Underfunding of public pension plans

Brad Smith discusses how actuaries must become part of the solution to the underfunding of public pension plans.

By Bradley M. Smith, SOA 2011-12 President

BradSmith The chronic underfunding of public pension plans has garnered much publicity over the last few years. Many of the largest public pension plans in the United States are severely underfunded. This underfunding represents a substantial financial burden on future generations of taxpayers.

To formulate a solution, the root causes of the problem must be understood.

We know the causes but we have failed to communicate them effectively to the general public.

1) Sponsors have failed to fund their plans at the level recommended by their actuaries. This is understandable. Tax revenues are down due to the financial crisis. There are pressing needs other than pension plans that must be funded on a current basis: education, transportation, healthcare, to name just a few. Many of these plans already have billions of dollars of assets invested. Why should they pay more into these plans when they have more pressing current needs? It is our role as their actuaries to answer this question. Given the reality of funding at a level substantially less than recommended, it is clear that, in some cases, we have not been as effective as we need to be.

2) The investment returns of the past decade have been calamitous. Equities have severely underperformed from their historical level and markets have been volatile. This has led to an asymmetrical response to these volatile returns by plan sponsors. In the late 1990s and early 2000s during the dot-com bubble, investment returns greatly exceeded expectations. This led to the overfunding of some plans. Assuming that those returns were not an aberration, plan sponsors raised benefits, which, once granted, are typically guaranteed. When the bubble exploded, the excess returns disappeared and, due at least in part to increases in benefits that became guaranteed, the plans were left severely underfunded.

3) Politicians appealed to public employees by promising increases in their benefits. These promises were made with the knowledge that such increases would be substantially funded only after they had left office.

4) Plan administrators of final average defined benefit pension plans allowed the “spiking” of benefit levels. In some instances, employees near retirement have been permitted to work additional overtime in the years immediately prior to retirement.

5) Early retirements of older, higher paid employees who were replaced by younger, lesser paid employees. This was seen as a way to reduce current payroll, without recognizing the impact that these early retirements would have on the funded status of the pension plan.

6) Post retirement health costs were either not funded at all or were funded at a level well below their expected cost. If we do not start working to resolve these problems, we may wake up one day and find that the actuarial profession is being blamed for these problems. This is all the more reason for the profession to become a part of the solution.

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Discussion

One response to "Underfunding of public pension plans"

  • Thank you Brad for posting this.

    First, one critisism; the use of “chronic” is perhaps unjustified when applied to all plans. Many public plans were reasonably well funded prior to the current economic downturn. In my experience, the chronically underfunded plans are the exception rather than the rule.

    It might be helpful to have some idea of the relative magnitude of the six points you identified. I cannot give a definitive answer and the answers will vary by plan but my best guess is that a relative ranking (from most to least significant cause) would be:

    1) Post retirement health costs were either not funded at all or were funded at a level well below their expected cost.

    2) The investment returns of the past decade have been calamitous.

    3) Sponsors have failed to fund their plans at the level recommended by their actuaries.

    4) Politicians appealed to public employees by promising increases in their benefits.

    5) Either:

    Early retirements of older, higher paid employees who were replaced by younger, lesser paid employees.

    or

    Plan administrators (or employers) of final average defined benefit pension plans allowed the “spiking” of benefit levels.

    This is just my ranking based on what I see and it will vary depending on the particular public employer one is talking about but I think it is pretty good ranking of the causes.

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