What’s a state pension?
A state pension is a specific type of benefit that the government offers American citizens to help them financially cope with the expenses of retirement. Most state and local government employees (meaning 86%) had access to a defined benefit pension plan in 2022.
Moreover, 87% of those workers participated in the DB pension plans. These public pension plans generally provide pensions based on members’ years of service and average salary over a specified number of years of employment.
Numerous members also get cost-of-living adjustments that help maintain the purchasing power of their benefits in retirement. On the other side, in the private sector, where defined contribution or 401(k)-style plans rule, only 15% of workers have access to a DB plan in 2022 and 74% of those with access participated.
State and local pensions have attracted a lot of attention in the most recent years. Inadequate contributions also left pension plans underfunded by a minimum of $1.6 trillion, even if estimates vary depending on modeling assumptions.
How many state and local pension plans are out there?
State and local governments sponsored over 4,000 pension plans in 2022. Over 34 million members decided to participate in such plans, including active public employees, former public employees who have earned benefits that they’re not collecting just yet, and current retirees.
Locally administered pension plans greatly outnumbered their state counterparts: 4,328 versus 304. However, the wide majority of plan members, meaning 88%, and assets, meaning 82%, were in state-administered systems.
That’s mostly because many local government employees are still covered by state plans. For instance, almost two-thirds of local government pension contributions went directly to state-administered rather than local-administered plans in 2020.
Let’s take Florida, Hawaii, Kansas, South Dakota, and Wisconsin for example. They all had one state-administered plan in 2022, as Massachusetts had the most with 14 plans. Five states didn’t have any plans in 2022, and seven states had over 100. Pennsylvania had 1,569 locally administered plans in 2022, which is way more than any other state.
How are state and local pension plans funded?
Historically, it seems that state and local governments funded pensions out of general revenues on a pay-as-you-go basis. Some states and localities started pre-funding pensions in the 1970s and 1980s after many private pension plans failed and Congress decided to pass the Employee Retirement Income Security Act.
Even if the law didn’t apply to state and local governments, it still mandated a certain congressional report of public pensions that found plenty of faults in many common practices at the state and local levels.
Nowadays, states and localities still follow pension accounting standards decided by the Government Accounting Standards Board (GASB).
The standards also require pension plans to fully retain actuaries to project future assets and liabilities depending on demographic and economic assumptions.
Actuaries then go on and calculate the employer contributions needed to fully cover liabilities incurred by current employees and any other amounts needed to address past unfunded liabilities.
For now, pension plans receive the wide majority of their annual revenue from government contributions. In 2022 at least, 57% of total pension plan revenue came only from government contributions, and 28% from net investment earnings, with 16% coming from employee contributions.
Since investment returns are volatile, those shared differed over time. For instance, in 2014, 77% of total pension plan revenue came from net investment earnings.
How much do state and local pension plans contribute to retirement savings?
State and local government pensions are fairly important to overall national savings. They account for 21 percent of total retirement saving assets. By comparison, individual retirement accounts, like 401(k)s, account for 30 percent of assets.
Public pensions are even more important for the 27% of state and local government workers not covered by Social Security. The SS originally excluded state and local government employees because of constitutionality concerns over levying a federal payroll tax on states and local governments.
Well, later congressional action allowed employees to enroll in Social Security, but SS coverage of state and local workers still widely depends on the state. For example, non-covered workers range from 2 percent in Vermont to 97 percent in Massachusetts and Ohio.
How do pensions affect state and local government budgets?
Let’s take 2021 for example. In fiscal year 2021, state and local governments made a contribution of 5.1 percent of direct general expenditures to employee retirement systems.
The total amount includes contributions from the local government that also administers the system, contributions from other governments for their own employees to the government administering the system, as well as contributions from other governments for their own employees to the government administering the system, and state government contributions to its own system whether for its employees or simply on behalf of local employees.
State and local government contributions as a share of direct general expenditures managed to increase from 3.9 percent in 2012 all the way to 5%.
However, these contributions still don’t account for unfunded future liabilities, and thus they underestimate the full burden of pensions on state and local governments.
Estimates of unfunded liabilities circle around $1.6 trillion. Differences among some of these estimates come from different discount rates, meant to calculate the value of future benefit obligations.
How are state and local governments changing these pension plans?
All states decided to enact major changes to their public pension systems, to efficiently reduce costs in the most recent years. Among some of the most frequent reforms, there are reduced benefit levels, longer vesting periods, and increased age with service requirements, as well as limited cost-of-living adjustments.
Some governments also moved new employees onto DC plans, or simply hybrid plans meant to combine both aspects of DB and DC plans. That’s partly because DC plans shift risk from employers to employees.
But public employees are still contesting most of these changes in court. They argue that state and local government actions could potentially violate pensions’ contractual nature.
According to Census data, across both state and local governments, this ratio is currently standing at 1.24 to-1, but there is still plenty of variation across states.
For example, Texas, Colorado, and Nebraska marked the highest rations, with 1.7 active workers per retiree in 2022. In exchange, Alaska (0.3), Michigan (0.6), and both Pennsylvania and Illinois (0.9) had fewer than one active worker per retiree.
Since 2023, public pensions in the U.S. entered a new era of threats and more uncertainty than ever. The stagnant funding trend that emerged from the global financial crisis of 2008-2009 lingered for a decade and a half.
This left pension plans fragile and vulnerable to volatile market swings. Moreover, 2021 and 2022 made this quite clear. In the last year at least, political forces subjected state and local pension funds to increasing pressure on how they invest their assets.
If that wasn’t enough already, there’s another emerging threat to public pensions, and that is valuation risk.
What we can say for sure is that public pension funds are in a much better place this year than they were before the pandemic in 2019.
However, there isn’t much of a difference between a 2% increase or a 2% decrease in funded status relative to the status quo. The bottom line is that the current state of public pension plans is stagnation and fragility, unfortunately.
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