Research by The PEW Charitable Trusts (PEW) has assessed what policies and factors could be preventing certain states from reducing funding gaps in their public pension systems.

There is a $ 1.28 trillion funding gap in public pension funds cumulatively across all 50 states, according to a June 2019 PEW report titled “The State Pension Funding Gap: 2017.” States have assets of just $ 2.9 trillion to offset pension obligations of $ 4.1 trillion.

A pension fund gap is the difference between the assets and liabilities of a state retirement system. Each state funding gap grew after the Great Recession (2007 to 2009) and to this day, many states continue to struggle to fund their pension systems. Additionally, states with the best-funded pension systems before the recession hit have recovered, while states with the lowest-funded pension systems continue to struggle.

Funding tiers are the assets required for a state to fully fund its pension obligations. The median funding level for all states in 2017 was 69 percent. Before the Great Recession hit, the median funding level was 86 percent. Additionally, one of the lowest-funded states, Kentucky, had only 34 percent funding in 2017. Only Idaho, Nebraska, New York, North Carolina, South Dakota, Tennessee, Utah, and Wisconsin received at least 90 percent. percent of financing in 2017.

States with well-funded pension systems, such as Wisconsin, Tennessee, and South Dakota, have two policies that they and other states with well-funded pension systems follow. These states:

  1. Consistently make full actuarial contributions regardless of market conditions; and
  2. Follow risk management policies that can account for bad investments and other risks.

The states with the lowest funded pension systems (New Jersey, Kentucky, and Illinois) are inconsistent in paying the full actuarial contributions necessary to cover the cost of retiree benefits. Additionally, these underfunded states continue to raise employer contributions and take money that could be allocated to other public priorities to try to narrow their funding gaps, but to no avail.

States may find it useful to look at two measures described below, the net amortization rate and the operating cash flow ratio, to assess whether their pension system financing policies are adequate.

Net amortization measures of the pension plan

Net amortization measures whether total contributions to a pension system will be sufficient to reduce liabilities if all expectations are met that year, including expected returns on investment, as defined by PEW research. For example, New Jersey, one of the least funded states, has not met minimum actuarial funding standards since 2000. New Jersey’s average net amortization from 2015-17 was -25 percent, meaning New Jersey Jersey would have needed additional contributions worth 25 percent of payroll from 2015 to 2017 in order to cover expenses and not increase its pension debt.

On average, states that stick to their contribution and plan assumptions get a positive net amortization and, in turn, can slowly reduce pension debt.

Measures of the operating cash flow ratio of the pension plan

An operating cash flow ratio measures the difference between the cash entering the pension system (primarily through employer and employee contributions) and the cash leaving the pension system in the form of benefit payments. The difference between the cash inflow and outflow would then be divided by the value of the plan assets and, in turn, provide a benchmark for the rate of return required to prevent the plan assets from declining. For most states, this ratio is often a negative percentage showing how dependent the statements are on investments for financing and how sensitive pension systems are to market fluctuations. A warning sign of fiscal distress can come from states with a constant -5 percent cash flow ratio. This means that asset levels for these states will drop if investments fall below 5 percent.

A framework for state pension financing policies

If a state looks at both its net amortization and operating cash flow ratio and realizes that its pension fund policies may need to be modified, Wisconsin, Tennessee, and South Dakota can provide a useful framework.

Wisconsin’s funding level in 2017 was 103 percent. Wisconsin consistently makes full actuarial contributions and also follows its risk management policies, as do all states with well-funded systems. Additionally, Wisconsin has employers, employees, and retirees who share the cost of low investment returns and benefit from strong investment returns. Furthermore, they also manipulate employer and employee contributions alike to fluctuate with market conditions. Finally, Wisconsin sets cost-of-living adjustments (COLA) on an assumption of 5 percent return, which is below the long-term average of 7.2 percent to provide protection for funds. pension if necessary.

Like Wisconsin, Tennessee also makes full actuarial contributions and follows its risk management policies. Tennessee also offers a hybrid benefits system with risk management for new employees and teachers in the state. The hybrid benefits system with risk management gives the employee a fixed benefit and gives the employer a defined contribution plan, but the final benefit of the employee will depend on the return on the investment. This system distributes the risk between the employer and the employee.

As a third example, South Dakota sets its contribution rates through statute. Although statutes cannot account for a fluctuating market, South Dakota COLAs remain below the level that plan actuaries estimate is required to maintain full funding. They do this to account for potential bad investments or other funding changes.

All states have changed their pension funding policies since the Great Recession. States that are still struggling with underfunded systems may find helpful guidance on how Wisconsin, Tennessee, and South Dakota handle market fluctuations and other risks.

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