The State of Public Pension Benefits

Introduction

This highlights the current challenges and best practices for maintaining pension soundness, focusing on sustainability, contributions, the impact of economic downturns, and reforms enacted since the 2007 financial crisis.

Pension Soundness

Pension soundness is a key concept in ensuring that long-term assets match long-term liabilities, an essential balance for public pension plans. This balance is maintained by ensuring that contributions from employers and members, plus returns on investment assets, cover the costs of benefit payments and administrative expenses.

While the equation seems simple, it is influenced by many factors, making its management complex and dynamic.

The formula for pension soundness is defined as Contributions (C) plus Investment Returns (I) equals Benefits (B) plus Expenses (E). Each part of the equation is subject to variability over time, meaning pension plans must continuously adjust their expectations and strategies.

Contributions are determined through an expected rate of return on investments, and the benefit costs must be projected based on actuarial analyses.

Administrative expenses, although stable and relatively minor in comparison, are also a component of the equation. Importantly, there is no permanent or fixed answer to maintaining pension balance, as it constantly shifts with market conditions, changes in legislation, and demographic factors.

Actuarially Determined Contribution

(ADC) A crucial aspect of maintaining pension soundness is the consistent payment of the Actuarially Determined Contribution (ADC), also known as the Annual Required Contribution (ARC). This is the amount of money that needs to be contributed annually to ensure the pension plan is adequately funded for current and future benefits.

Pension plans that receive their full ADC on a consistent basis are in a much stronger financial position, while those that fail to receive adequate contributions are more vulnerable to long-term financial challenges.

The National Association of State Retirement Administrators (NASRA) emphasizes that policies mandating the payment of the ARC, such as statutes or constitutional provisions, lead to more stable pension funding outcomes.

Despite the existence of such policies, some plan sponsors do not consistently meet their contribution requirements, leading to underfunded pensions. While most states have made good-faith eWorts to meet these obligations, a few have failed to adequately fund their pension plans, creating financial instability.

On average, employer contributions to public pension funds account for about 4.7% of total state and local government spending, though this figure can vary by jurisdiction. NASRA suggests that to fully fund pensions, many governments may need to increase their contributions.

Public pension plans are long-term investors, and thus, like other investors, are exposed to market fluctuations. The last two decades have seen two significant downturns: the 2001 dot-com bubble burst, the 2008 financial crisis and the 2020 COVID-19 pandemic.

During these periods, pension funds experienced substantial losses, but those that received consistent contributions from employers have been able to weather the storm better than those that did not.

The key is maintaining a long-term investment strategy, even in the face of market volatility. Prudent investment policies and diversified portfolios help pension funds mitigate the impact of economic downturns and recover over time.

Pension Reforms

Since the 2007 financial crisis, most states have enacted pension reforms aimed at improving the sustainability of their retirement plans. These reforms have included requiring employees to contribute more toward their pensions, shifting more financial risk to employees through changes in plan designs (such as variable contribution rates or hybrid plans), lowering benefit multipliers, reducing cost-of-living adjustments, and raising the retirement age or lengthening service requirements.

These changes have generally been successful in helping states retain their traditional defined benefit pension plans, which, according to research, provide better financial security for workers in retirement than 401k-style defined contribution plans.

The COVID-19 pandemic added a new layer of complexity to pension fund management, as the first quarter of 2020 saw U.S. public pension funds lose approximately $850 billion in aggregate value.

Despite those record-setting losses, most pension plans were positioned to recover due to their long-term investment horizon and the diversified portfolios built during more favorable market conditions.

Experts like Ian Toner, Chief Investment Officer of Verus Advisory Inc., suggested that most public pension funds have stayed the course, relying on their existing portfolio management strategies to weather this difficult period.

Although additional pension reforms may needed to address future economic challenges, any such reforms should be carefully analyzed and implemented with a measured response.

Lessons Learned

The sustainability of public pension funds depends not only on market performance but also on the continued contributions from employers. It is critical for state and local governments to keep making their required payments to ensure the long-term health of their pension plans. As public pension funds are long-term investors, they are well-positioned to recover from short-term economic shocks, provided they continue to receive the support they need.

Summary

The state of public pensions is rooted in balancing long-term assets and liabilities, which requires consistent contributions, prudent investments, and adaptive reforms. Public pension funds are built to endure, but their success depends on the continued collaboration of employers, employees, and policymakers.