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The Impact of Public Pensions on State and Local Budgets

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    Center for Retirement Research

    Source: Authors calculations from the U.S. Census Bureau(a).

    O S L P

    The nations public pension system consists of bothstate and locally-administered plans. The state sys-tems usually cover general state government employ-

    ees and teachers; locally-administered systems oftencover police and fire, as well as general municipal em-ployees. But the structure varies enormously. Somestates (Maine and Hawaii) have a single system cover-ing all types of employees, while other states (Florida,Illinois, Massachusetts, Michigan, Minnesota, andPennsylvania) have more than systems.

    State-administered plans account for a tiny frac-tion of the systems, but almost all the participants andassets. Specifically, state-administered plans accountfor only percent of the systems, but percent ofthe active members and percent of assets (seeFigure ).

    F. S-A P P T S L P, A M, A, F Y

    Thus, as a generalization, state plans are big andlocally-administered plans are small. On average in

    , state plans held $. billion in assets, whilelocal plans held $. billion (see Figure ). Of course,every generalization has notable exceptions; sixlocally-administered plans held more than $ billioneach.

    In addition to looking at states and localities inthe aggregate, we will examine six states more closely.Three Florida, Georgia, and Massachusetts havelow normal cost, sponsors that pay percent oftheir annual required contribution (ARC), and tendto be reasonably well funded (with the exception ofthe Teachers plan in Massachusetts). Three Cali-fornia, Illinois, and New Jersey have plans that havereceived a lot of press attention. Indeed, these plansare generous as measured by their normal cost, their

    sponsors fail to pay the full ARC, and they have lowerfunded ratios (see Table ).

    Source: Authors calculations from the U.S. Census Bureau

    (a).

    F. A A P TA, B, F Y

    T. N C, ARC P, F R S S

    State

    Florida .

    Georgia .

    Massachusetts .

    California .

    Illinois .

    New Jersey .

    Sources: Authors calculations from the Center for Retire-ment Research at Boston College Public Plans Database(CRR PPD) ; and various plan reports.

    %

    %

    %

    %

    %

    %Plans Active members Assets

    %

    %%

    $

    $

    $

    $

    $

    $

    $

    $

    $.

    $.

    State Local

    Normalcost

    ARCpaid

    Fundedratio

    % %%

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    Issue in Brief

    One further consideration is important namely,local governments make considerable contributionsto state systems. In the aggregate, percent of thecontributions to state-administered plans comesfrom local governments. But, as shown in Figure ,this percentage varies enormously across states. Inour sample of six states, the fraction ranges fromzero percent in Massachusetts, where the entire stateretirement system is financed at the state level, to

    percent in Florida, where localities pay almost the fullcost. This variation fairly well reflects the variationacross the universe of state and local plans.

    P C S S L B

    Legislatures and pension-plan administrators oftenfocus on pension contributions as a percent of pay-roll. Pension contributions as a percent of budgets,however, provides a broader framework for project-ing how public plans will aect other state and local

    activities. The starting point for our analysis is theshare of state and local budgets devoted to pensions todate. Figure shows that in pensions account-ed for . percent of state and local direct that is,non-capital expenditures for the country as whole.

    Source: Authors calculations from the U.S. Census Bureau(a).

    F. P C S-A P C LG, S S N,

    Note: Total budget equals direct expenditures from the

    general fund, excluding capital outlays.Sources: Authors calculations from the U.S. Census Bureau(a); and U.S. Census Bureau (b).

    F. S L G DE T E,

    Source: Authors calculations from the U.S. Census Bureau

    (a); and U.S. Census Bureau (b).

    F. D S GP C P SL B,

    %

    %

    %

    %

    %

    %.% .%

    .%.%

    .%

    .%

    .%

    MA NJ GA IL CA FL UnitedStates

    Salaries, .%

    Other, .%

    Pension contributions,.%

    Education,.%

    Governmental Admin.,

    !"#$

    Social services,.%

    - - --- -

    This share varied somewhat among individualstates. However, for more than half of the states, stateand local pension contributions represented between and percent of state and local government budgetsin (see Figure ). The range in our sample of sixstates was similarly narrow . percent in Florida to. percent in California.

