State and Local Government Pensions
Most state and local government employees (87 percent of those working full time) participate in a defined benefit (DB) pension plan. These plans typically provide pensions based on members’ years of service and average salary over a specified period before retirement. Many members also receive cost-of-living adjustments that help maintain the purchasing power of their benefits in retirement. In the private sector, where defined contribution (DC) or 401(k)-style plans dominate, only 19 percent of full-time workers belong to DB plans.
State and local pensions have attracted considerable attention in recent years. Large investment losses during the Great Recession and inadequate past contributions have left pension plans underfunded by at least $800 billion and possibly as much as $3 to $4 trillion depending on modeling assumptions.
This backgrounder answers four questions:
- How many state and local pension plans are there?
- How are state and local pension plans funded?
- How much do state and local pension plans contribute to retirement savings?
- How do pensions affect state and local government budgets?
All data come from the US Census Bureau’s Annual or Quarterly Surveys of Public Pensions unless otherwise noted.
State and local governments sponsor nearly 4,000 pension plans on behalf of 19.5 million active employees, former employees who have earned benefits that they are not yet collecting, and current retirees.
Locally administered pension plans vastly outnumber their state counterparts: 3,761 versus 231. However, most plan members (88 percent) and assets (83 percent) are in state systems, in part because many local government employees are covered by state plans. Almost 60 percent of local government pension contributions go to state rather than local plans. Seven states and the District of Columbia have no locally administered pension plans (table 1). Six states have more than 100 local plans each, topped by Pennsylvania with 1,577.
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, and the report found fault with many common practices.
Today, states and localities follow pension accounting standards set by the Government Accounting Standards Board. 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 receive most of their annual income from investments rather than contributions. In 2013, 71 percent of total pension plan revenue came from net investment earnings; 20 percent came from employer contributions, and 8 percent came from employee contributions. Because investment returns are volatile, however, those shares vary widely over time (figure 1).
Assets in state and local government pension plans totaled roughly $3.5 trillion as of the third quarter of 2014. Corporate equities accounted for nearly two-thirds of assets (figure 2).
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 compared with half that over the previous 20 years.
State and local government pensions are important to national savings, accounting for about 18 percent of total retirement savings in the household and not-for-profit sector—a category that also includes individual retirement accounts or 401(k)s, annuities, and other private-sector pension plans (figure 3).
Public pensions are especially important for the roughly 28 percent of state and local government workers who are not covered by Social Security.1 Social Security coverage of state and local workers varies widely by state; the greatest concentrations of noncovered workers are in Ohio (97 percent), Massachusetts (96 percent), and Nevada (82 percent; figure 4).
In fiscal year 2012, state and local governments dedicated 9 percent of direct general expenditures to employee retirement systems. However, these expenditures do not account for unfunded future liabilities and thus underestimate the full burden of pensions on state and local governments.
Estimates of unfunded pension plan liabilities vary widely. The Federal Reserve Board estimated in the third quarter of 2014 that unfunded state and local liabilities total $1.3 trillion, equivalent to about 60 percent of these governments’ annual revenue. In contrast, the states estimated their funding gap at just $800 billion in fiscal 2013, while outside estimates pegged the total at $3 to $4 trillion in the same year.
Differences among these estimates stem mostly from discount rates used to calculate the value of future benefit obligations.2 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 investments.
Since 2009, all states have enacted major changes to their public pension systems to reduce costs. 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. DC plans shift risk from employers to employees. 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. Across all state and local governments, this ratio currently stands at 1.53-to-1, but there is a lot of variation. Some states have more than two active workers per retiree; others have less than one worker per retiree (figure 5).
- At its inception in 1935, Social Security excluded state and local government employees because of concerns about the constitutionality of its financing mechanism, a federal payroll tax on states and localities. In 1950, Congress made Social Security coverage optional for state and local employees subject to certain vote requirements. Reforms adopted in 1983 prohibited state and local governments from leaving Social Security once they had joined it. In 1990, Congress mandated Social Security coverage for all state and local government workers not covered by another retirement program. Some workers not covered by Social Security may nonetheless receive benefits through spousal coverage provisions or as a result of other employment.
- The discount rate is the interest rate used to convert future cash flows into “present value,” the amount needed today to pay future costs. Present value, or PV, 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. Other differences in unfunded pension liability estimates stem from technical decisions such as what liability concept to use (e.g., an accumulated benefit obligation if the plan were to terminate immediately versus a projected benefit obligation accounting for future years of service and contributions).