Pension Basics: Paying the Pension Bill

It is important that state and local governments pay at least 100% of their actuarially determined contributions (ADC) each year. The ADC is based on assumptions about how long public retirees will live, what kind of investment returns a pension fund can earn, and policies about how to backfill any shortfall in funding status, among other assumptions. It is kind of like getting a bill or invoice for services — actuaries for the pension fund calculate the contribution rates needed based on the rules and benefits authorized by a state or local government, and then figure out what that government should pay each year to fund the benefits.

When governments do not pay their pension bill, it is an almost certain path to the creation of pension debt.

Reasons Why the Pension Bill Might Not Get Paid

Fixed Rates — Some states and cities pay fixed contribution rates into their pension funds.

For example, until last year the Texas state government paid a fixed 6.8% of payroll into its teacher pension system, and 9.5% of payroll into its state employee pension system.[1]
The state government prefers to have these fixed rates so that the legislature feels a sense of control over what gets paid into pension funds.
In isolation, this may be a reasonable concern. However, in practice, the fixed contribution rates that the Texas legislature has authorized have only been enough to pay 100% of the teacher pension bill in two of the last 15 years.[2]

Economic Recessions — It is common for governments to reduce their payments into a pension fund when tax revenues decline.

For example, during the last recession (from 2008 to 2009), state tax income fell by 17% because of the slow down in economic activity.[3] This reduced the money available in state budgets by billions of dollars.
One of the common choices for states during and immediately after the recession was to reduce the amount of money paid into pension funds to balance state budgets. Depending on the situation, this may be a reasonable policy choice given various competing interests and need for trade-offs.
However, the states who followed best practice made sure to overfund their pensions in future years to make up the difference in shortchanging the pension bill in the past. Some states just went on as if they hadn’t stiffed the pension fund from the money it needed.

Pension Holidays — Sometimes pension funds achieve being 100% funded, meaning there is enough money in the pension fund to pay out all promised benefits, based on the current estimates of the value of pensions. In these cases, state and local governments have a habit of taking holidays from paying their pension bill (which would just include payments for normal cost). However, this can create problems because a well managed pension plan will use assets that are more than it needs today to cover future losses, and stay perpetually around 100% funding status.

Why Paying the Bill is Important

It can be very expensive and unpredictable for state and local governments to have to make pension debt payments for an extended period of time. Failing to pay at least 100% of the actuarially determined contribution each year — the pension bill — can mean causing a pension system to get mired in a funding shortfall. And that isn’t good for government budgets, municipal finance stability, or the retirement security of public workers.

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[1] The Texas state contribution rate for teacher pensions is now scheduled to increase to 8.25% of payroll over five years, and school districts pay their own fixed contribution rate (1.5% of payroll today, 2% of payroll by 2025). For more, see Equable’s discussion of improvements to Texas Teachers Retirement System.

[2] See analysis developed by Equable titled Texas Takes Next Steps Towards Improving Teachers Retirement System Sustainability.

[3] See analysis of the recession from the Brookings Institution.

This article is part of Equable’s Pension Basics series. To learn more about how your pension works, check out the other articles in the series:

1. How Pension Benefits Are Calculated

2. Vesting

3. The Pension Funding Formula

4. Assumed Rate of Return

5. Normal Cost

6. Unfunded Liabilities (aka Pension Debt)

7. Actuarially Determined Contributions

8. Paying the Pension Bill

9. Funded Status