    Pension contribution as a percent of state and local budgets

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    Center for Retirement Research

    It is also interesting to look at the pattern of con-tributions over time. As shown in Figure , for statesand localities as a whole, contributions to pensionshave ranged from to percent of their combined

    budgets. Contributions were about

    percent fromthe mid-s to the mid-s, rose to percent be-tween the mid-s and the mid-s when statesand localities got religion about the importance offunding, then dropped back as the long bull marketboosted asset values. Figure also presents infor-mation for states and localities separately. Until thes, pensions accounted for a much higher shareof state budgets than local budgets. Today, the sharesare roughly equal, as non-pension expenditures forstates have grown more rapidly than those at the locallevel.

    is, they have not been putting aside the full amountrecommended by the Government Accounting Stan-dards Board (GASB). Finally, the method of calculat-ing pension liabilities may change over time. State

    and local plans generally follow an actuarial modeland discount their liabilities by the expected long-term yield on the assets held in the pension fund,roughly percent. Most economists contend that thediscount rate should reflect the risk associated withthe liabilities and, given that benefits are guaranteedunder most state laws, the appropriate discount factoris a riskless rate, roughly percent. Thus, the econo-mists model would produce much higher normalcost and liabilities than currently reported.

    AU L

    The first step in estimating pension contributions as apercent of budgets is to project budgets for states andlocalities. This projection is based on the relation-ship of state and local budgets to GDP. While thesebudgets rose sharply until , since that time theyhave held relatively steady (see Figure ). We assumethat the ratio of budgets to GDP will hold intothe future, so we derive dollar amounts by applyingthe ratio to GDP projections from the Congres-sional Budget Oce. The same approach was used toproject budgets for the six sample states.

    F. G P C P S L B, -

    Sources: Authors calculations from the U.S. Census Bureau

    (a); and U.S. Census Bureau (b).

    O F

    Pension contributions are likely to account for alarger share of state and local budgets in the future

    than in the past for a number of reasons. First, statesand localities have relied on a rising stock market toincrease funding, and a repeat of the - stockmarket boom is unlikely. Second, states and localitieshave not been contributing their full ARC, which cov-ers accruing normal cost and a payment to amortizethe unfunded liability over a -year period. That

    F. S L B PGDP, -

    Sources: Authors calculations from the U.S. Census Bureau(a); U.S. Census Bureau (b); and the Congressio-nal Budget Oce ().

    %

    %

    %

    %

    %

    %

    %

    %

    State and local governmentsState governmentsLocal governments

    %

    %

    %

    %

    %

    State and local governments

    State governmentsLocal governments

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    Issue in Brief

    The next step is to project future pension con-tributions. We assume that states and localitiesincrease their contributions incrementally between and , and then start to pay the full ARC,amortizing their unfunded liabilities over a -year

    period. Normal cost and unfunded liabilities are cal-culated under two interest rate assumptions per-cent and percent. The results are shown in Figure. Assuming an -percent discount rate, governmentcontributions to pensions will rise from . percentof state and local budgets today to . percent in .With a -percent discount rate, pension contributionswould increase to . percent in . In both cases,the contribution rate remains constant thereafter for years because contributions are usually set as afixed percent of payrolls and we have assumed thatpayrolls are a fixed percent of state and local budgets.

    E A RP---

    The projections for the high-cost states suggest a verylarge increase in the share of the state-local budgetthat would need to be allocated to pensions. If policy-makers are unable or unwilling to make such a com-mitment, what is the alternative? Promised benefitsare legally protected and will be paid. One alternativeis to contribute at current levels, run down assets, andthen pay promised benefits on a pay-as-you go basis.Take Illinois as an example. Figure on the nextpage shows the pattern of expenditure as a percentof the budget under a pay-as-you-go scenario. Thepattern is complicated by the fact that Illinois has fourmain pension plans, and each runs out of money at a

    di

    erent time. Since the plan financed by localities isrelatively well funded and state government currentlypays the majority of pension costs for the three poorlyfunded plans, the burden of covering benefits paidon a pay-as-you-go basis would fall primarily on thestate. Pay-as-you go costs are projected to exceed percent of the Illinois state government budget in.

    F. G C P S L B, -

    Sources: Authors calculations from the U.S. Census Bureau(a); U.S. Census Bureau (b); and CRR PPD.

