Understanding the True Cost of State and Local Pensions

Abstract

The financial health of defined benefit pension plans for state and local government workers is a matter of policy concern and analytical contention. Pensions have come under increased scrutiny as funding levels have dropped and required contributions have risen. Around the nation elected officials have undertaken pension reforms to correct those funding shortfalls, which were caused by market declines, funding holidays, and benefit increases passed during the prosperous days of the late 1990s. Numerous states have enacted pension reforms, although those mostly have been incremental reforms such as increasing contributions or retirement ages and most significant benefit or structural changes have been aimed only at newly hired employees. A few states, such as Utah, have made more far-reaching reforms to limit pension liabilities. Michigan and Alaska have shifted newly hired employees into defined contribution (DC), 401(k)-style pension plans. In other places, attempted reforms have been rebuffed by powerful public employee unions. Unfortunately, these reforms won't come close to restoring plans to true full funding, because current accounting conventions systematically understate pensions' benefit liabilities and thereby overstate their financial health. Current pension accounting standards also encourage pensions to take excessive investment risk. Correct accounting reveals that the costs of putting the plans back on a stable financial basis is likely be prohibitive, which may prompt a shift to defined contribution pensions, mirroring the shift experienced in the private sector and in other countries.