Unlike private single-employer pension plans and multi-employer pension plans, there is no equivalent to the Pension Benefit Guaranty Corporation (PBGC) to take over failing pension plans, including those underfunded plans that are assumed in a bankruptcy transaction. In addition, as a result of existing collective bargaining arrangements and certain state laws, it will be difficult to reduce or curtail pension plans, except for future hires.

However, as part of this analysis, it is possible to begin a process of better managing the liability and charting out a path to de-risk and ultimately eliminate pension debt. Rather than focus on the total underfunded liability, plan sponsors must begin to understand their liabilities, as broken down among:

  • Current Retirees – retirees and beneficiaries that are currently collecting benefits. This requires a portion of the fund assets to remain fairly liquid to meet retiree payroll. What is the liability for this group by individual and what is their demographic composition?
  • Deferred Vested Participants – former employees and beneficiaries who have a vested pension benefit that will commence upon becoming retirement eligible. This will require liquidity at some time in the future. What is the liability for this group by individual and what is their demographic composition?
  • Future Retirees – current employees who are continuing to accrue benefits and are contributing to their pension plan. This will require liquidity at some time in the future. What is the liability for this group and what is their demographic composition?

It will not be possible for plan sponsors to invest their way out of the underfunding problem, and restrictions under state law will most likely prevent the ability to curtail benefits for future retirees, deferred vested participants and current retirees. However, splitting the liability into tranches will permit a more focused approach to implement immediate short-term solutions designed to chip away at the problem.

It is possible, with some governmental assistance, to begin a process of eliminating the liability on a targeted basis, starting with current retiree liability. The best investment choice is one that eliminates the liability. Under this approach, state and local governments should consider purchasing non-participating annuity contracts for some or all current retirees. This process effectively takes current plan assets and uses them to settle retiree liabilities, with no trailing risk to the plan or the government. The state general budget (or local government) can create subsidies or assist in reimbursing the plan for some or all losses that may arise in settling the obligation. For example, assume the carrying value for the current retirees is $50 million and the annuity purchase expense is $55 million. In order to assist the plan in eliminating this liability, the state government would provide a financing package to the pension plan to make up for some or all of the loss. The goal of this state assistance is to eliminate the loss generated from this transaction.

A similar process can be followed for the deferred vested participants. For this group, it may be possible to offer a voluntary lump-sum window on a favorable interest rate basis, from the plan’s perspective. As such, if a deferred vested participant elects this option, there could be a potential gain to the pension plan. This would then eliminate the liability for the pension plan and permit the deferred vested participant to roll over the lump-sum benefit into a tax-deferred vehicle.

The last group is the future retirees. Once some or all of the liability is eliminated for current retirees and/or deferred vested participants, a stricter funding and liability management policy must be adopted and then enforced.

A rehabilitation plan, modeled along the lines of multi-employer pension plan rules, can be created for municipal pension plans. Government subsidies, loans and bond issuances can be created and provide an incentive for municipal plans that aggressively take actions to better manage the situation. This focused approach will help better create a short-term financial plan to assist in the rescue.

About the Author

Elliot Dinkin is President and CEO at Cowden Associates, Inc. He earned his MBA in Finance and Accounting from the University of Pittsburgh and a BA in Economics (Cum Laude) from Dickinson College. You can follow him on Twitter.

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