    The pattern diers across states. Essentially thestates that have been conscientious about fundingtheir pensions would see only a small increase intheir contributions as a percent of budget roughly

    to percent (see Table ). This increase reflectsprimarily the increase in unfunded liabilities as a re-sult of the collapse in equity prices. If liabilities werediscounted at percent, the percent of the budgetdevoted to pension contributions would rise to justover percent. In contrast, those states with expen-sive and/or underfunded plans would see the percentof their budgets going to pensions rise from about .percent to about percent (assuming an -percentdiscount rate) and to . percent (assuming a -per-cent discount rate).

    T. P C PS L B, S S, -

    U.S. state and . . .

    Florida . . .

    Georgia . . .

    Massachusetts . . .

    California . . .

    Illinois . . .

    New Jersey . . .

    Government

    Contribution as a percent of budget

    -

    percent percent

    % %%

    a a

    bb

    a Massachusetts contribution level is based on legisla-

    tion that requires the systems to be fully funded by .Our analysis extends the full funding date to forpurposes of comparison with other states.b New Jersey contribution rates are for the fiscal years after, when New Jersey legislation requires plans to fullypay the ARC.Sources: Authors calculations from the U.S. Census Bureau(a); U.S. Census Bureau (b); and CRR PPD.

    %

    %

    %

    %

    %

    %

    -percent discount rate-percent discount rate

    local

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    Sources: Authors calculations from the U.S. Census Bureau(a); U.S. Census Bureau (b); the Congressional

    Budget Oce (); and the CRR PPD.

    Center for Retirement Research

    It is also interesting to compare contributions tostate-administered plans with the alternative fundingscenarios (see Figure ). In the short run, the stateof Illinois saves a lot of money by not funding. But,after , pay-as-you-go payments exceed the cost offunding with liabilities discounted by percent. In

    F. P--- CP S L B S I, -

    Note: The pay-as-you-go costs are estimated assuming an-percent return prior to exhaustion. If assets yield only percent, costs start to rise two years earlier in , andpeak two yearsearlier in , but the overall pattern looksvery much the same.Sources: Authors calculations from the U.S. Census Bureau(a); U.S. Census Bureau (b); the Congressional

    Budget Oce (); and the CRR PPD.

    F. C S-AP P S L B S I, -

    plans reach full-funded status and contributionsdrop back to only normal cost, while pay-as-you-gopayments continue to remain high.

    CThe funding shortfall of public pension plans hasmade national news since the financial collapse re-duced asset values at the same time that state and lo-cal revenues began to dry up. The size of the fundinghole diers depending on the rate used to discount li-abilities but, regardless of assumptions, governmentswill eventually have to ante up. How much? In ,pension contributions amounted to about . percentof total state and local budgets. Assuming -yearamortization beginning in , this share would riseto only . percent and even assuming a -percent

    discount rate to only . percent.Aggregate data, however, hide substantial varia-

    tion. States with seriously underfunded plans and/or generous benefits, such as California, Illinois, andNew Jersey, would see contributions rise to about percent of budgets with an -percent discount rateand . percent with a -percent discount rate. And,in states such as California, local governments makemore than half of the contributions, which meansthat the burden of increased future pension contribu-tions will fall on the shoulders of localities as well.

    How reliable are our estimates? On the one hand,our assumption that plans fund responsibly in thenear-term may be optimistic in light of the currenteconomic conditions. To the extent they do not, ourestimates understate the long-term pension costs. Onthe other hand, we assume no changes in benefits oremployee contributions. In fact, states are alreadyraising employee contributions and reducing benefitsfor new employees, which means that we overstatelong-run employer pension costs. These osettingeects may well cancel out, so that this briefprovidesa reasonable picture of future pension costs as a shareof state and local spending.

    %

    %

    %

    %

    %

    %

    %

    %

    %

    %

    %

    %

    %

    -percent discount ratePay-as-you-go

    -percent discount rate

    State and localgovernmentState governmentLocal government

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    Issue in Brief

    Most local plans ( percent) are administered bymunicipalities and townships, with the remainder bycounties, special districts, and school districts.

    Leading the list were New York City Employees,New York City Teachers, and Los Angeles County Em-ployees with about $ billion each. The other largelocally-administered plans are New York Police ($billion), Los Angeles Fire and Police ($ billion), andSan Francisco City and County Employees ($ bil-lion). See U.S. Census Bureau (a).

