Tackling $8.28 Trillion in Unfunded State Pension Liabilities
In the sixth edition of Unaccountable and Unaffordable, the authors observed that unfunded state pension liabilities in the United States today stand at a whopping $8.28 trillion, a number that represents a third of our national product. This situation poses an existential threat to state budgets and their ability to finance essential services, and to keep the pension promises made to state employees.
While this dramatic increase from last year’s report is in part due to the reduction in the risk-free discount rate because of the fall in U.S. Treasury bond yields, it still highlights the increasingly risky investments pension funds are taking on across the country.
State pension funds use historical trends to forecast the future values of their assets and liabilities. Over the past 20 years, the annual return assumption these fund managers use has hovered between 7% and 8%. However, actual returns on their investments have manifested between a rollercoaster range of -9.5% and +15.3% – which is dangerously volatile. As a consequence, returns have, on average, been about 1% lower than expected, leading to actuarial gaps and risks of insolvency, threatening the economic well-being of our retirees and the states’ financial health.
ALEC’s Lee Schalk and Thomas Savidge’s op-ed in Orange County Register explains on California’s plans to divest two of the country’s largest pension funds from fossil fuel companies by 2030, “If the Fossil Fuel Divestment Act (Senate Bill 1173) becomes law, CalPERS and CalSTRS will join the University of California and Cal State University pension systems in fully divesting from fossil fuels. They will also be prohibited from making new investments in fossil fuel companies.” This move will cost the state’s pension funds billions of dollars, which already stand at $1.5 trillion in the hole.
“When lawmakers are allowed to use retirement funds for their own political activism, investment returns suffer, and unfunded liabilities grow at a faster pace. This higher volatility means taxpayers must pay more in pension contributions when investment returns fall short of assumed returns. Additionally, every state employee should have confidence that their retirement funds are being invested for maximum growth and not to promote a political agenda.”
This brings us to how pension plans work. Most public pension funds follow a “defined-benefit” framework, where the state employee, their state employer (such as the school district), and local and state governments make certain contributions towards a fund which is then invested into various assets and securities. This model is meant to guarantee the future retiree a designated compensation (benefit) as a return for their participation in the retirement plan.
Often enforced by contract law, constitutional mandates, or other rules, states are obligated to pay out pensions (see fig. 7 in ALEC’s latest report) – regardless of economic conditions or fund’s monetary value. In such cases, states are forced to either raise taxes, slash other programs, or take on debt to finance these pension plans. In the end, the losing parties are the taxpayers – while pension fund managers remain largely unaccountable for their failure to produce promised investment returns.
ALEC recommends prudence and sensible promise-making on part of state governments. States can start with a shift from a defined-benefit model to a defined-contribution model, which is similar to the common 401(k) plan found at most private companies.
This defined-contribution plan will ensure that pension plans are funded, and states aren’t just “kicking-the-can-down-the-road” for future generations to worry about. With the ever-rising increase in the number of jobs people now do (people switch jobs eight times between 18 and 30 years of age in the U.S.), defined-contribution plans, much like the 401(k) plans, will allow for transferability of the pension plan across public and private sector jobs. If someone chooses to make investments based on political causes with a 401(k), they are free to do so, bearing full responsibility y for all losses incurred. Simultaneously, other public employees who want to focus on building a nest egg for retirement are free to do so without fear that someone will use those investments for political causes.
In our last report, we highlighted how pension funds for states like California experience greater risk, higher costs, and lose out on billions of dollars in foregone investment returns because they allow politics to drive investment strategy.
Such investment behavior raises several concerns. ALEC’s latest Unaccountable and Unaffordable report highlights key problems and prescribes scientific and empirical reform. Pensions funds, one of America’s largest investor entities, are actively pursuing non-financial, and often political, motives through their investment decisions, threatening pension fund solvency.
Research from the Center for Retirement Research at Boston College found that ESG constraints yield lower returns and do not achieve their intended social gains, yet political crusades take retirees’ money hostage to secondary, non-financial motives.
ALEC supports the re-institutionalization of the importance of fiduciary responsibility and ensuring that pension fund managers and trustees act in the best interests of contributing members and not their political allies or crony agendas. Our “State Government Employee Retirement Protection Act” model policy provides a framework based on 11 principles of sound pension practices like transparency, predictability, and responsibility. For, in the end, the goal for states and their pension funds is to stay solvent and to keep the promises they made to workers and taxpayers.