Most state and local government employees (83 percent of those working full time) participated in a defined benefit (DB) pension plan in 2018, and nearly all (94 percent) had access to such plans. These public pension plans typically provide pensions based on members’ years of service and average salary over a specified number of years of employment. Many members also receive cost-of-living adjustments that help maintain the purchasing power of their benefits in retirement. By contrast, in the private sector, where defined contribution (DC) or 401(k)-style plans dominate, only 16 percent of full-time workers participated in DB plans in 2018 (20 percent had access).
State and local pensions have attracted considerable attention in recent years. Inadequate contributions have left pension plans underfunded by at least $1 trillion and possibly by as much as $3 to $4 trillion depending on modeling assumptions.
State and local governments sponsor more than 5,500 pension plans. Nearly 21 million members participate in these plans, including active public employees, former public employees who have earned benefits that they are not yet collecting, and current retirees.
Locally administered pension plans vastly outnumber their state counterparts: 5,232 versus 297. However, most plan members (90 percent) and assets (82 percent) are in state-administered systems, in part because many local government employees are covered by state plans. Almost 60 percent of local government pension contributions went to state-administered rather than local-administered plans in 2017.
Florida and Hawaii had one state-administered plan in 2017, while Massachusetts had the most with 14 plans. For locally administered plans, six states had no local plans in 2017 and eight states had more than 100. Pennsylvania had 1,594 locally administered plans in 2017, far more than any other state.
Assets in state-administered and local-administered government pension plans totaled roughly $4.0 trillion in 2017. Corporate equities accounted for two-thirds of assets. These investments are riskier than fixed-income assets, such as corporate bonds, US Treasury bonds, and other federal agency-backed securities, though they also tend to generate higher returns. Corporate equities have increased as a share of pension assets, averaging roughly 60 percent of total investments since the mid-1990s. In recent years, public pension plans have also increased their holdings of so-called alternative investments—private equity, hedge funds, real estate, and commodities—that could produce higher returns but also expose plans to more risk.
Historically, state and local governments funded pensions out of general revenues on a pay-as-you-go basis. States and localities began prefunding pensions in the 1970s and 1980s after several private pension plans failed and Congress passed the Employee Retirement Income Security Act. Although the law did not apply to state and local governments, it mandated a congressional report of public pensions that found fault with many common practices at the state and local level.
Today, states and localities follow pension accounting standards set by the Government Accounting Standards Board (GASB). The standards require pension plans to retain actuaries to project future assets and liabilities based on demographic and economic assumptions. Actuaries then calculate the employer contributions necessary to cover liabilities incurred by current employees plus any amounts needed to address past unfunded liabilities.
Pension plans currently receive most of their annual income from investments rather than contributions. In 2017, 69 percent of total pension plan revenue came from net investment earnings, 22 percent came from employer contributions, and 8 percent came from employee contributions. Because investment returns are volatile, however, those shares vary widely over time.
State and local government pensions are important to overall national savings, accounting for 19 percent of total retirement saving assets. By comparison, individual retirement accounts, such as 401(k)s, account for 28 percent of assets.
Public pensions are especially important for the 28 percent of state and local government workers not covered by Social Security. Social Security originally excluded state and local government employees because of constitutionality concerns over levying a federal payroll tax on states and local governments. Later congressional action allowed employees to enroll in Social Security, but Social Security coverage of state and local workers still varies widely by state: non-covered workers range from 2 percent in Vermont to 98 percent in Ohio.
In fiscal year 2016, state and local governments contributed 4.6 percent of direct general expenditures to employee retirement systems. This total includes contributions from the local government that is administering the system (i.e., the local agencies' employer share of contributions for their employees), contributions from other governments for their own employees to the government administering the system (i.e., a local government's contribution as employers to a state-run system), and state government contributions to its own system whether for its employees or on behalf of local employees.
Still, these contributions do not account for unfunded future liabilities and thus underestimate the full burden of pensions on state and local governments. Estimates of unfunded liabilities range from $1 trillion to $4 trillion. Differences among these estimates stem mostly from different discount rates used to calculate the value of future benefit obligations.
The present value, or PV, of future pension liabilities is calculated using the following formula: PV = FV/(1 + i)n, where FV is future value, n is the number of years in the future, and i is the discount rate. Pension plans have traditionally used a discount rate based on expected investment returns. However, many economists argue that the proper discount rate should also reflect the riskiness of the liabilities. Because pensions are often constitutionally or otherwise legally protected, these economists argue pension liabilities should be discounted using a rate closer to that of “risk-free” US Treasuries rather than higher rates based on past investment returns.
Other differences stem from actuarial cost methods used to allocate benefits to past and future service. Beyond valuing liabilities, plans have discretion over amortization methods, or how to “stretch out” paying off unfunded liabilities. Previously, plans had discretion over asset smoothing, or determining how and when swings in asset values were reflected in financial statements, but GASB now requires them to report assets at fair market values.
Paying down unfunded liabilities will require a combination of reforms (see next section) and tax increases or spending cuts. A 2016 Brookings study estimated state and local governments would need to reduce direct general expenditures 5.7 percent to ensure unfunded public pension liabilities do not rise—if they took no other actions. Similarly, the study reported state and local governments would need to increase total own-source revenues (taxes, fees, etc.) 5.3 percent to close the pension liability gap—again, if they took no other actions. Both estimates were national and did not account for the wide variation in unfunded pensions across states.
All states have enacted major changes to their public pension systems to reduce costs in recent years. Among the most frequent reforms are reduced benefit levels, longer vesting periods, increased age and service requirements, limited cost-of-living adjustments, and increased employer and employee contributions. Some governments have also moved new employees onto DC plans, or hybrid plans combining aspects of both DB and DC plans, in part because DC plans shift risk from employers to employees. However, public employees are contesting many of these changes in court, arguing that state and local government actions violate pensions’ contractual nature.
Going forward, pensions that are already underfunded may face additional demographic pressures, as fewer active workers are available to provide contributions that help support benefit payments to current retirees. According to Census, across all state and local governments, this ratio currently stands at 1.35-to-1, but there is a lot of variation. Only Wyoming had more than two active workers per retiree in 2017, while Alaska, the District of Columbia, Michigan, Pennsylvania, and West Virginia had fewer than one active worker per retiree.
Interactive Data Tools
Evaluating Pension Reform Options with the Public Pension Simulator
Richard W. Johnson and Owen Haaga (2017)
Pension Plan Structures before and after the Pension Protection Act of 2006
Barbara Butricia and Keenan Dworak-Fisher (2015)
Negative Returns: How State Pensions Shortchange Teachers
Chad Aldeman and Richard W. Johnson (2015)
Reforming Government Pensions to Better Distribute Benefits
Richard W. Johnson (2015)