    For example, see Perez-Pena () and Walsh(a, b).

    See Munnell et al. () for a more detailed dis-cussion of the appropriate discount rate.

    See Appendix for a detailed description of themethodology used in these calculations.

    Our analysis projects future ARC for the larg-est state-administered pensions in the United Statesunder an -percent and -percent discount rate.These plans account for more than percent of totalstate and local pension contributions in the UnitedStates.

    Three states Illinois, Massachusetts, and NewJersey do not follow the traditional -year fund-ing schedule described above. In Illinois, currentlegislation mandates that the state plans become percent funded by . In , Illinois issued $billion in general obligation bonds, the proceeds ofwhich reduced the unfunded liabilities of the stateplans. Contribution rates in this state are thereforeset as the minimum of either the statutory rate, orthe dierence between the statutory rate and theamount required to service the debt (Illinois, ).In Massachusetts, the state retirement plans havehistorically been required by statute to be fully funded

    by . In , this period was extended to .Lastly, in New Jersey, legislation allows the stateto pay only one-seventh of its full ARC in . Eachsubsequent years payment increases by an addi-tional one-seventh, until the full ARC is paid in (NCSL, ). We account for this gradual increasewhen calculating future normal cost and amortizationpayments.

    In reality, state and local payrolls as a percent ofbudgets have steadily declined about percent overthe past years. This decline is somewhat greater

    for states than for localities. If this trend continues,as the GAO projects (GAO, ), our assumptionthat payrolls remain a constant percent of budgets inthe future overstates the eect of pension contribu-tions on future state and local budgets.

    In states where local governments are responsiblefor a large percentage of the total required contribu-tion, such as Florida and California, these projectionsimply that rising pension costs could become a majorburden on cities and towns.

    See Appendix for a detailed description of themethodology used in these calculations.

    Illinois Municipal Retirement Fund is entirelyfinanced by localities. Illinois State EmployeesRetirement System and Illinois University Systemare entirely financed by the State. Illinois TeachersRetirement System is financed jointly, . percent ofcontributions from localities and . percent fromthe State.

    E

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    APPENDIX

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    Issue in Brief

    A

    Estimating the eect of future pension costs on future budgets requires making projections of state and localbudgets, amortization payments, normal cost, and benefit payments.

    B B

    Throughout this analysis, state and local budgets are equal to direct expenditures from the general fund, minuscapital outlays, plus pension contributions. The primary data source for the first two terms is the Census ofGovernments Government Finances dataset. These data contain detailed information on each governmentstotal expenditures, but exclude contributions to pension plans that the government administers. For example,expenditure data for the state government of Massachusetts do not include contributions to either the Massa-chusetts State Employees Retirement System or the Teachers Retirement System. A separate Employee Retire-ment Systems dataset, also collected by the Census, provides the missing pension contribution informationneeded to calculate total government expenditures.

    Budgett = general direct expendituret capital outlayst + pension contributions to own plant

    To project baseline budgets into the future, we assume that state and local budgets remain a constant percentof GDP.

    Budgett+ = (Budgett / GDPt) * GDPt+

    Pension contributions and salaries are similarly assumed to remain a constant portion of future budgets.

    R B P P CF-F S

    The analysis assumes that, in the near future, governments will continue to pay less than their requiredcontributions in order to weather the current financial crisis. We estimate that plans will not make their fullARC until . Because, historically, contribution payments have held relatively steady for each plan, weestimate contributions from to based on an average of the prior three years, plus a -percent per-year increase (the average increase between -). To obtain estimates of pension costs in , we firstmust determine the funded level of plans in . To do this, we draw on the model developed in Munnell,Aubry, and Quinby (a), which uses each individual plans actuarial asset calculation method and historicalliability growth to project funded levels in under various economic performance scenarios. The analysisin this briefuses the most likely scenario, which assumes economic growth sucient to reduce unemploymentslightly, increase profits by percent annually, and produce a Wilshire of, by .

    In order to calculate the contributions towards the unfunded liability, the unfunded liability is amortizedas a level percent of payroll over a closed -year period until it is reduced to zero:

    UAALt+ = (UAALt (contribution rateplan * payrollt)) * ( + discount rate)

    The discount rate and future payroll growth are those used in each plans most recent valuation. For the plansin our sample, the discount rate falls between . and . percent, and the assumed future payroll growthranges from . to . percent.

    In order to calculate UAAL contributions under the -percent discount rate projection, the amortization exer-cise described above is repeated with the initial unfunded liability discounted at percent, and setting thediscount rate to percent in the above equation. Munnell et al. () developed the actuarial model used torecalculate unfunded liabilities under dierent discount rates.

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    Center for Retirement Research

    For both the -percent and -percent projections, we assume that normal cost stays constant as a percent ofpayroll. The -percent scenario uses the normal cost reported in plans most recent actuarial valuations, whilethe -percent scenario uses the method developed in Munnell et al. () to estimate normal cost.

    Budget estimates for

    onward replace pension contributions from the baseline budget with our estimatednormal cost and the amortization payments.

    New Budgett = Budgett contributions to state plant + normal costt + amortization paymentst

    R B P B PP--- S

    For the years to , projected future benefit payments for the Illinois SERS, Illinois TRS, and IllinoisUniversities are taken directly each plans most recent actuarial valuation. Because benefit projections are notreported in the actuarial valuation for the Illinois Municipal Retirement System, we apply the average changein annual projected benefits among the other three plans in order to estimate future benefits for the Illinois

    Municipal Plan. For years beyond , the model first described in Munnell et al. () calculates futurebenefit payments for all four plans. Using these projections, we estimate the year that each plan would exhaustits assets if it were to continue contributing at historical rates as a percent of payroll going forward. Assets areassumed to grow according to the increase in the Dow Jones under the most likely scenario described in Mun-nell, Aubry, and Quinby (a). To determine the budget, as each of the four plans exhausts, contributions forthat plan are replaced with its benefit payments.

    {Budgett contributionsplan,t + benefit paymentsplan,tif exhaustion date

    allplans> t

    New Budgett=if t exhaustion date

    plan

    Budgett

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    Issue in Brief

    R

    California Public Employees Retirement System.. Comprehensive Annual Financial Report:Fiscal Year Ended June , .

    California State Teachers Retirement System. .Defined Benefit Program Actuarial Valu-ation.

    Center for Retirement Research at Boston College.Public Plans Database, -. Chestnut Hill,MA.

    Congressional Budget Oce. . SupplementalData for the Congressional Budget Oces Long-TermBudget Outlook. Washington, D.C. Available at:

    http://www.cbo.gov/doc.cfm?index=

    .

    Munnell, Alicia H., Jean-Pierre Aubry, and LauraQuinby. a. The Funding of State and LocalPensions: -. Issue in BriefSLP-. Chest-nut Hill, MA: Center for Retirement Research atBoston College.

    . b. Public Pension Funding Standards inPractice. Presented at the NBER State and LocalPension Conference. Jackson Hole, Wyoming.August and , .

    Munnell, Alicia H., Richard W. Kopcke, Jean-PierreAubry, and Laura Quinby. . Valuing Li-abilities in State and Local Plans. Issue in BriefSLP-. Chestnut Hill, MA: Center for RetirementResearch at Boston College.

    National Conference of State Legislators. . StatePensions and Retirement Legislation .Washington, D.C. Available at: http://www.ncsl.org/?TabId=.

    Perez-Pena, Richard.. Behind Fraud Charges,New Jerseys Deep Crisis. New York Times, August

    .

    State Employees Retirement System of Illinois. .Annual Actuarial Valuation as of June , .

    U.S. Census Bureau. -a. Employee-Retire-ment Systems of State and Local Governments.Washington, D.C. Available: at http://www.census.gov/govs/retire.

    U.S. Census Bureau. -b. State and LocalGovernment Finances. Washington, D.C. Availableat: http://www.census.gov/govs/estimate.

    U.S. Government Accountability Oce. . StateAnd Local Governments Fiscal Outlook. GAO--. Washington, D.C.

    Walsh, Mary Williams.a. Analysis of CaliforniaPensions Finds Half-Trillion-Dollar Gap. New

    York Times, April

    .

    . b. In Budget Crisis, States Take Aim atPension Costs. New York Times, June .

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